How does settlement cash work? In settlement cash, a forward or futures contract is settled by cash instead of delivering physically the underlying asset. Agreement between the buyer and the seller is settled by paying/ receiving the loss or gain relevant to the contract in cash at its expiry. In this contract, both parties establish an agreement that the price of the asset to be purchased in the future be agreed upon today or on the date of settlement.
There are several reasons why parties use cash settlement. The physical delivery of assets may be costly. Transaction charges or costs are incurred with it. Through the contract, transaction costs can be surely diminished or lowered. It also eliminates the chance of each party’s being unable to pay his dues. Thus credit risks are reduced because each party ought to deposit an amount into a margin account for the gains and losses. This transaction shall take place on a daily basis.
Going back to the question above, how does settlement cash work? We can elaborate on how settlement cash at forward and futures contracts actually work by an illustration. In a physically settled forward and futures contract, say for instance person A purchases an asset from person B. In this scenario, person A is the buyer and person B is the seller of the asset. The agreed price on the settlement date is $100 for one unit of such asset. Before the asset is delivered, the buyer must pay the full purchase price. If the spot price or the current market price of that asset is $75, the buyer will have a loss of $25 since he paid $100 to procure such asset. On the other hand, if the spot price is higher than the agreed future price, let’s say $150, the buyer will have a profit of $50 for the same reason.
In the cash settled forward or futures contract, person A will receive the difference in cash between the spot price and the agreed future price. In the example above, if the spot price is higher than the fully paid purchase or agreed future price, person A will have a profit of significant amount and can even generate an immediate profit by selling the asset at the current market price.
The amount paid by the buyer to the seller is pre-settlement cash since payments have to be made before the entire settlement cash process is closed and that delivery of the asset is undertaken.