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There are two types of futures contracts, those that
provide for physical delivery of a particular
commodity or item and those which call for a cash
settlement. The month during which delivery or
settlement is to occur is specified. Thus, a July
futures contract is one providing for delivery or
settlement in July.
It should be noted that even in the case of
delivery-type futures contracts, very few actually
result in delivery. * Not many speculators have the
desire to take or make delivery of, say, 5,000
bushels of wheat, or 112,000 pounds of sugar, or a
million dollars worth of U.S. Treasury bills for
that matter. Rather, the vast majority of
speculators in futures markets choose to realize
their gains or losses by buying or selling
offsetting futures contracts prior to the delivery
date. Selling a contract that was previously
purchased liquidates a futures position in exactly
the same way, for example, that selling 100 shares
of IBM stock liquidates an earlier purchase of 100
shares of IBM stock. Similarly, a futures contract
that was initially sold can be liquidated by an
offsetting purchase. In either case, gain or loss is
the difference between the buying price and the
selling price.
Even hedgers generally don't make or take
delivery. Most, like the jewelry manufacturer
illustrated earlier, find it more convenient to
liquidate their futures positions and (if they
realize a gain) use the money to offset whatever
adverse price change has occurred in the cash
market.
*
When delivery does occur it is in the form of a
negotiable instrument (such as a warehouse receipt) that
evidences the holder's ownership of the commodity, at some
designated location.
Since delivery on futures contracts is the exception
rather than the rule, why do most contracts even have a
delivery provision? There are two reasons. One is that it
offers buyers and sellers the opportunity to take or make
delivery of the physical commodity if they so choose. More
importantly, however, the fact that buyers and sellers can
take or make delivery helps to assure that futures prices
will accurately reflect the cash market value of the
commodity at the time the contract expires--i.e., that
futures and cash prices will eventually converge. It is
convergence that makes hedging an effective way to obtain
protection against an adverse change in the cash market
price.*
*
Convergence occurs at the expiration of the
futures contract because any difference between the cash and futures prices
would quickly be negated by profit-minded investors who would buy the commodity
in the lowest-price market and sell it in the highest-price market until the
price difference disappeared. This is known as arbitrage and is a form of
trading generally best left to professionals in the cash and futures markets.
Cash settlement futures contracts are precisely
that, contracts which are settled in cash rather
than by delivery at the time the contract expires.
Stock index futures contracts, for example, are
settled in cash on the basis of the index number at
the close of the final day of trading. There is no
provision for delivery of the shares of stock that
make up the various indexes. That would be
impractical. With a cash settlement contract,
convergence is automatic.
Next: What is a Futures Contract?
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