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Definition: Cash Settlement
Cash Settlement is a method of settling certain forwards, futures and options contract by cash rather than by physical delivery of the underlying asset. Settlement takes place by paying/receiving the loss/gain related to the contract in cash on contract expiration.
The value of options and futures contracts are based on an underlying asset that may be purchased and sold upon exercise (determined by the price) or expiration (determined by the date). The holders of these contracts are generally not concerned with the ownership of the underlying stock or physical commodity. As a result, the majority of the holders choose to settle with cash; settling the contract with the spread between the spot value of the underlying asset and the price mentioned in the contract either recognizing a gain or a loss. For sellers unwilling to take the actual possession of the underlying commodity, cash settlement is a more convenient method of settling futures and options contracts.
For example consider a cash settlement for a put options contract, on contract expiration the spot price in the market of the underlying stock A is Rs 50. The price specified in the contract is Rs 40. Under the terms of the contract, the writer of the put must purchase the underlying stock at the exercise price. If the contract is settled in cash, he or she will incur a Rs 10 loss.
Example for a futures contract can also been seen. Suppose, on contract expiration, the spot price of the underlying asset in the market is, Rs 100. The price mentioned in the contract is Rs 150. Under the terms of the contract, the long must purchase the underlying asset at expiration. Rather than receiving some pre-determined quantity of underlying asset, the contract holder who has a short position takes a cash settlement of Rs 50 (Rs 150 contract – Rs 100 market).