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Cash settlement

Cash Settlement is a method of settling forward contracts or futures contracts by cash rather than by physical delivery of the underlying asset. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires. In forward or future contracts, the buyer agrees to purchase some asset in the future at a price agreed upon today. In physically settled forward and future contracts, the full purchase price is paid by the buyer, and the actual asset is delivered by the seller. For example: Company A enters into a forward contract to buy 1 million barrels of oil at $70/barrel from company B on a future date. On that future date, Company A would have to pay $70 million to company B and in exchange receive 1 million barrels of oil. However, if the contract was cash-settled, the buyer and the seller would simply exchange the difference in the associated cash positions. The cash position is the difference between the spot pri...
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Why do parties use cash settlement?

Cash settlement is useful and often preferred because it eliminates much of the transaction costs that would otherwise be incurred when physically delivering a good. For example, a futures contract on a basket of stocks such as the S&P 500 (SPX) will always be cash settled because of the inconvenience, impracticality, and extremely high transaction costs associated with delivering shares of all 500 companies. Because the costs associated with cash settled contracts are lower, it appeals to both hedgers and speculators. Cash settlement also helps reduce credit risk for futures contracts. When entering into a futures contract, each party must deposit money into a margin account where gains and losses are paid into or taken out of. Futures contracts are cash settled daily and gains/losses are received/paid each day, eliminating the chance that a party will be unable to pay. Most forwards and futures on financial assets are cash settled. For instance, forward...
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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 co...
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Forward contract

A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. However, this also means it is more difficult to reverse a position, as the counterparty must agree to canceling the contract, or you must find a third party to take an offsetting position in. ...
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Economic Importance of the Futures Market

Because the futures market is both highly active and central to the global marketplace, it's a good source for vital market information and sentiment indicators. Price Discovery - Due to its highly competitive nature, the futures market has become an important economic tool to determine prices based on today's and tomorrow's estimated amount of supply and demand. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Factors such as weather, war, debt default, refugee displacement, land reclamation and deforestation can all have a major effect on supply and demand and, as a result, the present and future price of a commodity. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery. Risk Reduction - Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced b...
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Futures

A futures contract is a financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage relative to stock markets. Futures contracts do not refer to future values. Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures. The primary difference between options and futures is that o...
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