How are Futures Physically Settled in India?
Derivatives contracts are either cash-based or physically distributed on the expiry date of the deal. When the contract is concluded in cash, the net cash value of the contract on the expiry date shall be passed between the purchaser and the seller.
In a physical settlement, the payer trades the underlying asset for the notional principal at the end of the swap period/ futures contract.
One of the parties to the forward contract takes a long role and decides to buy the underlying commodity at a given future date at a predetermined amount. The other party takes a short position and offers to sell the asset for the same price on the same day.
For a physical transfer, the underlying asset of the option or derivative contract is physically delivered on a fixed delivery date.
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Example:
- Assume the two parties enter into a one-year Crude Oil futures contract starting from March 2020 at a future price of Rs. 4400. Notwithstanding the spot price of the product on the date of settlement, the purchaser is obliged to buy 1,000 barrels of crude oil i.e. the unit for 1 crude oil futures contract from the seller.
- When the final spot price on the negotiated settlement day at any point in March is below Rs. 4400, the long-term contract holder loses, and the short-term owner gains.
- If the spot price is higher than the Rs. 4400 futures price, the long-term benefit position, and the seller must report the loss.
In India, beginning from the October 2019 period, all stock options began to get physically settled as the market regulator sought to curb risk and volatility, as well as to encourage borrowing and lending of shares.
For the 161 stocks on the futures and options exchanges, there was already a physical settlement process for 116 stocks. Beginning Sept. 27, 2019, or the beginning of the October period, 45 stocks — extremely liquid and most traded in the F&O section — were also to be circulated on a physical basis at the end of the expiry date, unless squared off or rolled over.
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How Physical Settlement Happens Stock Futures?
- If traders enter into a long security deal and the contract is not closed before the expiry date, they will have to compulsorily collect shares against the derivative interest and pay the entire contract value and the securities transaction tax applicable in the cash market.
- When traders sell stock futures and the position is not protected or rolled over until the expiry date, they will have to deliver shares.
- If the dealer does not possess the underlying asset, he will have to pay the penalty by engaging in the auction, where he will have to purchase the stock from the market at a price higher than the current market price.
Issues with Physical Settlements.
- Due to short selling where traders sell stocks without owning them and have to deliver at the time of settlement, traders have to pay a premium by purchasing shares at a higher price from the auction, while their position stays on the short side.
- Liquidity may also be a problem. Even if traders are in cash, not all stock options are necessarily liquid. There are times where traders take a position in stock options where there is momentum, but there isn’t a counterparty to square off. In these situations, traders would be forcibly required to move to a physical settlement.
Author: Abhay Kanodia
About the author: An undergraduate student from the Birla Institute of Technology and Sciences, Pilani(BITS Pilani). Exploring the fields of finance and data analytics and its applications in other different domains.
Related: What are Forward Contracts?
