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Learn about cash settlement and physical delivery, how they work, their advantages, and key differences.
In financial markets, contracts can be settled either through physical delivery or cash settlement. Understanding the difference between these two settlement methods is important for traders and investors to make informed decisions and manage their positions effectively.
Physical delivery is a settlement method in which the actual underlying asset of a contract is delivered to the buyer upon contract expiry. This method is commonly used in commodity markets, futures contracts, and certain equity derivatives. It requires logistical arrangements to transfer the asset from seller to buyer.
Cash settlement is a method of settling contracts by paying the net cash difference between the contract price and the market price at expiry. No physical asset is exchanged; instead, the profit or loss is calculated in monetary terms. This method is widely used for index futures and derivatives where physical delivery is impractical.
Physical delivery and cash settlement are two distinct settlement mechanisms used in financial and commodity markets, each suited to different asset types and trading objectives.
Nature of settlement: Physical delivery requires the actual transfer of the underlying asset from the seller to the buyer, whereas cash settlement involves only a monetary adjustment based on price differences.
Process complexity: Cash settlement is faster and operationally simpler, while physical delivery involves logistics, documentation, and acceptance of the asset.
Asset suitability: Physical delivery is typically used for tangible assets such as commodities, while cash settlement is preferred for indices, derivatives, and non-physical instruments.
In physical delivery, settlement is completed through the actual exchange of the underlying asset:
Asset transfer: The seller delivers the agreed quantity and quality of the underlying asset to the buyer within the stipulated timeframe.
Ownership confirmation: Relevant documents, certificates, or warehouse receipts are exchanged to establish legal ownership.
Payment settlement: The buyer makes payment as per the contract terms and settlement schedule.
Completion: The transaction concludes once the asset is delivered, verified, and formally accepted by the buyer.
Cash settlement finalises contracts without transferring the underlying asset:
Price comparison: The contract price is compared with the market price at expiry or settlement.
Profit or loss calculation: The difference between these prices determines the gain or loss.
Account adjustment: The net amount is credited or debited to the trader’s account.
No physical exchange: Settlement occurs entirely in cash, with no movement of the underlying asset.
Physical delivery involves the actual transfer of the underlying asset at settlement and has the following benefits:
Assured ownership: Confirms legal ownership of the underlying asset, making it suitable for participants seeking possession.
Practical use or resale: Enables investors or businesses to use, store, or sell the asset in the physical market.
Relevance in commodity markets: Particularly useful in commodities and real assets where delivery has commercial value.
Lower speculative exposure: Reduces purely speculative activity by requiring commitment to actual delivery.
Cash settlement concludes trades by exchanging price differences instead of assets, providing operational convenience:
Simplified settlement process: Eliminates the need for handling, transferring, or verifying physical assets.
No logistics or storage costs: Avoids expenses related to warehousing, transportation, and insurance.
Speed and efficiency: Allows quicker settlement, especially for index-based or derivative contracts.
Reduced operational risk: Removes delivery-related risks such as quality disputes or settlement failures.
Here's a comparison between Deferred Tax and Tax Payable:
| Aspect | Physical Delivery | Cash Settlement |
|---|---|---|
Nature of settlement |
Involves the transfer of the actual underlying asset. |
Involves only the transfer of the cash price difference. |
Speed of settlement |
Takes longer due to delivery and verification processes. |
Faster due to simplified cash-based settlement. |
Cost implications |
May include transportation, storage, and insurance costs. |
Avoids logistics and storage-related expenses. |
Market suitability |
Typically used for tangible assets such as commodities. |
Typically used for indices, derivatives, and non-physical assets. |
Risk exposure |
Includes delivery, quality, and storage-related risks. |
Eliminates physical delivery and operational risks. |
Understanding the differences between cash settlement and physical delivery helps investors and traders choose the appropriate method for their contracts.
Key points to remember:
Physical delivery involves actual transfer of assets, while cash settlement involves only monetary adjustment.
Cash settlement is commonly used for indices and derivatives due to operational simplicity.
Physical delivery is typically chosen when the actual asset is required for use or resale.
Knowing the advantages and limitations of each method ensures improved risk management.
This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.
Physical delivery settles a contract by transferring the actual underlying asset to the buyer.
Cash settlement settles a contract by paying the net cash difference between the contract price and the market price at expiry, without transferring the asset.
Physical delivery transfers the actual asset, while cash settlement transfers only money based on contract price differences.
Cash-settled contracts pay the difference in cash, while stock-settled contracts involve transferring shares of the underlying stock to fulfill the contract.
Anshika brings 7+ years of experience in stock market operations, project management, and investment banking processes. She has led cross-functional initiatives and managed the delivery of digital investment portals. Backed by industry certifications, she holds a strong foundation in financial operations. With deep expertise in capital markets, she connects strategy with execution, ensuring compliance to deliver impact.
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