A commodity swap is a derivative contract in which two parties agree to exchange cash flows based on the price fluctuations of an underlying commodity. This financial instrument helps mitigate the risks associated with price volatility in the commodity market. Various elements of swaps play a crucial role in enhancing risk management for investors. Let’s learn more about it below.
Introduction
A commodity swap is a derivative contract whereby two parties exchange cash flows based on the prices of an underlying commodity. This allows better hedging against possible price volatility. In some cases, corporations use swaps as a way to control costs.
Why does it matter?
- Companies/investors can protect themselves from price fluctuations/swings in what commodities they buy or sell, thus enabling better risk management.
- They allow investors/businesses to establish and agree upon prices of commodities at future dates.
- An investor can diversify portfolios while increasing exposure to the commodity market.
- They are also much more efficient since they tend to drastically reduce transaction costs.
Examples of commodities traded in this manner include the hard (gold, oil, natural resources, etc.) and soft (wheat, coffee, corn, sugar, etc.) commodities.
Concept of Commodity Swaps
Understand this very basic structure of commodity swaps –
- One party or the fixed rate payer will pay a certain amount for the specified quantity of any commodity to the other party or floating rate payer.
- In return for this service, the floating rate payer will pay an amount to the fixed rate payer tied to the commodity price in the market.
These types of items swap are different from that of futures and options. All these belong to derivatives but differ in nature and purpose. Swaps represent the cash flow exchange based on commodity prices, futures are known to be standard contracts for any commodity for future delivery, whereas options would give the power to the holder and not the obligation to buy/sell.
How Commodity Swaps Work
Here are further insights into the working of commodity swaps:
- Commodity swaps are executed over-the-counter between the two parties, usually with the involvement of a financial institution.
- In most instances, the two actors will not actually exchange the commodity; rather, they will exchange cash flows based on the price variation of the commodity.
- The settlement can be either in the form of physical settlement or cash settlement.
Physical Settlement – Involves the physical delivery of the underlying commodity. It is useful for companies that intend to physically use/retain the commodity but make it costlier and logistically complex, involving quality control, storage, transportation, etc.
Cash Settlement– Cash is exchanged if the difference in value is the only thing that really matters to the parties involved; this is most commonly the case, though it does involve the delivery of the underlying commodity.
Pricing Considerations:
- Some of the major considerations in pricing swaps relate to the underlying commodity’s forward curve, hedging costs, and interest rates.
- The swap’s fixed price stems from a combination of the expected future price of the underlying commodity, as evidenced by the forward curve. The fixed price will also be contingent on the duration of the swap (longer-term swaps necessitate higher fixed prices to compensate for price fluctuation risks over a larger duration). The timing of the payment will also affect pricing.
- Interest rates are considered for discounting the anticipated future cash flows into the present. It is a very important consideration in the determination of the fixed price. In addition, the risk-free rate is taken as the basis for pricing the swap.
- The cost of hedging would also have an effect on the fixed price, which depends on the liquidity of the underlying commodity market.
- There are other factors, such as seasonality, commodity market structure, and credit risks, among others.
Advantages of Commodity Swaps
Several advantages accrue to commodity swaps in particular. Some of them are discussed below:
Hedge Against Future Volatility – By either party in the contract exercising this hedge against the risks of volatility in commodity market price fluctuations, both parties are well protected. A company can lock in the price of a commodity and thereby protect itself from increasing prices. Conversely, a company that agrees to pay for the commodity at a price linked to the market price can benefit in case of a decline in prices.
The hedging ability may become a boon in times of increased market volatility and unpredictability in which case companies may be able to stabilize operating costs, cash flows, and profit margins.
Predictable Cash Flows – A commodity swap helps a company actually have predictable cash flows. If it fixes prices for commodities about which there is high level of certainty, such cash flows become stabilized. This enhances financial planning and budgeting, helps maintain steady cash inflows for the organization during a price drop, and thus paying the commodity at market price is given.
Risk Management – Swaps are a most effective tool for risk management on the part of both consumers and producers. They allow the exchange of variable cash flows for outside sources for use within its operations so as to lower exposure to price fluctuations while structurally consolidating cash flows. Under such contracts, locking in a price would help hedge against price movements for chosen commodities through custom-made risk management strategies.
Example of a Commodity Swap
Let us take a more specific example to give you a better idea.
Suppose an airline enters into a contract for paying a fixed rate of ₹1,000 per gallon for its fuel requirements of 100 gallons. If at the payment period, the price of the fuel is ₹1,200 per gallon, then the airline would say it has saved ₹200 per gallon, that is 200*100 = ₹20,000. The other party will pay this difference to the airline, enabling the airline to alleviate the pressure of rising fuel prices. Thus, the airline can maintain its margins better and stabilize cash flow.
Conclusion
A commodity swap is a way to hedge against price volatility in the future, stabilize cash flow, and smoothen operations for producers and users of commodities. You can position yourself in the commodity market through tactical swaps while diversifying your portfolio.
