Understanding corporate finance: derivatives: settlement
How derivatives are settled
Although though a derivative may have a deliverable asset as its subject matter, in practice only a very small proportion end with an asset such as a share, gilt or bond, or commodity actually being delivered.
Most contracts are cash settled. In some cases a contract is cash settled because there is no underlying which is capable of being physically delivered. Examples include derivatives where the underlying is an index such as the FTSE 100 (where it would not be realistic to expect that a basket of 100 shares in the right quantities could be delivered), or the weather (where delivery is not possible in any event).
Even where an underlying asset is deliverable, the holder of the contract can opt to receive (or pay) cash when the contract matures rather than taking delivery of the physical asset. In fact some commodity contracts specify that settlement can only be in cash because physical delivery would be very difficult - certain live cattle futures are an example.
It is also usual, especially where exchange-traded contracts (CFM13050) are concerned, for holders of derivative contracts to ‘close out’ their positions by entering into offsetting contracts. This locks in a predetermined net payment when the offsetting contracts mature.
You may also see cases where, although the contract specifies that an asset will be delivered at the end, the parties agree instead to settle their obligations by making cash payments.
Where, under the terms of a derivative, party A is due to make a payment to party B and, at the same time, B is due to make a payment to A, it is very common for the two parties to settle matters by the making of a single net payment.
Example of cash settlement
Acknet Ltd orders raw materials from a US supplier, to be paid for in US dollars. At the beginning of July 2009, it expects to have to pay $1.5 million on 1 September 2009. Since the company wants to be sure how much in sterling terms it will need to pay, it enters into a forward contract with its bank to buy $1.5 million for £1,056,000 on 1 September. But when the shipment arrives there is a quality problem, and payment is disputed. Rather than receiving the $1.5 million, which it no longer needs, Acknet Ltd agrees with the bank to terminate the forward contract by means of a cash payment.
On 1 September 2009, $1.5 million is worth £1,062,500. The bank would therefore be due to pay £1,062,500 to Acknet Ltd, while Acknet Ltd would pay £1,056,000 to the bank. They agree to settle their mutual obligations by a net payment of £6,500 from the bank to Acknet Ltd.
Settlement by delivery
If a derivative contract is closed out by delivery, rather than cash payment, there may be a difference between the asset specified in the contract and the asset which the trader actually receives or delivers. For example, precious metal contracts frequently specify an almost unattainable degree of purity, and a contract would normally be closed out by delivery of a greater weight of less pure metal.
It is also possible for additional payments (or reductions in the amount paid) to be made to compensate for differences in quality or other departures in the delivered commodity from the contract specification. The amounts may be fixed in the contract or under the rules of the exchange or clearing house concerned.