Physical and Cash Settlement: What Actually Arrives

Cash settlement closes a position with one payment, struck on the final settlement price. Physical settlement closes it by moving the reference asset one way and the whole agreed price the other. The net to each side is identical either way. The two arrangements part company only on what has to be found on the last morning: a difference, or a whole price and a whole thing.

Every promise eventually has to be discharged, and a promise that references something has only two honest ways to end. Either the two sides work out the difference between the price they agreed and what the thing turned out to be worth, and one of them pays that difference to the other, or one side hands over the thing and the other hands over the money. There is no third arrangement hiding behind those two. The arithmetic ends in exactly the same place under both, and what has to be in the account on the morning of the last day does not.

Identical results, wildly different preparations. Almost every mistake made in this corner of the machinery comes from getting that pairing backwards. Readers assume the two arrangements produce different results and demand similar preparations, and the truth is the exact reverse. Both ends of the equality are worked below on one set of figures, so the equality can be checked rather than taken on trust.

What figures does the arithmetic run on, and where did they come from?

One invented set of numbers is fixed before anything else happens, and everything below runs on it. There is a reference asset, invented for this guide, standing in for whatever a contract might reference. Its spot price is Rs 2,000.00/-, and that same Rs 2,000.00/- is the exposureThe value of the referenced thing that one position stands on. It is the base a margin percentage is struck on. It is not an amount that changes hands. carried by one unit. The exposure is a PRICE. The reference asset pays nothing at all while it is held. A payout during the holding period would change every carried figure below, and these figures carry no payout.

Financing costs 6.50 per cent a year. Carry one unit for a year at that rate and the cost of carrying it is Rs 2,000.00/- multiplied by 0.065, or Rs 130.00/-. The price agreed today for delivery in a year is then Rs 2,000.00/- plus Rs 130.00/-, or Rs 2,130.00/-. Rs 2,130.00/- is the agreed priceThe price a position was struck at. It is fixed the moment the two sides agree and it does not move afterwards, whatever the referenced thing does. throughout, and the agreed price is a PRICE. Rs 2,130.00/- is arithmetic on a financing rate, and arithmetic on a financing rate forecasts nothing. The reference asset may be worth anything at all in a year. Buying it now with borrowed money costs Rs 2,130.00/- by then, so a promise to sell it for less than that would be somebody handing out money.

Against the position sits collateral. The initial margin used throughout is 8.0 per cent of the Rs 2,000.00/- exposure. On one unit that comes to Rs 160.00/-, and the 8.0 per cent is a teaching figure rather than a requirement anybody has set. The requirement actually asked for is set by clearing corporations under the framework of the Securities and Exchange Board of India (SEBI) at sebi.gov.in. The requirement differs by contract and by day, and it moves, so it is read at the source rather than carried away from any secondary account. The invented figure earns its place through the ratio it exposes. Rs 2,000.00/- of exposure standing on Rs 160.00/- put up is 12.50 times, and an adverse move of 4.0 per cent of the Rs 2,000.00/- exposure, or Rs 80.00/-, is 50.0 per cent of the Rs 160.00/- put up. The relationship survives whatever the real percentage turns out to be.

One more party, and it is deliberately faceless. Standing between the two sides of every position is a clearing corporationThe party that stands between the two sides of a position, so that neither side has to look at the other.. The clearing corporation is left unnamed, and naming one would drop a real institution into an invented example. The participant carrying the position is called the position holder, another invention for teaching.

Physical Settlement vs Cash Settlement: what is the one difference the rest follows from?

Before either arrangement gets a definition, hold on to the single question they answer differently. The question is what actually arrives. Under one arrangement a payment arrives and nothing else moves at all. Under the other the thing itself moves in one direction and the whole agreed price moves in the other. Every further difference between them, and there are several worth knowing, falls straight out of that one.

Run the everyday version alongside it. The everyday version does the work of a paragraph. A household agrees in the summer to buy its winter stock of grain at a fixed price, settled in advance so that neither side is exposed to the winter price. When winter arrives there are two ways to be honest about that bargain. The household can take the grain and pay the whole agreed price. Delivery needs a truck, a store room, and the whole price in hand. Or the two sides can read the grain price on the day and settle the difference between that price and the agreed price in cash. Settling in cash needs neither a truck nor a store room, only the difference. Both of those are complete and honest settlements of the same bargain. Only one of them involves grain.

