Explanation:
D is correct. Very few futures contracts lead to the delivery of an underlying asset because traders usually prefer to close out contracts before the delivery period. A is incorrect. Regulators do not like cash settlement because it makes futures contracts seem like gambling. As such, they prefer physical settlements to take place whenever possible. B is incorrect: The opposite is true, forward contracts trade OTC and are subject to higher credit risks than futures contracts, which trade on exchanges. C is incorrect: The exact underlying asset, delivery location and delivery time are specified in the contracts, so are not sources of risk. Learning Objective: Describe the mechanics of the delivery process and contrast it with cash settlement. Reference: Global Association of Risk Professionals, Financial Markets and Products (New York, NY: Pearson, 2023). Chapter 7. Futures Markets
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Question 56 of 100: A first-year analyst on the commodity futures trading desk of a bank is assessing the desk's current portfolio and its typical trading patterns. The analyst examines why a large majority of the trades made by the desk are cash-settled and reviews the delivery mechanics of cash-settled and physically settled futures contracts. Which of the following observations is the most likely for the analyst to make?
A
Regulators prefer that cash settlements take place whenever possible due to the inconvenient delivery process involved in physically settling futures contracts.
B
The bank should trade physically delivered commodities using forward contracts since they provide a similar payoff to futures contracts, but unlike futures, they trade on exchanges and are less prone to credit risks.
C
It is risky for the bank to take physical delivery of commodities due to uncertainty about the exact underlying asset, delivery location, and delivery timeframe.
D
Taking physical delivery of commodities can involve warehousing costs and storage costs, so traders usually prefer using futures for financial purposes and not for consumption.
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