Appendix B to Part 151 - Examples of Bona Fide Hedging Transactions and Positions
17:2.0.1.1.23.0.1.14.20 : Appendix B
Appendix B to Part 151 - Examples of Bona Fide Hedging Transactions
and Positions
A non-exhaustive list of examples of bona fide hedging
transactions or positions under § 151.5 is presented below. A
transaction or position qualifies as a bona fide hedging
transaction or position when it meets the requirements under §
151.5(a)(1) and one of the enumerated provisions under §
151.5(a)(2). With respect to a transaction or position that does
not fall within an example in this appendix , a person seeking to
rely on a bona fide hedging exemption under § 151.5 may seek
guidance from the Division of Market Oversight.
1. Royalty Payments
a. Fact Pattern: In order to develop an oil field,
Company A approaches Bank B for financing. To facilitate the loan,
Bank B first establishes an independent legal entity commonly known
as a special purpose vehicle (SPV). Bank B then provides a loan to
the SPV. Payments of principal and interest from the SPV to the
Bank are based on a fixed price for crude oil. The SPV in turn
makes a production loan to Company A. The terms of the production
loan require Company A to provide the SPV with volumetric
production payments (VPPs) based on the SPV's share of the
production and the prevailing price of crude oil. Because the price
of crude may fall, the SPV reduces that risk by entering into a
NYMEX Light Sweet Crude Oil crude oil swap with Swap Dealer C. The
swap requires the SPV to pay Swap Dealer C the floating price of
crude oil and for Swap Dealer C to pay a fixed price. The notional
quantity for the swap is equal to the expected production
underlying the VPPs to the SPV.
Analysis: The swap between Swap Dealer C and the SPV
meets the general requirements for bona fide hedging transactions
(§ 151.5(a)(1)(i)-(iii)) and the specific requirements for royalty
payments (§ 151.5(a)(2)(vi)). The VPPs that the SPV receives
represent anticipated royalty payments from the oil field's
production. The swap represents a substitute for transactions to be
made in the physical marketing channel. The SPV's swap position
qualifies as a hedge because it is economically appropriate to the
reduction of risk. The SPV is reasonably certain that the notional
quantity of the swap is equal to the expected production underlying
the VPPs. The swap reduces the risk associated with a change in
value of a royalty asset. The fluctuations in value of the SPV's
anticipated royalties are substantially related to the fluctuations
in value of the NYMEX Light Sweet Crude Oil Referenced Contract
swap with Swap Dealer C. The risk-reducing position will not
qualify as a bona fide hedge in a physical-delivery Referenced
Contract during the spot month.
b. Continuation of Fact Pattern: Swap Dealer C offsets
the risk associated with the swap to the SPV by selling Referenced
Contracts. The notional quantity of the Referenced Contracts sold
by Swap Dealer C exactly matches the notional quantity of the swap
with the SPV.
Analysis: Because the SPV enters the swap as a bona fide
hedger under § 151.5(a)(2)(vi), the offset of the risk of the swap
in a Referenced Contract by Swap Dealer C qualifies as a bona fide
hedging transaction under § 151.5(a)(3). As provided in §
151.5(a)(3), the risk reducing position of Swap Dealer C does not
qualify as a bona fide hedge in a physical-delivery Referenced
Contract during the spot month.
2. Sovereigns
a. Fact Pattern: A Sovereign induces a farmer to sell his
anticipated production of 100,000 bushels of corn forward to User A
at a fixed price for delivery during the expected harvest. In
return for the farmer entering into the fixed-price forward sale,
the Sovereign agrees to pay the farmer the difference between the
market price at the time of harvest and the price of the
fixed-price forward, in the event that the market price is above
the price of the forward. The fixed-price forward sale of 100,000
bushels of corn reduces the farmer's downside price risk associated
with his anticipated agricultural production. The Sovereign faces
commodity price risk as it stands ready to pay the farmer the
difference between the market price and the price of the
fixed-price contract. To reduce that risk, the Sovereign purchases
100,000 bushels of Chicago Board of Trade (“CBOT”) Corn Referenced
Contract call options.