Notice what did not differ in that example. In both endings the household ends up in the same economic position relative to the bargain it struck. If grain is dear, it gains, whether the gain arrives as grain worth more than the price paid or as a cash difference. If grain is cheap, it loses, in exactly the same size, and in exactly the same way. The arrangement changes the logistics and the readiness, never the result.

What is cash settlement, said completely and on its own?

Under cash settlementClosing a position with one payment, struck on the price determined for the last day. No referenced thing moves and neither side ever holds it., the last day arrives, a final settlement priceThe price that closes the obligation itself on the last day of a contract. Unlike the price on an ordinary day, nothing follows it to correct it. is determined, the position is revalued against that price one last time, and the difference between it and the price the position was struck at moves between the two sides. Then the position is gone. Nothing else changes hands, on either side, at any point. The reference asset never moves. Neither side ever holds it, before or after, and neither side needs anywhere to put it.

The shape of that ending is smaller than people expect. One number is determined. One subtraction is performed. One payment moves. The entire ending of a cash settled position is a single arithmetic operation followed by a single transfer. Such a small ending is why cash settlement can exist for contracts written on things that could not be handed over at all, and why cash settlement is the arrangement most readers have quietly assumed applies everywhere.

How the final settlement price is arrived at, and from what, is set under the framework of SEBI at sebi.gov.in. The method matters enormously. The final settlement price is the number the whole ending hangs on, and the method behind it differs by contract and moves over time, so the method is read from the source itself.

One thing is worth pinning down while cash settlement is fresh, and readers slip on it more often than anywhere else. The payment that moves at the end is a PAYMENT. The final settlement price is a PRICE. A payment and a price are different objects that sit in the same sentence, and only one of them actually travels. At a final settlement price of Rs 2,400.00/- against an agreed price of Rs 2,130.00/-, the price is Rs 2,400.00/- and the payment is Rs 270.00/-, being Rs 2,400.00/- less Rs 2,130.00/-. Confusing them is the commonest error in the whole of this machinery.

What is physical settlement, said completely and on its own?

Under physical settlementClosing a position by moving the referenced thing itself in one direction and the whole price the position was struck at in the other., the last day arrives and the two sides do something quite different. The party bound to buy pays the whole agreed price and receives the reference asset. The party bound to sell produces the reference asset and receives the whole agreed price. The word whole is doing the entire job here. The amount that moves is not the difference between two prices. The amount that moves is the price itself.

On the figures worked here, the buyer pays Rs 2,130.00/-, all of it, and one unit of the reference asset arrives. Not Rs 270.00/-. Not Rs 530.00/-. Rs 2,130.00/-, in full, on that day, against a thing that has to be there to receive. And the seller has to actually have the reference asset, or be able to get hold of it. Producing the thing is an entirely separate problem from having been right about the price.

The separation between those two capacities is the failure worked at the end of this walkthrough. Being right about where a price went and being able to produce a thing are two unrelated capacities. Because the obligation is not about the price at all on the last day, a position holder can have judged the price perfectly and still be unable to discharge it. The obligation is about the thing.

Note also what physical settlement does not require. Physical settlement does not require either side to want the reference asset. Wanting it is irrelevant. The contract said the thing would move, so the thing moves, and whether either party has any use for it is a question the arrangement never asks. Delivery feels different from every other part of this machinery, where wanting and choosing do most of the work.

Why is the net the same under both while the gross is not?

Now the reconciliation, and it is the sharpest arithmetic in this guide. The case is a long position agreed at Rs 2,130.00/- on one unit of the reference asset, worked at a final settlement price of Rs 2,400.00/-, both ways, with the same figures on both sides.

Under cash settlement, the final settlement price is Rs 2,400.00/-, the agreed price is Rs 2,130.00/-, and Rs 2,400.00/- less Rs 2,130.00/- is Rs 270.00/-. One PAYMENT of Rs 270.00/- moves to the long position. The ending is complete.

