Definition
Cash settlement and physical settlement are methods used to complete the trade of derivatives such as options and futures. Cash settlement refers to the method where the settlement in these instruments at expiration is done over cash, meaning the profit or loss is just credited or debited from or to the trader’s account. Physical settlement, on the other hand, involves the actual delivery of the underlying asset upon expiration of the derivative contract.
Key Takeaways
- Cash Settlement and Physical Settlement are two methods of settling contracts. In Cash Settlement, the difference in the contract price and the market price at the contract’s end is paid in cash. In Physical Settlement, the actual underlying asset is delivered.
- Cash Settlement is commonly used in financial derivative markets where it would be impractical or inconvenient to deliver physical assets. This method reduces the risk of price fluctuations and is generally faster and more convenient than Physical Settlement.
- Physical Settlement is used primarily in commodity markets but can also be used in some financial markets. This method involves additional considerations such as storage, transport, and insurance of the physical asset. This can make the process more complex and time-consuming than Cash Settlement.
Importance
Cash Settlement and Physical Settlement are two different methods of executing futures and derivatives contracts. The importance of these terms lies in financial risk management.
Cash Settlement involves a cash payment equivalent to the market price of a contract at the point of expiry, reducing risks and costs associated with the delivery, storage or transfer of physical assets. This method is common in financial derivative transactions.
Physical Settlement, on the other hand, involves the actual delivery of the underlying asset described in the contract. This is mainly used in commodity futures contracts and carries risks of default by the counterparty, high cost and logistical complications of physical delivery.
Understanding the difference between the two is crucial for businesses and investors to manage their risks and costs effectively when considering futures and derivatives contracts.
Explanation
Cash settlement and physical settlement are two separate methods used to be in charge of the settlement of futures or options contracts. The purpose of these methods is to provide a way for the contractual obligations to be fulfilled upon the expiration or exercise of the contract. Understanding the nature and the purpose of these two types of settlements is essential for the market participants in financial trading, involved in derivative contracts.
Cash settlement is typically used in contracts that involve stock indices and other financial or non-tangible instruments. In a cash settlement, the payment is made in cash rather than the physical delivery of the underlying asset. It essentially balances out the difference in the contract’s closing price and the strike price.
On the other hand, physical settlement involves the actual delivery of the underlying asset or commodity by the seller to the buyer of the contract. It is usually used for tangible assets like commodities, or financial instruments like bonds and stocks. The purpose is to allow the buyer to take physical possession of the asset, and the seller to effectively sell the asset.
The method chosen largely depends on the nature of the contract and the preferences of the parties involved.
Examples of Cash Settlement vs Physical Settlement
Derivative Contracts: In stock markets, derivative contracts such as futures or options, can be settled in two ways: cash settlement or physical settlement. For example, an investor who has a futures contract on crude oil can opt for a physical settlement, where they would receive actual barrels of oil when the futures contract expires. On the other hand, they can choose a cash settlement in which they get the difference between the futures price and the spot price when the contract expires. Most of the investors prefer the cash settlement because they do not have the ability to store or handle the physical goods.
Insurance Policies: In the insurance world, if an insured object is destroyed, an insurance company can either physically replace the item (physical settlement) or provide a cash payout equivalent to the decided value of the item (cash settlement). So, considering an auto insurance, in case of a car accident that results in a total loss, the insurance company may choose to replace the car (physical settlement) or pay out the actual cash value of the car to the policyholder (cash settlement).
Real Estate Transactions: In a property purchase, physical settlement happens when the ownership of the property is transferred to the buyer, usually by handing over the keys. Cash settlement happens when the buyer transfers the agreed amount of money to the seller. Typically, the transaction involves both, where the physical settlement happens after the cash settlement. This ensures that the buyer doesn’t take possession without paying, and the seller doesn’t receive payment without transferring ownership.
FAQ: Cash Settlement vs Physical Settlement
1. What is Cash Settlement?
Cash settlement is a method used in certain derivatives contracts where, upon expiration or exercise, the seller of the instrument provides a monetary payment to the buyer instead of a physical delivery of the underlying asset.
2. What is Physical Settlement?
In a physical settlement, the seller of the derivative contracts must deliver the underlying asset to the buyer at the expiration of the contract. This is less common than cash settlement because of the additional cost and complexity of transferring ownership of a physical asset.
3. What is the main difference between Cash and Physical Settlement?
The main difference between cash and physical settlement is the way the contract is settled at expiration. With cash settlement, the seller makes a payment to the buyer in cash. With physical settlement, the seller delivers the actual underlying asset to the buyer.
4. Which type of settlement is most commonly used?
Cash settlement is more commonly used because it is simpler, less expensive, and more convenient than physical settlement. It is particularly common in contracts where the underlying asset is difficult to transfer physically.
5. Can a trader choose between Cash and Physical Settlement?
The type of settlement is typically specified in the contract terms when the derivative is initiated. Some contracts may give the holder the right to choose between cash and physical settlement, but this is not typically the norm.
Related Entrepreneurship Terms
- Derivatives Contracts
- Clearing House
- Settlement Date
- Contract Obligations
- Futures Contract
Sources for More Information
- Investopedia: A comprehensive website providing definitions of financial, investing and trading terms including Cash Settlement vs Physical Settlement.
- Bloomberg: A global information and technology company, that provides financial news and information, including articles about Cash Settlement vs Physical Settlement.
- Reuters: A financial news website that also provides financial tools and education, including topics on Cash Settlement vs Physical Settlement.
- Financial Times: An international daily newspaper printed in broadsheet and posted online that covers business and economic current affairs, including Cash Settlement vs Physical Settlement.