Analysis: Because the Sovereign and the farmer are acting
together pursuant to an express agreement, the aggregation
provisions of § 151.7 and § 151.5(b) apply and they are treated as
a single person. Taking the positions of the Sovereign and farmer
jointly, the risk profile of the combination of the forward sale
and the long call is approximately equivalent to the risk profile
of a synthetic long put. 521 A synthetic long put may be a bona
fide hedge for anticipated production. Thus, that single person
satisfies the general requirements for bona fide hedging
transactions (§ 151.5(a)(1)(i)-(iii)) and specific requirements for
anticipated agricultural production (§ 151.5(a)(2)(i)(B)). The
synthetic long put is a substitute for transactions that the farmer
will make at a later time in the physical marketing channel after
the crop is harvested. The synthetic long put reduces the price
risk associated with anticipated agricultural production. The size
of the hedge is equivalent to the size of the Sovereign's risk
exposure. As provided under § 151.5(a)(2)(i)(B), the Sovereign's
risk-reducing position will not qualify as a bona fide hedge in a
physical-delivery Referenced Contract during the last five trading
days.
521 Put-call parity describes the mathematical relationship
between price of a put and call with identical strike prices and
expiry.
3. Services
a. Fact Pattern: Company A enters into a risk service
agreement to drill an oil well with Company B. The risk service
agreement provides that a portion of the revenue receipts to
Company A depends on the value of the oil produced. Company A is
concerned that the price of oil may fall resulting in lower
anticipated revenues from the risk service agreement. To reduce
that risk, Company A sells 5,000 NYMEX Light Sweet Crude Oil
Referenced Contracts, which is equivalent to the firm's anticipated
share of the oil produced.
Analysis: Company A's hedge of a portion of its revenue
stream from the risk service agreement meets the general
requirements for bona fide hedging (§ 151.5(a)(1)(i)-(iii)) and the
specific provisions for services (§ 151.5(a)(2)(vii)). Selling
NYMEX Light Sweet Crude Oil Referenced Contracts is a substitute
for transactions to be taken at a later time in the physical
marketing channel once the oil is produced. The Referenced
Contracts sold by Company A are economically appropriate to the
reduction of risk because the total notional quantity of the
Referenced Contracts sold by Company A equals its share of the
expected quantity of future production under the risk service
agreement. Because the price of oil may fall, the transactions in
Referenced Contracts arise from a potential reduction in the value
of the service that Company A is providing to Company B. The
contract for services involves the production of a commodity
underlying the NYMEX Exchange Light Sweet Crude Oil Referenced
Contract. As provided under § 151.5(a)(2)(vii), the risk reducing
position will not qualify as a bona fide hedge during the spot
month of the physical-delivery Referenced Contract.
b. Fact Pattern: A City contracts with Firm A to provide
waste management services. The contract requires that the trucks
used to transport the solid waste use natural gas as a power
source. According to the contract, the City will pay for the cost
of the natural gas used to transport the solid waste by Firm A. In
the event that natural gas prices rise, the City's waste transport
expenses rise. To mitigate this risk, the City establishes a long
position in NYMEX Natural Gas Referenced Contracts that is
equivalent to the expected use of natural gas over the life of the
service contract.
Analysis: This transaction meets the general requirements
for bona fide hedging transaction (§ 151.5(a)(1)(i)-(iii)) and the
specific provisions for services (§ 151.5(a)(2)(vii)). Because the
City is responsible for paying the cash price for the natural gas
used to power the trucks that transport the solid waste under the
services agreement, the long hedge is a substitute for transactions
to be taken at a later time in the physical marketing channel. The
transaction is economically appropriate to the reduction of risk
because the total notional quantity of the positions Referenced
Contracts purchased equals the expected use of natural gas over the
life of the contract. The positions in Referenced Contracts reduce
the risk associated with an increase in anticipated liabilities
that the City may incur in the event that the price of natural gas
increases. The service contract involves the use of a commodity
underlying a Referenced Contract. As provided under §
151.5(a)(2)(vii), the risk reducing position will not qualify as a
bona fide hedge during the spot month of the physical-delivery
Referenced Contract.
c. Fact Pattern: Natural Gas Producer A induces Pipeline
Operator B to build a pipeline between Producer A's natural gas
wells and the Henry Hub pipeline interconnection by entering into a
fixed-price contract for natural gas transportation that guarantees
a specified quantity of gas to be transported over the pipeline.
