How Settlement Type Affects European Option Valuation and Counterparty Exposure
Summary
The document explains when cash settlement versus physical delivery changes the daily valuation of a European option. For a call with the same underlying and strike, the expiry value from exchanging the asset for the strike is economically equivalent to paying the cash difference. Under those matching payoff assumptions, settlement form should not change theoretical price, so the same option pricing framework can apply.
Practical differences can arise from settlement delays or from products whose cash and physical payoffs are not equivalent, with cash-settled swaptions given as an example. Settlement also affects counterparty exposure: a cash payoff generally ends exposure at option expiry, while physical delivery of an OTC instrument may leave exposure until the underlying expires. The excerpt therefore distinguishes payoff equivalence from operational and credit adjustments. It does not provide a quantitative valuation model or quantify the size of settlement-related price differences.
Key ideas
- Equivalent cash and physical European option payoffs should have the same theoretical value.
- Settlement timing can create small practical valuation differences.
- Some products have genuinely different cash and physical payoff definitions.
- Physical delivery may extend counterparty exposure beyond option expiry and affect CVA.
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Full text
# Valuation of non-deliverable option # Valuation of non-deliverable option What is the difference between valuation of deliverable and non-deliverable European options? I am not asking settlement-wise, but daily valuation. Will Black-Scholes be used for both? ## Answer by Daneel Olivaw (score 6, accepted) https://quant.stackexchange.com/a/67830 Without loss of generality, for a European call option with payoff $(S_T-K)^+$ at expiry $T$, whether the option is settled in cash or rather the strike/asset are exchanged should in theory have no impact on price. The net value of exchanging $S_T$ against $K$ if positive is equal to $S_T-K$, which is equal to the amount paid/received if the option is cash-settled. Idiosyncratic market features might in practice result in some valuation differences between cash and physical delivery, which should probably be minor. For example, settlement lag between the option’s expiry and the date the trade is effectively settled might be different for cash and physical deliveries, which should translate in (tiny) valuation differences. Note that there might products for which the cash-settled version has actually a different payoff that the physical delivery version. For example, a cash-settled swaption is not equivalent to a physically-settled one. In this case, physical delivery consists on delivery of the swap, whose value is implicitly based on discounting using the whole yield curve, whereas in cash delivery the discount rate used is assumed to be flat and equal to the prevailing swap rate. For the purpose of computing counterpary adjustments such as CVA, cash and physical delivery also has an effect. With a cash settled option, your exposure to the counterparty vanishes at option expiry when the payoff is settled. On the other hand, for a physical settlement option on an OTC trade such as a non-cleared swap, you will remain exposed to the counterparty until the expiry of the underlying. Hence the CVA of a physically-settled option should be higher than that of the equivalent, cash-settled trade.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.