Cash settlement
Settling a derivative on expiry or exercise by exchanging the price difference, without delivering the underlying asset. SEBI mandates physical settlement for stock derivatives, not index derivatives.
In plain language
A futures contract on the Nifty 50 cannot end with anyone handing over "the Nifty". Something else has to happen when it ends. That something is cash settlement.
Here is the idea behind the workbook's definition. A derivatives contract reaches its end date, or is exercised. The two sides then settle by paying the price difference. Neither side has to deliver the actual (physical) asset the contract is based on.
The winner gets the difference. The loser pays it. Nobody hands over shares, gold or wheat.
The other method is physical settlement. Here the asset itself is delivered. In India, SEBI has made physical settlement the rule for stock derivatives. Index derivatives settle in cash.
How it works
Settlement mechanism (Chapter 5, section 5.6).
| Cash settlement | Physical settlement | |
|---|---|---|
| At expiry or exercise | Price difference paid | Underlying delivered |
| Workbook note | Most derivative contracts are settled in cash | SEBI mandated for all stock derivatives unless squared off before expiry |
| Exception | — | Index derivatives (Nifty, BankNifty etc.) are excepted from physical settlement |
Zero-sum game. The buyer and seller of a futures contract have opposing views. At maturity the underlying's price is the same for both, so one's gain is the other's loss; net positions always amount to zero — assuming no taxes and no transaction costs.
Margins. To avoid counterparty risk, both parties deposit margin money with the clearing house before executing a trade. Its size depends on the underlying's price volatility and the contract's value-at-risk — a statistical measure of loss within a defined confidence interval.
In a PMS (section 5.7). Portfolio managers may invest in derivatives — including for hedging and portfolio rebalancing — through recognised stock exchanges, on terms in the agreement: quantum of exposure, instruments, purpose, position type, valuation and liquidation terms. Total derivatives exposure should not exceed the client's portfolio value, and portfolio managers may not leverage client portfolios for investment in derivatives (Chapter 7). For tax, F&O income in PMS is business income (Chapter 11).
A worked example
Illustrative contract size, prices and parties; the settlement rules are the workbook's.
Two PMS clients take opposite positions in a Nifty 50 index futures contract with a notional contract size of 50 units:
| Client P (buyer) | Client Q (seller) | |
|---|---|---|
| Entry price | 22,000 | 22,000 |
| Final settlement price at expiry | 22,300 | 22,300 |
| Gain or loss per unit | +300 | −300 |
| Cash settled | Receives ₹15,000 (300 × 50) | Pays ₹15,000 |
No shares change hands — this is an index derivative, so it is cash settled. P's ₹15,000 gain equals Q's ₹15,000 loss: a zero-sum outcome before taxes and costs.
Now change the contract to futures on a single stock. If neither client squares off before expiry, the contract is physically settled: the buyer must take delivery of the shares and pay for them in full, and the seller must deliver them. That is a very different cash and holdings requirement — a reason portfolio managers track expiry dates closely in the agreement's derivatives terms.
Why NISM asks about it
Cash settlement is defined in Chapter 5 (Derivatives), section 5.6, "Underlying concepts in derivatives", together with SEBI's physical-settlement mandate for stock derivatives, the zero-sum nature of futures and margins. Section 5.7 sets out how portfolio managers may use derivatives, and Chapter 11 (Taxation) treats F&O income in PMS as business income. Expect questions on which contracts settle in cash and which physically.
Common exam traps
- Stock derivatives are physically settled in India unless squared off before expiry; index derivatives are the exception and settle in cash.
- "Most derivative contracts are settled in cash" — the workbook's general statement — does not override SEBI's stock-derivative rule.
- Zero-sum assumes no taxes and no transaction costs.
- Margins are deposited before the trade, by both parties.
- Derivatives exposure in PMS must not exceed the client's portfolio value, and portfolios may not be leveraged for derivatives.
- F&O income in PMS is business income, not capital gains.
Where this is taught
- Series X-A · Chapter 10: Understanding Derivativesintroduced here
- Series XXI-A · Chapter 5: Derivativesintroduced here
Related terms
- DerivativeA contract whose value is derived from the value of something else — the underlying — rather than from anything the contract itself owns or produces.
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- MarginThe money a buyer or seller must deposit before a trade is allowed to stand, so that the clearing corporation is covered if they fail to bring in funds or to deliver securities.
- Index derivativesDerivative contracts — chiefly index futures and index options — that have a stock index as the underlying asset. In India they are cash settled and used to hedge market risk.
- Physical settlementSettling a derivative on expiry by actual delivery of the underlying shares against payment. In India, all stock futures and options open at expiry have been physically settled since October 2019.
- Zero sum gameThe principle that every derivative long has a matching short, so one side's gain is exactly the other side's loss and the net value of all derivative positions is zero.
- AssignmentThe allocation of exercised options to one or more option sellers — the moment the writer's obligation becomes a real cash outflow, decided by the exchange and not by the writer.
- Non-deliverable forwardA cash-settled, usually short-term currency forward in which the notional amount is never exchanged — only the difference between the contracted rate and the reference rate changes hands.
- Carry forward of lossesUsing a loss not absorbed in the current year against income of later years. For F&O losses in PMS: up to 8 assessment years, and only against business income.
- Over-the-counterA bilateral market where two parties negotiate a contract's terms directly, with no exchange or clearing house between them, unlike a standardised, centrally cleared exchange-traded market.