With the construction of the new pipeline, Producer A plans to
deliver natural gas to Henry Hub at a price differential between
his gas wells and Henry Hub that is higher than its transportation
cost. Producer A is concerned, however, that the price differential
may decline. To lock in the price differential, Producer A decides
to sell outright NYMEX Henry Hub Natural Gas Referenced Contract
cash-settled futures contracts and buy an outright swap that NYMEX
Henry Hub Natural Gas at his gas wells.
Analysis: This transaction satisfies the general
requirements for a bona fide hedge exemption (§§
151.5(a)(1)(i)-(iii)) and specific provisions for services (§
151.5(a)(2)(vii)). 522 The hedge represents a substitute for
transactions to be taken in the future (e.g., selling
natural gas at Henry Hub). The hedge is economically appropriate to
the reduction of risk that the location differential will decline,
provided the hedge is not larger than the quantity equivalent of
the cash market commodity to be produced and transported. As
provided under § 151.5(a)(2)(vii), the risk reducing position will
not qualify as a bona fide hedge during the spot month of the
physical-delivery Referenced Contract.
522 Note that in addition to the use of Referenced Contracts,
Producer A could have hedged this risk by using a basis contract,
which is excluded from the definition of Referenced Contracts.
4. Lending a Commodity
a. Fact Pattern: Bank B lends 1,000 ounces of gold to
Jewelry Fabricator J at LIBOR plus a differential. Under the terms
of the loan, Jewelry Fabricator J may later purchase the gold at a
differential to the prevailing price of Commodity Exchange, Inc.
(“COMEX”) Gold (i.e., an open-price purchase agreement
embedded in the terms of the loan). Jewelry Fabricator J intends to
use the gold to make jewelry and reimburse Bank B for the loan
using the proceeds from jewelry sales. Because Bank B is concerned
about its potential loss if the price of gold drops, it reduces the
risk of a potential loss in the value of the gold by selling COMEX
Gold Referenced Contracts with an equivalent notional quantity of
1,000 ounces of gold.
Analysis: This transaction meets the general bona fide
hedge exemption requirements (§§ 151.5(a)(1)(i)-(iii)) and the
specific requirements associated with owing a cash commodity (§
151.5(a)(2)(i)). Bank B's short hedge of the gold represents a
substitute for a transaction to be made in the physical marketing
channel. Because the total notional quantity of the amount of gold
contracts sold is equal to the amount of gold that Bank B owns, the
hedge is economically appropriate to the reduction of risk.
Finally, the transactions in Referenced Contracts arise from a
potential change in the value of the gold owned by Bank B.
b. Fact Pattern: Silver Processor A agrees to purchase
scrap metal from a Scrap Yard that will be processed into 5,000
ounces of silver. To finance the purchase, Silver Processor A
borrows 5,000 ounces of silver from Bank B and sells the silver in
the cash market. Using the proceeds from the sale of silver in the
cash market, Silver Processor A pays the Scrap Yard for the scrap
metal containing 5,000 ounces of silver at a negotiated discount
from the current spot price. To repay Bank B, Silver Processor A
may either: Provide Bank B with 5,000 ounces of silver and an
interest payment based on a differential to LIBOR; or repay the
Bank at the current COMEX Silver settlement price plus an interest
payment based on a differential to LIBOR (i.e., an
open-price purchase agreement). Silver Processor A processes and
refines the scrap to repay Bank B. Although Bank B has lent the
silver, it is still exposed to a reduction in value if the price of
silver falls. Bank B reduces the risk of a possible decline in the
value of their silver asset over the loan period by selling COMEX
Silver Referenced Contracts with a total notional quantity equal to
5,000 ounces.
