Commodity Swap
It is defined as a financial derivative that is not traded on exchanges. Rather, they are traded over the counter (OTC).
What Is a Commodity Swap?
A commodity swap is defined as a financial derivative that is not traded on exchanges. Rather, they are traded over the counter (OTC).
It allows for two separate parties to agree to exchange cash flows tied to the price of a certain underlying commodity. It is voluntary swaps, and cash flows are swapped per indenture agreements.
Since these swaps are not traded on exchanges, they are traded over the counter, mediated by financial companies. These swaps are used primarily to hedge against market volatility and swings in market prices of underlying commodities.
While one party is typically a hedger (commodity producer) seeking to hedge against price volatility, the other party can be a speculator, an investor, or another hedger looking to take the opposite position.
The end users are those who actually produce the commodity and are doing this swap to hedge against market price volatility. The counterparty is the investor. Investors speculate and bet on the commodity's price going either up or down.
There are two types of speculators, chiefly.
- The type who are mainly in the commodity market in order to hedge themselves against inflation.
- Those who hope to see an opportunity to derive high profits while in the commodity markets.
The mediator, or the one financing these types of swaps, are the swap dealers. These swap dealers are market makers and match speculators with commodity hedgers. They profit from the difference between the bid-ask spread.
Key Takeaways
- Commodity swaps are financial derivatives that allow parties to exchange cash flows based on the price of a specific commodity. These swaps are traded over the counter, providing flexibility and customization.
- Commodity swaps serve the purpose of hedging against market volatility and protecting against price fluctuations.
- Various types of commodity swaps exist, including excess return swaps, total return swaps, basis swaps, variance swaps, and volatility swaps.
- Commodity swaps can be cash-settled or physically settled, depending on the agreements between the parties.
- Commodity swaps are traded over the counter, offering greater flexibility and fewer regulatory constraints compared to exchange-traded futures contracts.
Fixed-Floating Commodity Swaps
The commodity's hedger seeking to hedge against volatility and swings in market prices will pay a fixed price for a specific quantity of the commodity for a specific time frame. In contrast, the swap dealer will negotiate to pay the commodity's market price.
This type of swap contract, which is fixed by the indenture agreement, revolves around two legs:
- The floating leg
- The fixed leg
The floating leg is tied to the commodity's market price. The fixed leg is tied to the agreed-upon price specified in the contract.
In this instance, both the hedger and the swap dealer will compare the price they must pay. The party requiring to pay more would pay the delta of the excess sum against the fixed price to the counterparty.
For instance, the swap dealer pays $x + 10, while the hedger pays $x. The delta would be:
$(x + 10 - x) = $10
which the swap dealer pays the hedger.
Likewise, if the hedger pays $x, and the swap dealer pays $x - 10. The delta would be:
$(x - x + 10) = $10
which the hedger pays to the swap dealer.
As the swap dealer is a market maker and would not directly profit through this method but the bid-ask spread, it will identify speculators who will be the counterparty to the deal instead of it.
Hence, the speculator (which the market maker will identify and use as a counterparty) will take a position on the floating leg (the underlying market price of the commodity).
The speculator now takes the place of the swap dealer in the above example, with the swap dealer profiting against the bid-ask spread.
Commodity-For-Interest Swaps
Similar to the fixed-floating rate swaps, commodity-for-interest swaps use the floating leg of the outstanding market price of the commodity, which the speculator will pay against the delta of either the floating interest rates such as SOFR, or fixed-rate agreed per indenture agreement.
For instance, the price of gold (or rate of it vis-a-vis its starting rate, or specifically, the fluctuations in the price of gold. In this case, the rare instance of a commodity fluctuation can be measured against another commodity's (gold) fluctuation.
The commodity has to be rather common; for instance, in this case, gold is a common commodity used as a measurement.
Note
Take note that despite floating interest rates being used highly attributable to financial instruments or rates set by central banks, other instruments can also be used that are more commodity-based.
Periodic payments (per indenture agreements) will result between the hedger and the speculator, and the party who has the higher price to pay will subtract his total against the party taking the lower price, with the delta paid out to the party who has the lower price.
Importantly, this helps the hedger protect against downside risks of poor returns on commodity market prices.
For instance, take a fixed interest rate of 4% against the volatility of the market spot price of gold in a one-year period.
We assume a notional amount of 1 million dollars, paid once every year at the end of the swap period, then:
Fixed-rate payment = Notional Amount * Fixed Rate * Time Period
Which is the amount the fixed investor will pay the investor backing the floating rate investor.
For the floating rate investor backing the rate of the market spot price for gold:
Assume the percentage change in the price of gold is 5%, then:
Variable Rate Payment = Notional Amount * Variable Rate * Time Period
The floating rate investor has to pay a sum of 50,000 to the investor backing the fixed rate.
Therefore, all cash flow flows equate to the floating rate investor having to pay a sum of 10,000 to the investor backing the fixed rate (after both cash flows are net summed).
