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Outline how delivery of the underlying works, and set it against cash settlement.

FRM® Part I · Financial Markets and Products · Futures Markets · FRM1.FM.7.d

The idea

Most futures positions are closed out with an offsetting trade before the delivery period, so only a tiny fraction ends in delivery. When delivery occurs, the short chooses the timing within the delivery period, the delivery location and, where several grades are allowed, the grade. The short also gives notice of intention to deliver. The long pays the invoice price, which is set by the final settlement price. For bond futures, the short receives the settlement price × conversion factor plus accrued interest. The short picks the cheapest-to-deliver bond, the one with the lowest quoted price − settlement price × conversion factor. Cash-settled contracts, such as equity index futures, deliver nothing. The final settlement price equals the spot value, and the difference is paid in cash, which avoids physical-delivery costs.

A practice question

From the question bank, with the reason each wrong option is wrong.

How is an equity index futures contract typically settled at expiry?

  1. By the short delivering the full basket of stocks that make up the index to the long at expiry.Why not: Physical delivery of a stock basket is impractical; index futures are cash settled.
  2. In cash, with the difference between the final settlement price and the contract price paid through the margin account. - correct
  3. By the short delivering a warehouse receipt for the index.Why not: An index is not a physical commodity, so there is no receipt to deliver.
  4. By the long paying the full index value and receiving the cheapest-to-deliver stock.Why not: Cheapest-to-deliver applies to bond futures, not to cash-settled index futures.

Index futures are cash settled: at expiry the contract is marked to the final settlement price (the index level) and any remaining difference is paid in cash.

A harder one

In a physically settled futures contract with a delivery month, which party chooses the timing of delivery within the month, the delivery location and the permitted grade?

  1. The long, since the long pays the invoice price.Why not: The delivery options belong to the party who must deliver, not the one who receives.
  2. The exchange, which assigns each delivery individually.Why not: The exchange sets the permitted range; the short decides within it.
  3. Both parties jointly, by negotiating the details with each other at the time of delivery.Why not: Futures terms are standardised; the short exercises the options without needing the long's agreement.
  4. The short, who gives notice of intention to deliver. - correct

The short holds the delivery options (timing, place, grade within the rules) and notifies the clearing house of its intention; the long is assigned and must pay the invoice price.

The hardest tier

A bond futures contract settles at 118.50. The short may deliver any of four bonds, with quoted prices and conversion factors: A at 112.00 (0.9420), B at 126.50 (1.0650), C at 98.80 (0.8150), D at 104.20 (0.8900). Which bond is cheapest to deliver?

  1. Bond CWhy not: Selects the bond with the lowest quoted price instead of the lowest quote minus settlement price times conversion factor.
  2. Bond D - correct
  3. Bond BWhy not: Takes the smallest absolute difference (0.2975) rather than the most negative net cost.
  4. Bond AWhy not: Picks the bond whose conversion factor is closest to 1.00, which is not the criterion.

Cost = quote - 118.50 x CF: A 0.373, B 0.2975, C 2.2225, D -1.265. D has the lowest net cost, so it is cheapest to deliver.

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