Physical Settlement, Cash Settlement

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">Physical Settlement, Cash Settlement</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="0%" align="left" valign="top"><p class="word_list"> <a href="#cash settlement">cash settlement</a><p class="word_list"> <a href="#paper market">paper market</a><p class="word_list"> <a href="#physically delivered">physical delivery</a><p class="word_list"> <a href="#physical market">physical market</a><p class="word_list"> <a href="#physically settled">physical settlement</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p class="body">Certain <a href="../articles/derivative_instrument.htm">derivative instruments</a>, such as <a href="../articles/forward.htm">forwards</a> and <a href="../articles/option.htm">options</a>, provide for the purchase or sale of some <a href="../articles/derivative_instrument.htm">underlier</a>. In many cases, parties to such derivatives don't want to physically deliver or receive the underlier. Instead, they enter into the derivative contract for purely financial reasons. </p> <p class="body">For example, an airline might enter into an <a href="../articles/exchange_traded.htm">OTC</a> option contract to <a href="../articles/hedging_and_diversification.htm">hedge</a> its cost of jet fuel. It has established dealers from whom it purchases fuel, so it doesn't want to take actual delivery of fuel under the option contract. Instead, it negotiates for the option to be cash settled—should it exercise the option, the counterparty will not delver fuel in exchange for payment. It will instead pay the airline the option's <a href="../articles/time_value_and_intrinsic_value.htm">intrinsic value</a>. In this manner, the airline is protected against rising fuel prices but can purchase its fuel through its usual dealers.</p> <p class="body" style="margin-bottom: 20">A derivative instrument is <b> <a name="physically settled">physically settled</a></b> if the underlier is to be <b><a name="physically delivered">physically delivered</a></b> in exchange for a specified payment. With <b><a name="cash settlement">cash settlement</a></b>, the underlier is not physically delivered. Instead, the derivative settles for an amount of money equal to what the derivative's <a href="../articles/valuation.htm">market value</a> would be at maturity/expiration if it were a physically settled derivative. In the case of a forward, this equals the notional amount multiplied by the difference between the market price of the underlier at maturity and the forward's <a href="../articles/forward.htm">delivery price</a>. In the case of an option, it is the intrinsic value.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p class="body" style="margin-top: 24; margin-bottom: 24">Certain types of derivatives are routinely cash settled because physical delivery would be inconvenient or impossible. For example, an option on a basket of <a href="../articles/common_stock.htm">stocks</a>, such as the S&P 500, will generally be cash settled because it would be inconvenient and entail considerable <a href="../articles/transaction_costs.htm">transaction costs</a> to deliver all five hundred stocks that comprise that index. An <a href="../articles/cap.htm">interest rate cap</a> has has to be cash settled because the underlier is an interest rate, which cannot be physically delivered.</p> <p class="body" style="margin-top: 24; margin-bottom: 36">In commodity and energy markets, people informally distinguish between the <b> <a name="physical market">physical market</a></b> and <b> <a name="paper market">paper market</a></b>. The physical market encompasses all transactions in which there is physical delivery—cash, spot and physically-settled forward transactions. Paper markets encompass all derivatives transactions that have cash settlement.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/derivative_instrument.htm">derivative instrument</a> <strong style="FONT-WEIGHT: 400"> An instrument which derives its value from the value of other financial instruments. Article includes a list of vanilla and exotic derivatives.</strong><p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/future.htm">future</a> An exchange-traded derivative that is similar to a forward.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/settlement.htm">settlement</a> Performance on a contractual obligation.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_1.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%" bgcolor="#FFFFFF">  <p align="center"><map name="FPMap0_I1"> <area target="_top" href="http://www.riskglossary.com" shape="rect" coords="0, 0, 164, 102"> </map><img border="0" src="../images/logo.jpg" usemap="#FPMap0_I1" width="165" height="103"></p> <p align="center"><span class="verdana10"> <a href="http://www.riskglossary.com/main/disclaimer.htm">Disclaimer</a></span></p> <p align="center">website: <span class="verdana10"> <a target="_top" href="http://www.contingencyanalysis.com">http://www.contingencyanalysis.com</a></span><br> glossary direct link: <span class="verdana10"> <a target="_top" href="http://www.riskglossary.com">http://www.riskglossary.com</a></span><br> copyright © Contingency Analysis, 1996 - current</p> <p align="center"><map name="FPMap1_I1"> <area target="_top" href="http://www.contingencyanalysis.com" shape="rect" coords="0, 0, 240, 88"> </map><img border="0" src="../images/logo_glossary_white.gif" usemap="#FPMap1_I1" width="241" height="89"></p> </td> </tr> </table> </td> </tr> </table> </td> <td>  </td> </tr> </table> </div> </body>