CFA Level 1
Derivatives - Forward Markets and Contracts: Settlement Procedures
The differences between long and short positions in forward markets are as follows:
- The long position holder is the buyer of the contract and the short position holder is the seller of the contract.
- The long position will take the delivery of the asset and pay the seller of the asset the contract value, while the seller is obligated to deliver the asset versus the cash value of the contract at the origination date of this transaction.
- When it comes to default, both parties are at risk because typically no cash is exchanged at the beginning of the transaction. However, some transactions do require that one or both sides put up some form of collateral to protect them from the defaulted party.
Procedures for Settling a Forward Contract at Expiration
A forward contact at expiration can be settled in one of two ways:
Physical Delivery - Refers to an option or futures contract that requires the actual underlying asset to be delivered on the specified delivery date, rather than being traded out with offsetting contracts. Most derivatives are not actually exercised, but are traded out before their delivery dates. However, physical delivery still occurs with some trades: it is most common with commodities, but can also occur with other financial instruments. Settlement by physical delivery is carried out by clearing brokers or their agents. Promptly after the last day of trading, the regulated exchange's clearing organization will report a purchase and sale of the underlying asset at the previous day's settlement price (also referred to as the "invoice price"). Traders who hold a short position in a physically settled security futures contract to expiration are required to make delivery of the underlying asset. Those who already own the assets may tender them to the appropriate clearing organization. Traders who do not own assets are obligated to purchase them at the current price.
Exchanges specify the conditions of delivery for the contracts they cover. Acceptable locations for delivery (in the case of commodities or energies) and requirements as to the quality, grade or nature of the underlying asset to be delivered are regulated by the exchanges. For example, only certain Treasury bonds may be delivered under the Chicago Board of Trade's Treasury bond future. Only certain growths of coffee may be delivered under the Coffee, Sugar and Cocoa Exchange's coffee future. In many commodity or energy markets, parties want to settle futures by delivery, but exchange rules are too restrictive for their needs. For example, the New York Mercantile Exchange requires that natural gas be delivered only at the Henry Hub in Louisiana, a location that may not be convenient for all futures traders.
- Cash Settlement - Refers to an option or futures contract that requires the counterparties to the contract to net out the cash difference in the value of their positions. The appropriate party receives the cash difference.In the case of cash settlement, no actual assets are delivered at the expiration of a futures contract. Instead, traders must settle any open positions by making or receiving a cash payment based on the difference between the final settlement price and the previous day's settlement price. Under normal circumstances, the final settlement price for a cash-settled contract will reflect the opening price for the underlying asset. Once this payment is made, neither the buyer nor the seller of the futures contract has any further obligations on the contract.
Example: Settling a Forward Contract
Let's return to our sailboat example from the first part of this section. Assume that at the end of 12 months you are a bit ambivalent about sailing. In this case, you could settle your forward contract with John in one of two ways:
- Physical Delivery - John delivers that sailboat to you and you pay him $150,000, as agreed.
- Cash Settlement - John sends you a check for $15,000 (The difference between your contract's purchase price of $150,000 and the sail boat's current market value of $165,000).
The same options are available if the current market price is lower than the forward contract's settlement price. If John's sailboat decreases in value to $135,000, you could simply pay John $15,000 to settle the contract, or you could pay him $150,000 and take physical possession of the boat. (You would still suffer a $15,000 loss when you sold the boat for the current price of $135,000.)
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