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| The finance ministry has finally approved physical settlement of derivatives contracts. The original plan was to have physical delivery by December 2001, six months after stock options started trading, and the deadline was later shifted to April 2002. |
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| With physical delivery, the linkages between derivatives and cash markets become stronger, so it makes sense to introduce it now, since the derivatives markets are more mature and liquid. |
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| Having physical delivery has its obvious advantages - traders, being wary about the fact that a trade may end in delivery, would exercise more caution especially while taking a short position. |
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| In other words, there would be more trading discipline. Besides, having physical delivery acts as a safeguard against short-term price movements in the underlying asset. |
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| For instance, taking physical delivery will guard a market player from any manipulative movement in the stock price just before the expiry of the futures contract. |
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| Further, it would make arbitrage more efficient. Right now, under cash settlement, what investors do is square off their positions in the cash markets since no delivery is required to be made in the derivatives market. This could result in a slight deviation in the amount of profit booked because of impact cost or price movement in the underlying. |
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| Physical settlement will have more of an impact on the options market, especially on option writers. Take for instance, a call option writer who has to give delivery of shares if the option is exercised. |
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| With physical settlement, he would prefer writing a covered call rather than rely on the other option of acquiring shares once the option is exercised. So, in essence, there would be fewer naked calls being written. |
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| True, there is also the option of borrowing shares for the delivery, but then something needs to be done to make the borrowing and lending mechanism more efficient. |
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The only issue is that some stocks in which derivatives trading is allowed could be prone to short squeezes. The Sebi Advisory Committee on Derivatives (ACD) on
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