Commodity Swap

What Is a Commodity Swap?

A commodity swap is a type of derivative contract where two gatherings consent to exchange cash flows dependent on the price of an underlying commodity. A commodity swap is typically used to hedge against price swings in the market for a commodity, like oil and domesticated animals. Commodity swaps consider the producers of a commodity and consumers to lock in a set price for a given commodity.

Commodity swaps are not traded on exchanges. Rather, they are tweaked deals that are executed outside of formal exchanges and without the oversight of an exchange regulator. Most frequently, the deals are made by financial services companies.

How a Commodity Swap Works

A commodity swap comprises of a floating-leg component and a fixed-leg component. The floating-leg component is tied to the market price of the underlying commodity or settled upon commodity index, while the fixed-leg component is determined in the contract. Most commodity swaps depend on oil, however any type of commodity might be underlying the swap, like precious metals, industrial metals, natural gas, animals, or grains. In view of the nature and sizes of the contracts, ordinarily just large financial institutions participate in commodity swaps, not individual investors.

Generally, the floating-leg component of the swap is held by the consumer of the commodity being referred to, or the institution ready to pay a fixed price for the commodity. The fixed-leg component is generally held by the producer of the commodity who consents to pay a floating rate, not entirely settled by the spot market price of the underlying commodity.

The final product is that the consumer of the commodity gets a guaranteed price over a predetermined period of time, and the producer is in a hedged position, protecting them from a decline in the commodity's price over a similar period of time. Ordinarily, commodity swaps are cash-settled, however physical delivery can be stipulated in the contract.

Notwithstanding fixed-floating swaps, there is one more type of commodity swap, called a commodity-for-interest swap. In this type of swap, one party consents to pay a return in light of the commodity price while the other party is tied to a floating interest rate or a settled upon fixed interest rate. This type of swap incorporates a notional principal- a foreordained dollar amount on which the exchanged interest payments are based-a predetermined duration, and pre-determined payment periods. This type of swap shields the commodity producer from the downside risk of a poor return in the event of a downturn in the commodity's market price.

As a general rule, the purpose of commodity swaps is to limit the amount of risk for a given party inside the swap. A party that needs to hedge their risk against the volatility of a specific commodity price will go into a commodity swap and concur, in light of the contract set forward, to acknowledge a specific price, one that they will either pay or receive all through the agreement. Airline companies are intensely dependent on fuel for their operations. Swings in the price of oil can be especially trying for their organizations, so an airline company might go into a commodity swap agreement to reduce their exposure to any volatility in the oil markets.

Illustration of a Commodity Swap

For instance, accept that Company X necessities to purchase 250,000 barrels of oil every year for the next two years. The forward prices for delivery on oil in one year and two years are $50 per barrel and $51 per barrel. Additionally, the one-year and two-year zero-coupon bond yields are 2% and 2.5%. Two situations can occur: paying the whole cost upfront or paying every year upon delivery.

To compute the upfront cost per barrel, take the forward prices, and gap by their particular zero-coupon rates, adjusted for time. In this model, the cost per barrel would be:

Barrel cost = $50/(1 + 2%) + $51/(1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56.

By paying $97.56 x 250,000, or $24,390,536 today, the consumer is guaranteed 250,000 barrels of oil each year for a long time. Be that as it may, there is a counterparty risk, and the oil may not be delivered. In this case, the consumer might opt to pay two payments, one every year, as the barrels are being delivered. Here, the accompanying equation must be addressed to compare the total cost to the above model:

Barrel cost = X/(1 + 2%) + X/(1 + 2.5%) ^ 2 = $97.56.

Given this, it very well may be calculated that the consumer must pay $50.49 per barrel every year.

Features

A commodity swap is typically used to hedge against price swings in the market for a commodity, like oil and animals.
Commodity swaps are not traded on exchanges; they are altered deals that are executed outside of formal exchanges and without the oversight of an exchange regulator.
A commodity swap is a type of derivative contract where two gatherings consent to exchange cash flows dependent on the price of an underlying commodity.