EXCHANGE OF FUTURES FOR PHYSICAL (EFP) An exchange of futures for physical (EFP) is a negotiated off market transaction in which one counterpart buys the commodity and simultaneously sells futures contracts (for same underlying asset), while another counterparty sells the commodity and buys corresponding futures contracts. This results in the flexibility of an over-the-counter market for customizing the physical market transaction and also provides the benefits of settlement guarantee in an exchange market The EFP is an off market transaction which involves an over-the-counter (OTC) position and an opposite futures position. The OTC and futures positions must be preferably for the same underlying assets or should be at least similar in terms of value and quantity. Usually after negotiation of an EFP in an OTC market, the same is registered with the exchange. Benefits of EFP An EFP transaction has the following benefits: When an existing OTC market exposure is hedged using a corresponding futures position, this reduces the risk exposure and results in release of cash flows. The netting of open positions in the OTC market against opposing futures positions results in lower credit risk on balance sheet. EFP transactions can be negotiated 24 hours, but need to be registered at exchange specified timings on business days. Due to the customized nature of OTC transactions, the EFP can be executed at mutually agreed price and not necessarily based on the exchange futures price. Margin requirement is lower for EFP transactions due to the inherent hedge positions between OTC and Exchange markets Hypothetical Example of an EFP, where an inventory hedge is already in place: In the beginning of January 2009, assume that a crude oil producer has 100,000 barrels of crude oil in inventory. The producer has a risk of inventory devaluation – i.e. reduction in crude oil price. Assume that the prevailing price of crude oil in the cash market is USD 50 per barrel. In order to protect against a risk of decrease in crude oil price, the producer shorts the March crude oil futures contracts. On the other hand, an oil refiner has estimated a requirement of 500,000 barrels of crude oil in March 2009. The oil refiner has a risk of increase in crude oil prices. He has nevertheless, not hedged against crude oil price movement, anticipating a decline in crude oil prices. By end of January 2009, when the crude oil price has decreased to USD 45 per barrel, the oil refiner decides to enter into an EFP with the oil producer. In this process, the crude oil producer and refiner negotiate the basis differential between the March crude oil futures contracts and the cash price that is expected to prevail in March 2009, at the time of delivery of crude oil on a pre-determined date in March 2009. After mutual agreement, the exchange is informed about the EFP transaction, the details of which are as follows: The existing short futures position of the crude oil producer is closed out and simultaneously, a new short futures position is created for the oil refiner. This is to protect the refiner against further decline in crude oil prices. The day after the registration of this EFP, the margin deposit against the short futures position of the producer is released and simultaneously, the margin amount for the refiner’s short futures position is blocked from the deposit amount. The benefit for the crude oil producer from such an arrangement is that, the producer has fixated a final sale price for the crude oil in March 2009. The benefit for the crude oil refiner from the EFP is that they have fixated the purchase price of the crude oil for the month of March 2009 and also hedged against a potential further decline in the crude oil prices between the date of the EFP and the date of the delivery. Agree to sell crude oil in March 2009 based on price of March Futures contract ± negotiated basis; Transfer short futures position Crude Oil Crude Oil Producer Refiner Agree to buy crude oil in March 2009 based on price of March Futures contract ± negotiated basis; Transfer short futures position Inform exchange Inform exchange about about the EFP; the EFP; To transfer short Commodity To obtain short futures futures position to oil Exchange position from oil refiner refiner Records EFP transaction and transfers ownership of short futures position Thus, the EFP results in a win-win situation for both the crude oil producer and refiner. At the time of registration of an EFP, it is essential to ensure that the details of EFP transactions such as the futures quantity, negotiated price and acknowledgement from the counterparties that a similar OTC transaction has been transacted needs to be provided to the exchange. Usually, the pricing of EFP transactions depends on a number of parameters including: Prevailing futures price on date of transaction Valuation of OTC credit exposures Cost-of-carry considerations Terms and conditions of the OTC transaction Given the number of variables involved, EFP transactions will typically trade at a discount/premium to the original swap (OTC) price. COMMODITY SWAPS Commodity swaps are a very recent market innovation, dating from the late 1980s. To be more specific, The Chase Manhattan Bank introduced commodity swaps in 1986 1 , to enable hedgers to mitigate long term multi-period risk. Swaps can be used to guarantee income streams (cash flows are exchanged on pre-determined dates). In the case of commodity sales, a company's expected income stream during a certain period is equal to the amount of commodities it expects to sell, multiplied by expected prices over this period. In actual physical sales, prices may turn out to be higher or lower, and consequently, the company's income stream will be higher or lower than expected. For