CFA, Financial Products, FRM

Settlement of Futures Contract – Complete Understanding

Settlement of Futures Contract

Derivatives settlement is a business process where the contract is executed on a pre-decided date and at a pre-determined price. On the settlement date, a person having a short position either deliver the actual underlying asset which is called as Physical Delivery for which the derivative contract has been undertaken. The other method is the Cash settlement method in which the cash position is transferred from the buyer to the seller on the settlement date.

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Cash Settlement of Futures Contract:

  • In cash settlement, there is no need for physical delivery of the contract. Instead, transfer of Net Cash position takes place. For an instance, an investor having long position on Gold futures, who wants to settle the contract in cash, will have to pay/receive the difference between the Spot price of the contract and predetermined settlement price.
  • The positions in the futures contracts for each member is marked-to-market to the daily settlement price of the futures contracts at the end of each trade day. The profits/ losses are computed as the difference between the trade price or the previous day’s settlement price and the current day’s settlement price.
  • Let’s take an example where an investor goes long on Crude futures. He enters into the trade at $100 per barrel (One contract has 100 barrels). Suppose crude price rallies and on expiry, it settles at $107. Here investors gains: $107 – $100 = $7 per barrel. Net profit of $7 * 100 = $700 will be credited into the trading account of the investor. At the same time, the seller of futures contract incurred a loss of $700 which will be debited from his account.

Advantages of cash settlement

  • The single largest advantage of cash settlement is that it represents a way of trading Futures on Index which would practically be impossible with the physical settlement.
  • They reduce the overall time and costs required during a contract’s finalization.
  • Cash-settled contracts are relatively simple to deliver because they require the only the transfer of money.
  • Future contracts require a deposit of margin while entering into a trade, it acts as a hedge against credit risk in the futures contract

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Physical Settlement of Futures Contract

  • It is a settlement method where an investor makes/takes actual delivery of the underlying asset at the expiration of the futures contract. Mostly in the futures market, the physical delivery of an underlying instrument occurs in the case of a commodity contract. Crude Palm Oil Futures (FCPO) and Soybean Futures (ZS) are specified for physical delivery.
  • Here, the clearinghouse will select a counterparty for physical settlement (accept delivery) of the futures contract. Typically the counterpart selected will be the one with the oldest long position. So, at the expiry of the futures contract, the short position holder will deliver the underlying asset to the long position holder. Traders not owning underlying instrument are obligated to buy them at the current price and those who already own the assets have to hand it over to the requisite clearing organization.
  • Exchange play a crucial role in physical delivery of futures contract. The Quality, Grade or Nature of the underlying asset to be delivered and Location for delivery is regulated by exchanges.

Advantages and disadvantages of physical settlement:

  • Here cash exchange doesn’t take place hence price manipulation of the underlying instruments is rare.
  • The major disadvantage of physical settlement is an additional cost which is incurred while the delivery of the underlying instrument.
  • The physical settlement does not factor in futuristic change or market fluctuations.
  • Counterparty risk needs to be monitored.

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