physical settlement

physical settlement
Settlement occurs when a financial instrument reaches maturity or expires. A financial instrument is physically settled if the underlying asset is delivered or transferred to the counterparty in exchange for a specified payment. For example, if an option over shares is physically settled, the shares will be transferred into the name of the person who owns the option in return for payment of the amount specified in the option contract. The distinction between physical settlement and cash settlement is an important one for derivatives where both types of settlement are common and the choice of settlement type reflects the purpose of the contract. For instance, where a derivative is being used to hedge risk cash settlement will usually suffice.
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United Kingdom
A financial instrument is physically settled if the underlying asset is delivered or transferred to the counterparty in exchange for a specified payment. For example, if an option over shares is physically settled, the shares will be transferred into the name of the person who owns the option in return for payment of the amount specified in the option contract. The distinction between physical settlement and cash settlement is an important one for derivatives where both types of settlement are common and the choice of settlement type reflects the purpose of the contract. For instance, where a derivative is being used to hedge a risk, cash settlement will usually suffice.
For an overview on derivatives and physical settlement, see PLC Finance, Practice note, Derivatives: overview (www.practicallaw.com/8-385-8330).
USA
A manner of settling a credit derivative transaction such as a credit default swap (CDS) under which the credit protection seller makes cash payments equal to the par value of the reference obligation to the credit protection buyer upon the occurrence of a credit event with respect to the reference entity and the fulfilment of any other conditions to settlement, and the credit protection buyer delivers to the credit protection seller a deliverable obligation meeting the criteria specified in the transaction confirmation with a face value equal to the par value of the reference obligation. Physical settlement does not, require market valuation of the reference obligation, as is required in a cash settled transaction (cash settlement ), which can present timing and valuation issues that do not exist with physical settlement. The election of whether a transaction will be subject to cash settlement or physical settlement is typically made in the transaction confirmation at the transaction's outset. Issues sometimes arise with physical settlement in instances where the notional amount of CDS written on a particular reference entity exceeds the amount of the debt obligations (deliverable obligations) of that reference entity available for purchase in the market.
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Practical Law Dictionary. Glossary of UK, US and international legal terms. . 2010.

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