Commodity Swap: Types, Valuation, and Definition

A commodity swap helps producers manage their exposure to fluctuations in their products’ prices, and although they can be risky, these swaps are important for energy, chemical and agricultural companies. The speculators who buy and sell these commodities through various types of swaps are a crucial part of the market and play a key role in pricing these commodities.

Commodities are physical assets such as precious and base metals, energy stores (natural gas or crude oil) and food (including wheat, pork bellies and cattle). These can be swapped for cash flows under what’s called a commodity swap, through markets that involve two kinds of agents: end-users (hedgers) and investors (speculators).

Commodity Swap Users

Commodity producers need to manage their exposure to fluctuations in the prices for their products. They’re primarily concerned with fixing prices on contracts to sell their commodities. A gold producer will want to hedge losses related to a fall in the price of gold for his current inventory, while a cattle farmer will seek to hedge his exposure to changes in the price of livestock.

End-users need to hedge the prices at which they can purchase these commodities. A university might want to lock in the price at which it purchases electricity to supply its air conditioning units for the upcoming summer months; an airline will need to lock in the price of the jet fuel it needs to purchase in order to satisfy the peak in seasonal demand for travel.

Speculators are funds or individual investors who can either buy or sell commodities by participating in the global commodities market. While many may argue that their involvement is fundamentally destabilizing, it’s the liquidity they provide in normal markets that facilitates the business of the producer and of the end-user.

Why Would Speculators Look at the Commodities Markets?

Traditionally, speculators looked at the commodities market as a way to hedge against inflation and offset increased prices stemming from higher input costs.

Or, speculators can also find tremendous opportunity in commodity markets. Some analysts argue that commodity markets are more technically-driven or more likely to show a persistent trend compared to other markets like bonds or foreign exchange.

The futures markets have been the traditional vehicles for participating in the commodities markets. In fact, derivatives markets started in the commodities field.

Types of Commodity Swaps

There are two types of commodity swaps: fixed-floating and commodity-for-interest.

Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market, but they involve commodity-based indices.

General market indices in the commodities market like the Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board Index (CRB) place different weights on the various commodities, so they’ll be used according to the swap agent’s requirements.

Commodity-for-interest swaps are similar to the equity swap in that a total return on the commodity in question is exchanged for some money market rate (plus or minus a spread).

Valuing a Commodity Swap

In pricing a commodity swap, it’s helpful to think of the swap as a strip of forward contracts, each priced at inception with zero market value (in a present value sense). Thinking of a swap as a strip of at-the-money forwards is also a useful and intuitive way of interpreting interest rate swaps or equity swaps.

A commodity swap is characterized by some idiosyncratic peculiarities that we should take into account. These include:

  1. The cost of hedging
  2. The institutional structure of the particular commodity market in question
  3. he liquidity of the underlying commodity market
  4. Seasonality and its effects on the underlying commodity market
  5. The variability of the futures bid/offer spread
  6. Brokerage fees
  7. Credit risk, capital costs and administrative costs

Some of these factors must be extended to the pricing and hedging of interest rate swaps, currency swaps and equity swaps as well. The idiosyncratic nature of the commodity markets refers more to the often-limited number of participants in these markets (naturally begging questions of liquidity and market information), the unique factors driving these markets, the inter-relations with cognate markets and the individual participants in these markets.

Correlation and Basis

Many times when using commodity derivatives to hedge an exposure to a financial price, there is not one exact contract that can be used to hedge the exposure. If you are trying to hedge the value of a particular type of a refined chemical derived from crude oil, you may not find a listed contract for that individual product. But if you’re lucky, you’ll find an over-the-counter price.

How do the OTC Traders Hedge this Risk

OTC traders hedge the risk involved in commodity markets by looking at the correlation for clues as to how to price the OTC product they’re offering. They make assumptions about the stability of the correlation and its volatility, using that to “shade” the price they ultimately put forward.

Correlation is an unhedgeable risk for the OTC market maker and there is very little that he can do if the correlation breaks down.

For example, if the price for your individual chemical suddenly starts dropping faster than the correlation of the chemical’s price with crude oil suggests it should, the OTC dealer has to start dumping more crude oil in order to compensate.

The OTC market maker’s best hope is to see enough “two-way” business involving end-users and producers so that his exposure is “naturally” hedged by people seeking to benefit from price movement in either direction.

While a commodity swap and commodity derivatives can be risky business, they’re a useful and important risk-hedging tool employed by most leading energy, chemical and agricultural corporations.

4 years ago