I was reading one of fabozzi’s book and here is an excerpt: “All financial markets eventually evolve to have activity in three areas: spot trading for immediate delivery, trading with forward delivery, and trading with contingent forward delivery. Most of the activity of the last two forms is reserved for large institutions, which is why most people are unaware of them. Yet their existence is necessary for the smooth functioning of the spot markets. The trading for forward and contingent forward delivery allows dynamic risk sharing for holders of cash securities who trade in and out of contracts tied to different dates and future uncertain events. This risk-sharing activity, by signaling the constantly changing price of risk, in turn facilitates the flow of the fundamental information that determines the “bundled” value of the spot securities. In a way, the spot securities that we are all familiar with are the most complicated ones from the informational content perspective.” I don’t get how he argues that the forward/futures/options markets is NECESSARY for the smooth functioning of the spot markets. Hoping someone could explain this in simpler terms. Thanks.
he’s not saying they’re necessary for their function but their smooth function. he’s just saying that the spot prices flow into the futures prices and that better decisions can be made if you know what the product will be worth x days from now. the fact that you can offset future liabilities through the “risk-sharing activity” allows the system to be more stable as all the players, in normal times, can hedge their exposure and not get killed by what the spot may be an a given day should there be no prediction of prices. as most people buying these goods plan for what they need in the future opposed to making split second decisions, the spot prices are a result of future demand and expected general economic price levels. to sum: without futures markets, the spot prices would be much more volatile as there are no expectations period. futures markets are really just a result of human nature as we are always creating expectations.