Delivery: Physical Settlement and Who Actually Takes It

Delivery is what a position turns into when nobody closes it. On the final date the buyer pays and takes the reference asset, and the seller hands it across. Most positions never get there. Almost all are closed first by taking the opposite position. Whether a given contract delivers the thing or pays a money difference instead is set by the exchange, and it changes.

Every contract in this part of the subject is one promise: exchange a thing for a price on a later date. Delivery is nothing more than that later date arriving with the promise still standing. Everything that feels complicated about it comes from one fact. On a cleared position most of the money has already moved by the time the date gets there, so what actually crosses on the day is not the number a reader expects to see.

What is delivery, and how does a position end up at one?

Delivery is the exchange the contract described from the very beginning. The buyer pays, the buyer takes the reference asset, and the seller supplies it. No new obligation appears on the final date. The obligation that was struck months earlier simply comes due, and the two parties do the thing they said they would do.

The route in is where the confusion sits. A position does not choose delivery. A position arrives at delivery by not having been closed. The ordinary end of a cleared position is a closing: the holder takes the opposite position in the very same contract, the two cancel, and the holder walks away with whatever cash has accumulated. A position closed that way makes the final date somebody else's problem. A position left open, whether through omission or by intention from the outset, makes the final date its holder's own. Delivery is the residue of everything nobody closed.

Think of what that means for the population of positions in any contract. A great many are opened, and almost all of them are shut again by the opposite trade. The handful still standing when the contract reaches its expiryThe day a contract's life runs out. Which day that falls on is not the same from one contract to the next. are the ones that go through the exchange of thing for price. Delivery is therefore both the whole purpose of the instrument and a rare event in practice. Delivery is the backstop that makes the price mean anything, and a small minority use it.

Two words name one object, and the arithmetic below is easier once both are on the table. The thing being referenced is called the reference asset throughout. Other writing calls it the underlyingOther writing calls the thing a contract is written over the underlying. Reference asset names the very same idea., and the two words point at exactly the same object.

The last thing to say about arrival is that the timing is not open to invention. The moment at which a position still open crosses into the delivery process, and the window inside which the exchange has to happen, are written by the Securities and Exchange Board of India (SEBI) at sebi.gov.in. The timings are not identical from one contract to the next, and they get amended.

Who is actually standing there on the final date?

Two very different sorts of party end up at delivery, and their reasons for being there have nothing in common. Separate them before anything else.

The first party wanted the reference asset, or wanted to be rid of it. Somebody who genuinely deals in the thing, a hedgerSomebody who genuinely deals in the thing itself and takes a contract to pin down what it will cost them or fetch them. in the ordinary sense of the word, uses the contract to pin down what the purchase or the sale will cost long before it happens. For that party delivery is not an accident and not a residue. Delivery is the entire object of the exercise, and closing the position early would have defeated the reason for entering it.

The second party never wanted the reference asset at all. The position was taken for the price movement, the intention was always to close before the final date, and for one reason or another the closing did not happen. Perhaps it was left too late. Perhaps the position was simply forgotten. The reason does not matter, and that is the point worth holding on to.

An obligation carries no record of why it was entered, so the contract cannot tell those two parties apart and does not try. Nobody signs a box on the way in saying whether they mean to deliver. On the final date the party that wanted the thing and the party that meant to close are standing in exactly the same position with exactly the same duty, and the arithmetic that follows applies to both without a single adjustment.

There is a limit on who may stand there at all. Which participants are permitted to carry a position into the delivery process, and what has to be arranged with whoever clears on their behalf before that happens, come from SEBI, sebi.gov.in.

What is paid, and what is handed over?

The bilateral agreement has the fewest moving parts, so start there. One unit of the reference asset, one buyer, one seller, one price fixed at the start. On the final date the forward buyer hands over Rs 2,130.00/- and receives the unit. The forward seller receives Rs 2,130.00/- and supplies the unit. The exchange is the whole event.

Where did Rs 2,130.00/- come from, though? A reader who cannot place that number will read it as somebody's opinion about the future, and that reading has to be shut down before it takes hold. Set the financing rate of 6.50 per cent a year against the spot price of Rs 2,000.00/- and Rs 130.00/- drops out as the cost of carrying the thing for twelve months. Stack that on top of the spot price and Rs 2,130.00/- is where the figure lands. The agreed price is a carrying charge run forward to the final date, nothing more. The agreed price is not a view about where the reference asset price is going.

One condition makes that build as short as it is. The reference asset sends nobody a payment while it is being held. Nothing subtracts from the carry, so the whole Rs 130.00/- survives to the final date. A reference asset that did pay something out over the same stretch would carry to a smaller figure, and with payouts big enough the spot price would end up standing above the agreed one. Reference assets that pay something out are covered separately.

A tent contractor takes a booking eight months ahead of a wedding and writes the rate on the slip that day. Two things then sit and wait. On the morning of the function the tents have to reach the ground and the balance has to reach the contractor, and neither event is a decision anybody makes that morning. Both events are what the slip has been promising the whole time. Delivery on a forward is that morning, with a reference asset in place of the tents and Rs 2,130.00/- in place of the balance.

