Cash Settlement

When a futures or options contract expires or is exercised, the seller of the financial instrument does not deliver the real underlying asset (physically) but instead transfers the cash position that goes with it.

What Is a Cash Settlement?

Futures and options contracts are derivative products that are based on an underlying asset, such as a stock or a commodity, and have a value depending on that underlying asset. Contract holders must provide physical commodities or transfer stock in order to fulfill their contractual obligations when futures and options contracts expire or are executed. When a settlement is made in the form of a check, this is referred to as a “cash settlement”.

It would be cumbersome for an investor who goes short on a futures contract of $10,000 worth of silver to physically transfer the silver to another investor when the contract ends. So, futures and options contracts can be settled with a cash settlement, where the holder of the position is either credited or debited for the difference between the beginning price and final settlement. This is one way to avoid the problem.

When purchasing a cash-settled cotton futures contract, for example, the buyer is only obligated to pay the difference between the spot price of cotton and the futures price. The physical settlement, on the other hand, involves the actual delivery of the underlying instrument(s).

Roles of Cash Settlement

• The market relies heavily on cash settlement since it increases market liquidity and enables more investors to participate in the market without having to have a stake in a specific security.
• Any buyer would be unable to acquire the agreed-upon amount of gold on the settlement day since it would be inconvenient for them to do so. As a result, trading becomes more accessible, which in turn leads to increased activity on the market.
• Due to the fact that contracts are paid in cash, there is only one transaction required to occur at the end of the contract, which reduces costs. Additionally, as there is no physical delivery required, this results in significant time and cost savings for the market.
• Even though cash-settled accounts require margins to trade and they must maintain a minimum amount in the account to allow for market trading, they are just as safe as cash-settled accounts.

Cash Settlement vs. Physical Settlement

Cash settlement is one of the most popular and frequently used settlement options used in option contracts and futures trading. The best part about cash settlement is that it enables liquidity in the market. This is why it allows more investors to take part in the investment market. A widespread practice in the financial market is for buyers to fix the price of a commodity in order to prevent the possibility of paying higher prices in the future. However, physical settlement deals involving commodities are also popular. The derivatives market relies on a cash settlement to get off the ground and grow its trading volume.

Advantages

As cash settlements only need a margin to establish a position in the market, they incentivize traders to trade more.

On settlement day, there is just one transaction, therefore the transaction cost is very low.

Since the agreements are cash-settled, there is no danger of delivering or purchasing a physical security, which encourages more traders to participate in the market.

Disadvantages

American options can be exercised at any time during the transaction’s life, as compared to European options, which are less flexible since they can be executed only during the maturity period.

Frequently Asked Questions