What is the Cash Settlement?
Cash settlement is a settlement option frequently used in trading of futures and options contracts, where at the expiration date the underlying assets are not physically delivered while only the difference is being paid by either of the parties depending on the market rate at that point of time; it is the more convenient and preferred method of settlement as it doesn’t require to take a physical position in any trade.
- Futures and options enable the buyer of the contract to honor the contract by buying the security at a future date; like for instance, the buyer of an equity call optionCall OptionCall Options are derivative contracts that enable the buyer of the option to exercise his right to buying particular security at a pre-specified price popularly known as strike price on the date of the expiry of such a derivative contract. It is important to note that the call option is a right, not an obligation. buys the option to buy the security at a certain price on a certain date, so instead of delivering the security on settlement date they just calculate the difference between the current market price and price mentioned in the contract and that difference is exchanged between the parties.
- Most of the transactions intend to earn from the positive spread by taking a position in any of the securities using these derivative products or futures.
- The buyer doesn’t actually buy the security and just pays a premium to take the position while enjoying the upside without possessing the security, and the cash settlement option lures them to transact more since it is an easy way to settle.
Roles of Cash Settlement
- Cash settlement plays a very vital role in the market since it is enabling liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. in the market and allows more investors to take a position in the market without actually taking exposure in any particular security.
- If an investor is buying 1000 contracts of gold to be purchased at a future date at a pre-decided price, but it is inconvenient for any buyer to physically buy that quantity on the settlement dateSettlement DateThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade.. So, they give ease of doing trading, and it also encourages more trading in the market.
- The main contribution of cash settlement would be to reduce the cost and time for the contract settlement since it is cash-settled, there is only one transaction bound to happen during the end of the contract reducing the cost, and since there is no physical delivery, it saves a lot of time and money resulting in high volumes in the market.
- It is equally safe, too, as cash-settled accounts require margins to trade and they have to maintain a minimum balance in the account to facilitate trading in the market, which kind of ensures the party against any future default.
Example of Cash Settlement
- We will take an example of two investment banks here, Morgan Stanley (MS) and BNP Paribas enter into a Put OptionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated. trade where MS buys the 1000 put contracts of Berkshire Hathway at $8 premium for three months.
- So, as per the contract, MS agrees to deliver the 1000 shares of Berkshire Hathway to BNP after three months on the settlement date, and BNP as a seller of the put option is obliged to buy those at the specified price of $8 per share.
- On the settlement date, the market price turns out to be $10, but MS will still have to sell at $8 since it is the pre-decided price, so it is profit for BNP since it will get the share at $8 instead of $10. This is the scenario in a physical settlement where the security will have to be delivered.
- In this, MS will just pay the difference to BNP of $2, and the deal gets settled; like in this case, MS will pay 1000*2 = $2000 to BNP, and the trade is cash-settled.
Cash Settled Options
- Options work in a similar manner with cash settlement, as we had a look at the example above of the put option.
- The actual delivery is of the cash where the accounts get debited or credited with the difference, and there is no physical delivery of shares to either of the parties.
- This type of settlement in options avoids high costs and transaction fees where securities are not transferred, but the upside is enjoyed by all the traders.
Cash Settlement vs. Physical Settlement
- Sash settlement is a type of settlement where there is no transfer of securities, and only the difference amount is transferred against the physical settlement where securities are ought to be transferred.
- Most of the physical settlement trades are made with commodities in the futures market where the buyer locks in the price of the commodity to avoid the risk of paying the high prices in the future, whereas it is also a common phenomenon in the financial marketFinancial MarketThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.. A cash settlement is done to create the market and increase the trading volume in the derivatives marketDerivatives MarketThe derivatives market is that financial market which facilitates hedgers, margin traders, arbitrageurs and speculators in trading the futures and options that track the performance of their underlying assets..
- They encourage traders to trade more in the market since they only require a margin to take the position in the market.
- The transaction cost is also very limited since there is only one transaction bound to happen in the whole deal, and that is on the settlement day.
- The risk of buying or delivering physical security is not there since the deals are to be cash-settled; this enables more volume in the market as more and more traders will be encouraged to trade.
It is only available with the European optionsEuropean OptionsA European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In layman's terms, once an investor has purchased a European option, even if the underlying security's price moves in a favourable direction, the investor cannot take advantage by exercising the option early. and not on American options; European options are not very flexible as compared to European options as they can only be exercised during the maturity, and an American option can be exercised throughout the life of the transaction.
It is a very practical and convenient way to trade and enable liquidity in the market since it involves low cost and time; however, having said that, it is equally important to keep track of the credibility and financial health of the investors as it only requires a margin to take huge positions in the market.
This has been a guide to what is Cash Settlement and its meaning. Here we discuss the role and cash-settled options along with an example, benefits, and disadvantages. You may learn more about financing from the following articles –