Commodity Swap Definition

What Is a Commodity Swap?

A commodity swap is a kind of by-product contract the place two events comply with trade money flows depending on the worth of an underlying commodity. A commodity swap is normally used to hedge in opposition to value swings available in the market for a commodity, reminiscent of oil and livestock. Commodity swaps enable for the producers of a commodity and customers to lock in a set value for a given commodity.

Commodity swaps are usually not traded on exchanges. Relatively, they’re personalized offers which are executed exterior of formal exchanges and with out the oversight of an trade regulator. Most frequently, the offers are created by monetary companies firms.

How a Commodity Swap Works

A commodity swap consists of a floating-leg part and a fixed-leg part. The floating-leg part is tied to the market value of the underlying commodity or agreed-upon commodity index, whereas the fixed-leg part is specified within the contract. Most commodity swaps are primarily based on oil, although any sort of commodity could also be underlying the swap, reminiscent of valuable metals, industrial metals, pure gasoline, livestock, or grains. Due to the character and sizes of the contracts, usually solely massive monetary establishments interact in commodity swaps, not particular person traders.

Usually, the floating-leg part of the swap is held by the patron of the commodity in query, or the establishment keen to pay a set value for the commodity. The fixed-leg part is mostly held by the producer of the commodity who agrees to pay a floating fee, which is set by the spot market value of the underlying commodity.

The top result’s that the patron of the commodity will get a assured value over a specified time frame, and the producer is in a hedged place, defending them from a decline within the commodity’s value over the identical time frame. Usually, commodity swaps are cash-settled, although bodily supply might be stipulated within the contract.

Along with fixed-floating swaps, there’s one other sort of commodity swap, referred to as a commodity-for-interest swap. In one of these swap, one celebration agrees to pay a return primarily based on the commodity value whereas the opposite celebration is tied to a floating rate of interest or an agreed-upon mounted rate of interest. One of these swap features a notional principal–a predetermined greenback quantity on which the exchanged curiosity funds are primarily based–a specified length, and pre-specified fee intervals. One of these swap helps shield the commodity producer from the draw back threat of a poor return within the occasion of a downturn within the commodity’s market value.

Basically, the aim of commodity swaps is to restrict the quantity of threat for a given celebration throughout the swap. A celebration that desires to hedge their threat in opposition to the volatility of a selected commodity value will enter right into a commodity swap and agree, primarily based on the contract set forth, to just accept a selected value, one which they are going to both pay or obtain all through the course of the settlement. Airline firms are closely depending on gasoline for his or her operations. Swings within the value of oil might be notably difficult for his or her companies, so an airline firm might enter right into a commodity swap settlement to scale back their publicity to any volatility within the oil markets.

Instance of a Commodity Swap

For instance, assume that Firm X must buy 250,000 barrels of oil every year for the subsequent two years. The ahead costs for supply on oil in a single yr 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 a couple of.5%. Two eventualities can occur: paying your complete value upfront or paying every year upon supply.

To calculate the upfront value per barrel, take the ahead costs, and divide by their respective zero-coupon charges, adjusted for time. On this instance, the fee per barrel could be:

Barrel value = $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 in the present day, the patron is assured 250,000 barrels of oil per yr for 2 years. Nonetheless, there’s a counterparty threat, and the oil will not be delivered. On this case, the patron might choose to pay two funds, one every year, because the barrels are being delivered. Right here, the next equation should be solved to equate the full value to the above instance:

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

Given this, it may be calculated that the patron should pay $50.49 per barrel every year.