What is a Commodity Swap?

Commodity swap refers to a financial transaction between two parties who agree to exchange commodity prices cash flow so that they can manage commodity price-related risks. Commodities involved in swaps include livestock, precious metals, or oil. In most cases, airline companies engage in commodity swap agreements to be able to secure oil at lower prices for a long period. Commodity swaps settlement is done in cash and sometimes through physical delivery. Another term for commodity swap is commodity price swap.

How Does a Commodity Swap Work?

In commodity swap, the consumer becomes a fixed payer while the product becomes a floating payer. When the floating price rate of a commodity surpasses that of a fixed price, then the floating payer pays the difference. On the other hand, if the fixed price exceeds that of the floating price, then the difference is paid by the fixed payer. Note that in commodity swap, it is the payment streams that are exchanged and not the principal amount. Also, there is no exchange of commodities when it comes to commodity swap. Instead, the two parties involved in buying and selling basically swap cash flows in order to hedge against price changes in the market. Generally, commodity swaps are important in various commodity-based industries that deal with products such as oil, gas, and livestock. Also, it enables such industries including the end-users to unanimously agree on the price for the underlying commodity. Where future contracts cannot be hedged, business owners instead use swaps to hedge such risks. Note that due to the size and complexity involved in commodity swaps, it is large financial institutions that mostly use it. The risks may be either of the following:

• Geographically related risks
• Quality related risks
• Maturity transaction-related risks

Types of Commodity Swaps

There exist two types of commodity swaps. They include the following: Fixed Floating Swaps Fixed-floating swaps are the same as the interest rate swap market. However, they involve indices that are based on commodities. Initially, market indices place various weights on different commodities. It ensures that they are used as per the swap's agent requirements.   Commodity-for-Interest Swaps   Commodity-for-interest swaps refer to the total return on the commodity being exchanged at a given money market rate. It may or may not include a spread.

Commodity Swaps Uses

Commodity Swaps can be used to achieve various things. Some of the uses include the following:

• Business parties use commodity swap to manage risks. If a party is willing to hedge against commodity price volatility, then swap is used to either receive or pay a fixed price.
• Another commodity swap benefit is high returns. Commodity swap contracts are financial instruments that are settled through cash. For this reason, investors are able to cut down costs related to the physical delivery of commodities, hence maximizing on their returns.

Key Takeaways

Commodity swap refers to a financial transaction where two parties agree to exchange commodity prices cash flow so that they can manage commodity price-related risks.

• There is no exchange of commodities when it comes to commodity swap. Instead, cash flow is used.
• Due to the size and complexity involved in commodity swaps, it is large financial institutions that use it.
• Where future contracts cannot be hedged, business owners use swaps to hedge the risks.