The older legal word for what each side hands across is considerationThe older legal word for whatever one side hands across in return for what the other side hands across., and it insists that both sides are giving something. The buyer is not merely receiving. The seller is not merely paying out. Two movements happen at once and in opposite directions, and that opposition is what separates a delivery day from every other cash movement in this subject.

Two quantities that look alike and are not

A delivery day puts two quantities side by side, and blurring them misreads everything that follows. Nail the labelling down before the cleared version arrives. Take twelve units of the reference asset. Multiply twelve by the agreed price of Rs 2,130.00/- and Rs 25,560.00/- appears: that figure is the notional, and on the morning before the final date not one paisa of it has gone anywhere. Multiply twelve by the spot price of Rs 2,000.00/- and a different figure lands, Rs 24,000.00/-. Call that one the exposure. The exposure measures the worth of reference asset the position stands on.

The gap between the two is Rs 1,560.00/-, twelve lots of the Rs 130.00/- carry and nothing else. A notional is a face amount that never moves, an exposure is the worth the position actually rides on, and mixing the two makes an arrangement look larger or smaller than it is. The same discipline applies to every figure below: a price is what was agreed or quoted, a payoff is what the position produces on the final date before anything paid to get there, and a profit is that payoff after everything paid. Neither arrangement cost anything to enter, so on both of them payoff and profit land on one and the same figure, and that coincidence is worth naming rather than letting slip.

Why does the cleared buyer pay a completely different number on the day?

Now the same delivery day on a cleared position. The cleared buyer does not pay Rs 2,130.00/- on the final date. The cleared buyer pays the final settlement price, whatever it turns out to be. Take a final settlement price of Rs 2,400.00/-, and the buyer hands over Rs 2,400.00/- to receive one unit.

The unit is the same unit and the position was opened at the same price, so the extra Rs 270.00/- has to have come from somewhere.

The resolution is that the cleared position was restruck every single day of its life. Each day the difference between where the position stood and where the contract settled that evening moved in cash. The daily instalments are not a side effect and not a fee. The instalments are the price difference itself, paid in pieces, day by day, ahead of the final date.

Work it out. The position was opened at Rs 2,130.00/- and the contract finished at Rs 2,400.00/-. Daily settlement moved every rupee of that Rs 270.00/- gap to the buyer as instalments before the final date arrived. So on the day the buyer pays Rs 2,400.00/-, and against it holds Rs 270.00/- that came in earlier. Rs 2,400.00/- less Rs 270.00/- leaves Rs 2,130.00/-.

The bilateral buyer paid Rs 2,130.00/- in one movement and the cleared buyer paid Rs 2,130.00/- in pieces, and the two figures are the same to the rupee. What differs between the two arrangements is when the money crossed. Nothing else about the cost differs at all, and any comparison claiming one of them is dearer has been assembled around a gap nobody ever paid.

Put the cleared side on its own and the arithmetic becomes a single movement between two numbers. Start at what crossed on the day. Take away what had already come in. The remainder is the price the position was struck at. The instalments were built out of that very difference, so the remainder could not be anything else.

Does the same reconciliation close when the price fell?

One direction proves nothing. A reader who has only seen the rising case is entitled to suspect that the numbers were chosen to work, so run the whole thing again with the price going the other way.

The final settlement price this time is Rs 1,600.00/-. The position was still opened at Rs 2,130.00/-, so the contract finished Rs 530.00/- below where the buyer struck it, and every rupee of that Rs 530.00/- left the buyer as daily instalments before the final date. On the day the buyer pays only Rs 1,600.00/- for the unit. The bargain disappears once the earlier payments are counted. Rs 1,600.00/- paid on the day plus Rs 530.00/- already paid out is Rs 2,130.00/-.

The reconciliation closes at every possible settlement price, and not by luck: the instalments are defined as the difference between the agreed price and the final price, so adding them back can only ever return the agreed price. The reconciliation is worth watching twice. In the rising case the instalments came in and are subtracted. In the falling case they went out and are added. Either way the two parts sum to what the position was struck at.

The falling case is the honest half of the picture. Note what the bilateral buyer experiences there. The bilateral buyer pays Rs 2,130.00/- for something worth Rs 1,600.00/- on the day. The payoff on the position is minus Rs 530.00/-, and since nothing was paid to enter, the profit is minus Rs 530.00/- as well. Once the price on a contract like this is fixed, neither side keeps a way out. Nobody steps away because the day turned out badly.

What happens when nothing physical moves at all?

Some contracts never hand anything over. On a cash settled contract the final date arrives, the last difference is paid in money, and the position ends. No unit changes hands, nobody has to store anything, and nobody has to arrange to receive anything.

