Cash settlement

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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 price of the asset on the settlement date and the agreed upon price as dictated by the forward/future contract. Continuing from the example above, if on the settlement date the price of oil was $50 per barrel, the buyer, instead of paying the seller $70 million, would pay him $20 million. This is the difference between the price of 1 million barrels on that day and the agreed upon price -- and the seller would not deliver any oil to the buyer. If, on the other hand, the price of oil was $80 per barrel, the seller would pay the buyer $10 million in cash and deliver no oil.

It may seem confusing as to why the cash position is the difference between the spot price at settlement and the agreed upon forward/futures price. Using the example above again, consider if the spot price of oil was $50 per barrel, and the contract were physically settled. It would pay the seller $70 million, and received 1 million barrels in return. However, the market value of the oil is only $50 per barrel, meaning it paid more than the spot (market) price for oil. In other words, if Company A were to sell the oil immediately after it received the oil, it would only receive $50 million, incurring a loss of $20 million. The same principle holds true if the spot price of oil is $80 per barrel at expiry; rather than having a loss, Company A now has a profit.

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 rate agreements, which are forward contracts on an interest rate, are always cash settled because the underlying is an interest rate, which is not physically deliverable. Commodities, while often physically settled, can also be cash settled as long as an observable, undisputed measure of the spot price is agreed upon beforehand. Cash settling commodities lets companies reduce the cost of hedging.

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. bestcashloans.org.uk

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