Tricky futures question

A futures trader goes long one futures contract at $450. The settlement price 1 day before expiration is $500. On expiration day, the future is trading at $505. The least likely way the futures trader will lock in her profits on expiration is: A) take delivery of the underlying asset and pay $500 to the short B) close out the futures position by selling the futures contract at $505 C) take delivery of the underlying asset and pay the expiration settlement price to the short D) cash settle the futures and recieve the difference between $500 and the expiration settlement price Answer: To lock profits, take delivery and pay short the settlement price of the previous day, not the expiration day. I understand the fact that you pay the previous day’s price, not the expiration day price. But I don’t understand why the long is making a payment. If the contract was locked in at $450, doesn’t the long recieve a payment (in the amount of $50, if cash settlement)?

Yes, you are correct. But you’re looking for the least likely (false) answer.

my brain is so fried, i’m reading the answer and still don’t know the answer. which one is correct? A?

The least answer is C

bpdulog Wrote: ------------------------------------------------------- > Yes, you are correct. But you’re looking for the > least likely (false) answer. That would mean that the others (A,B,D) are true. I don’t see how they are. In A for example, it describes the long paying the short, when in fact the long won. If the long is taking delivery, he should be paying 450.

A is false. If you wanted to lock in your profits at expiration, why would you take delivery the day before? The kinda defeats the purpose.

C appears false as well because hes paying the short and using the expiration price

A is the answer

A) take delivery of the underlying asset and pay $500 to the short B) close out the futures position by selling the futures contract at $505 C) take delivery of the underlying asset and pay the expiration settlement price to the short D) cash settle the futures and recieve the difference between $500 and the expiration settlement price The answer is A, because that’s IMPOSSIBLE. You cannot take delivery and pay $500, because that’s not the settlement price. B) is MOST LIKELY, most futures are settled by a closeout C) is the least likely possibility of the possible choices D) happens all the time for cash settled futures

Another thing. NO the long does not pay $450 on expiration day. Futures are marked to market daily. If you take physical delivery, you pay the settlement price as determined by the contract you entered into. Be careful about “expiration settlement price”. Some futures do not have a single delivery date, for example, the US Bond futures (TU, FV, TY, and US) have a first delivery date and last delivery date, and the last trade date is > first delivery and < last delivery, and the settle price you use in determining payments depends on when the short announces the intention to deliver (yes, the short has the option of choosing what to deliver and when, hence why futures are generally traded @ a discount to the CTD issue). The cash flows made upon delivery are also NOT fixed. For ex: - Bond futures, the notional is adjusted based on the issue the short delivers - Rough Rice futures, there’s an adjustment made if the post-milling yield is outside of a certain range - WTI oil futures used to allow delivery of brent (not sure if they still do or not) and there was a spread in the payment if brent is delivered in lieu of WTI (Note that quality is based purely on API specific gravity & sulfur content, it doesn’t matter where it *actually* came from). Now brent futures trade seperately on ICE I’m sure a lot of this stuff won’t be covered in Level I, but just be cautious when making assumptions about settling futures contracts.

f2d Wrote: ------------------------------------------------------- > A) take delivery of the underlying asset and pay > $500 to the short I GET IT, IT’S FALSE BECAUSE YOU CAN’T TAKE DELIVERY AND PAY TOO > B) close out the futures position by selling the > futures contract at $505 MAKES PERFECT SENSE, ONCE IT EXPIRES YOU CAN GO IN THE MARKET AND SELL FOR 505 > C) take delivery of the underlying asset and pay > the expiration settlement price to the short STILL DONT GET WHY THIS IS TRUE. IF YOU TAKE DELIVERY, WHY DO YOU PAY ANYTHING TO THE SHORT, IF YOU’VE MADE MONEY > D) cash settle the futures and recieve the > difference between $500 and the expiration > settlement price MAKES SENSE BECAUSE YOU MARK TO MARKET, THE PRICE THE DAY BEFORE WAS 500, SO YOU SETTLE FOR 505-500 > > The answer is A, because that’s IMPOSSIBLE. You > cannot take delivery and pay $500, because that’s > not the settlement price. > > B) is MOST LIKELY, most futures are settled by a > closeout > C) is the least likely possibility of the possible > choices > D) happens all the time for cash settled futures

WRONG! A is INCORRECT because the PRICE PAID IS WRONG. C is a perfectly valid scenario. If you take delivery, you’re paying for the goods. ANY PROFITS ARE SITTING AS CASH IN YOUR FUTURES ACCOUNT. IN ADDITION, if you enter into a futures contract @ 450, you’re NOT actually paying 450 for the contract. You pay NOTHING (yes, there is margin requirements though, but that remains as cash/collateral in your account, it doesn’t get transferred to the short when you open the position). When you take delivery, you pay the deliverer the appropriate settlement price +/- any applicable adjustments. Trust me on this one, I know, in depth, how the futures markets function.

Just remember this for a futures contract: A Futures contract is an agreement to swap X units of A for Y units of B at some point in the future. There’s no exchange when you make the agreement! Futures are marked to market by the clearinghouse though to protect itself from default risk, which is why PnL is paid out / collected daily.