Analysis: This transaction meets the general requirements
for a bona fide hedging transaction (§§ 151.5(a)(1)(i)-(iii)) and
specific provisions for owning a commodity (§ 151.5(a)(2)(i)). Bank
B's hedge of the silver that it owns represents a substitute for a
transaction in the physical marketing channel. The hedge is
economically appropriate to the reduction of risk because the bank
owns 5,000 ounces of silver. The hedge reduces the risk of a
potential change in the value of the silver that it owns.
5. Processor Margins
a. Fact Pattern: Soybean Processor A has a total
throughput capacity of 100 million tons of soybeans per year.
Soybean Processor A “crushes” soybeans into products (soybean oil
and meal). It currently has 20 million tons of soybeans in storage
and has offset that risk through fixed-price forward sales of the
amount of products expected to be produced from crushing 20 million
tons of soybeans, thus locking in the crushing margin on 20 million
tons of soybeans. Because it has consistently operated its plant at
full capacity over the last three years, it anticipates purchasing
another 80 million tons of soybeans over the next year. It has not
sold the crushed products forward. Processor A faces the risk that
the difference in price between soybeans and the crushed products
could change such that crush products (i.e., the crush
spread) will be insufficient to cover its operating margins. To
lock in the crush spread, Processor A purchases 80 million tons of
CBOT Soybean Referenced Contracts and sells CBOT Soybean Meal and
Soybean Oil Referenced Contracts, such that the total notional
quantity of soybean meal and oil Referenced Contracts equals the
expected production from crushing soybeans into soybean meal and
oil respectively.
Analysis: These hedging transactions meet the general
requirements for bona fide hedging transactions (§§
151.5(a)(1)(i)-(iii)) and the specific provisions for unfilled
anticipated requirements and unsold anticipated agricultural
production (§§ 151.5(a)(2)(i)-(ii)). Purchases of soybean
Referenced Contracts qualify as bona fide hedging transaction
provided they do not exceed the unfilled anticipated requirements
of the cash commodity for one year (in this case 80 million tons).
Such transactions are a substitute for purchases to be made at a
later time in the physical marketing channel and are economically
appropriate to the reduction of risk. The transactions in
Referenced Contracts arise from a potential change in the value of
soybeans that the processor anticipates owning. The size of the
permissible hedge position in soybeans must be reduced by any
inventories and fixed-price purchases because they are no longer
unfilled requirements. As provided under § 151.5(a)(2)(ii)(C), the
risk reduction position that is not in excess of the anticipated
requirements for soybeans for that month and the next succeeding
month qualifies as a bona fide hedge during the last five trading
days provided it is not in a physical-delivery Referenced
Contract.
Given that Soybean Processor A has purchased 80 million tons
worth of CBOT Soybean Referenced Contracts, it can reduce its
processing risk by selling soybean meal and oil Referenced
Contracts equivalent to the expected production. The sale of CBOT
Soybean, Soybean Meal, and Soybean Oil contracts represents a
substitute for transactions to be taken at a later time in the
physical marketing channel by the soybean processor. Because the
amount of soybean meal and oil Referenced Contracts sold forward by
the soybean processor corresponds to expected production from 80
million tons of soybeans, the hedging transactions are economically
appropriate to the reduction of risk in the conduct and management
of the commercial enterprise. These transactions arise from a
potential change in the value of soybean meal and oil that is
expected to be produced. The size of the permissible hedge position
in the products must be reduced by any fixed-price sales because
they are no longer unsold production. As provided under §
151.5(a)(2)(i)(B), the risk reducing position does not qualify as a
bona fide hedge in a physical-delivery Referenced Contract during
the last five trading days in the event the anticipated crushed
products have not been produced.
6. Portfolio Hedging
a. Fact Pattern: It is currently January and Participant
A owns five million bushels of corn located in its warehouses.