The reason one can stand in for the other is that the amounts agree. Look back at the rising case. The buyer who took physical settlement paid Rs 2,130.00/- in total and ended up holding a unit worth Rs 2,400.00/-. The physical buyer is Rs 270.00/- better off. The buyer on a cash settled contract simply receives Rs 270.00/-. Same payoff, same rupees, delivered in a different form. Cash settlement pays the difference the exchange of thing for price would have produced. Nobody is owed anything different, so one form replaces the other without loss.

Now the part that matters most and is most often assumed. Which contracts hand over the reference asset and which pay a money difference is decided by the exchange, and it is a property of the individual contract rather than of futures as a class. There is no general rule to remember here. SEBI settles it, sebi.gov.in, it is not the same from one contract to the next, and it gets amended. A reader who arrives with a recollection of what some contract used to do is working from something that may not be true any more.

What has to be arranged before a position is carried that far?

Everything above is the exchange itself. Scaffolding has to be in place before a position is allowed anywhere near a delivery period, and that scaffolding is where almost every real question actually lands.

Six things decide how a delivery day runs, and their values come from SEBI. Whether this particular contract hands over the thing or pays a difference. The point at which a position still open crosses into delivery, and the window the exchange has to happen inside. How many days pass before the thing itself is in the buyer's hands, and how many before the cash lands. The number of units a contract is drawn across, and what those units are measured in. The day the contract stops trading. And what a party lodges before carrying a position at all.

Each one of those sits in the exchange's own contract specificationThe document an exchange publishes setting out every fixed term of one of its own contracts., written under rules SEBI keeps at sebi.gov.in. Two contracts on the same exchange can answer them differently. The same contract can answer them differently a year apart. Anyone taking a position that far needs a custodianAn outside body whose business is holding assets for other people and shifting them from one holder to another when it is told to. or an equivalent arrangement able to receive the thing or supply it, and needs that agreed with the clearing member long before the final period opens.

The International Organization of Securities Commissions (IOSCO), iosco.org, sets down principles that many countries recognise for markets with a clearing body sitting in the middle. India works from SEBI's own rendering of them, sebi.gov.in, and that rendering, not the international one, decides how an Indian delivery period runs.

Whose desk does a delivery period actually land on?

The moment a position crosses into a delivery period, four separate pieces of work start, and each one belongs to somebody different. None of them is arithmetic.

The first is a physical question. Somewhere there has to be a place able to receive one unit of the reference asset, or to supply it. Whoever runs operations for the party holding the position has to have that arranged, with a custodian or an equivalent, before the window opens and not during it. A position that reaches its final date with nowhere for the thing to go is not a pricing problem. The failure is logistical, and it has a settlement deadline attached.

The second is a cash question, and it is bigger than readers expect. The cleared buyer at a final settlement price of Rs 2,400.00/- has to find Rs 2,400.00/- on the day, in full, even though the true cost of the unit is Rs 2,130.00/-. The Rs 270.00/- came in earlier and may well have been spent. Whoever runs the treasury function has to fund the gross amount crossing on the day, not the net amount the position cost. The distinction between the gross payment and the net cost is the single most practical consequence of the whole reconciliation.

The third belongs to whoever clears for the party. A clearing member has to have agreed in advance that this participant may carry this position into this delivery period, on terms set out before anybody knew which way the price would go. The conversation happens weeks ahead of the day and is nobody's idea of urgent until it is far too late to have it.

The fourth is a reading question, and it falls on anybody looking at the position from outside: a lender assessing what a borrower is committed to, an analyst going through published accounts, somebody in a household trying to make sense of a statement. An outsider needs two facts: the tenorThe stretch of time a contract runs for, counted from the day it starts to the day it ends. of the position, and whether it delivers the thing or a difference. Together those two decide whether a payment of Rs 2,400.00/- is about to appear and whether a unit of something is about to appear with it. Nothing on the position itself tells them which of those is coming, and that is why the delivery arrangement of the specific contract is the first thing to look up rather than the last.

What goes wrong when the final settlement price is read as the price paid?

Here is the trap, and it catches readers who have understood everything else. The cleared buyer pays Rs 2,400.00/- on the day. Written down without its context, that is a bigger number than the Rs 2,130.00/- the bilateral buyer paid, and the conclusion writes itself: the cleared arrangement cost more.

What does the arithmetic not settle?

Whether a position should be run to the final date or shut before it is not a question the arithmetic settles. Four separate matters decide it, and none of them is visible in the arithmetic above. Was the position ever there to obtain the reference asset at all. Can the party physically receive it, or supply it. Has anything already been agreed with whoever clears on their behalf. Does the authority ask more of somebody carrying a position that far. The arithmetic above describes an obligation to the rupee and settles not one of the four.

Nobody knows where a reference asset price finishes. The arithmetic behind these numbers carries no history for this one, no spread of places it might finish and no odds on any of them, so whether carrying a position to delivery works out well is beyond it. The arithmetic settles the useful part instead: what each side owes on the day, and that the amount is the same whichever route the money took.

The reference asset, the spot price of Rs 2,000.00/-, the financing rate of 6.50 per cent a year and every settlement price above are invented.
Educational material. Not advice on any investment, tax, budget or market position.