What are Commodity Swaps Used For?
Although most commodity swaps are cash settled, some can be arranged to allow for physical delivery of the commodity as per the indenture agreement signed before the agreements between the parties start.
The examples presented above mainly present the case of cash-settled transactions between speculators and producers (hedgers). Cash-settled transactions are more common in dealings.
The main reason for commodity swaps is to ensure that the commodity consumer (speculators in most cash-settled cases) is properly hedged, ensuring protection against a decline in the commodity's spot price.
The institution buying the product paying a floating rate is guaranteed to receive a fixed commodity price.
Although multiple payment periods might exist for physically settled cases, the hedger pays at the pre-existing fixed price. The commodity is settled at the existing fixed price, which has been agreed upon as per the indenture statement.
Note the difference in the two cases, where the first (cash-settled) would involve the two parties of speculators and commodity producers(usually the hedger).
Commodity Swap Worked Example
In the physical delivery case (second case), the two parties of the commodity producer and the institution (this is now the hedger) have the role of the hedger swapped around. In this case, the hedger is now the institution that protects itself against volatility by locking in fixed prices.
In this hypothetical example, Party A, a gold producer, and Party B, a financial institution, engage in a commodity and interest rate swap. Party A seeks to manage the price fluctuations of gold, while Party B aims to manage exposure to the SOFR (Secured Overnight Financing Rate) interest rate over a 1-year period.
1. Parties Involved:
Party A, representing the gold producer, and Party B, representing the financial institution, participate in this swap.
2. Swap Details:
Party A and Party B agree to exchange the price movements of gold and the fluctuations in the SOFR interest rate.
- Duration: 1 year
- Notional Amount for Gold: $1,000,000
- Notional Amount for SOFR: $10,000,000
3. Pricing and Settlement:
Initial Agreement: At the start, Party A and Party B establish the prevailing price of gold and the current SOFR rate.
- Settlement Frequency: Monthly
4. Payment Calculation:
Monthly, both parties calculate the difference between the initially agreed gold price and the current market gold price. Additionally, Party B computes the change in the SOFR rate for the month.
If the gold price fluctuation is in favor of Party A or the SOFR change benefits Party B, the respective party compensates the other party.
5. Example Calculation (for illustration):
For Month 1:
- Agreed-upon gold price: $1,800 per ounce
- Agreed-upon SOFR rate: 0.25%
- Market gold price: $1,750 per ounce
- Market SOFR rate: 0.30%
Gold Payment:
Party B pays Party A ($1,800 - $1,750) * Notional Amount = $5,000
SOFR Payment:
Party A pays Party B ($10,000,000 * (0.30% - 0.25%)) = $500
6. Termination
At the conclusion of the 1-year term, outstanding payments are reconciled, and the final settlement is made.
7. Risks and Considerations
Counterparty Risk: Both parties assume the risk of the other party defaulting on payment commitments.
Market and Interest Rate Risk: Fluctuations in gold prices and SOFR rates can lead to unpredictable payment variations.
8. Legal and Financial Consultation
For a comprehensive agreement, it is recommended that both parties consult legal and financial experts. The formal contract should cover all terms, conditions, and potential scenarios.
Conclusion
In conclusion, commodity swaps play a significant role in the financial markets, providing a means for hedging against market volatility and swings in commodity prices.
These swaps involve two parties:
- The hedger, typically the commodity producer seeking protection against price fluctuations
- The counterparty, often a speculator or investor
The swaps can be either cash-settled or physically settled, depending on the agreements between the parties.
Fixed-floating commodity swaps involve exchanging cash flows based on the fixed price specified in the contract and the market price of the commodity. The party paying more than the agreed fixed price pays the difference to the counterparty.
Commodity-for-interest swaps operate similarly, but the floating leg is tied to a floating interest rate or a fixed rate, offering protection against poor returns on commodity market prices.
Commodity swaps ensure that commodities' consumers are properly hedged and protected against declines in spot prices. They allow institutions or consumers buying the product to guarantee a fixed commodity price, thus mitigating downside risks.
Swap dealers act as market makers, matching speculators with commodity hedgers and profiting from the bid-ask spread.
There are various types of commodity swaps, including excess return swaps, total return swaps, basis swaps, variance swaps, and volatility swaps.
These swaps offer flexibility and customization, catering to specific needs and correlations between different commodities or indices. They allow parties to trade on expectations of price volatility, observed variances, or actual market deviations, depending on the type of swap.
Unlike futures contracts traded on exchanges, commodity swaps are traded over the counter, providing greater versatility and fewer regulatory constraints. This makes swaps a valuable tool for hedging against specific measures and managing risks in commodity markets.
Overall, commodity swaps enable market participants to navigate the challenges posed by price fluctuations and market uncertainties, fostering stability and efficiency in the commodity trading landscape.
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