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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

                                 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
                                                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 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:

    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                                  Commodity
                                              Producer                                 Swap Dealer
                      Copper (physical                             USD 0.80 per lb
                                                                                                 Hedge using


In the above example, the commodity swap dealer can hedge his risk using copper futures at the

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

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

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 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
    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
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.

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