When you get involved with a futures contract transaction, you are obligated to complete the transaction upon the settlement date. The settlement date is the future date that was established at the time of the transaction that determined when the transaction needed to be complete. In the case of futures contracts, both parties are obligated to complete the transaction when the settlement date arrives.
When the transaction is completed, this transaction is referred to simple as the settlement. Depending upon the type of futures contract that is in question, the settlement can occur in two different ways.
One type of settlement is the physical delivery. With the physical delivery settlement, the person selling the contract must deliver the specified agreed upon amount to the exchange. The amount of the underlying asset is then delivered to the person that purchased the futures contract. This method must be used because the exchange acts as the middle person and the two parties do not actually know each other.
The physical delivery settlement method is the most commonly used when it comes to bonds and commodities, but it is not so common when it comes to futures contracts. In reality, the majority of futures contracts are cancelled with the purchase of a covering position. In other words, the contract is purchased in order to cancel out the earlier sale by a process referred to as covering a short. Or, the contract is sold in order to liquidate the earlier purchase through a process referred to as covering a long.
The other method of settlement that can be used to finalize the futures contract transaction is the cash settlement method. Through this method, a cash payment, which is determined by the underlying reference rate of the commodity, is made. The closing value of the stock market index or information gathered from a short term interest rate index may be used to determine this amount. Another option with the cash settlement method is to settle against an index, which is based on trade.
The third method that may be used to complete the settlement is the expiry method. The expiry is the day on which the futures final price is determined. In many cases, this date takes place on the third Friday of a specified trading month. When this day is reached, the futures contract
(t + l) becomes the forward contract (t). In other words, if the expiry date is in December, the March futures will be considered the nearest contract. During this time period, the underlying assets of the futures contracts are even more liquid than usual and arbitrageurs go to work trying
to earn a quick profit.
Before finalizing a futures contract transaction, it is important to be fully aware of the settlement method that will be used when the settlement date occurs. In this way, you can determine whether or not you are comfortable with the terms of the agreement and if it is a deal that you would like to complete.