Physical settlement refers to the compulsory settlement of Futures and Options (F&O) trading positions on the day of expiry of the contract. All stock F&O contracts at expiry are required to give or take delivery of the underlying security. The SEBI (Securities & Exchange Board of India) mandated the physical delivery of stocks in 2019 for all F&O stocks to curb the speculation that would result in excessive volatility in individual stocks.
On the other hand, cash settlement in contrast leads to speculative trading where actual asset ownership is not needed. Under physical settlement, the trader has to physically exchange the underlying stocks or pay the full contract value to settle the F&O stock position. Physical settlement ensures that financial contracts end with physical delivery of the real asset instead of simply exchanging money.
Settlement Methods
A derivative contract settles under two ways: physical delivery or cash settlement. Let’s explore:
Physical Settlement: The actual asset like stocks, commodities, or bonds are delivered to fulfill the contract. Delivery margin is the minimum amount of capital, which is required to be maintained in trader’s account to place a trade of certain value. If the delivery margin is not maintained, the trader will have to bear the margin shortfall penalty.
If a trader is unable to close his position till expiry, he will have to settle the contract physically and pay the full contract amount. Physical Delivery brokerage is charged at 0.25% of the physical contract value + STT of 0.1% + 0.05% on Margin shortfall if any.
Example: Mr. Khanna sells 1 lot (1500 shares) of HDFCBANK call options with a strike price of ₹550.
Physical Settlement Price = Strike Price*Quantity
Assuming that the closing price of HDFCBANK on expiry date is ₹650. To physically settle the contract, Mr. Khanna will have to give delivery of 1500 HDFCBANK from his DMAT account against which he will receive a payment of ₹8,25,000 (550*1500)
Example: A trader buys a gold futures contract for 1 kg of gold. On the settlement date, the seller delivers 1 kg of actual gold to him and the trader pays the agreed price for the gold.
Cash Settlement: In cash settlement, there is no exchange of the physical asset. The contract is settled by paying the profit or loss in cash. No delivery of underlying assets occurs. It is common in Index derivatives. Capital requirement is lower. Instead, the trader pays the difference between the agreed price and the market price at the time of settlement in cash. The trader only exchanges profit or loss in cash.
For example, a trader buys a NIFTY Index Futures Contract (reflects the Nifty Index performance). On the settlement date, no physical delivery is done as the underlying is an index itself. Hence in this case, if the index value has risen, the trader will receive profit in cash, otherwise he will bear a loss.
Who Opts for Physical Settlement?
The main traders who opt for it are the investors, hedgers and commodity buyers. They seek to protect against price fluctuations in the underlying asset. They don't want to profit from price changes. They want to secure a future price for an asset they produce or consume.
For example, a farmer who grows wheat may enter a derivative contract to sell wheat at a fixed price in the future. By doing so, the farmer can guarantee a stable income, regardless of whether the price of wheat falls before harvest.
A company that uses oil in its production might hedge against rising oil prices by locking in a price through a futures contract.
Conclusion
Settlement process is chosen by the users depending on their need to either acquire the actual asset or just trading for profit or loss. Settlement approach has to be cautiously gauged and chosen.
SEBI mandates that traders must either deliver the stocks they sold or pay the full price for the stocks they bought to keep the speculative activities in the market at bay. Traders who don’t have the intention to hold the underlying assets may stay away from the market and foster trust in the derivative market.