Cash settlement
Cash settlement
Cash settlement is a method to settle Forwards or Futures contracts for cash instead of making the physical delivery of the underlying asset once the contract expires. The negotiating parties settle the contract by payment/receipt of the loss/gain related to the contract in cash once it expires. In Forwards or Futures contracts, the buyer agrees to purchase an asset in the future at an agreed price at the time the contract is negotiated (the current date).
In Forwards or Futures contracts physically liquidated, the total price of the purchase is paid by the buyer and the real asset is delivered by the seller.
For example, A company negotiates a Forward contract to buy one million barrels of oil at $ 90 / barrel from company B at a future date. On that future date company, A will have to pay $ 90 million to company B in exchange for receiving 1 million barrels of oil.
However, if the contract had been negotiated for the settlement to be made in cash, then 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 an asset on the settlement date of the contract and the agreed price as dictated by the Forwards / Futures contract.
Continuing with the previous example, suppose that on the expiration date of the contract, the price of oil is $ 70 per barrel and that the Forwards / Futures contract specifies that the settlement is made in cash. This means that the buyer, instead of paying the seller $ 70 million for the million barrels agreed in the contract, would have to pay him $ 20 million.
This is the difference between the total price of 1 million barrels of oil that day and the total price of 1 million barrels based on the price agreed in the contract - in this case, the seller would not have to enter any amount of oil at any time. buyer. If, on the other hand, the price of oil on the date of settlement of the contract is $ 100 per barrel, then the seller would have to pay the buyer $ 10 million in cash and would not have to deliver the oil either.
It may seem confusing at the beginning why the cash position is the difference between the spot price at the time of the settlement or expiration of the contract and the price negotiated in the Forwards / Futures contract. Using the example above again, suppose that at the time the contract was liquidated, the price of oil was $ 70 per barrel, and the contract was liquidated physically.
The buyer would have paid the seller $ 90 million and in turn, would have received part of this 1 million barrels of oil. However, because the value of the oil market at the time of liquidation is only $ 70 per barrel, this means that the buyer paid a higher price than the current market price for oil (spot price).
In other words, if company A wanted to immediately sell the oil after receiving it, it would only get $ 70 million, which means it would incur a loss of $ 20 million. The same principle applies if at the time of the expiration of the contract the spot price of oil is $ 100 per barrel; instead of having a loss, company A would have a profit of $ 10 million.
Cash settlement
