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The modes of settlement for most options and futures contracts can be either of the following two methods:
1. Cash Settlement
The cash settlement method of settling commodities does not involve the physical delivery of the asset(s) under consideration. It instead involves the settlement of net cash on the settlement date. Cash settlement involves the purchaser or the contract holder to pay the net cash amount on the settlement date and execute the commodity settlement. The net cash amount is the difference between the spot price (SP) and the futures price (FP) of the underlying(s).
2. Physical Delivery
The physical delivery method of settling commodities involves the literal physical delivery of the underlying asset(s) on the settlement date of the contract. The physical delivery settlement process is coordinated and settled via a clearing broker or a clearing agent. If the contract holder opts to take a short position, they are responsible for the physical delivery of the commodity. If the holder opts to take a long position, they will be taking, i.e., receiving physical delivery of the commodity.
Cash Settlement vs Physical Delivery:Popularity and Additional Costs
Cash settlement is the more popular settlement method for commodities because of the convenience and instantaneity the method offers. Also, cash settlement is the more popular method of settlement because of the liquidity it brings to the market.
In addition, because of its popularity, most financial derivatives, especially options and futures contracts, are cash-settled. Cash settlement is the more simple and convenient mode of settlement, as it only involves the upfront net cash amount as the total cost. Settlement transactions do not come with additional costs or fees.
Finally, cash settlement is one of the prime reasons for the increased entry of speculators in the derivatives market. It consequently amplifies the liquidity of the derivatives market, making it a more sought-after mode of settlement.
Unlike most options and futures contracts that, as mentioned earlier, are cash-settled, physical delivery is the more popular mode of settlement for equity options contracts. Physical delivery involves a number of additional costs, including delivery costs, transportation costs, brokerage fees, and so on.
What are Futures Contracts?
A futures contract is a financial derivative. It is a type of forward commitment entered into by parties who agree to purchase or sell a specific underlying asset at an agreed-upon price on a specific future date. Since it is a financial derivative, its price is derived from the price of the underlying asset(s).Futures contracts are standardized contracts, meaning they are traded on the exchange market.
What are Options?
Options are financial derivative contracts that give the buyer the right, but not the obligation, to purchase or sell an underlying asset at a specific price during a specific period of time. The specific price is called the strike price. An investor can exercise American options at any time before the expiry of their option period. However, European options can only be exercised on their expiration date.
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FAQs
Final settlement is the price used by both the buyer (long) and the seller (short) to ultimately terminate a contract. In physical delivery, it represents the invoice price at which the commodity will be sold and change hands. In cash settlement, it is the price to which all financial obligations will be marked.
What is the difference between physical delivery and cash settlement? ›
Cash settlement involves the delivery of only the differential amount without any exchange of securities. It is different from the physical settlement, where securities must be exchanged. Physical settlement predominantly takes place in the futures and options market.
What is the difference between physical and cash settled FX? ›
The main benefit of physical settlement is potential manipulation by either party is removed because the transaction gets checked by the broker and the clearing exchange. The cash settlement method is where parties choose to settle the gains or losses of transactions through payment in cash once the contracts expire.
What are the different types of settlement in commodity market? ›
The modes of settlement for most options and futures contracts can be either of the following two methods:
- Cash Settlement. The cash settlement method of settling commodities does not involve the physical delivery of the asset(s) under consideration. ...
- Physical Delivery.
In the cash settlement method, the parties to a transaction settle by receiving or paying the gains or losses associated with accept cash at the expiry date. Within the physical settlement method, the parties to a transaction settle by delivering equity share for a long position.
Are commodity futures physically settled? ›
For the period up to the last trading day, the Commodity Futures Contracts (physical settlement) are settled through offsetting purchase or sale. * There will be a payment/receipt of the mark-to-market differences during the period from the trade execution to the settlement.
What is the difference between delivery and settlement? ›
DVP stipulates that the buyer's cash payment for securities must be made prior to or at the same time as the delivery of the security. Delivery versus payment is the settlement process from the buyer's perspective; from the seller's perspective, this settlement system is called receive versus payment (RVP).
Which futures are physically delivered? ›
A key feature of WTI Crude Oil futures at CME Group is that they're physically delivered. If a trader has a long or short position in the nearest futures contract at the end of the month, they will have to make or take delivery of actual Crude Oil at the WTI delivery point in Cushing, OK.
What does "commodity being delivered" mean? ›
Delivery of Commodity means delivery of the Commodity to the Customer who has requested to take physical possession of the Commodity.
How does cash settlement work? ›
A cash-settled option is a type of option for which actual physical delivery of the underlying asset or security is not required. The settlement results in a cash payment, instead of settling in stocks, bonds, commodities, or any other asset. This type of option avoids the high costs of transport or transaction fees.
In a physically settled credit derivative transaction such as a credit default swap (CDS), the credit protection seller makes cash payments equal to the par value of the reference obligation to the credit protection buyer upon the occurrence of a credit event with respect to the reference entity (and the fulfillment of ...
What is physically settled vs financially settled? ›
Cash settlement is an arrangement under which the seller in a contract chooses to transfer the net cash position instead of delivering the underlying assets whereas physical settlement can be defined as a method, under which the seller opts to go for the actual delivery of an underlying asset and that too on a ...
What is an example of a CDS cash settlement? ›
Cash Settlement
For example, An Investor buys a bond worth $1,000,000. Assume a recovery rate of 30%, the CDS seller pays compensation of $300,000 to the CDS buyer if the company defaults.
What is difference between cash and delivery? ›
Cash on delivery (COD) stipulates that goods must be paid for at the time of delivery, or else the goods are returned to the seller. Delivery-versus-payment (DVP) is an arrangement whereby securities are only delivered to the buyer once payment has been made.
What does physical delivery mean? ›
Physical delivery is a term in an options or futures contract which requires the actual underlying asset to be delivered upon the specified delivery date, rather than being traded out with offsetting contracts.
What is the physical settlement process? ›
Under the system of physical settlement, if stocks are the underlying asset in any options contract, the seller must deliver stocks and cannot settle the options contract by the transfer of cash according to the price difference between the contract's strike price (the price at which the asset may be bought or sold as ...