Participant A has entered into fixed-price forward sale contracts
with several processors for a total of five million bushels of corn
that will be delivered in May of this year. Participant A has
separately entered into fixed-price purchase contracts with several
merchandisers for a total of two million bushels of corn to be
delivered in March of this year. Participant A's gross long cash
position is equal to seven million bushels of corn. Because
Participant A has sold forward five million bushels of corn, its
net cash position is equal to long two million bushels of corn. To
reduce its price risk, Participant A chooses to sell the quantity
equivalent of two million bushels of CBOT Corn Referenced
Contracts.
Analysis: The cash position and the fixed-price forward
sale and purchases are all in the same crop year. Participant A
currently owns five million bushels of corn and has effectively
sold that amount forward. The firm is concerned that the remaining
amount - two million bushels worth of fixed-price purchase
contracts - will fall in value. Because the firm's net cash
position is equal to long two million bushels of corn, the firm is
exposed to price risk. Selling the quantity equivalent of two
million bushels of CBOT Corn Referenced Contracts satisfies the
general requirements for bona fide hedging transactions (§§
151.5(a)(1)(i)-(iii)) and the specific provisions associated with
owning a commodity (§ 151.5(a)(2)(i)). 523 Participant A's hedge of
the two million bushels represents a substitute to a fixed-price
forward sale at a later time in the physical marketing channel. The
transaction is economically appropriate to the reduction of risk
because the amount of Referenced Contracts sold does not exceed the
quantity equivalent risk exposure (on a net basis) in the cash
commodity in the current crop year. Lastly, the hedge arises from a
potential change in the value of corn owned by Participant A.
523 Participant A could also choose to hedge on a gross basis.
In that event, Participant A would sell the quantity equivalent of
seven million bushels of March Chicago Board of Trade Corn
Referenced Contracts, and separately purchase the quantity
equivalent of five million bushels of May Chicago Board of Trade
Corn Referenced Contracts.
7. Anticipated Merchandising
a. Fact Pattern: Elevator A, a grain merchandiser, owns a
31 million bushel storage facility. The facility currently has 1
million bushels of corn in storage. Based upon its historical
purchasing and selling patterns for the last three years, Elevator
A expects that in September it will enter into fixed-price forward
purchase contracts for 30 million bushels of corn that it expects
to sell in December. Currently the December corn futures price is
substantially higher than the September corn futures price. In
order to reduce the risk that its unfilled storage capacity will
not be utilized over this period and in turn reduce Elevator A's
profitability, Elevator A purchases the quantity equivalent of 30
million bushels of September CBOT Corn Referenced Contracts and
sells 30 million bushels of December CBOT Corn Referenced
Contracts.
Analysis: This hedging transaction meets the general
requirements for bona fide hedging transactions (§§
151.5(a)(1)(i)-(iii)) and specific provisions associated with
anticipated merchandising (§ 151.5(a)(2)(v)). The hedging
transaction is a substitute for transactions to be taken at a later
time in the physical marketing channel. The hedge is economically
appropriate to the reduction of risk associated with the firm's
unfilled storage capacity because: (1) The December CBOT Corn
futures price is substantially above the September CBOT Corn
futures price; and (2) Elevator A reasonably expects to engage in
the anticipated merchandising activity based on a review of its
historical purchasing and selling patterns at that time of the
year. The risk arises from a change in the value of an asset that
the firm owns. As provided by § 151.5(a)(2)(v), the size of the
hedge is equal to the firm's unfilled storage capacity relating to
its anticipated merchandising activity. The purchase and sale of
offsetting Referenced Contracts are in different months, which
settle in not more than twelve months. As provided under §
151.5(a)(2)(v), the risk reducing position will not qualify as a
bona fide hedge in a physical-delivery Referenced Contract during
the last 5 trading days of the September contract.
8. Aggregation of Persons
a. Fact Pattern: Company A owns 100 percent of Company B.
