What Is a Delivery Instrument?
The term delivery instrument refers to a document provided to the holder of a futures contract that represents ownership of the underlying commodity or asset. They are transferable, meaning sellers transfer ownership of delivery instruments to buyers when futures contracts expire. This eliminates the need to transfer the underlying asset or commodity in its physical form. Delivery instruments commonly take the form of shipping receipts or documents issued to the contract holder by a warehouse where the commodities are held.
- A delivery instrument is provided to the holder of a futures contract.
- When a contract expires, the seller transfers the delivery instrument to the buyer.
- Delivery instruments eliminate the need to transfer the actual commodity itself.
- This document commonly takes the form of shipping or warehouse receipts.
Understanding Delivery Instruments
A futures contract is a legally binding agreement between a buyer and a seller. Both parties agree to purchase and sell a certain amount of a commodity or another asset at a predetermined price by a certain date in the future. When the transaction is complete, the holder of the contract receives what the industry calls a delivery instrument. This is a document that verifies the name of the holder along with the type and amount of the specified asset in question. As noted above, it may come in the form of a shipping receipt or as a document issued from the warehouse where the asset(s) is held.
Trading a futures contract allows you to speculate on the direction of the price of the underlying asset.
Delivery instruments allow traders—notably, speculators—to engage in futures trading without the need to actually handle the commodities being traded. Although some futures contracts do result in the actual delivery of commodities to the contract holder, many do not. When a person buys a futures contract for a commodity that they never intend to physically receive, they are considered a speculator.
Speculators use futures contracts as investment vehicles but have no intention of receiving the commodity. Instead, they plan to sell the commodity for a profit when the commodity's price goes up in the future. Speculators can do this by transferring the delivery instrument to the new purchaser. This makes rolling futures contracts forward much simpler. That's because instead of the need to ship the commodity, traders can simply transfer the paper delivery instrument to the new buyer. For instance, a trader can transfer the delivery instrument for 500 bushels of wheat to a new buyer rather than the actual commodity itself.
When the delivery instrument is transferred from the seller to the buyer, the commodity normally remains wherever it is housed until a buyer purchases it with the intention to accept the actual asset. This means a shipment of 1000 barrels of oil may trade four or five times through speculators before a refining company purchases it and has the oil delivered to its oil refinery.
Engaging in futures trading with the intention of receiving the actual commodity is known as hedging. Companies may engage in hedging in order to save money on raw materials in the future. For example, a manufacturing plant may see that the price of steel is currently low. The company knows it needs 100 tons of steel every month to complete its orders, so it purchases 500 tons of steel at the current low price to be delivered in three months. By purchasing so much steel while prices are low, the company can improve its profit margins.
In order to do this, the company secures a futures contract through a broker. The broker provides the company with a delivery instrument for 500 tons of steel to be delivered in three months. The price of steel may rise in the following three months, but the company has locked in the previous low price. When the contract expires, the company can exchange the delivery instrument for 500 tons of steel.