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The spot market is a securities or commodities market where goods, both perishable and non-perishable, are sold for cash and delivered immediately or within a short period of time. Contracts sold on this market, which is also known as the “cash market” or “physical market,” are also effective immediately. Purchases are settled in cash at the current prices set by the market, as opposed to the price at the time of delivery. An example of a spot commodity that is regularly sold is crude oil; it is sold at the current prices, and physically delivered later.
A commodity is a basic good that is interchangeable with other like-kind goods. Some examples of commodities are grains, beef, oil, gold, silver, electricity, and natural gas. Technology has entered the market with commodities such as cell phone minutes and bandwidth. Commodities are standardized, and must meet specific standards to be sold.
The foreign currency trading (Forex) market is a huge spot market that allows for the simultaneous exchange of one nation’s currency for another’s. The way it works is through an investor selecting a currency pair. Currency from Great Britain (GBP) and the United States (USD) is a common pair that is bought and sold on this market. If the GBP is gaining strength against the USD, the investor buys; if it is weak, he sells. The benefit of foreign currency is that it is very liquid, so an investor can enter and exit the market as he chooses.
The futures market is different in that prices on the futures market are affected by the cost of storage and future price movements. In the spot market, prices can be affected by current supply and demand, which tends to make the prices more volatile.
Another factor that affects spot market prices is whether the commodity is perishable or non-perishable. A non-perishable commodity, such as gold or silver, will sell at a price that reflects future price movements. A perishable commodity, such as grain or fruit, will be affected by supply and demand. For example, tomatoes bought in July will reflect the current surplus of the commodity and will be less expensive than in January, when demand for a smaller crop drives costs up. An investor cannot purchase tomatoes for a January delivery at July’s prices.
The forward market allows the business to insure themselves against exchange rate changes by buying and selling currencies ahead.
Forward transactions were set up to tackle this problem of price risk. The two parties, buyers and sellers, agree in the present, that the seller will provide the buyer with a particular quantity of a particular product at a particular future date, at which time the buyer will pay to the seller the price, which is also agreed to in the present.
This eliminates the foreign exchange risk of non performance of a transaction being made by the buyer and seller.
How might one use the spot markets to obtain protection against foreign exchange risk?
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