Cash Settlement is the process wherein a forward, futures or options contract is settled by cash rather than by physical delivery of the goods or stocks or asset involved. Thus cash settlement is used for derivative trades and not those undertaken in the cash market. The parties to the contract settle the trade by paying out or receiving the gain or loss on the contract in cash on the expiry of the contract.
Cash settlement is in contrast to physical settlement of the asset in the following aspects:
- In cash settlement, chance to speculate in the prices is higher, as there is no actual buying or selling of the stock/ financial asset, thus creating an artificial product altogether.
- However, costs related to cash settlement are lower as it helps eliminates transaction costs that would be required to deliver the goods (e.g. commodities)
- Appeals to investors in the stock market as traditionally this method has been adopted for simplicity sake.
- Cash settlement also helps in reducing the credit risk involved in future contracts as the margin is deposited by each party while entering into a future contract. These contracts are settled daily and any gains or losses are adjusted each day, reducing the chance that a party will default in payment of its dues.
An example of cash settlement is:
A trader bought futures on 100 Reliance shares when the futures price was trading at Rs. 1,200 per share. The share price at the settlement date was Rs. 1,250 per share which means that the trader made a profit of Rs. 50 per share for 100 shares. This profit of Rs. 5,000 will be settled in cash instead of delivery of shares of Reliance on the settlement date. Thus the trader will receive Rs. 5,000 as cash on the settlement day.
SEBI has now made physical settlement of stock derivatives mandatory for some stocks and will soon be doing the same for all the stocks in Futures & Options. This is very similar to most international developed markets where the delivery of stocks will be made compulsory on the expiry date of the future if the position is not squared off. This would require the trader to bring in the whole money to get the delivery of the stock, where earlier he could have simply carried forward the future derivative by paying a certain amount of premium, which was considerably low. This would reduce the speculation and will also reduce the volumes across cash and derivatives segment and raise the bid-ask spreads.