Settlement and delivery options
In the world of finance, settlement of securities, including settlement and delivery options, is a business process whereby the contract is executed on pre-decided settlement date. In the case of derivative contracts of Futures or Optionson the settlement date, the seller of the contract will either deliver the actual underlying asset, which is called the Physical Derivative settlement and delivery options the underlying asset for which the derivative contract has been undertaken.
The second method is the Cash settlement methodin which case the cash position is transferred from the buyer to the seller on the settlement date. What is a Cash Settlement? 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 Sugarcane Futures contract, who wants to settle the contract in cash, will have to pay the difference between the Spot price of the contract as of the settlement date and the Futures price pre-decided. The purchaser is not required to take physical ownership of the sugarcane bundles.
Physical Delivery vs. Cash Settlement
In derivativescash settlement is used in the case of a Futures contract since it is monitored by an exchange, ensuring smooth execution of the contract. With the advent of technology and continuous operating of all the markets, it is relatively easy to fund an account and commence trading without any knowledge of the markets around the club.
The same principle is also applicable in the case of Options contracts.
This refers to a derivatives contract requiring the actual underlying asset to be delivered on the specified delivery date, rather than being traded out net cash position or offsetting of contracts.
The majority of the derivative transactions are not necessarily exercised but are traded prior to the delivery dates. However, physical delivery of the underlying asset does occur with some trades largely with commodities but can occur with other financial instruments.
Settlement by physical delivery is carried out by Clearing brokers or their agents. Traders who hold a short position in the physical settlement of futures contract to expiration are required to deliver the underlying asset. Traders not owning them are obligated to buy them at the current price, and those who already own the assets have to hand it over to the requisite clearing organization.
The role of the exchanges is very critical since they ensure the conditions for the contracts which they cover to ensure the contract is executed smoothly.
Settlement and Delivery Instructions
Exchanges also regulate the locations for delivery, especially in the cases of commodities. The Quality, Grade, or Nature of the underlying asset to be delivered is also regulated by the exchange.
Let us take an instance of a Commodity Futures contract, which is settled by Physical delivery upon expiration. For instance, a trader named Max has taken a long position of a Futures contract the buyer of futuresand upon expiration, he is obliged to receive the delivery of the underlying commodity, which in this case can be assumed to be Corn.
Cash Settlement vs Physical Settlement: A Quick Comparison
In return, Max is required to pay the agreed-upon price of the 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 corm farmer named Gary 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 bushels of CornCorn per acre average estimate and assume he has 70 acres of land.
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As per the exchange rules, every single corn futures contract calls for 5, bushels. Gary will probably sell 2 Futures contracts to hedge his crop every year.
This guarantees to hedge a substantial portion of his total growth. The quantity of CornCorn 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 Corn is assured of good quality once it has been successfully transported to the decided location. A similar process is also applicable to Financials, Metals, and Energy products as well. First Notice Day is notification has to be given to the exchange that the holder desires to deliver or take receive delivery of the underlying commodity of the contract Corn Once the exchange is communicated with the intent, a delivery intention is initiated, and a delivery notice is issued to confirm the commencement of the transaction.
The holder will be responsible for all the transaction costs until the possession of the commodity.
You completed this course. All futures contracts have a specified date on which they expire.
This is generally the process if one wants the physical delivery of the commodity. Mostly, one will just offset the position by purchasing it back if sold first or vice-versa. The broker has all the positions of the investor being monitored on a risk server, settlement and delivery options is dynamic and will intimate the broker whenever the contract is coming closer to a delivery situation.
As time draws near to a First Day Notice delivery situation and the open position still exists, the broker will notify the same to know of possible intentions.
If the holder does not have the full value of the contract, the broker will advise exiting the trade.
Brokers are responsible for any losses or fees towards the clearing exchange, and such expenses and losses are to be borne by the broker and not the brokerage house. This will motivate the broker to act in the best interest of the entire trade. Cash What are the best trading robots vs.
Physical Settlement Infographics Key Differences As the name implies, the Cash settlement method is a mechanism where the parties to a transaction choose to settle the gains or losses through payment in cash after the contract expires, while the physical settlement is a method is a mechanism where the parties to a transaction settle the payment by either paying in cash for securing long position or delivering shares for obtaining the long position.
The cash settlement method carries a minimal or negligible amount of risk, whereas a physical settlement method carries a higher amount of risk.
The cash settlement method offers greater liquidity in the derivatives market, whereas the physical settlement method offers an almost negligible amount of liquidity in the derivatives market.
The cash settlement method is quick since the transactions are supposedly done in cash, and it even takes a minimal amount of time until expiration, whereas physical settlement takes more time.
Contract sellers find the cash settlement method really quick, simple, easy, and very convenient, and this is why the method is extremely popular in the current time. Sellers to a contract will not need to pay extra costs or fees or commission for availing cash settlement transactions.
On the other hand, the physical settlement method is not that easy, and it is time-consuming too. The parties to a transaction will need to pay extra costs for availing physical delivery or physical settlement method.
Updated Apr 14, What is a Cash Settlement?