Define: Cash Settlement

A cash settlement is a payment in cash for the value of a stock or commodity underlying an options or futures contract upon exercise or expiration.

A cash settlement refers to a resolution of a legal dispute or claim where one party agrees to pay a specified amount of money to the other party. This agreement is typically reached outside of court and is binding upon both parties. The cash settlement serves as a means to resolve the dispute and avoid further litigation.

Cash settlement is a device used instead of physical deliveries to fulfil futures contract obligations upon contract maturity. In 1981, cash settlement was first applied to trading futures contracts in Eurodollar time deposits and to three different stock indexes. Since then, the method has been adapted to trading in seven more items on U.S. exchanges. Interestingly, some of these are physical rather than financial.

Moreover, many proposals embodying cash settlements are pending before the Commodity Futures Trading Commission (CFTC) and more are in prospect. Mostly, they reflect a wish to get around the intractable problems of delivery for items that are not now traded on futures exchanges but that can be well standardised and accurately described. These items cover a very broad field. Also, they reflect a wish to convert some existing futures contracts that have chronic delivery problems to cash settlements.

What is a cash settlement?

Under a cash settlement, the seller, who has not offset his or her contract by the end of trading, in effect gives the buyer a sum of money equal to the current economic value of the item less the sum the buyer originally agreed to pay. Therefore, only the difference needs to be paid by the seller to the buyer, or by the buyer to the seller, according to whether the price rose or fell during the contract interval. In practice, periodic additions to or subtractions from each party’s margin account are made during the life of the contract, according to the daily changes in the settlement prices. Thus, the final adjustment is the final “marking to the market” of the contract’s value at the end of the last day—based, however, on a reading of cash prices for immediate delivery or of some type of index. Clearly, the final futures price should not be determined on its own; to do so would permit the settlement to become quite artificial.

The final value of the futures contract is determined by a formula to which both parties subscribe on entering the contract. The formula requires objective numbers or informed estimates of what these numbers are. For cash settlement contracts to work, traders of futures contracts must have confidence that the settlement is a reasonably accurate reflection of current commercial values.

Potential Applications Of Cash Settlement Contracts

Commodities that are perishable, require special handling, or are geographically dispersed make physical delivery on futures relatively costly. For these, cash settlements may appear to be an attractive idea. The cash price indexes have their own problems, however. In practice, the indexes may be constructed from price quotations representing somewhat different grades, locations, or timing of transactions, or they could merely reflect different perceptions of price. In any case, for a futures contract to become actively traded over a substantial period of time, the changes in the index number must correlate fairly closely with changes in the individual prices facing a substantial number of hedgers; also, the index number must not be easily manipulated.

For financial instruments, physical delivery may entail various difficulties. There may be legal barriers to assigning a debt claim to a third party. The quality of debt issues deliverable on a futures contract may vary. If discounts are given for less desirable issues, these could turn out to be inadequate. If an index is traded on futures, the sellers may incur large costs if they are required to deliver certificates. Each of these difficulties could be bypassed if good price quotations with which to compute cash settlements were available for the items.

Designers of conventional contracts often try to deal with this matter by adding delivery points, but setting accurate differentials is difficult. Each added delivery point increases uncertainty for the longs and imposes added costs of taking delivery. If there is more than one delivery point, the long hedger who takes delivery must generally bear the costs of selling the commodity received on delivery and buying a similar quantity where it is wanted. The costs of selling out-of-location deliveries are avoided by cash settlement. This solution, however, requires a substantial body of good cash market prices with which to determine cash market values.

This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.

This glossary post was last updated: 11th April, 2024.