How does the cash market differ from the futures market?
It must be noted that the cash market differs from the futures or derivative markets, where contracts are settled only at the expiration date. Let us understand some key differences:
Parameters
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Cash market
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Futures market
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Settlement
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Transactions are settled immediately.
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Transactions are settled in the future at a predetermined price and date.
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Physical delivery
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The actual asset is exchanged between the buyer and the seller.
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In most cases, assets are not physically exchanged. Instead, futures contracts are:
- Sold before the expiration
- Allowed to expire
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Purpose
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Cash markets are primarily used for owning assets for investment purposes.
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Futures markets are primarily used for:
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How do cash markets operate?
Cash markets involve various participants, such as:
- Individual investors
- Mutual funds
- Pension funds
- Hedge funds
- Banks
- Corporations, and many more.
These market participants trade the financial instruments (such as stocks, bonds, commodities, and currencies) listed on:
- Exchanges or
- Over-the-counter (OTC) markets
Now, let us understand this trading process in simple steps:
Step I: Order placement
- Market participants express their intent to buy or sell financial instruments.
- They do so by placing orders through:
- Brokerage firms or
- Directly on the exchange platform
Step II: Matching buyers and sellers
- On the exchange, buy orders are matched with sell orders.
- This matching usually happens based on:
Step III: Execution
- A trade gets executed once a buy order is matched with a sell order.
- Then, the exchange confirms the trade details, which are:
- Quantity
- Price, and
- Parties involved
Step IV: Settlement
- After execution, the trade moves to the settlement phase.
- We can divide the process of settlement into two major parts:
- Part I: Transfer of ownership of the financial instrument from the seller to the buyer
- Part II: Transfer of payment from the buyer to the seller
- Settlement typically occurs on the same day (T+0) or within a few days (T+1, T+2)
- The time frame entirely depends on the market and local regulations.
Step V: Clearing and custody
- At last, clearinghouses come into the picture and play a crucial role in the settlement process.
- They ensure that trades are completed smoothly and efficiently.
- Additionally, they also perform the following functions:
- Manage the custody of securities
- Hold securities on behalf of investors
What are the pros and cons of the cash market?
In a cash market, you can trade a variety of financial instruments for immediate delivery and settlement. Besides several advantages, such as transparency and immediate ownership, it is also marred by a few limitations, such as illiquidity and zero leverage. Let us understand both pros and cons in detail.
Pros
- Transparency
- Cash markets allow investors to see real-time prices and trading volumes.
- This transparency enhances market efficiency.
Immediate ownership
- In cash markets, transactions result in immediate ownership of the traded asset.
- Once a trade is executed, the buyer becomes the owner of the asset.
- No margin calls
- In cash markets, investors do not face margin calls.
- Margin calls represent demands from brokers to deposit additional funds to cover losses in leveraged positions.
- This absence of margin calls eliminates:
- The risk of forced liquidation and
- Margin-related stress
Cons
- Lack of leverage
- Cash markets do not offer the leverage opportunity as derivative markets.
- Without leverage, investors need to commit a larger amount of capital to achieve desired exposure.
- Potential Illiquidity
- Sometimes cash markets suffer from periods of illiquidity.
- This illiquidity often leads to wider bid-ask spreads and makes it costly to execute trades.
- Limited risk management tools
- Compared to derivative markets, cash markets offer limited risk management tools due to the unavailability of derivative instruments.
- At times, cash market participants find it challenging to hedge against specific risks, such as:
- Currency fluctuations or
- Interest rate changes
Conclusion
So, what is a cash market? Cash markets are marketplaces where transactions are settled immediately. In India, stock market trades are usually settled following a T+1 (more recently, T+0) cycle. Cash markets differ from futures markets, where settlement occurs on a future date at a pre-determined price.
While cash markets promote transparency and allow for immediate ownership, they also suffer from several limitations, such as a lack of leverage and potential illiquidity.
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