Understanding Commodities Settlement: Cash vs. Physical Delivery

The modes of settlement for most options and futures contracts Futures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. Investors may purchase the right to buy or sell the underlying asset at a later date for a predetermined price.can be either of the following two methods:

1. Cash Settlement

The cash settlement method of settling commodities does not involve the physical delivery of the asset(s) under consideration. It instead involves the settlement of net cash on the settlement date. Cash settlement involves the purchaser or the contract holder to pay the net cash amount on the settlement date and execute the commodity settlement. The net cash amount is the difference between the spot price (SP)Spot PriceThe spot price is the current market price of a security, currency, or commodity available to be bought/sold for immediate settlement. In other words, it is the price at which the sellers and buyers value an asset right now. and the futures price (FP) of the underlying(s).

2. Physical Delivery

The physical delivery method of settling commodities involves the literal physical delivery of the underlying asset(s) on the settlement date of the contract. The physical delivery settlement process is coordinated and settled via a clearing broker or a clearing agent. If the contract holder opts to take a short position, they are responsible for the physical delivery of the commodity. If the holder opts to take a long position, they will be taking, i.e., receiving physical delivery of the commodity.

Cash Settlement vs Physical Delivery: Popularity and Additional Costs

Cash settlement is the more popular settlement method for commodities because of the convenience and instantaneity the method offers. Also, cash settlement is the more popular method of settlement because of the liquidityLiquidityIn financial markets, liquidity refers to how quickly an investment can be sold without negatively impacting its price. The more liquid an investment is, the more quickly it can be sold (and vice versa), and the easier it is to sell it for fair value. All else being equal, more liquid assets trade at a premium and illiquid assets trade at a discount. it brings to the market.

In addition, because of its popularity, most financial derivatives, especially options and futures contracts, are cash-settled. Cash settlement is the more simple and convenient mode of settlement, as it only involves the upfront net cash amount as the total cost. Settlement transactions do not come with additional costs or fees.

Finally, cash settlement is one of the prime reasons for the increased entry of speculators in the derivatives market. It consequently amplifies the liquidity of the derivatives market, making it a more sought-after mode of settlement.

Unlike most options and futures contracts that, as mentioned earlier, are cash-settled, physical delivery is the more popular mode of settlement for equity options contracts. Physical delivery involves a number of additional costs, including delivery costs, transportation costs, brokerage fees, and so on.

What are Futures Contracts?

A futures contract is a financial derivative. It is a type of forward commitmentForward CommitmentsA forward commitment refers to a contractual agreement between two parties to carry out a planned transaction, i.e., a transaction in the future. Forward entered into by parties who agree to purchase or sell a specific underlying asset at an agreed-upon price on a specific future date. Since it is a financial derivative, its price is derived from the price of the underlying asset(s). Futures contracts are standardized contracts, meaning they are traded on the exchange market.

What are Options?

Options are financial derivative contracts that give the buyer the right, but not the obligation, to purchase or sell an underlying asset at a specific price during a specific period of time. The specific price is called the strike price. An investor can exercise American options at any time before the expiry of their option period. However, European options can only be exercised on their expiration date.

More Resources

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• American vs European vs Bermudan OptionsAmerican vs European vs Bermudan OptionsThere are different types of options that differ in terms of their exercise restrictions. Let’s explore American vs European vs Bermudan options to find out
• Calendar SpreadCalendar SpreadA calendar spread involves the buying of a derivative of an asset in one month and selling a derivative of the same asset in another month.
• Forward ContractForward ContractA forward contract, often shortened to just "forward", is an agreement to buy or sell an asset at a specific price on a specified date in the future
• Options: Calls and PutsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price.