What Is Cash Delivery?
In the investment world, cash delivery is a settlement method when a futures contract expires or an options contract is exercised. Also known as cash settlement, it requires the party in a loss position to remit payment to the party in a gain position, rather than actually exchanging the underlying asset.
Alternatively, in the foreign exchange (forex) market, cash delivery means the settlement of a contract.
- Cash delivery is a settlement between the parties of certain derivatives contracts that does not require the actual exchange of an underlying asset.
- Investors who use these investments are known as speculators because their goal is to hedge against price changes—not to possess the underlying physical asset.
- Opting for cash delivery means either being credited or debited the difference between the initial price and the final settlement once the futures or options contract expires or is exercised.
- In the foreign exchange (forex) market, cash delivery means the settlement of a contract.
Understanding Cash Delivery
When these derivative instruments expire or are exercised, the holder of the contract should, in theory, deliver the physical commodity or transfer the actual shares of stock. In reality, the vast majority of futures and options contracts are actually delivered with cash instead.
Investors who use these investments are known as speculators. They are not interested in possessing the underlying physical asset and simply want to hedge against its price changes. Those who opt for a cash delivery will either be credited or debited the difference between the initial price and the final settlement once the futures or options contract expires or is exercised.
Example of Cash Delivery
Adam buys a cash-delivered futures contract, allowing him to purchase 100 head of cattle two months from now for $300 per head for a total of $30,000. The current price for a head of cattle is also $300. Adam has bought this contract to hedge against the potential of rising livestock prices.
If cattle trade for $350 per head by the contract’s expiration, Adam's cash-delivered futures contract profits by $5,000. He can use this to offset the $35,000 he will have to spend if he chooses to purchase 100 head of cattle. However, if the price falls to $250, his cash-delivered futures contract loses $5,000. In this case, if he wants to purchase the 100 head of cattle, he can do so at the market price of $25,000, but he must pay out a total of $30,000, counting the $5,000 cash-delivered futures loss.
Advantages and Disadvantages of Cash Delivery
Like any financial strategy, cash delivery has its benefits and drawbacks.
Cash delivery offers many advantages over physical delivery. First and foremost, it is less expensive and much simpler to exchange the contract's cash position—the net cash value of the assets—once a contract has expired.
Arranging delivery of physical assets, such as gold or livestock, is time-consuming and comes at a considerable expense. Many traders are not interested in stockpiling gold in warehouses or buying live animals to start a farm, anyway. All they want to do is make money from betting on the market value of these things.
Cash delivery also allows for the trading of assets that cannot be delivered physically, namely indexes, such as the S&P 500 or the Nikkei 225. In fact, cash delivery has been credited for making futures and options trading easier, helping to boost market liquidity and to pave the way for a broader choice of financial products to become available.
One potential drawback of cash delivery is the risk that this option could leave investors unhedged when the contract expires. Without the delivery of the actual underlying assets, any hedges in place before expiration will not be offset.
As a result, traders who opt for a cash delivery must be diligent to close out hedges or roll over expiring derivatives positions in order to replicate the expiring positions.
Other Types of Cash Delivery
The term cash delivery is also used in the forex or FX (foreign exchange) market. Here, it refers more generally to the settlement of a contract, which is always in cash (obviously, since currencies are what's being traded).
The forex market is open 24 hours a day, five days a week, except for holidays, and operates worldwide. To participate in forex trading, the investor must first establish and fund an International Monetary Market (IMM) delivery account. At a contract's end, funds are withdrawn or deposited into the delivery account in the domestic currency.
A spot forex deal is for immediate delivery, which is two business days for most currency pairs. The major exception is the purchase or sale of U.S. dollars (USD) vs. Canadian dollars (CAD), which settle in one business day. Weekends and holidays can cause the time between transaction and settlement dates to increase substantially, especially during holiday seasons, like Christmas and Easter. Also, the forex market practice requires that the settlement date be a valid business day in both countries.
Forex forward contracts are a special type of foreign currency transaction. These contracts always take place on a date after the date that the spot contract settles and are used to protect the buyer from fluctuations in currency prices.