Cash vs. Physical Settlement Agreements

Futures contracts terminate through either cash settlement or physical delivery. Cash settlement involves a final cash exchange based on a reference price, while physical settlement requires actual delivery of the underlying asset. The settlement method has significant implications for trading, hedging, and operational requirements.

Definition and Key Concepts

Cash Settlement

Cash settlement closes a futures position by exchanging cash equal to the difference between the contract price and a final settlement price. No physical asset changes hands.

Key characteristics:

• Final settlement price based on an index or reference rate
• Net cash payment from loser to winner
• No delivery logistics or storage requirements
• Common for financial futures and non-storable commodities

Cash-settled examples:

• E-mini S&P 500 futures (ES)
• Eurodollar futures (now SOFR futures)
• VIX futures
• Bitcoin futures (CME)

Physical Settlement

Physical settlement requires the short to deliver the actual underlying asset and the long to accept delivery and pay the contract price.

Key characteristics:

• Actual asset changes hands at contract maturity
• Delivery specifications defined by the exchange
• Requires storage, transportation, and logistics
• Common for commodity futures

Physically-settled examples:

• Crude oil futures (CL)
• Gold futures (GC)
• Corn futures (ZC)
• Treasury bond futures (ZB)

Comparison Table

How It Works in Practice

Cash Settlement Process

Example: E-mini S&P 500 Futures (ES)

Position: Long 1 ES contract Entry price: 4,500.00 points Final settlement: Third Friday of expiration month

Settlement calculation: Final settlement price is the Special Opening Quotation (SOQ) of the S&P 500 Index on expiration Friday morning.

If SOQ = 4,550.00: Final P/L = (4,550.00 - 4,500.00) × $50 = +$2,500

The $2,500 is credited to the long's account. The contract expires and disappears—no further obligations.

If SOQ = 4,450.00: Final P/L = (4,450.00 - 4,500.00) × $50 = -$2,500

The $2,500 is debited from the long's account.

Physical Settlement Process

Example: Crude Oil Futures (CL)

Position: Long 1 CL contract (1,000 barrels) Entry price: $75.00/barrel Delivery month: Front month contract

Delivery timeline:

1. First Notice Day: Longs may receive delivery notices
2. Last Trading Day: Final day to offset position
3. Delivery Period: Physical transfer occurs

If the long holds through expiration:

• Must accept delivery of 1,000 barrels of WTI crude oil
• Delivery point: Cushing, Oklahoma storage hub
• Pay $75,000 ($75 × 1,000 barrels)
• Take title to the physical barrels

Most traders offset before delivery: Only ~2% of futures contracts result in physical delivery. Speculators and hedgers typically close positions before first notice day.

Physical Delivery Specifications

Crude Oil (CL) Delivery Requirements:

Treasury Bond (ZB) Delivery:

Worked Example

Comparing Settlement Methods: Gold Futures

A jeweler hedges gold purchases using COMEX Gold futures.

Scenario: Needs 100 oz gold in 2 months Current spot: $1,950/oz Futures price: $1,960/oz (2-month contract)

Approach 1: Hold to Physical Delivery

Long 1 GC contract (100 oz)

If spot gold at delivery = $2,000/oz:

• Pay futures price: $196,000
• Receive 100 oz physical gold
• Market value: $200,000
• Effective savings: $4,000 vs. buying spot at delivery

Delivery requirements:

• Accept warehouse receipt from COMEX-approved depository
• Pay delivery fees (~$0.50/oz)
• Arrange transport or storage

Approach 2: Cash Offset + Spot Purchase

Long 1 GC contract, close before delivery:

• Close futures at $2,000: Profit = ($2,000 - $1,960) × 100 = +$4,000
• Buy physical gold in spot market: $2,000 × 100 = $200,000
• Net cost: $200,000 - $4,000 = $196,000

Outcome comparison:

Economically equivalent, but operational complexity differs.

When Physical Delivery Makes Sense:

• You actually need the commodity
• Delivery logistics are manageable
• Delivery grade matches your requirements
• Cost competitive with spot sourcing

When Cash Offset Is Better:

• You don't need physical commodity
• Delivery specs don't match your needs
• You lack storage/transport infrastructure
• More flexibility in timing

Risks, Limitations, and Tradeoffs

Physical Settlement Risks

Delivery mismatch: Futures specify a particular grade or location. If you need a different grade or location, basis risk exists between futures delivery and your actual needs.

Logistics requirements: Taking physical delivery requires storage capacity, insurance, and transport arrangements.

Quality variation: Deliverable grades may have quality ranges. You might receive minimum acceptable quality rather than premium grade.

Cash Settlement Risks

Index basis risk: Cash settlement is based on an index or reference rate. If your exposure doesn't perfectly match the index, settlement won't perfectly offset your risk.

Settlement timing: The exact moment of settlement may not align with your exposure timing.

Contract-Specific Considerations

First Notice Day Surprise: If you're long a physically-settled contract through first notice day, you may receive a delivery notice even before last trading day. Know the calendar.

Short Position Obligations: Shorts in physically-settled contracts must deliver if they hold through expiration. Don't accidentally take on delivery obligations.

Common Pitfalls

1. Holding through first notice day: Brokers often liquidate retail positions to prevent accidental delivery obligations.

2. Ignoring delivery specifications: Assuming any grade is deliverable when the contract specifies particular standards.

3. Underestimating delivery costs: Transport, storage, insurance, and handling fees can be substantial.

4. Settlement price confusion: Cash settlement uses a specific reference that may differ from the last traded price.

5. Conversion factor complexity: Treasury futures use conversion factors that can significantly affect delivery economics.

Checklist for Settlement Decisions

• Identify settlement method for the contract (cash or physical)
• Know first notice day and last trading day
• If physical: Review delivery specifications (grade, location, timing)
• If physical: Assess capacity for delivery/receipt
• If cash: Understand final settlement price calculation
• Plan exit strategy before entering position
• Set calendar alerts for key dates
• Coordinate with broker on position management near expiration
• Consider roll strategy for ongoing hedges
• Evaluate delivery economics vs. offset + spot

Next Steps

To learn how futures provide efficient market exposure, see Using Futures for Equity Beta Exposure.

For understanding daily settlement mechanics, review Mark-to-Market Accounting Mechanics.