Stock exchanges are marketplaces like physical markets that sell goods like fruits, vegetables, clothes, cosmetics, etc. The only difference is that most of the physical goods in India are sold at a pre-decided maximum retail price. The pricing system for physical goods is largely static, but stock markets are dynamic systems. The price discovery of securities takes place in real-time, especially in the spot market. But what is the spot market?
There are two major types of market—spot and futures. As the name suggests, the securities are delivered on the spot against payment in spot markets. In the future markets, the payment and delivery have to be concluded on a future date. Let us dive deeper into spot market definition.
What is the spot market?
Financial markets attract different types of participants. Some investors want instant delivery of securities while others get into contracts for delivery of shares at a future date. The immediate settlement of securities takes place in the spot market, also known as the cash market or liquid market. Ideally, the payment and the delivery of securities should take place immediately, but exchanges take time to process the transactions. Settlement on Indian stock exchanges take T+2 days, which is considered a spot transaction. In the spot market, the buyer and seller agree to transact on an immediate basis. The seller surrenders his/her holdings while the buyer pays the amount equivalent to the current market value of the securities. In the futures or ‘non-spot’ market, the price is decided in the present, but transfer of money and securities takes place on a future date. Sometimes, just before the expiry of futures contracts, futures trades become cash trades as the buyer and seller exchange money for the underlying asset immediately. The price of security decided in the spot market is known as the spot rate.
What is the spot rate?
Spot markets witness immediate settlement of shares, currencies and commodities. The rate quoted for immediate settlement is known as spot rate, or spot price of an asset. It is the current market value of the asset. The spot rate is decided by the amount buyers are willing to pay for the security coupled with the amount sellers are willing to accept for the security. The spot rate is essentially decided by the demand and supply scenario. But other factors like future prospects too have an impact on the spot rate.
Spot market and exchanges
A number of participants are required to run a spot market. Brokers, dealers, traders, investors and financial institutions everyone participates in the spot trade. The exchange is the place which provides the common infrastructure for all the participants to interact and transact with each other. The exchange authorises the depository participants or dealers, processes all the buy and sell orders and provides the information on the available volume and price of a security to the traders associated with the exchange. There are dedicated exchanges for every type of trade. Let us look at some spot market examples. The National Stock Exchange is a place where traders buy and sell stocks. It is a spot exchange, but also has a section for trading of stock futures. On the other hand, Multi Commodity Exchange or MCX is a futures exchange as futures contracts are traded on the MCX. There are certain trades that take place directly between buyers and sellers. Such trades are known as over the counter trades and these trades are not facilitated by centralised exchanges. The price in the OTC segment can be based on spot or the futures trade prices.
The spot market is an important component of the global financial system. It helps in maintaining liquidity and supports price discovery. Without the spot markets, estimation of the fair value of an asset would be a tricky affair. The immediate settlement mechanism of the spot markets, helps in circulating money in the system.