Gold futures from CME Group provide a deep and tightly quoted source of liquidity in the gold market and are used extensively to hedge over the counter (OTC) physical gold business.
While in the past, gold traders would frequently trade OTC with banks to hedge gold transactions, the majority of gold hedging is now conducted electronically with COMEX Gold futures (GC).
Exchange For Physical (EFP) allows traders to switch Gold futures positions to and from physical, unallocated accounts. Quoted as dollar basis, relative the current futures prices, EFP is a key component in pricing OTC spot gold.
EFP is calculated as a function of:
EFP is quoted as a two-way market by brokers or market makers. It fluctuates as a function of supply and demand, while converging toward zero over time, similar to how spot prices converge toward futures prices as the futures contract approaches expiration. If the gold market is in contango, meaning the forward price is above the spot price, traders would subtract the EFP price it from the futures price to quote the spot price.
For example, if futures are trading at 1,312, and the EFP is at 2, the spot price would be 1,310.
In a backwardated market, the EFP would be quoted as negative (e.g. 1,312, -2 = spot 1,314).
If a dealer sells the EFP, he is selling the futures contract, buying the physical gold equivalent in size (100 oz per lot)
If a dealer buys the EFP, he is buying the futures contract, selling the physical gold equivalent in size (100 oz per lot)
Once the EFP price is dealt, traders agree on a reference price for the COMEX Gold futures contract, which is then registered as a trade via their futures broker.
Physical gold is then exchanged using the reference price, adjusted by the EFP.
If we use the example above, dealing the EFP at 2 and using 1,312 as the futures contract reference price, gives 1,310 as the price for the spot physical gold.
Banks prefer to be short EFP, meaning short the futures contract and long the physical, as they get closer to the futures contract expiration.
Rather than having to square their OTC exposure systematically, across wider spreads and with less liquidity, EFP allows traders to hedge the gold markets more efficiently.
Traders typically run OTC positions with an offsetting futures position to be price risk neutral and use the EFP to manage basis risk.
Traders of Exchange Traded Funds (ETFs) use EFP for arbitrage while Authorized Participants create or redeem ETFs.
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