What Is a Cash Contract?
A cash contract is a financial agreement through which one celebration sees eye to eye to shop for a specified quantity of a commodity on a predetermined date. No longer like futures contracts through which the consumer without end closes out their contract for cash prior to the availability date, the patron in a cash contract at all times intends to take physically provide of the commodity.
Cash contracts are not unusual among industrial customers that rely on commodities for their production processes. Against this, futures contracts are without end used by financial speculators or buyers who need to hedge risks or speculate on price movements.
Key Takeaways
How a Cash Contract Works
Cash contracts are without end entered into all through the spot markets of quite a lot of commodities. Large manufacturers without end rely on the ones markets to shop for essential commodities, similar to raw materials for their factories, gas for their vehicles, and electric power to power their facilities and machines. The ones manufacturers don’t seem to be speculating on the price of the commodities they would like, which will also be completed throughout the futures market. As an alternative, they are physically purchasing the raw materials they would like for their day-to-day operations.
Together with purchasing the ones commodities immediately by the use of spot markets, another way for firms to enter into cash contracts is all through the over-the-counter (OTC) market. In OTC transactions, the patron will enter proper right into a cash contract immediately with a decided on counterparty, as opposed to relying on a third-party commodities exchange or clearinghouse. The advantage of OTC transactions is that they may be able to be extraordinarily customized, whilst exchange-based transactions rely on standardized contracts. Their primary problem, then again, is that they may be able to entail higher counterparty risk.
In observe, a purchaser would perhaps rely on a mixture of the ones methods when purchasing commodities. For example, a company would perhaps use cash contracts throughout the spot market to satisfy most of their brief supply needs, in particular when the commodities involved do not require customization. When non-standard provide circumstances, commodity sorts, or quantity sorts are required, the patron can rely on the OTC market. And in any case, when engaging in risk hedging, speculation, or simply planning farther prematurely, buyers can rely on commodity futures.
Precise International Example of a Cash Contract
For instance, consider the case of a hypothetical coffee products manufacturer referred to as ABC Coffee. To supply its product line, ABC must ensure that it has a steady supply of coffee beans. To reach this serve as, ABC purchases its commodities the usage of 3 elementary methods: cash contracts, futures contract, and OTC purchases.
ABC will depend on cash contracts to supply most of its coffee beans, paying in cash for specified quantities of beans and taking provide of them within a few days of the purchase. When making the ones purchases, ABC accepts the newest spot price of the beans.
In circumstances when ABC wants to plot farther into the longer term, it would use coffee bean futures contracts to lock in a longer-term supply. The program of the usage of futures contracts is especially attractive when ABC is concerned that the price of coffee beans would perhaps upward thrust in all places the forecasted period, given that futures allow ABC to lock in a recognized price at the present time for a lot of months’ supply of beans.
After all, ABC can use OTC contracts when it should provide coffee beans or other commodities that fall outside of the standardized quantities, provide circumstances, or commodity sorts offered by the use of the spot and futures markets.
