Understanding Commodity Swaps

Dec 31, 2021 09:00 AM ET
Understanding Commodity Swaps

In the financial world, a commodity swap is a sort of derivative contract in which two parties agree to exchange cash flows linked to particular underlying commodities. These assets may include commodities like oil, wheat, soybean, gold, etc.

In commodity swapping, there is no actual physical exchange of assets. On the contrary, the parties involved in the transaction simply exchange cash flows as a kind of risk management. This means that they don't swap the asset but rather utilize its price as a basis for determining how much money they will exchange. On the contrary, the parties involved in the transaction simply exchange cash flows as a kind of risk management.

Producers benefit from swaps, which allow them to hedge against price volatility. Markets in which commodities are traded for cash flows mainly attract two types of agents, namely hedgers, who are end-users and investors (speculators). Commodity swaps are mostly used by major financial organizations due to their size and complexity.

How do they function?

Centralized exchanges do not facilitate trade in commodity swaps. It is a tailored agreement that is made outside of a formal exchange and without the involvement of a regulatory body. Instead, over-the-counter transactions are often facilitated by financial services companies.

The buyer becomes a fixed payment in a commodities exchange, whereas the product becomes a floating payer in this arrangement. When the floating price rate is higher than its fixed price, the floating payer bears the additional cost.

If the fixed price is higher than the floating price, the difference must be covered by the person who paid the set price. When trading commodities, it is important to remember that the payment streams are traded rather than the principal amount.

What are the benefits?

Swaps are used by businesses to mitigate risk. They can use it as a measure to mitigate price volatility by using a swap to either receive or pay a predetermined price.

 Another advantage of using them is the high rate of return. They are cash-based financial products. Investing in this way allows investors to save on commodity delivery expenses, allowing them to earn a higher return.

Types of commodity swaps

Commodity-for-interest

The deal resembles an equity swap, except that the asset is commodity prices (rather than stock). In this case, the price will determine the return on one leg, while the interest rate on the other leg will be fixed or floating. Notional principal/face value, pre-specified length, and payment dates are all part of the swap.

As in the fixed-floating swap, the monthly payments will equalize, and the party that is supposed to make the extra payment will base the payment on the interest rate and face value. 

Fixed-floating

Floating and fixed legs are used in this form of the swap contract. The floating leg fluctuates alongside the market price of a commodity, while the fixed leg is the price agreed upon in the contract.

In order to hedge their position, a party will engage in a legally-binding agreement with a swap dealer to pay a predetermined price for a specified quantity of the commodity over a specified time interval. 

After agreeing to pay the party at market pricing for the asset, the swap dealer will pay the party the amount agreed upon. In the end, the party who has to pay more will be responsible for the difference in cash flows.

Additionally, the swap dealer will also find a buyer willing to pay for the product at its current market value. By agreeing to accept and pay a market price that fluctuates with supply and demand, the swap dealer is able to make money on both sides of the transaction.

Why use commodity swaps?

There are a number of sectors that depend on commodities swaps. They are employed as a form of insurance against price fluctuations in the market. For both producers and end-users, these instruments allow them to secure a fixed price for their commodities.

For end-users, it is imperative that they protect themselves against fluctuating commodity prices. If an airline wants to lock in commodity prices as a result of increasing uncertainty on the daily oil production among OPEC members, a swap involving oil may come in handy. If for some reason, the OPEC member states decide to cut production, the airline will have insulated itself from a rise in jet fuel prices even as global prices surge.

Commodity speculators are either firms or individual investors who can participate in the global commodities market and trade. While some may argue that their participation is inherently unstable, the producer and the end-user benefit from the liquidity they supply in regular markets.

Commodity markets are therefore a great place for speculators. According to some financial experts, these markets are more technical-driven or more likely to demonstrate a long-term trend than bond or foreign currency markets.

In summary

We looked at the instrument in which two parties agree to exchange cash flows based on the price of a commodity it tracks in exchange for a fixed amount of money.  They are essential to the operations of many companies, which employ them as a cushion against price fluctuations. They allow both sellers and buyers to guarantee a fixed price for a given product.


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