Settlement Date Essay

Settlement date, also known as delivery date, is the final date by which the parties involved in a trade must complete the transaction. The designated date itself varies with the type of assets being traded. For illustration, we consider futures contracts and foreign exchange settlements, which are adequately representative.

A futures contract is an agreement between a buyer and a seller whereby the buyer undertakes to receive delivery of something at a specified price at the end of a designated period of time. The seller undertakes to make delivery of the “something” at a specified price at the end of the designated period. At entry into the contract, no one actually buys or sells anything. The parties’ undertakings are all with reference to a future date. The price at which the parties agree to transact is called the futures price, while the designated date is the settlement date. The “something” the parties undertake to exchange is called the underlying asset. An investor agreeing to buy at a future date is said to have taken a long position, while one agreeing to sell will have taken the corresponding short position. Regardless of the positions taken, futures contracts typically have settlement dates in March, June, September, or December.

In practice, most futures contracts entered into do not culminate in the delivery of the underlying asset because many of them are closed out early. For those that do, however, the decision as to when to deliver is made by the party with the short position. After the decision, the investor’s broker issues a notice of intention to deliver to the exchange clearing house.

The notice specifies the number of contracts to be delivered, and when the underlying assets are commodities, it also specifies the location of the delivery and the grade of commodities. A party with a long position is then chosen by the exchange to accept delivery. The usual rule is to pass the notice of intention to deliver to the party with the oldest outstanding long position. There are three important days with respect to delivery. The first notice day is the first day on which notice of intention to deliver can be submitted to the exchange. The last notice day is the last day for the submission. The last trading day is typically several days before the last notice day.

In foreign exchange trades, the settlement date refers to the maturity date of a forward contract in currency. Foreign exchange transactions have both a trade date and a settlement date. The settlement date, also called the value date, is the forward banking (business) day common to both countries. On this day, parties to the transaction make currency payments with the expectation that they will receive the full amount that they are entitled to receive. Settlements in currencies can be made only on banking days. Bank holidays do not coincide in all countries, so some precision is required in fixing value dates.

Traders in foreign exchange settle according to standardized conventions. For a spot transaction in the interbank market, delivery and payment between banks usually take place on the second business day. Forward exchange rates, on the other hand, are normally quoted for value dates of one, two, three, six, and 12 months. Other arrangements for a different number of months can be made.

On the value date, most dollar transactions in the world get settled through the computerized Clearing House Interbank Payments System (CHIPS) in New York. There are four settlement dates for all foreign exchange futures traded on the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange. They also apply to those traded on the Finance Instrument Exchange (FINEX), a division of the New York Board of Trade. The dates are the Wednesday following the third Monday of March, June, September, and December.

Bibliography:

  1. Frank J. Fabozzi et al., Foundations of Financial Markets and Institutions (Prentice Hall, 2002);
  2. Gabriele Galati, “Settlement Risk in Foreign Exchange Markets and CLS Bank,” BIS Quarterly Review (December 2002);
  3. John C. Hull, Options, Futures and Other Derivatives (Pearson Wiley/Prentice Hall, 2009);
  4. John W. McPartland, “Foreign Exchange Trading and Settlement: Past and Present,” Chicago Fed Letter (v.223, 2006).

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