Cash settlement in futures contracts

[FlorenceCC]

Hi @David Harper CFA FRM

I think I am getting slightly confused regarding how a cash settlement actually works.
- > initially I thought we were basically realizing our payoff: for instance, an investor goes short on a futures contract for 100 bushels of wheat for a total of $10,000. Let's say at the maturity of our hedge, the spot price of 100 bushels has dropped to $8,000. Then the investor would receive a positive payoff of $10,000 - 8,000, so $2,000.
- > but are we actually receiving (or paying depending on which direction prices go) the difference between the price of our futures contract when we took our short hedge vs. the price of our futures contract at the time it arrives at maturity?
I guess under the assumption of price convergence, spot and futures prices would be equal so it wouldn't matter, but what if there is a basis at the end? For instance our spot dropped at $8,000 but the futures price is $9,000. What would we receive?
Many thanks in advance for your help. I thought I had this down but tons of questions keep popping up in my head

Florence

 

[David Harper CFA FRM]

HI @FlorenceCC You have it correctly. Cash settlement is the payoff, realized in cash, just like you show (see McDonald's good description below). The futures contract has a delivery price, K, which is fixed. For a long position, the payoff/settlement when closed = F(0) - K; for a short, the payoff = K - F(0). This is the futures contract by itself. The basis (e.g., converging basis) implies the futures is hedging something and concerns the relationship to the S(0), B = S(0) - F(0). It's two different positions, even if one is implicit. I hope that helps, good luck tomorrow!

"Cash Settlement Versus Delivery: The foregoing discussion assumed that at expiration of the forward contract, the contract called for the seller (the party short the forward contract) to deliver the cash S&R index to the buyer (the party long the forward contract). However, a physical transaction in a broad stock index will likely have significant transaction costs. An alternative settlement procedure that is widely used is cash settlement. Instead of requiring delivery of the actual index, the forward contract settles financially. The two parties make a net cash payment, which yields the same cash flow as if delivery had occurred and both parties had then closed out their positions. We can illustrate this with an example.

Example 2.2: Suppose that the S&R index at expiration is $1040. Because the forward price is $1020, the long position has a payoff of $20. Similarly, the short position loses $20. With cash settlement, the short simply pays $20 to the long, with no transfer of the physical asset, and hence no transaction costs. It is as if the long paid $1020, acquired the index worth $1040, and then immediately sold it with no transaction costs. If the S&R index price at expiration had instead been $960, the long position would have a payoff of−$60 and the short would have a payoff of $60.

Cash settlement in this case entails the long paying $60 to the short. Cash settlement is feasible only when there is an accepted reference price upon which the settlement can be based. Cash settlement is not limited to forward contracts—virtually any financial contract can be settled using cash rather than delivery." -- McDonald, Robert L.. Derivatives Markets (3rd Edition) (Pearson Series in Finance) (Page 34). Pearson HE, Inc.. Kindle Edition.

 

[FlorenceCC]

Many, many thanks as usual @David Harper CFA FRM.
I’m actually planning to take the test in November (full time job and little baby at home!), so I truly hope I didn’t keep you from answering more pressant questions from the Bionic Turtle community.