Updated: Sep 21, 2020
Derivative contracts are executed on predetermined settlement dates. For futures and options, the contract seller can decide for delivery of underlying asset (which is termed as physical settlement) or may simply settle the net position through cash (i.e. cash settlement).
Under this arrangement of physical settlement, the actual delivery of asset takes place, which is to be delivered on the specified delivery date. Most derivative transactions are traded prior to the delivery date and not necessarily exercised on expiration.
Physical settlement mostly takes place for commodities but it can also occur with financial instruments. (e.g. stock) The settlement of physical delivery is conducted by clearing brokers or their agents.
Sale and purchase of the underlying asset are reported by the clearing house of regulated exchange using the settlement price for previous day (usually the closing price) after the last trading day. Traders who hold long positions on the future settlement of the futures contract are obliged to buy them at the current price while those who went short in the asset are required to deliver the asset at the settlement date.
For instance, a trader has bought (taken a long position of) a soybean commodity Futures contract (and upon expiration, he is obliged to receive the delivery of the underlying commodity In return, heis required to pay the agreed-upon price of Futures contract was made for. Additionally, Max is also responsible for any Transaction cost which may include Transportation, Storage, Insurance, and inspections.
On the other hand, there is a soybean farmer who is looking to hedge his crop due to anticipation of possible fluctuation in the market prices in the commodities market. He calculates that he can grow around 100 bushels of soybean per acre (average estimate) and assume he has 70 acres of land.
In this way, Total Bushels = 100*70 =7000 bushels of soybean.
As per the exchange rules, every single corn futures contract calls for 5,000 bushels. The farmer will probably sell two Futures contracts to hedge his crop every year. This guarantees to hedge a substantial portion of his total growth.
The exchange will also state the standard/grade of the soybean which the farmer has to meet. The quantity of soybean in the contract will be thoroughly inspected to make sure it meets or exceeds the specifications which have been stated by the exchange. Post-inspection, the recipient of the soybean is assured of good quality once it has been successfully transported to the decided location
There is often very low liquidity in case of physically settled contracts on the last trading day of since traders who do not want to physically settle their futures contract have already allowed the trade to expire or exited the market by rolling their position to the next month. The traders who have large positions can significantly impact the market which leads to increased volatility just before expiry.
The electronic trading in the derivative market made it more institutionalized and created more transparency and efficiency for traders and funds.
It is not the settlement of contract that matters for the traders but the cost and liquidity since it will lead to an extended liability on the same.
This method of settlement involves the seller of the financial instrument not delivering the underlying asset but transfers the Net Cash position.
For instance, the purchaser of a soybean futures contract, who wants to settle the contract in cash, will have to pay the difference between the Spot price of the contract on the settlement date and the pre-determined Futures price. The purchaser is not required to take physical ownership of the soybean bundles.
Extending the previous example of soybean in the commodities futures market, assuming an investor goes long (buy) on 100 bushels of soybean with a current market price of $10 per bushel. If settlement date is after 3 months post which if the price per bushel increase to $15per bushel, then the investor gains:
$15 (Exit Price) – $10 (Entry Price) = $5 per bushel
Thus, Profit = $5*100 bushels = $500
In this case, the next profit = $500 which will be credited into the trading account of the investor.
On the contrary, if the price falls to $8, then the investor will face a loss of:
$8 (Exit Price) – $10 (Entry Price) = $2 per bushel
Thus, Loss = $2*100 = $200 which will be debited from the account of the investor.
The cash settlement carries a minimal risk while a physical settlement method carries more amount of risk.
The cash settlement offers greater liquidity in the derivatives market while the physical settlement method offers minimum liquidity
The cash settlement transactions are in cash, it is therefore quicker, it takes minimal time until expiration while physical settlement will take more time due to delivery.
Contract sellers consider cash settlement quick, simple, easy, and convenient, they do not need to pay extra costs or fees or commission,
Physical settlement is time-consuming and not so easy. The transaction parties will need to pay extra costs pertaining to delivery, inspection, transportation, brokerage fees etc.
Advantages & Disadvantages
The one large advantage of cash settlement is that it provides a practical way to settle futures trading based on assets and securities which would be very difficult to physically deliver.
Cash settlements have enabled traders to transact contracts on indices, interest rates and certain commodities that are either impossible or impractical to physically transfer.
Cash settlements reduces transaction costs which otherwise would be expenditures in case of physical delivery. E.g. a futures contract on a basket of stocks such as S&P 500 index will always have to be settled in cash due to impracticality and high transaction costs of physical delivery of individual shares of the 500 listed companies traded daily. Other futures contracts such as contracts on where underlying is an interest rate, cannot be delivered physically.
Cash settlements also acts as a hedge against credit risks in case of future contracts. When entering a Future contract, each party has to deposit collateral or performance bond into margin account to settle the net gains or losses. Since these accounts are regulated and monitored, they eliminates the possibility of a party being unable to fulfil the payment. The broker also ensures that the margin account does not fall below the minimum balance.
The primary benefit of Physical settlement is that it is not subject to manipulation by either parties since the entire activity is being monitored by the broker and the clearing exchange. The possibility of the counterparty risk will be monitored.
A major drawback of physical settlement is that in comparison to cash settlement it is a very expensive method since the physical delivery will incur additional costs. Additionally, physical settlement does not factor in market fluctuations.
Though argue that physical settlement can be beneficial to the overall ecosystem as it can aid in achieving at equilibrium price due to physical visibility of the underlying asset which can otherwise be manipulated with.
Whether a contract is to be settled physically or with cash can have an impact on the way the derivatives market can predict its future course. On the last day of trading, physically settled contracts will typically experience thin liquidity as those traders who are not willing to convert their futures contracts to physical goods have already exited the market by rolling out their position to the following month’s delivery date. Accomplished traders with large positions can have a large impact on the price movements and volatility increases towards the expiry date.
Large commercial traders who have the capacity to hold huge delivery may even possess many storehouses of the physical commodity. Therefore the exchange needs be vigilant so that such large traders with large positions do not have impact on the overall price movement of the commodity.
As cash-settled contracts settle before the physically settled contracts, they have less exposure to large traders pushing the contract around as it nears settlement date. Additionally, since financially settled contracts are frequently settled against market indexes, they are widely believed to be less prone to price manipulation than physically settled futures contracts.
As overall derivatives market becomes more institutionalized through electronic trading, the contracts evolve, creating more efficiency of funds and for the traders. The traders are more concerned with liquidity and associated transportation costs associated since the broker will have extended liability over the asset