Exchange of Futures for Physical (EFP): Definition and Example

Exchange of Futures for Physical (EFP) is a private agreement between two parties to trade a futures position for the basket of underlying actuals. EFPs are used for several reasons, including to open, close, or switch a futures position for the underlying asset, and they can be particularly useful for managing risk and establishing positions in related markets. Here's how EFPs work and their benefits: 1. **Risk Management**: EFPs allow traders to eliminate leg risk, which occurs when two legs of a transaction are executed as separate trades, and the price of the second leg changes after the first leg is executed. By trading both legs simultaneously, EFPs ensure that the price movements cancel each other out. 2. **Efficiency**: EFPs are used for efficiency reasons, particularly for large transactions that could impact the market if executed through the regular market. By negotiating the terms privately and registering the transaction with the exchange, EFPs can be a faster and more efficient way to manage positions. 3. **Market Flexibility**: EFPs provide flexibility for market participants to transfer their exposure between different markets. For example, a trader can use EFPs to switch their Treasury futures position for cash Treasuries, allowing them to adjust their interest rate risk exposure quickly and efficiently. 4. **Compliance and Legal Standards**: EFPs ensure compliance with legal and regulatory standards, providing a mechanism for companies to lock in commodity prices while adhering to these standards. In summary, EFPs are a valuable tool in the financial markets, offering efficiency, risk management, and flexibility to market participants. They allow for the private negotiation of terms, the elimination of leg risk, and the ability to manage positions and exposures in various markets.