What does "Cheapest to Deliver" Mean?

"Cheapest to deliver" refers to an approach to some types of futures contracts where people are allowed to swap underlying securities on the delivery date to reduce the cost of delivery. If this is an option available to the seller of the contract, the contract's price will usually be adjusted to reflect this, as there is a possibility that the seller will use an underlying security of lower value, making the contract less valuable. The cheapest to deliver clause is clearly spelled out in the terms of the contract so people have an opportunity to decide whether they want to invest in it.

In a futures contract, the seller agrees to provide a given number of shares of an underlying asset at a set price on a particular delivery date. The buyer purchasing the contract reserves the right to buy those assets at the set prices, potentially locking in a better price than might be available on the open market at the time. This is a form of financial speculation, with people relying on fluctuations in value to make money.

In a cheapest to deliver contract, the seller is allowed to substitute other types of underlying assets when the contract expires and the buyer can exercise it. People may do this because changing assets is less costly, because they cannot access a promised asset, or for other reasons. The buyer must accept the substitution under the terms of the contract. Substituting assets of different grades in a cheapest to deliver contract can result in a decline in value, as lower-graded assets are less stable and reliable and may not generate as much in terms of returns.

When people draft futures contracts, they consider all the available terms and develop a contract suited to their needs. Buyers can review a variety of contracts to see which they like best, looking both at the prices of various contracts and their stated terms. If a seller cannot find a buyer for a contract, it may need to be adjusted to make it more appealing to other investors. The process of buying, selling, and swapping contracts occurs all the time, in a variety of markets.

Cheapest to deliver provides a number of advantages to sellers. They can earn money from the contract, and stand a chance of making more on the delivery date by being able to substitute underlying securities. For buyers, it is a more risky investment decision, as there is a chance of receiving underlying assets of poor quality when the contract expires.