In commodity derivatives, physical settlement involves the physical delivery of the underlying commodity, typically at an accredited warehouse. This is not required in financial derivatives as the instrument is light and does not require storage facilities. Under the physical settlement, traders will have to compulsorily take delivery of shares on the expiry day against their derivative positions. Short sellers will now have to first borrow stocks under the SLB (securities lending and borrowing) mechanism, which allows the borrowing of securities from institutional investors.
For example – in the case of a cash settlement, if a trader bought future for XYZ Ltd (lot size – 5000) at Rs 100, then contract value is Rs 500000 and generally, on an average, he pays a margin of 20% (about Rs 100000). Suppose expiry day closing is Rs 102, then contract had been settle on a cash basis and he will get a profit of Rs 10000 and their margin has been released (Note: margin could be insecurity or cash basis).
In case of physical settlement (considering the above example), if the contract is open for exercise, then he has to take delivery of 5000 shares and need to pay contract value i.e. Rs 500000. And on this, he has to bear cash segment STT, transaction cost, brokerage.
The seller intending to make delivery of a commodity would have to take the goods to the designated warehouse and the buyer intending to take delivery would have to go to the designated warehouse and pick up the commodity. The issues faced in the physical settlement are large in number.
- There are limits on storage facilities in different states.
- There are restrictions on the interstate movement of commodities.
- Duties have an impact on the cost of the movement of goods across locations.
