- cash settlement
A financial instrument is cash settled if the underlying asset is not delivered or transferred to the counterparty in exchange for a specified payment when the instrument reaches maturity. Instead, the owner of the financial instrument accepts an amount of money equal to what the financial instrument's market value would be at maturity if it were physically settled (physical settlement). Cash settlement is particularly important in the derivatives market where certain types of derivatives are routinely cash settled because physical delivery would be inconvenient or impossible. For example, an interest rate cap has to be cash settled because the underlying asset is an interest rate, which cannot be delivered. An option on a group of shares will often be cash settled because it is expensive and time consuming to transfer all of the shares into the name of the owner of the option. The way in which the cash value of an instrument is calculated varies from contract to contract. In the case of a futures contract, the cash value equals the notional amount of the underlying asset (for example 100,000 barrels of oil, or 100 shares in a particular company) multiplied by the difference between the market price of the underlying asset at maturity and the future's delivery price. In the case of an option, it is the difference between the market value of the underlying asset and the exercise price of the option.Related links+ cash settlementUSAA manner of settling a credit derivative transaction such as a credit default swap (CDS) under which the credit protection seller makes cash payments to the credit protection buyer upon the occurrence of a credit event with respect to the reference entity and the fulfilment of any other conditions to settlement. The cash payments from the credit protection seller to the credit protection buyer are generally structured to equal the par value of the reference obligation less its market value. (Cash settlement, therefore, requires market valuation of the reference obligation, which can present timing and valuation issues.) The election of whether a transaction will be subject to cash settlement or physical settlement is typically made in the transaction confirmation at the transaction's outset. There is no deliverable obligation in a cash settled transaction, which makes it an appealing alternative to physical settlement in instances where the notional amount of CDS written on a particular reference entity exceeds the amount of the debt obligations of that reference entity available for purchase in the market.Related terms
Practical Law Dictionary. Glossary of UK, US and international legal terms. www.practicallaw.com. 2010.