What does "Exchange for Physical" Mean?

John Lister
John Lister
Man climbing a rope
Man climbing a rope

An exchange for physical is a type of agreement made most commonly in the commodities market. It involves exchanging ownership of the physical commodities for a futures contract, which entitles the holder to buy the commodities at a set price on a future date. The most common reason is where both parties in the trade are seeking to hedge a position.

The idea of an exchange for physical arises from the fact that there are two main types of commodities trade. A cash commodity means that a trader has paid money and taken immediate ownership of the physical commodity, such as gold, grain or oil. In practice, such traders won't usually take physical possession of the commodity, but will instead have bought it on behalf of a client.

The second type of commodities trade is the futures contract. This means that a trader has agreed the right to buy the commodities at a set price on a set future date, regardless of the actual market price at the time. Some such traders will be doing so on behalf of a client, for example, in the hope of getting the commodities at below market price. Other traders have no intention of ever owning the commodities and instead hope to sell their right, known as a contract position, at a profit to another trader before the contract comes due for completion.

An exchange for physical involves an immediate sale of a commodity. Instead of paying cash, the buyer of the commodity gives the seller an equivalent futures contract for the same commodity. In effect, the trade allows the two parties to switch between a cash commodity trade and a futures contract. This could be done because each party believes the other position is now likely offer a better outcome. It may also be done for hedging, with the two parties engaging in a small-scale exchange for physical to limit their losses if their main investment strategy proves the wrong choice.

It's also possible in some markets to carry out an exchange for physical with stocks. This works in the same way in that the parties exchange ownership of a stock for a futures contract involving the same stock. In this case, the term can be confusing, as the stocks do not physically exist in the same way as commodities.

There are several other terms that have the same meaning as exchange for physical. These include exchange against actuals, exchange of spot, and exchange versus cash. The process can also be known as an Ex-Pit transaction, or simple as AA, which is an abbreviates form of "against actuals."

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