What is a Cash Settlement?

Cash settlement refers to a settlement method of derivative contracts wherein at expiry or exercise, the seller of the option contract does not deliver the actual (physical) underlying asset (shares of the stock) instead settles it in cash

When does cash settlement take place?

It takes place when:

1. The position is squared off by the trader or;
2. Before the expiry, the trader has not opted for physical settlement

Cash settlement of Derivative Contracts

Cash settlement of Index Futures and Stock Futures  

• Before expiry there is a difference between the spot price and future price which arises due to variables such as interest rates, dividends, time to expiry, etc.
• At expiry however future prices converge to the spot price as time to expiry is zero.
• The cash settlement of futures can be calculated using the following formula: 

Profit / Loss={ [Selling price - Buying price] x Lot size x Number of lots}.

(Profit: When Selling price > Buying price).

(Loss: When Buying price > Selling price).

Note:

• The facility of physical settlement is only available on stock futures and not on index futures. Index futures can only be cash settled.
• In physical settlement, on an open long futures position at expiry, the investor has to take delivery i.e. the stocks are delivered to his/her demat account and he/she has to pay the full contract value. 
• However, if an investor has an open short position at expiry, the investor has to give delivery i.e. he/she is required to deliver the stocks to the exchange. 

Cash settlement of Index Options and Stock Options

• If at expiry, the option is out-of-the-money (OTM), it will expire worthless. The buyer will lose the entire premium and the seller will earn the entire premium.
• If at expiry, the option is at-the-money (ATM), it will also expire worthless. The buyer will lose the entire premium and the seller will earn the entire premium.
• If at expiry, the option is in-the-money (ITM), it will be deemed to be exercised and automatically assigned to short positions in option contracts with the same series. This assignment is done on a random basis. This is an important part of the settlement process for options. The intrinsic value of the ITM option contracts at expiry is the amount that is paid to the holder of the contracts by the seller.
• Option settlement period is T + 1 day; where “T” stands for trading day.

Note: 

• The facility of physical settlement is only available on stock options and not on index options. Index options can only be cash settled.
• STT (Securities Transaction Tax) is higher for options exercised than for options squared off:
• On the sale of an option in securities, the seller of an option has to pay 0.05% STT on the option premium.
• On the sale of an option in securities, where the option is exercised the purchaser has to pay 0.125% STT on the entire contract value.

Benefits of Cash settlement

• Cost effective and time efficient: Cash settlement reduces the cost and time for the contract settlement. There is only one transaction bound to happen during the end of the contract reducing the cost as there is no physical delivery. It saves a lot of time and money thereby facilitating higher volumes in the market.
• Facilitates liquidity: Cash settlement plays an essential role in the market as it enables liquidity in the market and allows more investors to take a position in the market without actually taking exposure in any particular security.
• Limited capital requirement: This is beneficial for traders that do not want to take positions in the cash market and own the asset outright but still want to benefit from it.