Cash Settlement: Meaning, Process, Benefits and Risks

Derivative contracts do not necessarily involve the physical delivery of the stock, commodity, or any other underlying asset at all times. In most instances, the buyer and seller settle their claims through cash settlement, which involves transferring the difference between the price quoted in the contract and the prevailing market price. The practice is common in finance since it makes derivative trading easier for traders, who need not own the underlying asset.

What is Cash Settlement?

Cash Settlement is one of the ways of settling financial contracts where the two parties involved simply settle the gain or loss in cash form instead of settling the underlying asset. The amount to be settled at the end of the financial contract depends on the difference between the price stipulated in the financial contract and the market price at the time of expiry.

For instance, in case the trader expects the price to go high and the market acts accordingly, then the gain realized is credited into his account. Conversely, any losses incurred are directly deducted from the account.

This type of financial settlement is common in index derivatives since there is no way one can deliver index in the stock markets.

Table of Contents

1. What is Cash Settlement?
2. How Does Cash Settlement Work?
3. Cash Settlement vs Physical Settlement
4. Examples of Cash Settlement

How Does Cash Settlement Work?

The method of cash settlement involves arriving at the difference between the price of the contract and the settlement price at maturity.

The general procedure for cash settlement is as follows:

1. A trader makes a futures or options contract.
2. The contract is held till maturity or settlement.
3. At the time of settlement, the exchange arrives at the settlement price.
4. The difference between the price of the contract and the settlement price is found out.
5. The profit or loss made from the transaction is settled through the account of the trader.

An example could be when an investor takes up an index futures contract at 25,000 points and the settlement price at maturity comes to 25,300 points.  The settlement system for derivatives is highly related to the larger securities settlement system used by the stock exchange. For investors seeking knowledge on the process that takes place following the execution of the trade, there is a guide on trade settlement in India that can provide the details.

Cash Settlement vs Physical Settlement

Even though both systems are employed to fulfill derivative agreements, they involve different processes altogether.

Physical settlement leads to the transfer of ownership of the underlying asset, while cash settlement only involves settling the difference in money. 

While in cash settlement profits and losses are transferred in cash form, in equity markets settlements are done in accordance with a settlement pattern in which the ownership of the security transfers from one person to another. For better understanding of this process, investors should get knowledge of rolling settlement which is widely adopted in India.

Examples of Cash Settlement

Index Futures
Index futures are also very typical cases of cash settlement due to the fact that an index comprises a collection of stocks but not a commodity that can be transferred.

Index Options
In case index options end up profitable, the profits will go straight into the trading account without any delivery of underlying assets.

Currency Derivatives
In certain instances, currency derivatives may also be settled in cash according to the rules of the exchange.