Delivery Contracts

A delivery contract (also known as a physical delivery contract) is a type of futures contract where the underlying asset is physically exchanged between the buyer and seller upon contract expiration. This distinguishes it from a cash-settled contract, where the difference between the contract price and the market price is paid in cash. Delivery contracts are common in commodity markets, such as agricultural products, energy resources, and metals. While widely used in traditional finance, understanding them is becoming increasingly relevant as cryptocurrency futures markets evolve and offer more physically delivered contracts.

How Delivery Contracts Work

The core principle of a delivery contract is the obligation to take or make delivery of the specified asset. Here's a breakdown of the process:

1. Contract Specification: The contract details, including the asset type, quantity, quality, delivery location, and delivery period, are precisely defined. These specifications are crucial and detailed within the contract specifications document published by the exchange. 2. Trading: Buyers and sellers trade the contract on an exchange or over-the-counter (OTC) market. Trading occurs much like any other financial instrument, with prices influenced by supply and demand. 3. Position Holding: Traders can take either a long position (buying the contract, anticipating price increases) or a short position (selling the contract, anticipating price decreases). Hedging and speculation are common motivations for taking positions. 4. Expiration Date: As the contract approaches its expiration date, holders must decide whether to close out their positions before delivery or prepare for physical delivery. 5. Delivery Process: If a trader holds a long position at expiration, they are obligated to *take* delivery of the underlying asset. Conversely, a short position holder must *make* delivery. This involves coordinating logistics, storage, and transportation, often through designated delivery points. 6. Settlement: The asset is transferred, and the final settlement occurs.

Key Components of a Delivery Contract

Underlying Asset: This is the commodity or financial instrument being traded. Examples include crude oil, gold, wheat, or, increasingly, cryptocurrencies.
Contract Size: Defines the quantity of the underlying asset covered by one contract.
Delivery Location: Specifies where the asset must be delivered. This can significantly impact price due to basis risk and transportation costs.
Delivery Period: A specified timeframe during which delivery can occur.
Quality Specifications: Defines the acceptable quality of the delivered asset. This prevents disputes and ensures standardization.
Contract Months: Futures contracts are typically listed for multiple delivery months, offering flexibility to traders. Understanding seasonal patterns can be crucial in these markets.

Contrast with Cash-Settled Contracts

| Feature | Delivery Contract | Cash-Settled Contract | |---|---|---| | Settlement | Physical delivery of asset | Cash payment of difference | | Logistics | Requires storage, transportation | No physical handling | | Underlying Asset | Typically commodities | Can be any asset, including indices and interest rates| | Price Discovery | Reflects spot market + cost of carry | Reflects expectations of future price | | Storage Costs | Relevant | Irrelevant |

Implications for Traders

Delivery contracts present unique challenges and opportunities for traders:

Storage Costs: Holding a long position to delivery requires arranging and paying for storage of the underlying asset. Inventory management becomes a factor.
Transportation Costs: Transporting the asset to the delivery location adds to the overall cost.
Basis Risk: The difference between the futures price and the spot price (the basis) can fluctuate, impacting profitability. Analyzing carry trade opportunities is important.
Rolling Contracts: Traders often 'roll' their positions forward by closing out the expiring contract and opening a new position in a further-out contract month. Analyzing contract roll yield is important.
Potential for Arbitrage: Discrepancies between the futures price and the spot price can create arbitrage opportunities. Statistical arbitrage can be applied.