Introduction
When most investors begin their journey in equity investments, they often start with the stock market. The idea is simple: buy shares at a low price and sell them when the prices increase to make a profit.
However, experienced investors know that relying solely on stocks can be risky. They diversify their investments across different asset classes as a hedge against the risk involved. One effective diversification strategy that many investors use is trading derivatives, which allows them to choose an underlying asset.
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Understanding derivatives can be confusing for new investors as it involves both physical and cash settlement. Let's learn more about the concept of cash settlement and its various implications.
What is a cash settlement?
In futures contracts, cash settlement is used when physical delivery of the underlying asset is not feasible. Instead of transferring the actual commodity, the seller transfers the corresponding cash position upon contract expiration or exercise. This approach enables investors to participate in derivative markets by injecting cash, ensuring faster and more cost-effective settlements.
For instance, let’s consider a gold futures contract where you are the seller. The contract states that you agree to sell 50 grams of gold at Rs. 60,000/10 grams. On the day of contract expiry, the market price of 10 grams of gold reaches Rs. 65,000. With its physical settlement, you now need to send 100 grams of gold to the buyer, amounting to a total of Rs. 3,00,000. However, with cash settlement, you can pay Rs. 50,000 to the buyer, reflecting the price difference.
What is the difference between Cash Settlement vs. Physical 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. Especially in commodities, it allows buyers to lock in the process and avoid future cost fluctuations.
On the other hand, cash settlement serves the purpose of fostering a market and increasing trading volume in a derivatives market. It eliminates the need for physical asset transfers, thereby streamlining transactions, enhancing market liquidity, and providing flexibility to traders in managing their positions.
How does cash settlement work?
Futures and options contracts are derivative securities linked to the value of an underlying asset, like stocks and commodities. Upon expiration or execution, contract owners have the choice of physical delivery or transferring the actual shares/commodity.
However, physical delivery is time-consuming, that’s where the cash settlement comes in. In futures and options, cash settlement involves bridging the price difference by sending cash to the buyer instead of physically delivering the underlying assets. This streamlined approach simplifies the process and offers greater flexibility in settling contracts.
What are the benefits of cash settlement?
Cash settlement provides the following benefits to the sellers:
- Hassle-Free: Cash settlement eliminates the need for physical asset delivery, sparing investors from arranging storage and finding buyers, streamlining the process.
- Transparent: With cash settlement, upfront margin requirements ensure mitigated default risks. Daily trade monitoring fosters transparency, ensuring a smooth and trustworthy trading experience.
- Cost and Time Effective: Cash settlement avoids physical delivery, thereby reducing costs. Moreover, settlements are swift, taking minutes, with funds reaching your account within days.
Cash settlement also provides several benefits to the buyers. It saves buyers from transaction costs, risks of loss or damage, and efforts of securely receiving and delivering assets. These advantages apply to stock trading as well. Here, the physical settlement requires additional efforts of buying or selling stocks in the market to realise profits. Cash settlement spares traders from the stress and risks associated with these subsequent steps, making the process more efficient and hassle-free.
To conclude
Cash settlement provides practicality and convenience. It fosters market liquidity with low cost and time requirements. However, it is crucial to assess investors' credibility and financial health before proceeding further. With cash settlement, investors can obtain a significant market position by paying the margin. Thus, responsible risk management is essential before proceeding further.
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