Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Cash Settlement

What it is:

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.

How it works (Example):

Options and futures contracts are valued based on an underlying security or commodity that may be purchased or sold upon exercise (determined by a price) or expiration (determined by a date). The holders of these contracts are seldom concerned with ownership of the stock or physical commodity. As a result, the majority of holders choose to settle with cash; fulfilling the contract with the spread between the current spot value of the underlying asset and the price specified in the contract (could be a gain or a loss).

To illustrate a cash settlement for a put options contract, suppose a contract expBies and the spot price in the market of the underlying stock X is $100. The price specified in the contract is $75. Under the terms of the contract, the holder must make the purchase, which is $25 higher than the price in the contract ($100 market - $75 contract = $25). If the contract holder settles in cash, he or she will incur a $25 loss.

To illustrate a cash settlement using a put futures contract, suppose a contract expires and the spot price in the market of the underlying asset (let's say oranges) is, $100. The price specified in the contract is $150. Under the terms of the contract, the holder must purchase the oranges. Rather than receive some pre-determined quantity of oranges, the contract holder takes a cash settlement of $50 ($150 contract - $100 market).

Why it Matters:

In most cases, investors purchase derivatives contracts for options and commodities with the expressed hope and intention of profiting from a positive spread in the contract/market price upon exercise or expiration of the contract. In this respect, the cash settlement of such contracts (be it a gain or loss) in lieu of receipt or delivery of securities or commodities represents the de-facto fulfillment of a contract's terms.