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What is the difference between cash settlement and physical settlement?
Let us see first understand what cash settlement and physical settlement are −
Cash settlement
In this net settlement is done with cash on settlement date, that means, it does not involve any physical delivery of assets or asset. In this, contractor pays the difference amount of spot price and future price. Contractor pays difference amount in cash at the time of settlement.
Physical settlement
It involves physical delivery of underlying asset or assets on settlement date. This process is coordinate by clearing agents or brokers. In this, if contractor holds SHORT POSITION then he will responsible for physical delivery. If contractor holds LONG POSITION, then he will receive physical delivery.
The major differences between a cash settlement and a physical settlement are as follows −
| Cash settlement | Physical settlement |
|---|---|
| Seller prefers settlement in cash in delivering the underlying asset. | Date of actual delivery of an asset is chosen. |
| High level of liquidity in derivatives markets. | Negligible or minimum level of liquidity in derivatives market. |
| Instantly done or takes less time. | Takes more time than cash settlement. |
| No cost or less cost involved. | Expensive than cash settlements (involves costs of transportation, delivery etc.) |
| Less risk involved. | High level of risk (involves documents, paper work etc.) |
| Used for settlement of commodities. | Not that simple when compared to cash settlement. |
| More practical as compared to physical settlement. | Used for settlement of contracts (equity options). |
| Pay gain/loss related to contract in cash (in case of expiry). | Less practical than cash settlement. Pay is in form of cash or equity shares in secure of long position. |
Conclusion
Cash settlement is convenient, simple mode and brings liquidity to market and it is more preferable method in future and options contracts where as physical delivery involves additional cots, transportation costs, delivery cost etc. and preferred in options contracts.
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