Cash Settlements

Cash settlement is a method wherein the settlement of futures and forward contracts is done by cash, rather than the delivery of the underlying commodity. The parties who are a part of these cash settlements contract usually pay their loss or receive their profit in cash at the end of the contract.

In usual futures or forward contracts, the buyer would agree to buy the underlying asset at a stipulated price in the future and would get the commodity in return for the cash paid. But the case is slightly different with cash settlements. The buyer here does not pay the entire amount but pays or gets the difference between the spot price and the agreed upon price at the time of entering into the contract. For example, in a futures contract, A decides to buy 1 million barrels of oil at the rate of $70 per barrel at a specified future date from B. Even if the price of a barrel goes down from $70 to $60, A would still buy 1 million barrels of oil from B at the rate of $70 per barrel at the end of the contract. However, if the contract was a cash settlements contract, then A would not buy the barrels but would give the difference of $10 per barrel for 1 million barrels to B at the expiration of the contract.

Most people prefer cash settlements because transaction costs are eliminated and there is no physical delivery of goods. Cash settlements are more practical and convenient for people.