Legal Definitions - derivative settlement

A derivative settlement refers to the final process of concluding a derivative contract. A derivative is a financial agreement whose value is "derived" from an underlying asset, such as a stock, bond, commodity, currency, or interest rate. When a derivative contract reaches its expiration date or is otherwise terminated, the parties involved must fulfill their obligations as specified in the agreement.

This fulfillment, known as the settlement, typically involves either a cash payment between the parties or the physical delivery of the underlying asset. The method of settlement (cash or physical delivery) is determined by the specific terms outlined in the derivative contract.

• Example 1: Cash-Settled Futures Contract

  Imagine a large airline company that wants to protect itself from potential increases in jet fuel prices. They enter into a futures contract to "buy" 10,000 barrels of jet fuel at a fixed price of $80 per barrel, with the contract expiring in six months. If, at the end of the six months, the market price for jet fuel is $85 per barrel, the futures contract is "in the money." Instead of the airline physically taking delivery of 10,000 barrels of fuel, the contract is cash-settled. The seller of the futures contract would pay the airline $50,000 (the $5 difference per barrel multiplied by 10,000 barrels).

  This illustrates a derivative settlement because the futures contract (a derivative) is concluded by a cash payment reflecting the difference between the contract price and the market price, rather than the physical exchange of the underlying asset (jet fuel).

• Example 2: Expiring Options Contract

  An individual investor buys a call option on a technology stock, giving them the right, but not the obligation, to purchase 100 shares at a "strike price" of $150 per share. The option expires in one month. If, on the expiration date, the stock's market price has risen to $155 per share, the option is "in the money." Rather than the investor exercising the option to buy the shares and then immediately selling them, the option contract might be cash-settled. The seller of the option would simply pay the investor $500 (the $5 difference per share multiplied by 100 shares).

  This demonstrates a derivative settlement because the option contract (a derivative) is finalized by a cash payment from one party to the other, representing the profit from the option's value at expiration, without the physical exchange of the underlying stock.

• Example 3: Interest Rate Swap

  Two financial institutions, Bank A and Bank B, enter into an interest rate swap agreement. Bank A agrees to pay Bank B a fixed interest rate (e.g., 3%) on a notional principal amount of $10 million, while Bank B agrees to pay Bank A a floating interest rate (e.g., based on LIBOR) on the same notional principal. At predetermined intervals (e.g., every three months), the banks calculate the difference between the fixed and floating interest payments for that period. Only the net difference is exchanged between them; the $10 million principal itself is never exchanged.

  This ongoing exchange of net interest payments constitutes a series of derivative settlements. The interest rate swap is a derivative, and the periodic cash exchanges finalize the obligations for each period without exchanging the notional principal, thereby settling the derivative contract's terms for that interval.