In finance especially in a derivative market, the contracts are often executed on pre-decided settlement date. In the case of futures and options, on the settlement date, the contract seller may either opt for delivery of the underlying asset (which is termed as physical settlement) or may simply settle the net position through cash (i.e. cash settlement). in this article, we have covered Cash Settlement vs Physical Settlement in the options market.
A futures contract may either be settled through cash or physical delivery.
In the case of physical delivery, the holder of the contract will either have to take the commodity from the exchange or produce the commodity.
However, cash settlement does not involve any delivery of assets, but just net cash is settled on contract expiration.
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What is Cash Settlement?
Under this method, the contract seller does not deliver the underlying asset but transfers the net cash position.
Say the buyer of a wheat futures contract is willing to settle the contract in cash, he/she is just required to pay the difference between Spot price and Futures price.
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However, the purchaser need not take the physical ownership of the wheat.
In the case of a Futures contract, it is mostly cash-settled unlike a forward contract (which is generally settled by physical delivery) since the exchange monitors the contract ensuring smooth execution.
Cash Settlement Example – Say you go long on 10 wheat contracts whose current market price is Rs 500 per contract.
On contract expiration (assuming it after three months), the price contract went up to Rs 600.
Your gain per contract stands at-
Rs 600 (Final price) – Rs 500 (Entry price) = Rs 100 per contract.
Thus, total profit= Price per contract x Number of contract = 100 x 10= Rs 1000
What is Physical settlement?
Under this arrangement, the actual delivery of asset takes place, which is to be delivered on the specified delivery date, instead of being cash-settled.
Most derivative transactions are traded prior to the delivery date and are not necessarily exercised on expiration.
Physical settlement mostly takes place with commodities but it can also occur with financial instruments.
The settlement of physical delivery is conducted by Clearing brokers or their agents.
Sale and purchase of the underlying asset are reported by the regulated exchange’s clearing organization at the prior day’s settlement price (usually the closing price) soon after the last day of trading.
Traders who went long on the future settlement of the futures contract are obliged to buy them at the current price while those who hold a short position in the asset are required to deliver the asset at the settlement date.
The settlement of derivative contract (whether physically or through cash) will have a significant impact on the future course of the derivative market.
There is often thin liquidity in the case of physically settled contracts on the last day of trading since the traders who are not willing to physically settle their futures contract or are not going to execute their contract have already allowed the trade to expire or exited the market by rolling their position to the next month.
The traders who have a large number of positions can significantly impact the market which often leads to an increase in volatility during expiry.
Electronic trading in the derivatives market has made the market more institutionalized and it has also helped the contracts to evolve, thus creating more efficiency both in the case of traders and funds.
It is not the settlement of the contract that matters for the traders but the cost and liquidity since it will lead to an extended liability on the same.
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