Cash Settlement
Cash settlement is a settlement option that is commonly applied in financial derivatives trading. When a financial asset is sold for cash, the seller doesn't really provide the tangible underlying asset but rather delivers the related cash position at the time of expiry or execution. Today we will go through the definition of cash settlements and how they work. We’ll also look at a few examples to understand it better.
Meaning of Cash Settlement
A cash settlement is a way of settling agreements in futures and options trading at the point of expiration. The seller doesn't give the physical underlying asset to the bidder while using the cash settlement method. Instead, the seller sends cash depending on the difference in cost between the agreement's strike price as well as the asset's current value.
Cash Settlement Definition
A cash settlement is a technique of settling contracts used in some futures contracts in which the vendor of the financial asset does not transfer the actual/physical underlying commodity but rather transfers the accompanying cash position when the contract expires or is exercised.
When physical delivery of an instrument is not possible at the time of execution or maturity, derivative trades are settled in cash. Investors have been able to inject cash into derivative markets because of it. Cash-settled contracts take less time and money to deliver when they expire.
How Does Cash Settlement Work?
Futures and options contracts refer to those derivative securities whose prices are dependent on the value of an underlying asset, which could be a stock or a commodity. When a Futures and Options contract expires or is executed, the owner of the contract has the theoretical option of delivering the physical commodity or transferring the actual stock shares. This is referred to as physical delivery, and it is far more time-consuming than a cash settlement. In Futures and Options, as the name implies, cash settlement works on the idea of sending the price gap in cash to the buyer rather than delivering the underlying commodity physically.
Examples of Cash Settlement
Investors who predict a commodity's value will rise or fall in the foreseeable future enter futures contracts. When an investor sells a corn futures contract short, they are betting that the price of corn will fall in the near future. A contract is formed with another buyer who is betting on the opposite side of the coin, that corn prices will rise.
For a total of $10,000, an investor sells a futures contract for 200 bushels of corn short. This indicates that if the price of 200 bushels of corn lowers to $8,000 by the time of the term, the investor will profit $2,000.
The investor, on the other hand, loses $2,000 if the cost of 200 bushels of corn rises to $12,000. In theory, the 200 bushels of corn are "delivered" to the long-position buyer at the expiry of the contract.
A cash settlement could be employed to make it simpler. Instead of sending the corn, the short investor must pay the gap of $12,000 - $10,000, or $2,000, if the value rises to $12,000. If the price falls to $8,000, the buyer receives $2,000 from the long position holder.
Why Should Investors Use Cash Settlement?
Since cash settlements only demand a buffer to have a position in the market, they incentivize traders to trade frequently.
The transaction costs are also kept to a minimum because there is only one transaction in the entire agreement, which occurs on settlement day.
Since the transactions will be completed in cash, there is no danger of purchasing or delivering physical assets. Since more traders are encouraged to participate, the market would be capable of handling increased volume.
What’s the Difference Between Cash Settlement vs. Physical Settlement?
A cash settlement is one in which no securities are exchanged and only the differential sum is delivered against a physical resolution in which securities should be delivered. The majority of physical settlement trades are performed in the futures and options market with commodities. Here the buyer fixes the price of the commodity to prevent paying excessive costs in the future. The purpose of a cash settlement is to establish a market and raise the volume of trade in the derivatives market.
Conclusion
We hope this guide was able to answer some of the most pertinent questions related to cash settlements.
FAQ
What is the difference between cash settlement and delivery?
When it comes to physical delivery, the contract bearer has to either own the commodity from the exchange or create it. Cash settlement, on the other hand, does not need the surrender of assets. It essentially includes net cash settled at the end of the contract.
Is cash settlement the same day?
No, cash settlement is done upon the expiry of the contract.