Cash Settlement

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.

cash-settlement-example

source: cmegroup.com

Explanation

Roles of Cash Settlement

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For eg:
Source: Cash Settlement (wallstreetmojo.com)

Example of Cash Settlement

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

Advantages

  • 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.

Disadvantages

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.read more 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.

Conclusion

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.

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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 –