Company B buys and sells a variety of agricultural products, such
as wheat and cotton. Company B currently owns 1 million bushels of
wheat. To reduce some of its price risk, Company B decides to sell
the quantity equivalent of 600,000 bushels of CBOT Wheat Referenced
Contracts. After communicating with Company B, Company A decides to
sell the quantity equivalent of 400,000 bushels of CBOT Wheat
Referenced Contracts.
Analysis: Because Company A owns more than 10 percent of
Company B, Company A and B are aggregated together as one person
under § 151.7. Under § 151.5(b), entities required to aggregate
accounts or positions under § 151.7 shall be considered the same
person for the purpose of determining whether a person or persons
are eligible for a bona fide hedge exemption under paragraph §
151.5(a). The sale of wheat Referenced Contracts by Company A and B
meets the general requirements for bona fide hedging transactions
(§§ 151.5(a)(1)(i)-(iii)) and the specific provisions for owning a
cash commodity (§ 151.5(a)(2)(i)). The transactions in Referenced
Contracts by Company A and B represent a substitute for
transactions to be taken at a later time in the physical marketing
channel. The transactions in Referenced Contracts by Company A and
B are economically appropriate to the reduction of risk because the
combined total of 1,000,000 bushels of CBOT Wheat Referenced
Contracts sold by Company A and Company B does not exceed the
1,000,000 bushels of wheat that is owned by Company A. The risk
exposure for Company A and B results from a potential change in the
value of wheat.
9. Repurchase Agreements
a. Fact Pattern: When Elevator A purchased 500,000
bushels of wheat in April it decided to reduce its price risk by
selling the quantity equivalent of 500,000 bushels of CBOT Wheat
Referenced Contracts. Because the price of wheat has steadily risen
since April, Elevator A has had to make substantial maintenance
margin payments. To alleviate its concern about further margin
payments, Elevator A decides to enter into a repurchase agreement
with Bank B. The repurchase agreement involves two separate
contracts: A fixed-price sale from Elevator A to Bank B at today's
spot price; and an open-priced purchase agreement that will allow
Elevator A to repurchase the wheat from Bank B at the prevailing
spot price three months from now. Because Bank B obtains title to
the wheat under the fixed-price purchase agreement, it is exposed
to price risk should the price of wheat drop. It therefore decides
to sell the quantity equivalent of 500,000 bushels of CBOT Wheat
Referenced Contracts.
Analysis: Bank B's hedging transaction meets the general
requirements for bona fide hedging transactions (§§
151.5(a)(1)(i)-(iii)) and the specific provisions for owning the
cash commodity (§ 151.5(a)(2)(i)). The sale of Referenced Contracts
by Bank B is a substitute for a transaction to be taken at a later
time in the physical marketing channel either to Elevator A or to
another commercial party. The transaction is economically
appropriate to the reduction of risk in the conduct and management
of the commercial enterprise of Bank B because the notional
quantity of Referenced Contracts sold by Bank B is not larger than
the quantity of cash wheat purchased by Bank B. Finally, the
purchase of CBOT Wheat Referenced Contracts reduces the risk
associated with owning cash wheat.
10. Inventory
a. Fact Pattern: Copper Wire Fabricator A is concerned
about possible reductions in the price of copper. Currently it is
November and it owns inventory of 100,000 pounds of copper and
50,000 pounds of finished copper wire. Currently, deferred futures
prices are lower than the nearby futures price. Copper Wire
Fabricator A expects to sell 150,000 pounds of finished copper wire
in February. To reduce its price risk, Copper Wire Fabricator A
sells 150,000 pounds of February COMEX Copper Referenced
Contracts.
Analysis: The Copper Wire Fabricator A's hedging
transaction meets the general requirements for bona fide hedging
transactions (§§ 151.5(a)(1)(i)-(iii)) and the provisions for
owning a commodity (§ 151.5(a)(2)(i)(A)). The sale of Referenced
Contracts represents a substitute for transactions to be taken at a
later time. The transactions are economically appropriate to the
reduction of risk in the conduct and management of the commercial
enterprise because the price of copper could drop further. The
transactions in Referenced Contracts arise from a possible
reduction in the value of the inventory that it owns.