Cash settlement is a method of closing out futures and options contracts by exchanging the net cash difference between the strike price and the current market price rather than delivering the physical underlying asset.
Understanding cash settlement
Fellow Elephants, when a derivative contract expires, the buyer and seller must settle their financial obligations. In physical delivery, the actual commodity or security changes hands between the parties. In cash settlement, the parties transfer money based on the final settlement price. This price is determined by the spot market value of the underlying asset at the time of expiration.
Many financial instruments are impossible to deliver physically. Stock market indices and interest rates are intangible concepts. Cash settlement makes it possible to trade derivatives on these underlying assets. It lowers transaction costs by removing the need for the transportation and storage of physical goods.
Speculators and hedgers use cash-settled contracts to gain exposure to price movements without dealing with the logistics of physical commodities. Retail traders prefer this method because they do not have the infrastructure to take delivery of items like barrels of oil or tons of wheat. The settlement process occurs automatically through the clearinghouse of the exchange. The final cash amount is credited or debited directly to the trading accounts of the participants.
Example
Two Elephants enter into a futures contract based on the price of peanuts. Elephant A expects the price of peanuts to rise and buys a contract for 10 tons of peanuts at a strike price of 1,000 currency units per ton. Elephant B expects the price to fall and sells the contract. The contract specifies cash settlement upon expiration.
On the expiration date, the spot market price of peanuts is 1,200 currency units per ton. Elephant A is correct about the price increase. Because the contract uses cash settlement, Elephant B does not need to source, load, and deliver physical peanuts to Elephant A. The clearinghouse calculates the difference between the strike price and the current spot price. Elephant B pays Elephant A the difference of 200 currency units per ton. Elephant A receives a total cash deposit of 2,000 currency units to close the contract.