Futures are derivative instruments containing leverage, that allow for hedging. Commodities are volatile assets. It is not unusual for the price of raw material to move dramatically higher or lower over a short timeframe. Hedgers can protect against price risks in the market. A hedger who is a producer can sell futures contracts to lock in a price for their output. Conversely, a hedger who is a consumer, can buy futures contracts to lock in a price for their requirements.
Convergence of Prices
One of the primary reasons that futures markets work so well is they allow for the smooth convergence of derivative prices with prices in the physical markets. The convergence of the two prices occurs by the delivery mechanism that exists in the futures market.
Although buyers and sellers of futures pay only a small, good-faith deposit in the form of initial margin, they are always at risk for the total contract value. That is why there are two types of margin, initial and maintenance margin. The most active trading in a futures contract is generally in the most nearby or active month contract. As the nearby future moves into the delivery period, a buyer of a futures contract who maintains their position must be ready to accept the actual commodity's delivery and pay full value for the raw material product. A seller is allowed to make the delivery.
The Delivery Process
Futures exchanges work with industry to develop standardized quantities, qualities, sizes, grades, and locations for a physical commodity delivery.
While many commodities have different characteristics, the delivery process often includes premiums and discounts for varying grades and distribution points for specific raw materials. The exchange designates warehouse and delivery locations for many commodities. The exchange also sets the rules and regulations for the delivery period, which can vary depending upon the particular product.
How a Futures Contract Can Become a Commodity Purchase
When delivery takes place, a warrant or bearer receipt representing a certain quantity and quality of a commodity in a specific location changes hands from the seller to the buyer, upon which full value payment occurs. The buyer has the right to remove the commodity from the warehouse at their option. Often, a purchaser will leave the raw material product at the storage location and pay a periodic storage fee. Exchanges also set fees for many aspects of the delivery process.
As you can see, the fact that a futures contract can become a physical commodity purchase or sale gives market participants tremendous flexibility. The ability to deliver or take delivery provides a critical link between the derivative instrument and the commodity. Therefore, as a futures contract approaches the delivery date, the price of the futures month will gravitate toward the actual physical or cash market price.
The Difference Between Futures and Physical Prices
The price differential between the derivative and underlying physical market can vary during the life of the futures contract. As an example, the price of a December corn futures contract can vary widely from the price of corn at a delivery location in October or November.
However, as the December delivery date approaches, the two prices will tend to converge. The difference between a nearby futures price and the price of the physical commodity is the basis. Not all commodity futures have a delivery mechanism. Some are cash-settled on the last trading or expiration day of the contract. For example, Feeder Cattle futures have no delivery mechanism. Those futures that are cash-settled tend to use a benchmark for pricing, such as an industry-accepted pricing mechanism or the final settlement price on the last day of trading in the instrument.
While less than 5% of futures with a delivery mechanism result in parties making or taking delivery of a commodity, the fact that it exists is a comfort to many hedgers and market participants. The goal of a futures contract or an option on a futures contract is to replicate the price action in the underlying commodity or instrument. The delivery mechanism almost ensures the convergence of the two prices over time.
The vast majority of market participants in futures markets pay no attention to delivery and for a good reason. Think of speculators who purchase a live cattle contract because they believe that the price will appreciate. Few, if any, have the ability or desire to take delivery of 40,000 pounds of cattle. Even if the cattle do not arrive on their doorsteps, owning cattle at a location requires a different set of skills than trading the animal and depends on having the contacts to market the beef to an ultimate buyer. After all, the futures contract buyers only purchased because they believed the price would move higher.
The Creation of Opportunities
However, there are circumstances where the delivery concept can create opportunities. A speculator, trader, or investor who goes long one contract of NYMEX platinum or COMEX gold could stand for delivery of the contract if they wish to own the physical metal. The platinum contract represents 50 ounces of the metal, while the gold contract is for 100 ounces. Instead of 40,000 pounds of live cattle, dealing with 3.4 or 6.8 lbs of platinum or gold is a lot easier.
A buyer that takes delivery of either of the precious metals would receive a warehouse receipt or warrant representing a particular platinum or gold bar or bars in an exchange-approved warehouse. The receipt includes the weight, size, and bar number of the metal in questions. The buyer would pay the full value for the metal plus or minus any premium or discount.
Taking the Metal off Warrant
The purchaser receives a receipt endorsed by the last owner, and the buyer then has the right to withdraw the metal from the warehouse. This process is called taking the metal off warrant, which tends to include a fee. The buyer could then arrange for the warehouse to deliver the metal to any location, including their home by registered mail or armored carrier. The buyer is responsible for any transportation fees. On the other hand, a purchaser could leave the metal on a warrant and pay a periodic storage fee to the warehouse to hold the metal on the buyer’s behalf.
The delivery mechanism differs for each commodity, and all exchanges, like the Chicago Mercantile Exchange (CME), have detailed information about the process available on their websites. Delivery is one of the primary reasons that futures prices converge with underlying physical commodities prices over time. If you ever decide to take delivery of a commodity, make sure you familiarize yourself with all of the rules and regulations of the exchange. Always look for updates to the delivery rules as amendments and changes often occur.