Introduction

Understanding how contracts get settled is essential for Indian derivatives market investors. Derivatives are options and futures that derive value from underlying asset performance, i.e., stocks, commodities, or indices. Once these contracts have expired, they 'settle,' or close, based on one or two factors: cash or delivery. Each method of settlement has its aspects, advantages, and disadvantages. Therefore, traders must understand these to differentiate between the two and make informed trading decisions.

Here is an article discussing settlement methods related to the Indian Market.

What is Cash Settlement?

Cash settlement is simple because it involves exchanging cash instead of the parties to a derivative contract having to settle their contractual obligations and deliver an underlying asset. The money exchanged is simply the price difference when the contract was entered into and the market price at expiry, versus the entry price of the contract. For example, if you have a futures contract on the Nifty 50 index, and at expiry the value of the index is higher or lower than the entry price, you either receive or pay the cash difference, as there is no underlying physical asset exchanged.

Cash settlement is commonly used for equity derivatives, such as index-based contracts like Nifty 50 or Bank Nifty futures and options in India, and some commodity contracts where the delivery of the physical asset is not feasible, such as gold futures on the Multi Commodity Exchange (MCX). It is popular with retail investors and speculators who want to benefit from price movements without taking delivery of the asset.

Benefits of cash settlement:

Simplicity: There are no logistics to consider, such as storage or transportation, which makes it more affordable for investors.

Ease of access: This benefits investors by allowing them to make trades without physically managing the asset.

Flexibility: It caters to speculators interested in price movement without intending to be the asset owners.

Shortcomings:

There is no ownership of the underlying asset, which can be problematic for investors who choose to hold ownership of the commodity itself.

Limited utility offered to hedgers who need to obtain the actual asset to transfer the risk.

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What is Physical Delivery?

Contrast that with physical delivery, which is the direct exchange of the underlying asset from seller to buyer at contract expiry. For commodities, in futures contracts for crude oil or agricultural items like soybeans, actual delivery of the underlying asset happens. For example, a seller delivers 100 barrels of crude oil (in a futures contract) to the buyer. Physical delivery occurs in India in commodity markets with exchanges like MCX and NCDEX under occasional equity options contracts for select stocks.

Institutional investors prefer the delivery method, as do hedgers or companies needing physical assets for their operations, such as jewellery businesses requiring gold or farmers needing to deliver wheat. However, for all its advantages, it can add lots of logistics for demanding storage, transportation, and verification of the quality of the underlying asset.

Advantages of Physical Delivery:

It provides actual possession of the asset, which is especially important for market participants having physical commodity operations.

Returns more closely to the actual price supply and demand.

Suitable for hedgers trying to get rid of a price risk by accessing the asset.

Drawbacks:

Citizens must also consider new costs associated with warehousing and transport.

Requires infrastructure, which may be an issue for retail investors.

Cash Settlement Vs Physical Delivery

The choice of cash settlement or the physical delivery of an asset depends on an investor's goals, the individual's resources, and the surrounding market conditions. Here are a few of the differences.

Settlement Facility: Cash settlement involves a financial transaction, which is only an exchange of money, whereas physical delivery requires an exchange of the actual asset.

Settlement Complexity: Cash settlement is different because it involves a financial transaction and does not have logistical complications. Physical settlement requires logistical coordination to set up storage and transport to receive the asset.

Settlement Costs: Cash settlement is generally straightforward and, therefore, usually cheaper than physical delivery, especially since you have avoided handling fees. Physical delivery usually involves more costs because of the logistics involved.

Settlement Use: Cash settlement dominates equity derivatives based on India's Nifty 50 index futures. However, physical delivery contracts, such as those for agricultural products and gold, are typically used in commodity markets.

Investor Type: Cash settlement is appropriate for speculators and retail traders because there is no actual receipt of the asset, whereas physical delivery is more appropriate for hedgers or physical businesses that also require the asset.

Which Should You Choose?

For Indian investors, it depends on your trading goals. For example, suppose you are a retail investor trading Nifty options to take advantage of market price movements. In that case, cash settlement is attractive in terms of low cost and simplicity. But if you are a business owner or manufacturer, for example, who might need raw materials, physical delivery gives you the actual asset to use in your business. Each exchange has its rules, so make sure you know them. The National Stock Exchange (NSE) primarily cash settles equity derivatives, but commodity exchanges like MCX could enforce physical delivery on some contracts.

Conclusion

As you can see, understanding the difference between cash settlement and physical delivery is critical to better grasping India's derivatives marketplace. Cash settlement is simple and offers flexibility that retail traders can appreciate, while physical delivery is about ownership of your asset and is ideal for hedgers and business users. Aligning with your personal goals and investing capabilities as an investor is the perfect way to establish a trading plan that works for you.

If you need clarification, always refer to the exchange rules or ask your financial advisor to ascertain that your actions comply with market practices and financial goals.

Related Blogs - Cash Settlements: Meanings, Benefits and Examples | How to trade gold in India: a step-by-step guide to Commodity Derivatives | What is Physical settlement in Options