Derivative Settlement Structures to Meet Your Needs

You’ve decided that an FX futures contract is a sound strategy to help mitigate your FX risk. So now you may be thinking: When the contract expires, does someone come to my house with a briefcase containing one million euros (EUR)? A courier might have done so a hundred years ago, but physical delivery has evolved.

Physical Delivery

Futures contracts are the original derivatives. They are essentially a buyer and seller agreeing on a price for a physical transaction of an asset (corn, gold, crude oil, euros, etc.) at a future date. For the first hundred years of their existence, all futures contracts were "physically deliverable." That means the short (seller) presented the long (buyer) with a warehouse receipt for the commodity (corn stored in a silo in Iowa, for example), and the long paid the cash value of the contract at that date. With the advent of certain financial futures, physical delivery became more complex. Physical delivery still means an exchange of money (now via wire transfer) for the actual asset.

Futures contracts are the original derivatives. They are essentially a buyer and seller agreeing on a price for a physical transaction of an asset at a future date.

Cash Settlement

Cash settlement came into being with the advent of stock index futures. Imagine delivering an S&P 500 contract comprised of 500 different companies’ shares. The solution became a cash settlement. Money is exchanged at the contract conclusion, instead of an exchange of the actual underlying asset. For our S&P 500 contract example, the contract settlement is determined by calculating the prices of the 500 stocks on the day of expiration and making cash adjustments. These adjustments are debits or credits to the long’s (buyer) or short’s (seller) accounts. Over time, more contracts were settled strictly by cash, including certain currency futures.

Futures Settlement

Futures contracts can be settled either by physical delivery or cash. You can find the settlement method of any particular contract on the exchange website:www.cmegroup.com

FX Forward Settlement

FX forward contracts are private over-the-counter (OTC) transactions. The two private parties determine the terms of settlement for the contract. That means settlement can be by delivery of currency or payment from one party to the other at the end of the contract.

An FX cash settlement might look like this:

Options Settlement

Options on currencies can be traded on an exchange or as an OTC transaction.

• If exchange-traded, like futures, the settlement will be a delivery of one side of a futures position (long or short).
• If OTC, like forwards, the settlement is determined by the parties of the contract and can be either physical delivery or cash. The settlement method is agreed to when the contract is established.

Settling Into the Conclusion

Settlement varies by derivative type. Understanding your options can help to determine the proper contract for you. Choosing the right delivery type can also make your life much easier. It’s best to get guidance from a financial services expert when navigating the complex world of derivatives for hedging.

Takeaways

1. There are two types of derivative settlements: physical delivery of an asset or cash settlement.
2. Details of the settlement will vary depending on the derivative type.
3. The derivative contract origination (exchange or OTC) determines the settlement method.

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