Cash Settlement for Futures on Non-Deliverable Underlyings

Summary

Futures do not always require delivery of a physical asset. Contracts referencing rates, volatility measures, commodity indices, or equity indices can settle in cash: the parties exchange an amount based on the contract’s final value rather than transferring the referenced quantity. This resolves the apparent problem of delivering an intangible quantity such as an interest rate.

The document names several examples and notes that pricing and risk models depend on whether the referenced underlying can be traded directly. Volatility futures such as VIX contracts are especially challenging because the underlying measure itself is not directly tradable. The examples clarify the settlement concept, but the discussion does not give contract specifications, settlement formulas, or a detailed account of the modeling challenges.

Key ideas

• Cash-settled futures settle through a payment based on contract value rather than physical delivery.
• Interest-rate, volatility, commodity-index, and equity-index futures are cited as examples.
• Pricing and risk analysis depend partly on whether the underlying can be traded.
• Volatility futures pose particular modeling challenges because volatility measures are not directly tradable.

Tags

# Intangible assets as underlying for Futures contracts


# Intangible assets as underlying for Futures contracts












How is it possible for a Futures contract to have an intangible underlying? For example, to my knowledge, there exist Futures that have interest rates as their underlying, come delivery date, how is the seller suppose to "deliver" interest rates?

## Answer by Brian B (score 2, accepted)

https://quant.stackexchange.com/a/7226

It's just cash settled, like a bet on a sports game. This was somewhat controversial when the financial index futures were first invented.

## Answer by Richi Wa (score 2)

https://quant.stackexchange.com/a/7227

Examples for cash-settled futures are:

- Interest Rate futures

- Futures on implied Volatility (e.g. on VIX)

- Futures on Commodity Indices: Indices such as the Dow Jones UBS consist of futures themselves. Furthermore in asset management you usually don't want physical delivery of the underlying (oil, gas, coal, pig, ... ;)

- Futures on Equity Indices

The pricing and the risk models differ for all these depending on whether you can trade the underlying or not. With VIX it becomes especially tricky.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.