Under physical settlement, Rs 2,130.00/- leaves the long position as a PRICE paid, and one unit of the reference asset arrives. The unit is worth Rs 2,400.00/-. Rs 2,400.00/- is what the last day determined it to be worth. So the position has given up Rs 2,130.00/- and received something worth Rs 2,400.00/-, and Rs 2,400.00/- less Rs 2,130.00/- is Rs 270.00/-. The same Rs 270.00/-, to the paisa, arrived at by a route that shares not one step with the other.

Now the direction that convinces people. The first direction can still feel like a coincidence. Run it backwards. Suppose the position settles in cash, so the holder receives a PAYMENT of Rs 270.00/-. Suppose the holder then simply buys one unit of the reference asset in the market at Rs 2,400.00/-, the price the last day determined. Total money out: Rs 2,400.00/- paid, less the Rs 270.00/- received, is Rs 2,130.00/-. Total holding: one unit of the reference asset. Which is precisely, and to the paisa, where the physically settled position stands. Rs 2,130.00/- gone, one unit held. Neither route is the cheaper one. The two routes do not lead to two places, they lead to one.

Work the falling case properly. A prediction is worth nothing until it has been checked. Under cash settlement, the final settlement price is Rs 1,600.00/-, the agreed price is Rs 2,130.00/-, and Rs 2,130.00/- less Rs 1,600.00/- is Rs 530.00/-. One PAYMENT of Rs 530.00/- moves away from the long position. Under physical settlement, Rs 2,130.00/- still leaves the long position as a PRICE paid, in full, and one unit still arrives, only now that unit is worth Rs 1,600.00/-. Rs 1,600.00/- less Rs 2,130.00/- is minus Rs 530.00/-. The same shortfall, the same size, arrived at the same way.

And the backwards direction holds too. Settle in cash, pay out Rs 530.00/-, then buy one unit in the market at Rs 1,600.00/-. Rs 530.00/- plus Rs 1,600.00/- is Rs 2,130.00/-, one unit held. Identical again. The match is not a coincidence at two prices but an identity at every price. The settlement price appears once on each side of the comparison and cancels.

Set the two endings side by side as a table and the pattern is unmissable. Read the NET column downwards: it never differs. Read the columns beside it: they differ by a great deal.

The difference in what travels can be sized on these figures. At a final settlement price of Rs 2,400.00/-, the money leg alone under delivery is Rs 2,130.00/- against a cash payment of Rs 270.00/-, and Rs 2,130.00/- divided by Rs 270.00/- is 7.89 times. Counting both legs of the delivery, the Rs 2,130.00/- of money and the unit worth Rs 2,400.00/-, Rs 4,530.00/- of value travels to produce Rs 270.00/- of net. The multiple there is 16.78 times. At a final settlement price of Rs 1,600.00/- the same two multiples come out at 4.02 times and 7.04 times. The cash payment is larger there. The multiple is not a fixed property of either arrangement. Work it at the price in hand rather than remembering it as a rule of thumb.

Is that difference in what travels just bookkeeping, or does it cost something real?

The difference is not bookkeeping. Take the words apart first. The grossThe whole amount that changes hands, rather than the difference between amounts going in both directions. is the whole of what moves in each direction. The netWhat is left after amounts running in both directions have been set against each other. It is the figure that describes the position; the gross is what has to be found. is what is left once the movements in both directions have been set against each other. On these figures the net at Rs 2,400.00/- is plus Rs 270.00/- under both arrangements, and the gross under delivery includes a Rs 2,130.00/- payment that somebody has to actually have.

The real cost sits there, and it is not measured in rupees of profit or loss. The cost is measured in readiness. A cash settled ending needs the difference in the account. A physically settled ending needs the whole price in the account on one side, and the whole thing in hand on the other. Two endings that are identical on the result can be very far apart on what has to be true about the position holder on the morning they happen.

The household with the winter grain feels this precisely. Settling the difference means finding a few hundred rupees. Taking delivery means finding the whole price and somewhere dry to put fifty kilogram sacks. The bargain was the same bargain. The Sunday before was not the same Sunday.

At which moment does the question stand, and why does that change the answer?

