How does physical settlement differ from cash settlement?

Physical settlement differs from cash settlement primarily in that it entails the actual delivery of the underlying commodity, rather than a financial exchange. In a physically settled contract, at the expiration or maturity date, the seller delivers the physical commodity to the buyer, and the buyer takes possession of it. This process is essential in markets where the actual commodity is the primary focus, such as in agriculture, energy, or metals.

On the other hand, cash settlement is designed for contracts where the parties do not wish to exchange the physical goods. Instead, at the contract's expiration, the difference between the contract price and the market price is settled in cash. This method is often preferred for its convenience and efficiency, especially in highly liquid markets where physical delivery might not be practical.

In summary, the defining characteristic of physical settlement is the tangible transfer of the commodity itself, which fundamentally distinguishes it from the cash settlement method, where financial compensation is provided instead.