What is a Cash Settlement?
How Does a Cash Settlement Work?
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 Does a Cash Settlement Matter?
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.