Cash Settlement vs Physical Settlement

Derivatives Definition

A derivative is a financial contract that derives its value from an underlying asset. The foremost common sorts of derivatives are futures, options, forwards, and swaps. Derivatives contracts are either cash-settled or physically delivered on the expiry date of the contract. When a contract is cash-settled, the internet cash position of the contract on the expiry date is transferred between the customer and therefore the seller.

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Cash Settlement vs Physical Settlement

1)Definition

Cash settlement is often defined as a way or an arrangement during which the vendor of a contract prefers to settle the transaction in cash rather than delivering an underlying asset.

Physical settlement is often defined as a way or an appointment during which the particular delivery of an asset is chosen which is meant to be delivered on a specific date. e.g. shares, commodities, etc.

2)Liquidity

A cash settlement offers a better rate of liquidity.

Physical settlement offers minimal or no liquidity.

3) Cost

The cash settlement contract involves lower or zero costs until expiration. This method of settlement might not end at the additional expense of any kind of commission or fees. Physical settlement contract can comparatively be little expensive since it involves a series of additional contracts like transportation cost, warehouse cost, delivery cost, etc

4) Risk

Cash settlement has a lower level of risk because it doesn’t require any specific product it’s to be cash-settled.

The physical settlement has a higher level of risk because it required a lot of documentation like transfer certificate, product standardization, etc. if such requirements aren’t met it’ll be risky.

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5) Settlement

Cash settlement is straightforward for settlement because it involves net settlement in cash, however, the physical settlement is often complicated because it involves the physical settlement of commodity.

6) Popularity

Most derivatives contracts are cash-settled. physical settlement takes place mostly for equity options.

7) Mode of settlement

In the cash settlement method, the parties to a transaction settle by receiving or paying the gains or losses associated with accept cash at the expiry date. Within the physical settlement method, the parties to a transaction settle by delivering equity share for a long position.

Author: Akshay Patil

About the Author: When I write I learn something new which acts as a value addition towards my career in finance.

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