Delivery options

[wrongsaidfred]

Hi David,

I am confused about the statement: If futures prices are increasing functions with time to maturity, short should deliver as soon as possible.

Maybe it is the pure mechanics of exactly what is taking place when a short closes out her position that is confusing me.

Please tell me if this is correct: Holder of short futures contract must either sell the underlying or buy a contract in the open market so that they are flat. If they buy back the contract, wouldn't they want the price of the contract to be as low as possible? In this case, it seems like the oposite would hod true than was stated above. It seems like the short would want to hold off until the last possible date because the longer the contract is held, the shorter the time to maturity and the lower the price of the contract. Where is my logic incorrect?

I also have a very basic question. If the holder of the short position decides to deliver, what exactly is the flow of funds? Lets say the seller shorts a contract to sell something at $50 and the price of this futures contract goes down to $45. Does this mean that the seller must sell this item at $45 to the long position holder? Something about that is not right because this way the seller would only be getting $45 instead of the $50 they tried to lock in.

Any explanation you could provide would be greatly appreciated.

Thanks,
Mike

 

[lRRAngle]

Hi David,

I was just watching the video on futures and couldn't get the logic behind "If futures prices are increasing functions with time to maturity, short should deliver as soon as possible." specifically, what do you mean by "this is because the interest earned on the cash received outweighs holding the asset." ? It would be great if you can break it down for me, I am missing some parts of this picture.

Thanks!

 

[David Harper CFA FRM]

@lRRAngle It's from Hull. If the futures curve is upward sloping, per F=S*exp[(r + λ - y)*T] = S*exp[(c - y)*T] where c is cost of carry and y is convenience, then c > y, and it must cost more to carry (own) than it benefits. If you own it, and its cost exceed the benefits, you want to get rid of it as soon as possible. But if y > c, the benefits of owning exceed the carry cost, and you want to hold on a long as possible. Interest is a cost of owning because we assume that ownership requires funding (if you buy cotton, it's opportunity cost for your cash).

 

[lRRAngle]

Cool - I think i got it now, mostly at least. Not sure about the part "Interest earned on the cash received outweighs holding the asset..." - i.e. what cash was received by the short?or are we saying the cash "to be received" upon delivery? [my insight here, if I am correct is that the timing of cash receipt for the short on a futures contract is a different (at the end) than with a short position on a stock option (at the beginning) ]

But based on your response, if i put it together in "my own words", is it correct to say in Contango S(0) <F(0) the short should deliver as soon as possible?

 

[David Harper CFA FRM]

Yes, exactly: contango implies c > y such that earlier delivery would be better. And delivery gets you the cash which earns interest.

 

[lRRAngle]

Understood. Thanks!