example, if the company can enter into a swap such that it will receive a compensatory financial payment if prices are indeed lower, but have to give up its unexpected benefits if prices turn out to be higher than expected; thus, it can ensure a more or less guaranteed "net price". A swap is a purely financial instrument. Normally, a producer (or consumer) enters into a swap with a bank or a large trading company. The advantages of a swap over futures are that swaps are available for periods much longer than one year, they can be tailor-made to cover the needs of a certain company—in terms of commodities and risks covered—and their requirements in terms of margin payments are much less strict than on futures markets. Swaps are usually OTC derivative instruments. Swaps are often attractive to lenders or investors as they provide security for the cash flow of the company to whom they are lending finance, and thus the ability of the company to repay a loan or pay a dividend is improved by providing this type of long-term custom-designed hedge. Therefore, much of the current use of swaps is in the context of project finance. Also, they can be used to obtain easier terms for the country's foreign debt; for example, as part of a debt- restructuring programme. Summing up, swaps can be used to: Lock in the price of commodities for a long period of time (for example, locking in copper prices for three-four years or aluminium prices up to five years poses few problems). Secure the income stream of operations or new investments. Help attract more capital at more favourable conditions. Hypothetical Example of Commodity Swap Assume that a copper producer averages a monthly production of approximately 100,000 tonnes of copper. The risk for the copper producer is a decline in copper price. Assume that the cash price of copper is averaging USD 0.80 per lb in January 2009. The copper producer enters into a swap transaction with a commodity swap dealer. The transactions are as follows: 1 Understanding Swaps by John Francis Marshall, Kenneth R Kapner The copper producer agrees to pay the spot price of copper for 100,000 tonnes every month to the dealer. In return, the commodity swap dealer agrees to pay the copper producer, USD 0.80 per lb for 100,000 tonnes every month. The commodity swap can be diagrammatically represented as follows: Spot Price Average Spot Price Copper Copper Commodity Cash Producer Swap Dealer Market Copper (physical USD 0.80 per lb delivery) Hedge using copper futures Commodity Exchange In the above example, the commodity swap dealer can hedge his risk using copper futures at the exchange. EXCHANGE OF FUTURES FOR SWAP AGREEMENTS Exchange of futures for Swaps (EFP) can be taken to avoid taking physical delivery of commodities. A commodity swap dealer can take, say for example, a bank's futures positions into his own account and swaps the commodity return for a funding rate. This funding rate may be fixed or floating rate, with reference to a specific benchmark rate. EFS is similar to EFP, but the major difference is that instead of a physical transfer of asset, futures are exchanged in lieu of a swap agreement. Exchange market participants can use EFS as an additional instrument to add flexibility to their trading and risk management portfolios. EFS allow market participants to exchange a position in a futures contract for a cash-settled position instead of delivery of the physical asset. EFS also give market participants the ability to liquidate an OTC market swap position in a market which may have limited liquidity. Over-the- counter (OTC) derivatives have extreme counterparty default risk and liquidity risk. One of the principal advantages of trading on the Exchange is the absorption of counterparty risk by the clearinghouse. The parties to EFS mutually negotiate the execution of an OTC swap and related futures transaction. The transaction must involve approximately equal but opposite quantities of futures and swap exposures in the same or related underlying asset. Both counterparties need to notify the Exchange of the amount and type of futures contracts involved, the price at which the futures transaction should be cleared. EFS allow market participants involved in the transaction to liquidate, initiate, and transfer futures market positions between them. Hypothetical Example of Exchange of Futures for Swap Agreement Scenario 1 A crude oil refiner can buy a swap from a commodity swap dealer, thereby, fixing the cost of crude oil procurement. The swap dealer buys crude oil futures contract to hedge his short position related to the swap agreement. At some point of time in the future, the crude oil refiner may prefer to take position in crude oil futures market, because the liquidity of the futures market allows him to liquidate his position at any time. Thus, using EFS enables the refiner who has reached credit limits with OTC market counterparties, to free the credit lines by transferring position onto the Exchange platform. By executing EFS, the refiner and swap dealer liquidate their swap exposure and create futures positions. In this example, the refiner assumes the open interest obligation created when the swap dealer hedges the original swap position. In this case, the swap dealer unwinds his OTC and exchange market position completely. Scenario 2 EFS can also be used to liquidate a hedge. A distillate products marketing company (let us denote it as say, counterparty A) that buys gasoline for resale at a fixed price would fix its purchase price through a long swaps position and simultaneously hedging the obligation by going short on equivalent number of gasoline futures contracts on the Exchange. Similarly, if another counterparty B in case of sale of gasoline (on future date) to a customer at