Commodities Cash Settlement Vs. Physical Delivery
Table of Contents
Difference Between Commodities Cash Settlement And Physical Delivery
The primary difference between commodities cash settlement and physical delivery lies in the nature of the settlement involved. Commodities cash settlement involves the settlement of commodities in cash without any physical delivery of the underlying assets. In contrast, physical delivery involves settlement through physical delivery of the underlying asset. Therefore, cash settlement offers more flexibility and simplicity in trading over physical delivery, which requires coordination and commodity storage.
Key Takeaways
- Cash settlement for commodities refers to the settlement of consumables in cash without actual delivery of the underlying item.
- Contrary to popular belief, physical delivery entails actual deliveries of the underlying asset and settlement using the commodity it represents.
- Cash settlement allows traders and investors to enter or exit positions quickly without physical transfer or exchange.
- Physical delivery is important for industries and commercial buyers to gain timely and reliable access to commodities.
Comparative Table
| Cash Settlement | Physical Delivery |
|---|---|
| It does not involve any physical delivery of the underlying asset. | It involves the physical delivery of the underlying asset. |
| All the trade settlement happens in cash. | All the trade settlement happens through transfer of the underlying commodity. |
| It has lesser requirements for logistical coordination. | It has requirements for logistical coordination for storage. |
| It helps lower the transaction cost to a great extent. | It increases the transaction cost to a great extent. |
| It shields from exposure to disruptions in the supply chain. | It requires exposure to disruptions in the supply chain. |
| It requires exposure to disruptions in the supply chain. | It has the characteristics of being a time-consuming and complex trading process. |
| It may be utilized for speculative trading. | It could be used for hedging and speculative purposes both. |
| Cash settlement is easy to design and works for any market and its participants. | Physical delivery required an exchange to devote significant time and investment. |
| Most of the financial markets use it. | It gets mostly used in all physical markets. |
What Is Commodities Cash Settlement?
Commodities cash settlement refers to a method where the full and final settlement of a commodity futures contract gets done utilizing cash without involving any physical delivery of the underlying asset. In addition, one could say that it acts as an agreement between the seller and the buyer to exchange only a commodity's value in cash instead of actually transferring the underlying commodity on the settlement date. The cash payable is calculated as the difference between the spot and futures prices of the asset in question.
For example, suppose an investor opts to go short on a gold futures contract worth $5,000. In that case, it will not be possible for the commodity holder to deliver the commodity physically to the person in concern. As a result, they make it a cash-settled deal by paying the investor the net cash.
Cash settlement is one of the most common settlement modes of settling trades as it is more convenient and offers instant action. As a result, most of the futures and options contracts are settled using this means. Such an approach provides several other advantages, like lower transaction costs and flexibility over the physical delivery settlement. Another important benefit it offers is the elimination of any need for storage plus transportation of physical commodities, making it a faster and more convenient process.
Moreover, it allows greater liquidity in the market, given that the contract settlement is usually done without any need for actual physical transfer, exchange, or commodity here. As a result, traders and investors who wish to enter or exit positions immediately use the cash settlement more often as it helps them in their hedging activities or speculative trading.
It is mostly used in commodity futures trading, which involves silver, agricultural products, gold and crude oil as the underlying asset, giving it an edge to investors and traders over the physical delivery of commodities.
What Is Physical Delivery?
Physical delivery refers to the method of settlement of futures contracts wherein the underlying assets, like commodities, get transferred physically to the buyer from the seller upon the end of their agreement. Moreover, it can be understood as a system of trade where no cash value gets involved. Rather, the actual transfer of physical goods or commodities takes place. In the process, if a trader chooses to short a position, they must deliver the commodity or asset in question. On the other hand, if traders go doe a long position, they would receive the delivered products under the contract.
Furthermore, if the buyer wants to physically deliver their commodity at their specified location from the seller, there must be seamless coordination between logistics providers, seller, and buyer. Hence, the transaction cost of trading a commodity is inclusive of the cost of its transportation plus storage charges, which increases the overall transaction cost. As a result, the physical delivery of commodities becomes less attractive to traders.
Nevertheless, for industries and commercial buyers who need the commodity to be delivered to their location in physical form to use in the production or operation of their business, then physical delivery becomes important and beneficial to them. Besides, physical delivery also allows this buyer to get timely and reliable access to the underlying commodity.
Also, traders utilize it for hedging purposes, where they lock in a commodity's price for future delivery, leading to managing the price risk of the commodity. Furthermore, it ensures that the buyer gets their commodity at increased certainty, agreed upon price and risks related to price dynamics. Hence, one can say that physical delivery helps those in need of physical commodities or for using futures contracts for hedging purposes despite the high transaction costs and logistics associated with it.
Similarities
Though there are a number of differences between these two concepts, they share a set of similarities, too, given their prominence in the commodities markets. Let us quickly check out the similarities between the commodities cash settlement and physical delivery below:
- Both get used for settling futures contracts.
- The funds' transfer is common in both.
- Both are used in hedging against the price fluctuation of commodities in the market.
- Both procedures involve a certain degree of risk.
- Both are governed by market regulations and standards.
- Both affect the supply and demand of the commodities in the market.
