Swaps & NDF
Cash Settlement Mechanism
Learning Outcome
5
Understand its role in financial markets.
4
Apply cash settlement in NDFs and swaps.
3
Explain the cash settlement process.
2
Differentiate cash and physical settlement.
1
Understand cash settlement in financial contracts.
What Is Cash Settlement?
Cash settlement is the process of closing out a financial contract by transferring only the net monetary difference between the contracted rate (or price) and the actual market rate (or price) on the settlement date — without exchanging the underlying asset or currency.
Meaning Inshort:
When a futures contract expires, no actual oil is delivered — only the profit or loss in rupees is settled. The exchange compares the trade price to the Final Settlement Price (FSP), and the difference is simply credited or debited in cash.
In Anjali's case, she bought at ₹6,000 and the FSP came in at ₹6,150, so she earned ₹150/barrel, credited straight to her account. No barrels, no warehouse, just money.
Types of Settlement
The Cash Settlement Process — Step by Step
While the exact steps vary slightly between NDFs and swaps, the general cash settlement process follows a common sequence:
Importance of Cash Settlement
Cash settlement is not just a technical back-office process — it has deep implications for market structure, risk, and accessibility. The table below explains why it matters:
Calculation Basis
The settlement amount depends on the type of instrument. Below are the formulas for the two most common instruments where cash settlement applies: NDFs and Interest Rate Swaps.
Where,
1. Notional (USD)- The agreed face value of the NDF contract — the USD amount on which the contract is based. (Note: this is never actually transferred).
2. NDF Rate- The contracted forward rate agreed at the time of trade. Example: USD/INR = 84.50.
3. Fixing Rate- The official benchmark rate observed on the fixing date. For USD/INR: the FBIL RBI Reference Rate published at 1:30 PM IST.
NDF Cash Settlement Formula
Settlement Amount (USD) = Notional (USD) × (NDF Rate − Fixing Rate) ÷ Fixing Rate
Interest Rate Swap (IRS) Cash Settlement Formula
Interest Rate Swap, one party pays a fixed rate and the other pays a floating rate on the same notional principal. On each payment date, only the net difference is exchanged — not the full interest amounts.
|
Net Settlement = (Fixed Rate − Floating Rate) × Notional × (Days / 360 or 365) |
Where,
1. Fixed Rate- The agreed fixed interest rate paid by one party throughout the swap's life.
2. Floating Rate - The benchmark rate (e.g., MIBOR in India, SOFR in the US) observed on the reset date for that payment period.
3. Notional - The principal amount on which interest is calculated. This is NEVER exchanged — only interest difference is paid.
4. Days / 360 or 365 - Day count convention. INR swaps use ACT/365. USD swaps typically use ACT/360
Worked Examples
Example 1 — NDF Cash Settlement (USD/INR)
Example 2 — Interest Rate Swap (IRS) Cash Settlement
Summary
5
Cash settlement reduces risk and improves efficiency.
4
NDFs and IRS commonly use cash settlement.
3
Settlement follows execution, fixing, calculation, and payment.
2
Physical settlement involves actual asset delivery.
1
Cash settlement transfers only the net difference.
Quiz
What is exchanged in cash settlement?
A. Physical asset
B. Net profit or loss amount
C. Commodity inventory
D. Ownership rights
Quiz-Answer
What is exchanged in cash settlement?
A. Physical asset
B. Net profit or loss amount
C. Commodity inventory
D. Ownership rights
