Cash settled futures: Meaning, Criticisms & Real-World Uses

What Is Cash Settled Futures?

Cash settled futures are a type of futures contracts where, upon expiration, the parties exchange a cash payment reflecting the difference between the contract price and the final settlement price, rather than the physical delivery of the underlying asset. This method of settlement is a key characteristic within the broader category of derivatives, which are financial instruments whose value is derived from an underlying asset or benchmark. Cash settled futures simplify trading by eliminating the logistical complexities and costs associated with storing and transporting physical goods, making them particularly suitable for assets that are impractical to deliver, such as stock indexes, interest rates, or certain commodities.

History and Origin

The concept of futures trading itself dates back centuries, with early forms emerging in agricultural markets to manage price risk. However, the introduction of cash settled futures marked a significant evolution in financial markets. Prior to cash settlement, most futures contracts required physical delivery of the commodity or asset. This became cumbersome and impractical as financial instruments like stock indexes gained popularity as underlying assets.

A pivotal moment in the history of cash settled futures occurred in the early 1980s. The CME Group, a leading derivatives exchange, launched the first cash-settled futures contract, the Eurodollar futures, in 1981. This was quickly followed by the successful launch of S&P 500 Index futures in 1982, which became a landmark product for equity market participants. These innovations allowed market participants to gain exposure to broad market indexes without the need to buy or sell every single stock, profoundly influencing the development of modern financial derivatives.⁴

Key Takeaways

Cash settled futures require a cash payment at expiration, representing the profit or loss, rather than physical delivery of the underlying asset.
They are especially useful for underlying assets that are intangible or difficult to physically deliver, such as stock indexes or interest rates.
This settlement method reduces logistical complexities and costs, enhancing market liquidity.
Cash settled futures are widely used for both hedging and speculation in various markets.
The final settlement price for cash settled futures is typically determined by reference to a specific index or benchmark on the expiration date.

Formula and Calculation

For cash settled futures, the calculation of profit or loss (P/L) is straightforward and depends on the difference between the price at which the contract was entered and its final settlement price upon expiration.

For a long position (buyer):

P/L = (\text{Final Settlement Price} - \text{Entry Price}) \times \text{Contract Multiplier}

For a short position (seller):

P/L = (\text{Entry Price} - \text{Final Settlement Price}) \times \text{Contract Multiplier}

Where:

Entry Price: The price at which the futures contract was initially bought or sold.
Final Settlement Price: The predetermined price at which the contract is settled on its expiration date, often based on an average or specific closing price of the underlying asset.
Contract Multiplier: A fixed value that determines the total notional value of the contract. For example, the E-mini S&P 500 futures contract has a multiplier of $50 per index point.

This calculation results in a direct cash credit or debit to the trader's account.

Interpreting the Cash Settled Futures

Interpreting cash settled futures primarily involves understanding the price movements of the underlying asset and their impact on the contract's value. Traders and investors use cash settled futures to express a view on the future direction of an index, commodity price, or interest rate without needing to handle the physical asset.

For example, if a trader buys a stock index futures contract (taking a long position) and the index rises, the value of their cash settled futures position increases. Conversely, if the index falls, the position loses value. The convenience of cash settlement allows for easy entry and exit from positions, facilitating rapid responses to market changes and enabling efficient speculation or hedging against existing portfolio exposure. The settlement price is crucial as it dictates the final financial obligation.

Hypothetical Example

Consider an investor, Sarah, who believes the S&P 500 index will rise. She decides to buy one E-mini S&P 500 futures contract, which is a popular cash settled futures product, with an entry price of 5,000 index points. Each E-mini S&P 500 futures contract has a multiplier of $50 per index point.

Opening the position: Sarah initiates a long position by buying one E-mini S&P 500 futures contract at 5,000. The notional value of her contract is 5,000 points * $50/point = $250,000.
Market movement: At the expiration date, the final settlement price for the E-mini S&P 500 futures contract is determined to be 5,050 index points.
Settlement: Since the final settlement price (5,050) is higher than her entry price (5,000), Sarah has made a profit.
Calculating profit:
Profit = (Final Settlement Price - Entry Price) × Contract Multiplier
Profit = (5,050 - 5,000) × $50
Profit = 50 × $50 = $2,500

On the other hand, if the final settlement price had been 4,980, Sarah would have incurred a loss:
Loss = (5,000 - 4,980) × $50
Loss = 20 × $50 = $1,000

This $1,000 loss would be debited from her trading account, without any physical delivery of stocks.

Practical Applications

Cash settled futures are indispensable tools in modern financial markets due to their versatility and efficiency.

