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How does cash settlement work?

A quick example would help illustrate the point. Assume Company Z, an airline company, purchases its fuel from local, familiar dealers, but wishes to hedge against rising fuel costs. It buys (take the long position) a futures contract at the price of $50 per barrel to lock in its purchase price. However, it has a long established relationship with local suppliers, and it would prefer to continue purchasing from its established suppliers rather than receive the fuel from the seller of the futures contract.
If the futures contract was physically settled, at expiry Company Z would pay the previously agreed upon futures price, and receive the actual fuel from the seller regardless of the spot price (current market price). If the spot price was $75 a barrel, Company Z has a profit of $25 per barrel, since it pays only $50 per barrel rather than $75. If the spot price was $25 a barrel, Company Z has a loss of $25 a barrel because it must pay $50 a barrel when it could have only paid $25 had it not entered into the contract. By entering into the futures contract, Company Z locks in its purchase price of fuel, effectively removing any uncertainty about the cost of the fuel. 
However, if the contract was cash settled, Company Z would receive the difference in cash between the spot price and the futures price. If the spot price at expiry is $75, Company Z has again earned a profit of $25 per barrel. This is because it only needs to pay $50 per barrel, but can immediately sell it for $75, turning a $25 immediate profit. This is where the convenience of cash settlement makes it desirable. Rather than paying $50 per barrel and receiving the actual fuel, in a cash settled contract the seller of the contract would simply pay Company Z $25, or the difference between the spot and futures price. This allows Company Z to then purchase fuel from its established supplier at the spot (market) price of $75. Since it received the $25 per barrel from the seller of the futures contract, the final net cost to Company Z remains $50 per barrel.
If the spot price were to decrease to $25 per barrel, then Company Z has a loss (since it could buy fuel in the open market for $25, but has locked in the purchase price at $50) and must pay the seller $25. However, despite the loss, it can now buy fuel at the spot price of $25 per barrel, and thus again the total cost is $50 per barrel. 
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Comments

  1. Ashton JonesApril 19, 2012 at 7:53 AM

    I strongly agree with this article. There are a lot of valid points about the directions of numbers used in cash settlements. People have various opinions on what to do in these kind of situations and I feel it is tough to make a good choice and who is right to seek out for financial restitution. It can be troubling especially because it can be so overwhelming to deal with lawsuits and settlements.

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