Automatic exercise

With a listed equity or index option, some in-the-money positions can still lapse unexercised if the holder does nothing. Exchange Traded Interest Rate Options do not leave that choice to the holder at all.

The workbook is direct about it: "all in-the-money contract get exercised automatically". The buyer of an in-the-money GOI bond option does not have to instruct anyone — the clearing corporation exercises it for him.

Currently, all ETIRD contracts available on exchanges are cash settled, which is what makes automatic exercise workable without anyone having to arrange physical delivery.

At expiry:

• All open long in-the-money contracts are automatically exercised at the final settlement price.
• They are assigned to short positions on a random basis, among short positions of the same series (same strike, same expiry).
• The resulting exercise settlement value is applied by debiting or crediting the relevant clearing accounts of clearing members with the respective clearing bank.
• Exercise settlement is effected on T+1 — the same cycle as daily and final futures settlement.
• Premium settlement for option contracts is also cash settled, on T+1, but with one difference from exercise settlement: any premium variation adjusted intraday is applied against the collateral placed, not settled in cash the way the final exercise value is.

Since exercise is automatic and random-assignment based, a short option writer cannot choose whether or when to be assigned — the clearing corporation's random draw decides that among all short positions of the matching series.

On the expiry day of a GOI bond option series, the final settlement price of the underlying notional bond futures works out to Rs 98.90.

An investor holds a long 98.50 call, which is in the money by Rs 0.40 at that price. He does nothing — no phone call to his broker, no instruction entered on the trading terminal. Because it is in the money, the clearing corporation automatically exercises it at Rs 98.90, and it is randomly assigned to one of the short 98.50 call positions in the same series.

On a T+1 basis, his clearing member's account is credited with the intrinsic value — 0.40 × 2,000 units per lot = Rs 800 per lot — while the assigned short writer's account is debited the same amount. Meanwhile, an out-of-the-money 99.50 call he also holds simply lapses — nothing is exercised, and no cash moves, because it never crossed into the money.

Chapter 7 (Clearing, Settlement and Risk Management of IRD), sections 7.7 (Settlement) and 7.7.3 (Final Settlement), state that all in-the-money contracts are automatically exercised at the final settlement price, assigned randomly, and settled on T+1. Expect a question distinguishing automatic exercise (no action needed) from voluntary exercise regimes, and one on the T+1 settlement cycle.

• Automatic exercise applies because ETIRD options are currently all cash settled. There is no physical delivery step to arrange, which is what makes automation practical.
• Assignment is random, among short positions of the same series — a writer cannot pick which of his short contracts gets assigned, or avoid assignment.
• Exercise settlement is T+1, matching futures final settlement, not an immediate same-day cash movement.
• An out-of-the-money contract simply lapses. Only in-the-money contracts are automatically exercised.
• Premium settlement and exercise settlement are both T+1, but premium variation is adjusted against collateral, not cash-settled the same way exercise value is.