Portfolio Hedging: Large institutional investors, such as mutual funds and pension funds, use stock index futures to hedge against broad market downturns without liquidating underlying stock positions. For instance, a fund manager with a diversified stock portfolio mirroring the S&P 500 could sell E-mini S&P 500 futures contracts to offset potential losses if they anticipate a market decline.
Speculation: Individual traders and hedge funds engage in speculation, aiming to profit from anticipated price movements in indexes, currencies, or commodities without the intention of taking physical delivery. The high leverage offered by futures contracts means a relatively small amount of margin can control a large notional value, amplifying potential gains or losses.
Arbitrage: Arbitrageurs exploit temporary price discrepancies between cash markets and futures markets. Cash settlement simplifies the process of closing out positions and realizing profits from these opportunities.
Risk Management for Intangibles: For assets like weather, inflation, or interest rates, where physical delivery is impossible, cash settled futures provide a vital mechanism for businesses and investors to manage associated risks.
Regulatory Oversight: The Commodity Futures Trading Commission (CFTC) oversees the U.S. derivatives markets, including futures. The CFTC's regulations ensure market integrity, protect participants from fraud, and promote transparency in trading practices.

³Limitations and Criticisms

While cash settled futures offer significant advantages, they also come with limitations and criticisms.

One primary concern relates to the determination of the final settlement price. Unlike physically delivered contracts where the price converges with the spot market through actual delivery, the final settlement price for cash settled futures is calculated based on a specified index or benchmark at expiration. If the methodology for this calculation is flawed or susceptible to manipulation, it could lead to distortions in the market.

Another limitation is the potential for systemic risk, especially in highly interconnected derivatives markets. While cash settlement avoids physical logistics, it does not eliminate counterparty risk, which is managed through a clearing house and margin requirements. However, large, concentrated exposures in derivatives can still pose risks to the broader financial system, as highlighted by various analyses of global financial derivatives markets.

Fur²thermore, the inherent leverage in futures contracts means that even small adverse price movements can lead to substantial losses exceeding the initial margin deposited. This amplified exposure can make cash settled futures highly volatile and risky for inexperienced traders or those without robust risk management strategies.

Cash Settled Futures vs. Physical Delivery Futures

The fundamental distinction between cash settled futures and physical delivery futures lies in their settlement mechanism at expiration.

Feature	Cash Settled Futures	Physical Delivery Futures
Settlement Method	Cash payment of profit/loss	Actual exchange of the underlying asset
Underlying Assets	Often intangible (indexes, interest rates), or hard-to-deliver commodities	Tangible commodities (oil, gold, grains, livestock)
Logistics	Simple, no storage or transportation issues	Complex, requires coordination for delivery/storage
Convenience	Higher, easier to enter and exit positions	Lower, involves physical handling of assets
Market Participants	Preferred by speculators and financial hedgers	Preferred by producers, consumers, and physical hedgers who need or possess the actual commodity
Costs	Generally lower (no storage, transport)	Can be higher (storage, transportation, insurance)

Cash settled futures facilitate broader participation in markets that would otherwise be impractical due to physical delivery constraints, leading to greater market liquidity. In contrast, physical delivery futures directly link the futures market with the underlying spot market, which is crucial for industries that rely on the actual commodity for their operations. While both types serve functions in risk management and price discovery, the choice between them depends on the nature of the underlying asset and the participants' objectives.

¹FAQs

What assets are typically settled in cash?

Cash settled futures are commonly used for financial instruments that are impractical or impossible to deliver physically, such as stock market indexes (e.g., S&P 500, Nasdaq 100), interest rates, currency indexes, and some commodities where physical delivery is logistically challenging or undesirable for many participants.

How is the final settlement price determined for cash settled futures?

The final settlement price for cash settled futures is typically determined by the exchange's clearing house based on a specific benchmark or calculation method on the contract's expiration date. This might involve an average of prices over a set period, the opening or closing price of the underlying index on a specific day, or a price provided by an independent price reporting agency.

Do I need to have the full value of the contract in my account to trade cash settled futures?

No, you do not need the full notional value. When trading futures contracts, you only need to deposit a fraction of the contract's total value, known as margin, into your trading account. This leverage allows traders to control a much larger position with a smaller capital outlay, but it also magnifies both potential gains and losses.

Can I close a cash settled futures position before expiration?

Yes, most participants in the futures market close their positions before the expiration date. You can always offset your position by taking an opposite trade—selling a contract you bought, or buying back a contract you sold. This allows traders to realize profits or losses and exit the market without waiting for the final settlement process.

Are cash settled futures regulated?

Yes, in the United States, cash settled futures, like other futures contracts, are regulated by the Commodity Futures Trading Commission (CFTC). The CFTC sets rules and oversees exchanges to ensure fair and transparent trading practices and to protect market participants.

Cash settled futures