Risk Management Basics
- Derivatives Basics
- Put-Call Parity
- Forwards vs Futures
- Spot Rate
- Forward Rate Formula
- Cash Settlement vs Physical Settlement
- Backwardation vs Contango
- Residual Risk
- Best Futures Books
- Futures vs Options
- What are Options in Finance?
- Exercise Price (Strike Price)
- In the Money
- Options Trading Strategies
- Call Options vs Put Options
- Options vs Warrants
- Writing Call Options
- Writing Put Options
- Gamma of an Option
- Options Trading Books
- International Option Exchanges
- Interest Rate Derivatives
- Interest Rate Swap
- Swap Rate
- Random vs Systematic ErrorÂ
- Equity Strategies
- Swaps in Finance
- Embedded Derivatives
- Commodity Derivatives
- Commodity Risk Management
- Managed Futures Strategy
- Top 7 Best Books on Derivatives
- Structured Finance Jobs
- Commodities Trading Books
- Best Commodities Books
Differences Between Cash Settlement and Physical Settlement
In the world of finance, settlement of securities including derivatives is a business process whereby the contract is executed on a pre-decided settlement date.
In case of derivative contracts of Futures or Options, on the settlement date, the seller of the contract will either deliver the actual underlying of the asset which is called as Physical Derivative of the underlying asset for which the derivative contract has been undertaken.
The second method is the Cash settlement method in which case the cash position is transferred from the buyer to the seller on the settlement date.
Let us discuss cash settlement vs physical settlement in detail:
- What is Cash Settlement?
- Advantages and Disadvantages of Cash Settlement
- What is Physical Settlement / Delivery?
- Advantages and Disadvantages of Physical Settlement
What is Cash Settlement?
This method of settlement involves the seller of the financial instrument not delivering the underlying asset but transfers the Net Cash position. For instance, the purchaser of a Sugarcane Futures contract, who wants to settle the contract in cash, will have to pay the difference between the Spot price of the contract as of the settlement date and the Futures price pre-decided. The purchaser is not required to take physical ownership of the sugarcane bundles.
In derivatives, cash settlement is used in the case of Futures contract since it is monitored by an exchange ensuring smooth execution of the contract.
Extending the previous example of sugarcane in the commodities future market, assuming an investor goes long (buy) on 100 bushels of Sugarcane with current market price of $50 per bushel. Assuming, the settlement date is after 3 months post which if the price per bushel increase to $60 per bushel, then the investor gains:
$60 (Exit Price) – $50 (Entry Price) = $10 per bushel
Thus, Profit = $10*100 bushels = $1000
In this case, the next profit = $1000 which will be credited into the trading account of the investor.
On the contrary, if the price falls to $45, then investor will face a loss of:
4.9 (1,067 ratings)
$45 (Exit Price) – $50 (Entry Price) = $5 per bushel
Thus, Loss = $5*100 = $500 which will be debited from the account of the investor.
With the advent of technology and continuous operating of all the markets, it is relatively easy to fund an account and commence trading without any knowledge of the markets around the club.
The same principle is also applicable in the case of Options contracts. To illustrate a cash settlement for a Put Options Contract, let us assume a Contract of Microsoft, expires on the last Thursday of the month and the spot price in the market is $100. The price specified in the contract is $75. This simply means the put contract was undertaken with the hope that the share price will fall below $75. However, now that the price is $100, the holder must make the purchase at $100 instead of $75. Hence if there were 5 lots of options to be purchased, then the net loss for the holder will be:
$100 – $75 = $25 per lot and Thus, Total Loss = $25*5 = $125.
Advantages and Disadvantages of Cash Settlement
- The single largest advantage of cash settlement is that it represents a way of trading Futures & Options based on assets and securities which would practically very difficult with physical settlement.
- Cash settlements have enabled the traders to buy and sell contracts on indices and certain commodities which are either impossible or impractical to physically transfer.
- It is a preferred method since it helps in reducing the transaction costs which otherwise would be expenditure in case of physical delivery. For e.g. a futures contract on a basket of stocks such as S&P 500 will always have to be settled in cash due to inconvenience, impracticality and high transaction costs attached with physical delivery of shares of the 500 listed companies getting traded on a daily basis.
- It also acts as a hedge against credit risks in case of future contracts. When a party enters into a Future contract, to ensure their intentions are clear, each party has to deposit a minimum amount of money in their Margin account. This account is essential for regular operations of such derivative contracts. It is used for settling the net gains or losses. Since these accounts are regularized and monitored daily, it eliminates the possibility of a party being unable to pay the monetary amount. The broker is also responsible for ensuring that the margin account does not fall below the minimum balance.
The primary Disadvantage of cash settlement in case of Options is that it is available only on European style options which are not flexible as American options and can only be exercised at its maturity. Similar feature is also applicable for Futures contract as well.
Most Futures and Forward contracts on various financial assets are settled in cash. For instance, Forward rate agreements, which are generally forward contracts on Interest rate, indicates the underlying is an interest rate, and thus such contracts have to be settled in cash. Such contracts cannot be delivered physically. Commodities, generally physically settled, also have the possibility of settlement in cash long as an undisputed spot price is available and mutually agreed upon. Cash settlement also reduces the companies cost of hedging.
What is Physical Settlement / Delivery?
