Cash Settlement

Cash Settlement

What is a ‘Cash Settlement’

A cash settlement is a settlement method used in certain futures and options contracts where, upon expiration or exercise, the seller of the financial instrument does not deliver the actual (physical) underlying asset but instead transfers the associated cash position. For sellers not wishing to take actual possession of the underlying cash commodity, a cash settlement is a more convenient method of transacting futures and options contracts. For example, the purchaser of a cash-settled cotton futures contract is required to pay the difference between the spot price of cotton and the futures price, rather than having to take ownership of physical bundles of cotton. This is in contrast to physical settlement, where delivery of the actual underlying instrument(s) does take place.

Most financial derivatives based on market indexes, such as options or futures based on the Nifty or MCX indexes, are most often cash-settled. On the other hand, listed equity options contracts are often settled by delivery of the actual underlying shares of stock. Cash settlement can become an issue at expiration because without the delivery of the actual underlying assets, any hedges in place before expiration will not be offset – this means that a trader must be diligent to close out hedges or roll over expiring derivatives positions in order to replicate the expiring positions. This issue does not occur with physical delivery.

BREAKING DOWN ‘Cash Settlement’

Futures and options contracts are derivative instruments that have values based on an underlying asset. The asset can be an equity or a commodity. When a futures contract or options contract is expired or exercised, the conceptual recourse is for the holder of the contract to deliver the physical commodity or transfer the actual shares of stock. This is known as physical delivery and is much more cumbersome than a cash settlement.

If an investor goes short on a futures contract for 10,000 worth of Stock Future, for example, it is inconvenient at the end of the contract for the holder to physically deliver the Stock to another investor. To circumvent this, futures and options contracts can be conducted with a cash settlement, where, at the end of the contract, the holder of the position is either credited or debited the difference between the initial price and the final settlement. This is also very true among traders and speculators in Commodity futures and options markets who trade things like precious metal and food grain. These traders are not farmers or jewellers  and only care about the market price, and so do not wish to take delivery of a metal or food grain.

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