a fixed price, the position can be hedged with an equivalent long futures contract. Thus, when trading terminates in the futures contracts, both counterparties can offset their swaps and futures positions at the final settlement price without incurring other obligations. The counterparties A and B can seek each other out where they exchange futures and swaps, in effect offsetting their respective market positions while preserving the desired profit margin they had originally hedged. Hedge example: Counterparty A agrees through a swap agreement, to supply gasoline to a customer for a fixed price of USD 2 per gallon. Counterparty A also hedges this position by buying the equivalent number of futures contracts at the prevailing price, USD 1.98 per gallon, thereby, locking in a profit of USD 0.02 per gallon. At the same time, counterparty B agrees to buy gasoline for USD 2.02 per gallon, which he then arranges to sell for USD 2.04, or a USD 0.02 per gallon profit. He fixes his cost by entering into a long swaps position for USD 2.02 per gallon and also hedges by taking a short futures position for the current price of USD 2.05 per gallon, yielding a USD 0.033 per gallon profit. Both marketers want to liquidate the hedges at the end-of-the-month gasoline settlement price on the Exchange. Assume that on the last day of trading, gasoline futures settle at USD 2.10 per gallon. A broker brings both the counterparties parties together: Counterparty A with short swap and long futures position as well as Counterparty B with long swap and short futures position. Both counterparties inform the exchange about the EFS, effectively exchanging positions. Counterparty A with a short USD 2 per gallon swap, effectively assumes the other party's long swap at USD 2.02 per gallon, thereby, incurring a loss of USD 0.02. At the same time, his long futures position, opened at USD 1.98 per gallon, is exchanged for counterparty B’s short futures position at USD 2.05 per gallon, for a USD 0.07 per gallon profit. The net result for counterparty A is a net profit of USD 0.05 per gallon. Counterparty B with a long swap purchased at USD 2,02 per gallon assumes the short swap at the settlement, USD 2 per gallon, generating a USD 0.02 per gallon loss. His short futures position, sold at USD 2.05 per gallon is exchanged for counterparty A’s long futures position at USD 1.98 per gallon thereby incurring profit of USD 0.07 per gallon. Thus, the net result for counterparty B is a net profit of USD 0.05 per gallon. Thus, both counterparties A and B have exchanges their OTC market swap positions for exchange traded futures contracts. COMMODITY BONDS AND LOANS Commodity bonds and loans are bonds and loans with a repayment (of the principal and/or interest rate) linked to commodity prices. This link can be in two major forms: The Loan or Bond Type: In this type of loan or bond, the principal and/or interest is repaid with the financial equivalent of a fixed amount of a commodity. For example, a bond of US$ 500 is written. The yearly interest payment is equal to the price of 0.1 ounce of gold, and after four years, a sum equal to the value of 1 ounce of gold is reimbursed. If, for example, during the period considered, gold prices have increased to an average of US$ 600/ounce, the investor obtains US$60 in interest payments and his bond is redeemed at US$600; but if gold prices have declined to US$300, then he only receives US$30 in interest payments and US$500 towards bond redemption. This type of commodity bonds or loans serves to manage a company's long-term risk exposure. The Option Type: Once the bond/loan matures, the investor or lender gets the choice to have a reimbursement of a fixed amount, or reimbursement of the monetary equivalent of a fixed amount of a commodity. For instance, in the case of a US$ 600 gold-linked bond, the investor gets the choice to redeem the bond at US$ 600, or to be paid the price of 1 ounce of gold. This type of commodity bonds or loans is often used to obtain finance more easily and at a lower cost; the commodity option is thrown in as a sweetener. Commodity bonds and loans are usually linked to investment projects (they have become very important to finance gold mining projects) or for debt rescheduling (they have played a role in the rescheduling of the official debts of Mexico, Venezuela, Uruguay and Nigeria). Their commodity coverage is somewhat limited: most commodity bonds and loans issued so far have been linked to gold, silver, and oil; some are issued on aluminium, copper, nickel, palm oil, coffee, and cocoa. Summing up, commodity bonds and loans can serve several goals, such as: They can provide access to financial markets that may not otherwise be available. As a result, bonds may lead to the improved creditworthiness of the company or country concerned. In a high-inflation economy, commodity-linked bonds (in particular gold-linked bonds) can provide sufficient anti-inflation guarantee to bond buyers; thus allowing the issuing government (or company) to pay a somewhat lower net interest on the bond. Cash-strapped producing companies or countries can expect to pay lower interest rates as a result of issuing commodity bonds. Commodity bonds with long-term commodity warrants attached can smooth the earnings of enterprises within commodity producing countries. In practice, the bonds can be designed to link the interest or principal payments of the bond to revenues rather than prices of the export commodity. They can be used as risk management tools, not only by commodity producers, but also by commodity consumers. In this respect, the commodity warrants that are often attached to bonds can be used by commodity consumers to hedge against commodity price increases above a certain pre-determined strike price.