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Cash Delivery / Cash Settlement

: Summary

Cash Delivery - Definition

Cash Delivery is when the net profit or loss is settled between the long and short upon expiration of a futures contract without delivery of the actual physical asset.

Cash Delivery - Introduction

Cash Delivery, also known as Cash Settlement, is one of two forms of delivery methods covered by futures contracts in futures trading. The other form of delivery is Physical Delivery.

Cash delivery derived its name from the fact that your profit is delivered to you in cash upon expiration of the futures contract without the obligation of purchasing the underlying asset from the short.

This tutorial shall explore indepth what Cash delivery is and how it is conducted for futures contracts with different underlying assets.

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What is Cash Delivery in Futures Trading?

Cash delivered futures contracts are futures contracts that do not obligate the long to purchase the underlying asset from the short upon maturity of the futures contracts. This means that if you bought a cash delivery futures contract, you won't need to buy the underlying asset upon maturity of the futures contracts. This can be due to the fact that the "underlying asset" isn't a physical asset in the first place (such as an index) or that these futures contracts are cash settled futures contracts written on assets that seperately have physically settled futures contracts available.

In cash delivery, the final profit or loss is settled between the long and the short during final settlement and then the futures contracts cease to exist. There is no obligation to buy or sell the underlying asset at all. In a way, cash delivered futures contracts are merely like betting tickets or lottery tickets between two betters with "wins" and "losses" settled in cash between the parties involved.

Purpose of Cash Delivered Futures Contracts

Cash delivery serves a unique purpose in the futures market and has been gaining importance and popularity in recent years. The fact that cash delivered futures contracts are often also available for assets that comes with physically delivered futures contracts shows that cash delivery serves a unique function in the futures market.

The first and most important purpose of cash delivery is that is enables trading of "assets" that cannot be physically delivered. The most important of such assets are indexes. Index Futures such as the Nikkei225 has been the baby of sophisticated futures traders around the world for decades. An index is nothing more than a number that aggregates the performance of a basket of stocks in a stock market as a reflection of the performance of the overall market or basket of interest. There is no such asset as an index and therefore no way of trading an index before the invention of cash settled futures and options contracts.

So why are cash settled futures also available for assets that can be physically delivered?

Even though futures contracts are invented as a hedging instrument for buyers and sellers of a certain commodity, there are futures traders who trade futures contracts purely on a speculation basis. These futures traders or futures speculators actually forms the majority of futures traders in the futures trading scene. Such futures traders do not trade futures in order to sell or buy the underlying asset but use it only as a leverage instrument to speculate on the price of the underlying asset. Yes, financial leverage is still the main reason why most people get into futures trading. Cash delivery serves the needs of this kind of speculative futures traders 100% and saves futures exchanges the hassle of handling the physical delivery of commodities in the end on contracts that are not offsetted.

Advantages of Cash Delivery

Futures exchanges these days are more willing to deal in cash delivery than physical delivery because it saves them time, money and effort. A lot of resources needs to be coordinated by a futures exchange in order to make sure physical delivery turns out the way it is supposed to be, fair for both parties. Such effort and resources are somewhat distant from the function of modern exchanges as a middleman for financial transactions and futures trading. Futures exchanges would also rather futures traders who are serious about using futures as a hedge on the underlying asset to hedge using cash settled futures and then take delivery of the actual asset through the spot market.

Another advantage of cash delivery is that cash settled futures contracts are theoretically slightly less subject to price cornering by large longs. Price cornering and price manipulation is a problem that is yet to be resolved in futures trading, especially for physically settled futures contracts. However, there has been recent studies on futures trading showing that cash delivery can equally be price manipulated especially on or near last trading day. As such, most retail futures traders would rather offset their futures positions or roll forward way before expiration.

Disadvantages of Cash Delivery

The only apparent disadvantage of cash delivery versus physical delivery is the fact that the actual asset do not exchange hands upon maturity. However, this really isn't much of a disadvantage as serious buyers could still buy the underlying asset in the spot market at the spot price which is usually the basis of final settlement price. The cash settled futures would already have provided the necessary hedge through cash profits.

Simplistic Cash Delivery and Spot Purchase Example:

John wishes to purchase an asset in 1 month's time at $200 per unit. That same asset is trading at $200 per unit right now. John decided to hedge against any price increases on this asset in 1 month's time by going long a cash delivered futures contract on the asset expiring in 1 month's time.

Scenario 1: Asset Rises to $250
John's cash delivered futures contracts profits by $50. John purchases the asset from the spot market at $250. The net amount paid by John for that asset is the $200 that he intended to pay it for in the first place ($200 out of pocket + $50 profit).

Scenario 2: Asset Falls to $150
John's cash delivered futures contracts losses by $50. John purchases the asset from the spot market at $150. The net amount paid by John for that asset is still the $200 that he intended to pay for it in the first place ($150 asset + $50 futures loss).

As you can see from the simple example above, cash delivery also serves the same hedging needs as physical delivery futures for traders who are using futures as a hedge. This is why more and more futures contracts traded in the world are cash delivery futures rather than physical delivery futures.

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