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.