Everything above is worked at one particular moment: the final date. The equality is a property of that moment and not of the arrangement in general. A one for one offset between a thing held and a contract sold cancels rupee for rupee at the final date, and it does not cancel mid life. Run the arithmetic and see why.

Suppose there is still a full year to run, and the spot price of the reference asset falls from Rs 2,000.00/- to Rs 1,920.00/-. The fall is a gap of Rs 80.00/- on a base of Rs 2,000.00/-. And the contract price? The contract price is still spot carried for a year at 6.50 per cent a year, so it becomes Rs 1,920.00/- multiplied by 1.065, or Rs 2,044.80/-. Against the agreed price of Rs 2,130.00/-, that is a gap of Rs 85.20/- on a base of Rs 2,130.00/-. Not Rs 80.00/-. Rs 85.20/-, and the carry applies to the new spot exactly as it did to the old one.

So a position holder who is long one unit of the reference asset and short one contract on it does not hold something that nets to nothing on an ordinary day. The two legs move by Rs 80.00/- and Rs 85.20/- respectively, and the offset is over complete before the end and exact only at it. Every claim of equality here is a claim about the final date. An account that draws a flat net line without naming the moment has taught an equality that holds on precisely one day of the position's life.

Notice also how those moves have been written. Not as percentages of an unnamed thing, but as a gap between two stated prices with its base attached. Rs 80.00/- on a base of Rs 2,000.00/-. Rs 85.20/- on a base of Rs 2,130.00/-. Say it that way and the two numbers cannot be confused for one another. Say it as four per cent and they will be, immediately and permanently.

What does the way a contract settles change about what has to be backed at the end?

Settlement joins the machinery around it here. Through the life of the position, the thing being backed is a difference. Collateral of Rs 160.00/- stands against an exposure of Rs 2,000.00/-, at a teaching figure of 8.0 per cent initial margin. An adverse move of 4.0 per cent of that Rs 2,000.00/- exposure, or Rs 80.00/-, takes 50.0 per cent of the Rs 160.00/- put up. The exposure standing on the collateral is 12.50 times. Read the two limbs together. Either one on its own misleads: the leverage without the move sounds abstract, and the move without the leverage sounds small.

The ordinary life of the position looks like that, and it goes on for months. Differences arrive, differences leave, and the balance moves around. Nothing in that experience is preparation for what a delivery contract does at the end. Under delivery the obligation stops being a difference and becomes a whole price on one side and a whole thing on the other. Rs 2,130.00/- has to be found. Not Rs 270.00/-. Not Rs 80.00/-.

Here is the misconception that has to be killed before it does damage, and it is the one readers most often arrive carrying. A margin payment is not a part payment of the price. The Rs 160.00/- put up against this position has paid none of the Rs 2,130.00/- agreed price. Not one paisa of it. The Rs 160.00/- is collateral held against a promise while the promise is open, and collateral is a different object from a price entirely. Subtracting it, and concluding that only Rs 1,970.00/- has to be found on the last day, is arithmetic performed on two things that do not belong in the same subtraction. The whole Rs 2,130.00/- has to be found.

Collateral arrangements as the final day comes closer, and the moment anything about them changes, are set by clearing corporations under the framework of SEBI at sebi.gov.in. The arrangements differ by contract and they move. In general the shape of what is being backed changes as the end approaches under a delivery contract, and the change is a change of kind rather than of size.

Who decides which contracts settle which way?

Not the position holder, and not anybody at the end. The way a contract settles is a term of the contract, fixed before anybody entered it, sitting in the specificationThe exchange's own statement of what a contract is and how it ends. It carries the terms nobody negotiates, and it is where a question about a particular contract is answered. beside all the other terms nobody negotiates. Standardisation settles that term in advance, and settling it in advance is the point: an arrangement that had to work out at the end how each position was going to close would be doing its hardest thinking at the moment it had the least time.

The everyday version is the printed terms on the back of a delivery slip. Nobody stands at the counter negotiating whether the sacks will be brought to the house or the difference refunded. The slip says which one it is, and the slip said so before the money changed hands, precisely so that nobody has to have that conversation on a bad day.

