Business, Legal & Accounting Glossary
Certain derivative instruments, such as forwards and options, provide for the purchase or sale of some underlier. In many cases, parties to such derivatives don’t want to physically deliver or receive the underlier. Instead, they enter into the derivative contract for purely financial reasons.
For example, an airline might enter into an OTC option contract to hedge its cost of jet fuel. It has established dealers from whom it purchases fuel, so it doesn’t want to take actual delivery of fuel under the option contract. Instead, it negotiates for the option to be cash-settled should it exercise the option, the counterparty will not delver fuel in exchange for payment. It will instead pay the airline the option’s intrinsic value. In this manner, the airline is protected against rising fuel prices but can purchase its fuel through its usual dealers.
A derivative instrument is physically settled if the underlier is to be physically delivered in exchange for a specified payment. With cash settlement, the underlier is not physically delivered. Instead, the derivative settles for an amount of money equal to what the derivative’s market value would be at maturity/expiration if it were a physically settled derivative. In the case of a forward, this equals the notional amount multiplied by the difference between the market price of the underlier at maturity and the forward’s delivery price. In the case of an option, it is the intrinsic value.
Certain types of derivatives are routinely cash-settled because physical delivery would be inconvenient or impossible. For example, an option on a basket of stocks, such as the S&P 500, will generally be cash-settled because it would be inconvenient and entail considerable transaction costs to deliver all five hundred stocks that comprise that index. An interest rate cap has to be cash-settled because the underlier is an interest rate, which cannot be physically delivered.
In commodity and energy markets, people informally distinguish between the physical market and paper market. The physical market encompasses all transactions in which there is physical delivery; cash, spot and physically-settled forward transactions. Paper markets encompass all derivatives transactions that have cash settlement.
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This glossary post was last updated: 16th April, 2020 | 0 Views.