Question

1. Provide a real example of each of the following and briefly discuss their role in the derivatives market

1. speculative market
2. spot market
3. dollar market

Answer 1

Speculation

In the world of finance, speculation, or speculative trading, refers to the act of conducting a financial transaction that has substantial risk of losing value but also holds the expectation of a significant gain or other major value. With speculation, the risk of loss is more than offset by the possibility of a substantial gain or other recompense.

An investor who purchases a speculative investment is likely focused on price fluctuations. While the risk associated with the investment is high, the investor is typically more concerned about generating a profit based on market value changes for that investment than on long-term investing. When speculative investing involves the purchase of a foreign currency, it is known as currency speculation. In this scenario, an investor buys a currency in an effort to later sell that currency at an appreciated rate, as opposed to an investor who buys a currency in order to pay for an import or to finance a foreign investment.

Without the prospect of substantial gains, there would be little motivation to engage in speculation. It may sometimes be difficult to distinguish between speculation and simple investment, forcing the market player to consider whether speculation or investment depends on factors that measure the nature of the asset, expected duration of the holding period and/or amount of leverage applied to the exposure.

For example, real estate can blur the line between investment and speculation when buying property with the intention of renting it out. While this would qualify as investing, buying multiple condominiums with minimal down payments for the purpose of reselling them quickly at a profit would undoubtedly be regarded as speculation.

Speculators can provide market liquidity and narrow the bid-ask spread, enabling producers to hedge price risk efficiently Speculative short-selling may also keep rampant bullishness in check and prevent the formation of asset price bubbles through betting against successful outcomes.

Mutual funds and hedge funds often engage in speculation in the foreign exchange markets as well as bond and stock markets.

Spot Market

The spot market is where financial instruments, such as commodities, currencies and securities, are traded for immediate delivery. Delivery is the exchange of cash for the financial instrument. A futures contract, on the other hand, is based on the delivery of the underlying asset at a future date.

Exchanges and over-the-counter (OTC) markets may provide spot trading and/or futures trading.

Spot markets are also referred to as “physical markets” or “cash markets” because trades are swapped for the asset effectively immediately. While the official transfer of funds between the buyer and seller may take time, such as T+2 in the stock market and in most currency transactions, both parties agree to the trade “right now.” A non-spot, or futures transaction, is agreeing to a price now, but delivery and transfer of funds will take place at a later date.

Futures trades in contracts that are about to expire are also sometimes called spot trades since the expiring contract means that the buyer and seller will be exchanging cash for the underlying asset immediately.

Real World Example of Dealing in the Spot Market

Let’s say an online furniture store in Germany offers a 30% discount to all international customers who pay within five business days after placing an order.

Danielle, who operates an online furniture business in the United States, sees the offer and decides to purchase $10,000 worth of tables from the online store. Since she needs to buy euros for (almost) immediate delivery and is happy with the current EUR/USD exchange rate of 1.1233, Danielle executes a foreign exchange transaction at the spot price to buy the equivalent of $10,000 in euros, which works out to be €8,902.34 ($10,000/1.1233). The spot transaction has a settlement date of T+2, so Danielle receives her euros in two days and settles her account to receive the 30% discount.

Dollar market

Dollar market share can be calculated by dividing the dollar revenue earned from a product by the total dollar sales including its competitors in that segment. Dollar market share is calculated by dividing the number of dollars earned by product sales by the total dollars earned by sales of units in the segment. Dollar market share gives the financial health of the company in the industry compared to competitors.

Importance of Dollar Market Share

Market share can be calculated on different bases, such as the number of units sold, or the share of dollar volume of the market. The market share is a marketing metric which indicates the percentage of the market that has been captured by a particular product or brand. Companies also use metrics like relative market share to compare their performance as compared to other competitors in the market.

Dollar market share can be used as an indicator to understand the financial performance of a firm. It shows where the company stands, relative to its peers or competitors. If the total dollar market size grows and the company maintains the same market share relative to its peers, it implies that the dollars earned from the product are also increasing.

Since dollar market share is a relation between a companies dollar sales and between that of the total market dollar sales, there are different ways in which it can be impacted. If a company improves its business & sales, and earns more, then the overall dollar market share would increase. However, in a scenario where the industry business increases and the companies business remains same, it would lead to a decline of the dollar market share. Hence, it is important for companies to constantly monitor, review and evaluate the dollar market share and devise strategies to increase the same.

Example of Dollar Market Share

For example, if the total dollar sales from a particular brand of biscuit, say X, is $200,000, and the total dollar sales of biscuits in general is $2,000,000, this implies that:

Dollar market share of X is $200000/$2000000 = 10%

In the same example, if suppose the overall market remains same, and the company's business increases to $300,000, then the dollar market share increases to:

$300000 / $2000000 = 15%

Hence dollar market share is a function of a company's performance as well as the performance of the industry & market.