This refers to a derivatives contract requiring the actual underlying asset to be delivered on the specified delivery date, rather than being traded out net cash position or offsetting of contracts. Majority of the derivative transactions are not necessarily exercised but are traded prior to the delivery dates. However, physical delivery of the underlying asset does occur with some trades (largely with commodities), but can occur with other financial instruments.
Settlement by physical delivery is carried out by Clearing brokers or their agents. Immediately, after the last day of trading, the regulated exchange’s clearing organization shall report a sale and a purchase of the underlying asset at the prior day’s settlement price (normally the closing price). Traders who hold a short position in the physical settlement of futures contract to expiration are required to deliver the underlying asset. Traders not owning them are obligated to buy them at the current price and those who already own the assets have to hand it over to the requisite clearing organization.
- The role of the exchanges is very critical since they ensure the conditions for the contracts which they cover to ensure the contract is executed smoothly.
- Exchanges also regulate the locations for delivery especially in the cases of commodities.
- The Quality, Grade or Nature of the underlying asset to be delivered is also regulated by the exchange.
Let us take an instance of Commodity Futures contract which are settled by Physical delivery upon expiration. For instance a trader named Max has taken a long position of a Futures contract (buyer of futures) and upon expiration he is obliged to receive the delivery of the underlying commodity which in this case can be assumed to be Corn. In return, Max is required to pay the agreed upon price of Futures contract was made for. Additionally, Max is also responsible for any Transaction cost which may include Transportation, Storage, Insurance and inspections.
On the other hand there is a corm farmer named Gary who is looking to hedge his crop due to anticipation of possible fluctuation in the market prices in the commodities market. He calculates that he can grow around 150 bushels of corn per acre (average estimate) and assume he has 70 acres of land.
In this way, Total Bushels = 150*70 = 10,500 bushels of corn.
As per the exchange rules, every single corn futures contract calls for 5,000 bushels. Gary, will probably sell 2 Futures contract to hedge his crop every year. This guarantees hedging a substantial portion of his total growth.
The exchange will also state the standard/grade of the Corn which the farmer has to meet. The quantity of corn in the contract will be thoroughly inspected to make sure it meets or exceeds the specifications which have been stated by the exchange. Post inspection, the recipient of the Corn is assured of good quality once it has been successfully transported to the decided location. Similar process is also applicable to Financials, Metals and Energy products as well.
This trade of Corn can be broken down in the following steps for granular understanding:
- One would have to be holding a Future contract with a long position for a Commodity Futures contract with physical delivery post the First Notice Day.
- First Notice Day is notification has to be given to the exchange that the holder desires to deliver or take receive delivery of the underlying commodity of the contract (Corn)
- Once the exchange is communicated with the intent, a delivery intention is initiated and a delivery notice is issued to confirm the commencement of the transaction.
- The holder will be responsible for all the transaction costs till the possession of the commodity.
This is generally the process if one wants the physical delivery of the commodity. Mostly, one will just offset the position by purchasing it back if sold first or vice-versa. The broker has all the positions of the investor being monitored on a risk server which is dynamic and will intimate the broker whenever the contract is coming closer to a delivery situation. As time draws near to a First Day Notice (delivery situation) and the open position still exists, the broker will notify the same to know of possible intentions. If the holder does not have the full value of the contract, the broker will advise to exit the trade.
Brokers are responsible for any losses or fees towards the clearing exchange and such expenses and losses are to be borne by the broker and not the brokerage house. This will motivate the broker to act in the best interest of the entire trade.
Also, checkout the difference between Futures vs Forwards
Advantages and Disadvantages of Physical Settlement
The primary benefit of Physical settlement is that it is not subject to manipulation by either of the parties since entire activity is being monitored by the broker and the clearing exchange. The possibility of the counterparty risk will be monitored and consequences are known for the same.
- A major drawback of physical settlement is that in comparison to cash settlement it is a very expensive method since the physical delivery will incur additional costs to maintain the same for a long period of time till it reaches the doorstep of the buyer.
- Additionally, physical settlement does not factor in futuristic change or market fluctuations.
Though some do argue that physical settlement can be beneficial to the overall ecosystem in the future as it can aid in achieving at equilibrium price due to the physical visibility of the underlying asset which otherwise can be manipulated with.
Conclusion – Cash Settlement vs Physical Settlement
Whether a contract is to be settled physically or with cash can have an impact on the way the derivatives market can predict its future course. On the last day of trading, physically settled contracts will typically experience thin liquidity. This is because those traders who are not willing to convert their futures contracts to physical goods or are not going to execute their options contract have already exited the market by either rolling out their position to the following month delivery date or allowing the trade to expire. Accomplished traders with large positions can have a large impact on the price movements and hence volatility increases as one heads towards expiry of the trade. This is often termed as “Time Value of Money” which is also factored in while arriving at the strike price of a trade. Large commercial traders who have the capacity to hold the delivery may even possess storehouses of the physical commodity. The exchange has to be vigilant so that such large traders with large positions do not have an impact on the overall price movement.
Since the cash settled contracts settle before the physically settled contracts, they have less exposure to large traders pushing the contract around as it nears closer to the settlement date. Additionally, since the financially settled contracts are frequently settled against indexes, they are widely believed to be less prone to price manipulation than physically settled future contracts.
With the overall derivatives market becoming more institutionalized through electronic trading, the contracts themselves evolve, creating more efficiency of funds and for the traders. For the traders, it is not the method of settlement that matters but the liquidity and transportation costs associated since broker will also have an extended liability towards the same.