What is a cash settlement?
There are different kinds of contracts, and some of the most famous ones include futures and options contracts. They are derivative instruments which means that their value depends on an underlying asset. These underlying assets can either be a commodity or equity. Futures and options will expire eventually. They can also be exercised. And when these kinds of situations happen, two things can happen.
What happens next?
We mentioned that futures and options have underlying assets like equity or a commodity. First, the contract holder can deliver the commodity physically. Physical deliveries are inconvenient for most. Let us cite some scenarios and examples of why we say this:
- Let us say that an investor shorts a futures contract for $5,000 worth of copper. It is not too convenient for the contract holder to physically deliver the copper to another investor.
- Traders and speculators can engage in futures and markets that they are not interested in. For example, they may engage in trades that involve cattle and livestock even when they are not farmers or in the meat business. However, they are interested in the market price, and they want to make profits. They never wanted to have the animals or products to be delivered to them.
There are many more reasons why the physical delivery of the underlying assets is inconvenient. Most of these traders just want to make a profit. So, the settlement on options and futures contracts is mainly on a cash basis. If a contract ends, the position holder can credit or debit the difference between the initial price and the last settlement.
Let us say that a person bought a corn futures contract with a cash settlement. He needs to pay the corn spot price and the futures price. This usually happens when underlying assets are commodities. In this case, the buyer does not really want to physically receive a massive amount of corn. However, there are other circumstances that delivery takes place, including equity options contracts. The settlement is usually done with a delivery of the actual underlying stock shares.
Why cash settlement?
With all the things that we mentioned earlier, you may already know why cash settlements are preferred by most. But let us try to explore further the benefits that one gets when doing settlements with cash. To name a few:
- Simple and fast. Now that the world has the internet and technology, transferring money is easy and fast. Unlike physical delivery, there is no need to pay fees for delivery, transportation, verification, etc. This makes contract finalization cheaper, faster, and more manageable.
- Security. When you settle with cash, there is no need to worry about defaults because they have a margin account requirement. These accounts are monitored, making sure that they have enough balance for a trade.
Take note of this
While it is true that cash settlements are convenient, they also come with issues. If the contract expires and the assets are not physically delivered, there will be no offset for the hedges before the expiration. Hence, the trader must close those hedges or scan through expiring derivatives positions to replace positions that are about to expire.