Cash Settlement – In the fast-paced world of finance, efficiency, and expediency have become paramount. Cash settlement, a mechanism that allows financial transactions to be concluded in cash rather than physical delivery of assets, has emerged as a game-changer in the realm of trading and investment.
It is a method used to fulfill a financial contract’s or derivative’s obligations by making a cash payment instead of delivering the underlying asset. Cash settlement is commonly used in financial markets, particularly for derivative contracts such as futures, options, and swaps.
In this article, we will explain what cash settlement is, how it works, what are its benefits and drawbacks, and what are some examples of cash-settled contracts.
- Invoice Factoring: A Guide for Small Businesses 2023
- Tax Exemption: What It Is and How It Works (Complete Guild)
- Enterprise Risk Management: Frameworks, Benefits, and Challenges
- Virtual Data Room: Everything You Need to Know in 2023
What Is Cash Settlement?
A derivative contract is an agreement between two parties to exchange the value or performance of an underlying asset at a specified date in the future. The underlying asset can be a commodity, a stock, an index, a currency, or any other financial instrument.
There are two ways to settle a derivative contract: physical delivery or cash settlement.
- Physical delivery means that the seller of the contract delivers the actual underlying asset to the buyer at the end of the contract’s term. For example, if a trader sells a futures contract for 100 ounces of gold, he or she must deliver 100 ounces of gold to the buyer when the contract expires.
- Cash settlement means that the seller of the contract pays the buyer the difference between the current market price of the underlying asset and the agreed-upon price in the contract. For example, if a trader sells a futures contract for 100 ounces of gold at $1,800 per ounce, and the market price of gold at expiration is $1,900 per ounce, he or she must pay the buyer $10,000 ($1,900 – $1,800) x 100.
It is more convenient and less costly than physical delivery for many types of derivatives, especially those that involve intangible or difficult-to-deliver assets. Cash settlement also enables investors to speculate on the price movements of assets without having to own or handle them.
How Does Cash Settlement Work?
Cash settlement occurs when a derivative contract expires or is exercised. The process of cash settlement varies depending on the type of derivative and the exchange or platform where it is traded. However, the general steps are as follows:
- The exchange or platform determines the final settlement price of the underlying asset based on its closing price or an average of its prices over a certain period.
- The exchange or platform calculates the net profit or loss for each contract holder based on the difference between the final settlement price and the initial price or strike price in the contract.
- The exchange or platform debits or credits the margin accounts of each contract holder with their respective profit or loss amount.
- The exchange or platform closes out all open positions and clears all outstanding obligations.
What Are the Benefits of Cash Settlement?
Cash settlement has several advantages over physical delivery for both buyers and sellers of derivative contracts. Some of these benefits are:
- Liquidity: It increases the liquidity and efficiency of derivative markets by allowing more participants to trade without having to worry about taking or making delivery of the underlying asset.
- Flexibility: It allows investors to trade derivatives on assets that are not easily deliverable, such as stock indexes, interest rates, or weather conditions.
- Cost-effectiveness: It reduces the transaction costs and risks associated with physical delivery, such as storage fees, transportation costs, insurance premiums, quality issues, or default risks.
- Diversification: It enables investors to diversify their portfolios by accessing different asset classes and markets that may not be available through physical delivery.
What Are the Drawbacks of Cash Settlement?
Cash settlement also has some disadvantages compared to physical delivery for some types of derivatives and investors. Some of these drawbacks are:
- Basis risk: It exposes investors to basis risk, which is the risk that the final settlement price may not reflect the actual market value of the underlying asset at expiration. This may occur due to factors such as illiquidity, manipulation, or volatility in the market.
- Regulatory risk: It may be subject to regulatory changes or restrictions that may affect its availability or terms. For example, some regulators may impose limits on cash-settled contracts to prevent excessive speculation or manipulation in certain markets.
- Tax implications: It may have different tax implications than physical delivery for some investors depending on their jurisdiction and tax status. For example, some jurisdictions may treat cash-settled contracts as ordinary income or loss rather than capital gain or loss.
What Are Some Examples of Cash-Settled Contracts?
Cash settlement is widely used in various types of derivative contracts across different asset classes and markets. Some examples of cash-settled contracts are:
- Futures contracts on stock indexes (such as S&P 500), interest rates (such as LIBOR), currencies (such as EUR/USD), commodities (such as natural gas), and cryptocurrencies (such as Bitcoin).
- Options contracts on stock indexes (such as S&P 500), interest rates (such as LIBOR), currencies (such as EUR/USD), commodities (such as natural gas), and cryptocurrencies (such as Bitcoin).
- Swaps contracts on interest rates (such as LIBOR), currencies (such as EUR/USD), commodities (such as natural gas), and credit events (such as the default).
- Contracts for difference (CFDs) on stocks, commodities, currencies, and indices.
In conclusion, 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 underlying asset but instead transfers the associated cash position.
It has several benefits over physical delivery, such as liquidity, flexibility, cost-effectiveness, and diversification. However, cash settlement also has some drawbacks, such as basis risk, regulatory risk, and tax implications.
It is widely used in various types of derivative contracts across different asset classes and markets, such as stock indexes, interest rates, currencies, commodities, and cryptocurrencies.