Which contracts deliver the thing and which settle in cash is set by the exchange under the framework of SEBI at sebi.gov.in. The answer differs by contract and it moves. A reader who needs the answer for a particular contract reads it from the specification. An answer written out in advance would not be merely out of date on the day it changed. An answer written out in advance would be wrong.

What happens if the thing itself cannot be produced?

The arrangement does not improvise. The refusal to improvise is the whole answer, and it is worth more than any of the details that sit under it. A party bound to deliver who cannot deliver meets consequences that were settled before anybody needed them, in advance, in writing, by people who did not know whose turn it would be. A position that has not been closed as the end approaches is dealt with under arrangements fixed in the same way rather than negotiated on the day.

The consequences, when a position that has not been closed is closed outA position ended without the position holder choosing to end it, under arrangements fixed in advance rather than agreed at the time. and by whom, and how long anything takes to move, are all set under the framework of SEBI at sebi.gov.in. No timetable is set out above, and none should be read into it.

One absence is worth naming, and it differs from the ones already named. The worked case holds no inventory, no holding of the reference asset by anybody, and no second referenced thing, so no delivery can be followed through from the moment it is due to the moment it lands. The figures do show exactly what would have to be produced and exactly what would have to be paid, and that is the part a position holder can check in advance.

Why does an arrangement bother fixing all of this in advance? Because the alternative is deciding it on the worst possible day. Every rule about what follows a failure is written at a moment when nobody knows who it will apply to. Only at such a moment can everybody agree to it honestly. Fix it afterwards and every party can first see whether the rule helps them. The order matters more than the content, and that is a general truth about this whole machinery rather than a fact about settlement.

What should a position holder check before the final day arrives?

Five questions, in a fixed order, and not one of them explains a mechanism. The omission is deliberate. A reading routine that stops to teach is a routine that gets abandoned halfway. The first, the second, the fifth and part of the fourth are answered from the exchange's own specification under SEBI at sebi.gov.in, and those rows stay empty here.

1. Which way does this contract settle? The thing itself, or cash. Everything else on this list depends on the answer, and the answer is a term of the contract rather than anybody's choice. Read it from the specification.
2. If it settles by delivery, what exactly has to be produced, and in what quantity? Not roughly. Exactly, in the units the contract is written in. Read it from the specification.
3. Is that thing already held, and if not, what would getting hold of it involve? Nobody else can answer this one. The question is about the position holder rather than about the contract, and that is why it sits in the middle of the list rather than at the end.
4. How large is the whole price that would have to move, set against the day-to-day differences already moving? On these invented figures that is Rs 2,130.00/- rather than Rs 270.00/-. The arithmetic side of this question can be worked here; the timing side belongs to the specification.
5. Where does the specification say all of this? Ask it plainly. The honest answer to the first four is usually a document rather than a memory. SEBI at sebi.gov.in is where the routing starts.

What question can never be answered in general about carrying a position to the end?

The arithmetic leads straight to one question. Somebody who has just seen that Rs 2,130.00/- can have to be found where Rs 270.00/- was expected, on a position backed by Rs 160.00/- put up against Rs 2,000.00/- of exposure, wants to know whether they should be carrying a position into its final days at all.

The question has no general answer. Not because the answer is uncomfortable, and not as a formality. Answering it would require knowing things about the particular position holder that no general account can know, and inventing those things would be worse than leaving the question open.

Five things would have to be known before anybody could answer it honestly. First, what the position exists to do: a position that offsets something a business already has is a different object from one that stands on its own. Second, which way the contract settles, a term rather than a preference. Third, what is already held against it, if anything. Fourth, what has been put up, and what else could be put up at short notice. And what can actually be produced or found on the worst morning rather than the average one. None of those five is stated here, and four of them belong to the position holder alone.

Neither arrangement carries an outcome, a track record, a probability or a distribution of any kind, so neither can be ranked against the other. Neither has been shown doing anything at all. All that has been shown is what each one collects and what each one requires. A description of an obligation is not a prediction and it is not a suggestion to take one on. Understanding how a settlement works is not a reason to be on either side of it.

The reference asset, the clearing corporation, the clearing member and the position holder are invented.
Educational material. Not advice on any investment, tax, budget or market position.