Why are Forwards / Futures contracts settled in cash?
Why are Forwards / Futures contracts settled in cash?
Cash settlement is useful and often the preferred method of the settlement because it eliminates many of the transaction costs that would otherwise be incurred when the physical delivery of the asset is made.
For example, a Futures contract based on a set or basket of shares such as the S & P 500 index will always be settled in cash due to the inconvenience, impracticability and extremely high transaction costs associated with the delivery of shares of all 500 companies. that make up this index.
Because the costs associated with contracts settled in cash are lower, they are the most used by both speculators and hedgers (agents that protect their investments by investing their capital in other assets and business options in order to anticipate possible future risks ).
Cash settlement also helps reduce the credit risk for Forwards / Futures contracts. When the negotiation and opening of a Futures contract are performed, for example, each trading party must deposit money in a margin account in which the gains and losses produced by the transaction are deposited or withdrawn.
Futures contracts are settled in cash daily and the gains/losses are received/paid each day, which eliminates the possibility that one of the parties will not be able to pay when the contract expires. Most Forwards and Futures on financial assets are settled in cash. For example, Forward rate agreements, which are Forward contracts based on an interest rate, are always settled in cash, because the underlying instrument is an interest rate. interest, which can not be physically delivered.
In the case of commodities such as precious metals, although they can be physically delivered, they can also be settled in cash as long as an indisputable and observable measure of the spot price is agreed in advance. Cash settlement of commodity-based transactions allows companies to reduce the cost of hedging.
