Cash for Settlement
Cash settlement is a way of settling futures contracts or forward contracts by cash instead of delivering the underlying asset as originally agreed upon. The involved parties settle by paying or receiving the loss or gain relative to the contract in cash form once the contract reaches its expiration.
In future or forward contracts, the purchaser agrees to buy some assets in the future at a predetermined price. In future or forward contracts, the actual and full purchase cost is reimbursed by the purchaser, while the actual asset is delivered by the seller. For instance, Enterprise A comes into a forward contract to purchase 1 million barrels of oil with the price of $80 each barrel from Enterprise B on a future date. On such date, Enterprise A will have to provide $80 million to Enterprise B and receive 1 million barrels of oil in return.
However, if the contract is converted to cash for settlement, the purchaser and the seller will just trade the difference in the integrated cash positions. The cash position is the discrepancy between the spot price of the underlying asset on the date of settlement and the established price as stipulated by the futures contract. Following the above example, if on the settlement date, the price of the oil was set at $50 every barrel, the purchaser, will not pay the $80 million, but instead recompense $30 million. This is the discrepancy between the value of 1 million barrels on the date of settlement and the agreed upon priccash settlement. In addition, the seller will not send any oil to the purchaser. However, if the oil price was at $80 each barrel, the seller would disburse the purchaser $10 million settled cash and would not deliver oil as well.
The Settlement Advantages
Settlement cash is advantageous and frequently preferred since it eradicates a huge portion of the transaction fees that would otherwise be acquired when delivering the goods physically. Another example is that in a forward contract involving basket of stocks like S&P 500, for the most part, will end up as advance cash settlement to avoid nuisance, impracticality, and expensive transaction fees linked with delivering shares of the participating companies. Because the costs coupled with cash settled agreements are lower, they became an attractive option to both speculators and hedgers.
Cash settlement can also reduce if not totally eliminate credit risk associated with futures contracts. When getting involved into a forward contract, every party should deposit money inside a margin account where both gains and losses are remunerated into or distributed from the account. Many futures contracts are cash settled every day through settlement loans, thus gains and losses are procured and paid daily, steering clear of the possibility that one party will fail to pay.
Conclusion
Many futures and forward contracts on financial assets become cash for settlement. Forward rate agreements for instance, which are agreements on a rate of interest, are for the most part cash settled since the underlying asset is a specific amount of money that is not deliverable physically. Commodities, while physically settled frequently, may also be cash settled provided that a definite and clear gauge of spot price is contracted ahead of time.