The point in time when a buyer and a seller agree to the terms of a transaction (the contract date ) need not be the same as the point in time when the transaction occurs (the execution date ). For example, on January 1 a buyer and a seller can agree on the terms of a transaction to be conducted on February 1. When the buyer and the seller agree to the terms of the transaction prior to the execution of the terms of the transaction, it is said that the transaction occurs on a futures or forward basis (wherein the distinction between the two involves specific terms as to how the transaction is to be handled). The agreed price is called a futures or forward price. Alternatively on January 1 a buyer and a seller can agree on the terms of a transaction to be conducted immediately. When the buyer and the seller agree to the terms of the transaction at the same time that the transaction is executed, it is said that the transaction occurred on a spot basis. The agreed price is called a spot price. Most consumer transactions, with the exceptions of major transactions such as home purchases, are conducted on spot bases.
The spot market is a formal market for buying and selling securities and commodities on a spot basis. In practice, while the physical transfer of the securities or commodities (called settlement ) may take a day or more, for legal and accounting purposes the transaction is assumed to have occurred instantaneously. In a futures or forward market, it is not the securities and commodities that are sold but rather contracts for the purchase or sale of securities and commodities at some future date. The purpose of the futures or forward markets is to enable the buyers and the sellers to mitigate the risk of future price fluctuations by locking in the price prior to the transaction occurring. Forward and futures markets evolved as a means of transacting business when the physical delivery of the product was forced to take place in the future. Examples include selling a crop prior to the harvest and buying a product that must be shipped from overseas. If sellers seek to mitigate risk, then they will be willing to sell their products on a forward or futures basis for less than they would otherwise sell them for on the spot market. If buyers seek to mitigate risk, then they will be willing to pay more on a forward or futures basis than they would be willing to pay on a spot basis.
The purchase of a security on a spot market with the intent of reselling the security at a later date on a spot market resale at a higher price is called speculation ; the purchase of a security on a spot market with the intent simultaneously to sell the security at a higher price on a different spot market is called arbitrage. For example, in arbitrage one might purchase €1,000 at a price of $1.25 per euro on the New York spot market and simultaneously sell the €1,000 at a price of $1.26 per euro on the London spot market, making a profit of $10. In speculation one might purchase €1,000 at a price of $1.25 per euro on January 1 and sell the €1,000 at a price of $1.26 per euro on February 1, making a profit of $10.
Arbitrageurs (those who conduct arbitrage) serve an important role in financial markets. By constantly looking for and exploiting pricing discrepancies, arbitrageurs force prices in different markets to equate. For example, if euros sell for a higher price on London markets than on New York markets, arbitrageurs will step into the market, buying up euros on the New York spot market and simultaneously selling them on the London spot market. This increase in the demand for euros in New York causes an increase in the price of euros on the New York market. Simultaneously the increase in the supply of euros in London causes a decrease in the price of euros on the London market. The arbitrage will continue, and the prices will continue to move until the prices on the two spot markets become equal. (In practice the prices will not become exactly equal due to small costs for conducting the transactions.) At that point there is no further incentive to arbitrage, and so the arbitrage stops. There are enough people attempting arbitrage and financial markets are efficient enough that computers are usually required to conduct arbitrage because price discrepancies, when they occur, are quickly arbitraged away. The benefit that arbitrageurs play is to alleviate people seeking to buy currency on spot markets from having to compare prices across many markets. Virtually all the time (non-arbitrage) buyers and sellers are guaranteed that the price they see on one spot market is identical to the prices they would find on all other spot markets.
SEE ALSO Arbitrage and Arbitrageurs; Equity Markets; Euro, The; Financial Markets; Interest Rates; Interest, Own Rate of; Returns; Speculation
Billingsley, Randall S. 2006. Understanding Arbitrage: An Intuitive Approach to Financial Analysis. Upper Saddle River, NJ: Wharton School Publications.
Cross, Samuel Y. 1998. All About … the Foreign Exchange Market in the United States. New York: Federal Reserve Bank of New York.
Cuthbertson, Keith, and Dirk Nitzsche. 2001. Investments: Spot and Derivatives Markets. New York: John Wiley.