In derivatives trading, futures contracts hold a vital place. They allow for future delivery of assets at predetermined prices. Often, these deliveries are made at a specified physical location, known as a delivery point. However, it must be noted that not all futures contracts are executed by making physical deliveries, as some are even settled in cash. Let us understand the concept of the delivery point through examples and learn its importance.
What is a delivery point in a futures contract?
To better understand the concept of delivery point, let us first see what futures contracts are:
- A futures contract is a financial agreement
- It is a part of the derivatives trading
- The parties to the contract buy or sell a specified asset on a future date
- The trading happens at a specified price
In India, futures contracts are actively traded for various assets, like stocks, commodities, and currencies. Now, coming back to the delivery point, futures contracts allow for physical settlement of the goods upon expiration. This usually happens by delivering the goods at a designated location, known as a delivery point. It is commonly used in commodity trading.
Let us study a hypothetical example involving a futures contract on wheat:
The scenario
- Say you are a wheat farmer in Punjab, India.
- You want to hedge against the risk of falling wheat prices before your harvest is ready for sale.
- You decide to enter into a futures contract on the Multi Commodity Exchange (MCX) for wheat.
Contract specifications
- Quantity: 10 tons of wheat
- Expiry: 3 months
- Contract price: Rs. 2,000 per ton
Trading process
- You enter into a futures contract to sell 10 tons of wheat at Rs. 2,000 per ton.
- The total contract amount is Rs. 20,000 (10 tons x Rs. 2,000 per ton).
- Another trader who needs wheat for his bakery business agrees to buy it from you at the agreed-upon price.
Delivery point
- Both the parties to the futures exchange decide designated delivery points.
- At these points, the wheat's physical delivery must occur upon expiration of the contract.
- Usually, these delivery points are:
- Warehouses or
- Storage facilities
Expiration, delivery, and logistics
- As the contract expiration date approaches, you prepare to deliver the wheat to the specified delivery point.
- You arrange for the transportation of the wheat to the delivery point.
- You incur costs associated with:
- Transportation
- Storage, and
- Handling of wheat
Settlement
- On the expiration date of the futures contract, you deliver the 10 tons of wheat to the designated delivery point.
- The buyer accepts the delivery.
- The transaction is settled according to the terms of the contract.
What is the importance of delivery point in futures contract?
In a futures contract, the choice of a delivery point is an important factor. It impacts the:
- Net delivery cost and
- Price of the physical commodity being delivered
Let us understand this better:
Delivery points affect transportation costs
The location of the delivery point significantly affects the transportation costs associated with delivering the physical commodity.
- If the delivery point is far from the producer's location, the transportation expenses will be higher.
- Conversely, transportation costs will be lower if the delivery point is closer to the producer or source.
Delivery points influence the cost of delivering the commodity
Delivery points often include storage facilities where the physical commodity can be held before delivery. The availability and cost of storage at the delivery point influence the overall cost of delivering the commodity.
- Higher storage costs, such as warehouse rental fees or inventory holding charges, often increase the net delivery cost.
Additionally, some other logistical factors also impact the net delivery cost or price of the physical commodity. Some common examples of these factors are:
- Accessibility
- Infrastructure
- Regulatory requirements
- Seasonal variations
These logistical factors lead to delays and disruptions in transportation and delivery processes. This, in turn, increases the cost of delivering the commodity.
Is every future contract physically settled?
No, not every futures contract is physically settled. As per a recent estimate, only 3% of the futures contracts are settled by taking physical delivery of the commodity involved. There are two primary ways of settling a futures contract:
- Physical settlement and
- Cash settlement
Let us understand both of them individually.
Method I: Physical settlement of futures contract
In physically settled futures contracts, the parties involved are obligated to deliver or take delivery of the underlying asset upon contract expiration. These contracts are typically used for commodities such as;
- Agricultural products (wheat, corn, soybeans)
- Energy products (crude oil, natural gas), and
- Metals (gold, silver)
However, it must be noted that parties who do not wish to take or make delivery of the physical asset can:
- Offset their positions
- Enter into an opposite trade before the contract expires
Method II: Cash settlement of futures contracts
In this method, settlement occurs in cash at a settlement amount. There is no physical exchange of the underlying asset on the expiration date. The settlement amount is determined based on the difference between:
- The contract price and
- The market price of the underlying asset at contract expiration.
Conclusion
Delivery point is a crucial concept applicable in derivatives trading. It represents a physical location mutually decided by the buyer and seller of a futures contract. When settled physically, the deliveries of commodities are made to the delivery points, which are usually warehouses or storage facilities. Furthermore, delivery points influence transportation costs and impact the net cost of delivering the commodity.
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