Settlement refers to the extinguishment of the obligation created under the forward contract. On the due date of the forward contract, i.e. upon the maturity, there are three possible ways of settling the obligation:
1. Physical Settlement: A forward contract can be settled by the physical delivery of the underlying asset by a short investor (i.e. the seller) to the long investor (i.e. the buyer) and the payment of the agreed forward price by the buyer to the seller on the agreed settlement date.
For example, company A enters into a forward contract to buy 1 million barrels of oil at $70/barrel from company B on a future date. On that future date.
Company A would have to pay $70 million to company B and in exchange receive 1 million barrels of oil.
2. Cash Settlement: Cash settlement does not involve actual delivery or receipt of the security. It is a method of settling forward contracts by cash rather than by physical delivery of the underlying asset.
The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires.
The cash position is the difference between the spot price of the asset on the settlement date and the agreed-upon price as dictated by the forward/future contract.
Cash settlement is useful and often preferred because it eliminates much of the transaction costs that would otherwise be incurred when physically delivering a good.
3. Settlement by Cancellation: Settlement by cancellation is done by entering into an offsetting contract opposite to that of the initial contract.
Buyer in the initial contract can sell the assets at the new price, at any time prior to maturity or upon maturity to another party or to the original seller.
Similarly, the seller in the initial contract can buy the assets from any party prior to or upon the maturity at the new price.