Delivery Option
What it is:
A delivery option is incorporated into an interest rate future contract and allows the writer to specify the time and place of delivery as well as the asset to be delivered.
How it works (Example):
An interest rate future contract contains an underlying short position supplied by the writing counterparty. If a delivery option is built into a contract, the writing counterparty is allowed to decide on which bond or other debt instrument, unknown to the holding counterparty, will serve as the asset to be delivered. Additionally, a delivery option allows the writing counterparty to specify the time and location at which the delivery will occur. For instance, a writing counterparty might, on the delivery date, choose a Treasury bond with a three percent yield to be delivered in New York.
Why it Matters:
While the incorporation of a delivery option into an interest rate future contract provides a low-risk hedging instrument to the writing counterparty, the holder takes on higher risk due to the uncertainty surrounding the debt instrument that will be delivered.
