When it comes to forward contracts, there are various types of settlements that can be used to determine the pricing and delivery of the underlying asset. These settlements can impact the risk and reward of the contract, and understanding the different types is important for any investor or trader. Let`s take a closer look at the three most common types of settlements in forward contracts.
1. Cash Settlement
Cash settlement is an easy and convenient way for traders to settle forward contracts. Under this type of settlement, the buyer and the seller settle the contract by exchanging the difference between the agreed-upon price and the market price of the underlying asset at the time of the contract`s expiration. This exchange of the difference is done in cash. This type of settlement is commonly used for contracts where it is challenging to deliver the underlying asset physically, such as with currencies, indices, or commodities.
2. Physical Delivery
Physical delivery is the type of settlement that is used when both parties agree to exchange the underlying asset physically at the expiration of the contract. Upon settlement, the buyer is required to pay the seller the agreed-upon price, and in return, the seller delivers the underlying asset. This type of settlement is commonly used for contracts involving commodities like oil, wheat, and gold.
3. Net Settlement
Net settlement is a type of settlement that combines both physical delivery and cash settlement. Under net settlement, the buyer and seller agree to settle the contract with either cash or physical delivery based on the net difference between the agreed-upon price and the market price of the underlying asset. This type of settlement is often used to hedge against risk, where the parties can choose between cash or physical delivery depending on market fluctuations.
In conclusion, choosing the right type of settlement in forward contracts is a critical aspect of the trading process. Deciding which one to use depends on various factors, including the asset being traded, market conditions and liquidity, and the parties’ preferences and risk appetite. Therefore, it is essential to consider all the aspects before entering into a forward contract with any settlement type.