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DELIVERY AND CASH SETTLEMENT

As previously described, a futures trader can close out a position before expiration. If the trader holds a long position, she can simply enter into a position to go short the same futures contract. From the clearinghouse’s perspective, the trader holds both a long and short position in the same contract. These positions are considered to offset and, therefore, there is no open position in place. Most futures contracts are offset before expiration. Those that remain in place are subject to either delivery or a final cash settlement. Here we explore this process, which determines how a futures contract terminates at expiration. When the exchange designs a futures contract, it specifies whether the contract will terminate with delivery or cash settlement. If the contract terminates in delivery, the clearinghouse selects a counterparty, usually the holder of the oldest long contract, to accept delivery. The holder of the short position then delivers the underlying to the holder of the long position, who pays the short the necessary cash for the underlying. Suppose, for example, that two days before expiration, a party goes long one futures contract at a price of $50. The following day (the day before expiration), the settlement price is $52. The trader’s margin account is then marked to market by crediting it with a gain of $2. Then suppose that the next day the contract expires with the settlement price at $53. As the end of the trading day draws near, the trader has two choices. She can attempt to close out the position by selling the futures contract. The margin account would then be marked to market at the price at which she sells. If she sells close enough to the expiration, the price she sold at would be very close to the final settlement price of $53. Doing so would add $1 to her margin account balance. The other choice is to leave the position open at the end of the trading day. Then she would have to take delivery. If that occurred, she would be required to take possession of the asset and pay the short the settlement price of the previous day. Doing so would be equivalent to paying $52 and receiving the asset. She could then sell the asset for its price of $53, netting a $1 gain, which is equivalent to the final $1 credited to her margin account if she had terminated the position at the settlement price of $53, as described above.An alternative settlement procedure, is cash settlement. The exchange designates certain futures contracts as cash-settled contracts. If the contract used in this example were cash settled, then the trader would not need to close out the position close to the end of the expiration day. She could simply leave the position open. When the contract expires, her margin account would be marked to market for a gain on the final day of $1. Cash settlement contracts have some advantages over delivery contracts, particularly with respect to significant savings in transaction cost.
Contracts designated for delivery have a variety of features that can complicate delivery. In most cases, delivery does not occur immediately after expiration but takes place over several days. In addition, many contracts permit the short to choose when delivery takes place. For many contracts, delivery can be made any business day of the month. The delivery period usually includes the days following the last trading day of the month, which is usually in the third week of the month.
In addition, the short often has other choices regarding delivery, a major one being exactly which underlying asset is delivered. For example, a futures contract on U.S. Treasury bonds trading at the Chicago Board of Trade permits the short to deliver any of a number of U.S. Treasury bonds.14 The wheat futures contract at the Chicago Board of Trade permits delivery of any of several types of wheat. Futures contracts calling for physical delivery of commodities often permit delivery at different locations. A given commodity delivered to one location is not the same as that commodity delivered to another because of the costs involved in transporting the commodity. The short holds the sole right to make decisions about what, when, and where to deliver, and the right to make these decisions can be extremely valuable. The right to make a decision concerning these aspects of delivery is called a delivery option.
Some futures contracts that call for delivery require delivery of the actual asset, and some use only a book entry. For example, in this day and age, no one physically handles U.S. Treasury bonds in the form of pieces of paper. Bonds are transferred electronically over the Federal Reserve’s wire system. Other contracts, such as oil or wheat, do actually involve the physical transfer of the asset. Physical delivery is more common when the underlying is a physical commodity, whereas book entry is more common when the under- lying is a financial asset.
Futures market participants use one additional delivery procedure, which is called exchange for physicals (EFP). In an EFP transaction, the long and short arrange an alternative delivery procedure. For example, the Chicago Board of Trade’s wheat futures contracts require delivery on certain dates at certain locations either in Chicago or in a few other specified locations in the Midwest. If the long and short agree, they could effect delivery by having the short deliver the wheat to the long in, for example, Omaha. The two parties would then report to the Chicago Board of Trade that they had settled their contract outside of the exchange’s normal delivery procedures, which would be satisfactory to the exchange.