Commodity Swap – Definition

Cite this article as:"Commodity Swap – Definition," in The Business Professor, updated September 14, 2019, last accessed August 7, 2020, https://thebusinessprofessor.com/lesson/commodity-swap-definition/.

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Commodity Swap Definition

Commodity swap refers to a financial transaction between two parties who agree to exchange commodity price’s 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.

A Little More on What is Commodity Swap

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 price’s 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.

References for Commodity Swap

http://www.businessdictionary.com/definition/commodity-swap.html

https://www.investopedia.com/terms/c/commodityswap.asp

https://en.wikipedia.org/wiki/Commodity_swap

https://www.risk.net/definition/commodity-swap

Academic Research for Commodity Swap

The impact of index and swap funds on commodity futures markets, Irwin, S. H., & Sanders, D. R. (2010). This research analyses the price effect of long-only funds from Jan 2004 to Jan 2008 in the commodity futures markets. The authors draw index traders positions daily in twelve markets from the internal large reporting system of traders, the CFTC uses. The index traders affect commodity future returns irrespective of considering the market participation measure. The findings are that the signs of few important coefficients are relatively as negative as positive and the economic impacts magnitudes are small enough. The index traders presence in many markets has affected volatility but it only uses one measure of index positions changes.

Financial engineering in Islamic finance, Iqbal, Z. (1999). Thunderbird International Business Review, 41(45), 541-559. This paper highlights the scope of engineering and financial innovation in an Islamic financial system. Unlike common beliefs, Islamic finance builds the foundation to construct more complex tools increasing liquidity and propose tools of risk management. The author addresses the problems of risk management and secondary markets. First, he describes the importance of innovation in Islamic markets and secondly, elaborates the process of selling new goods in the market. Third, he explains Islamic asset securitization as an illustration of financial engineering. Finally, he examines the framework of a product swap transaction for determination of its validity and draws conclusions accordingly.

Hidden Debt: From Enron’s Commodity Prepays to Lehman’s Repo 105s, Smith, D. J. (2011). Financial Analysts Journal, 67(5), 15-22. The latest examples of hidden debt to apparently make the financial condition of a company better are Repo (Repurchase) 105s by Lehman Brothers’ and Commodity Prepays by Enron Corporation. The author makes a comparison of both of these models and draws conclusions. Lehman uses sale repo agreements for removing debt from the balance sheet for dates around quarterly periods of reporting while Enron uses derivatives for the transformation of cash flows from financing to the ones from operations. Both of these techniques depend on a narrow focus by external auditors on accounting rules and internal procedures.

Index funds, financialization, and commodity futures markets, Irwin, S. H., & Sanders, D. R. (2011). Applied Economic Perspectives and Policy, 33(1), 1-31. Some policymakers and market contributors believe that the spike in the future prices of the commodity from 2007 to 2008 was because of index funds investment. One empirical evidence is presented as there was an effect of commodity index investment on the future prices level. However, the methods and data used have been criticized on the ground of limiting the confidence a person can place in his results. Another group of researchers find that there is no systematic evidence of relation in commodity future prices level and index funds positions. The lack of direct statistical connection in these two factors makes the belief considerably doubtful that index funds caused a price bubble.

The impact of index funds in commodity futures markets: A systems approach, Sanders, D. R., & Irwin, S. H. (2011). Journal of Alternative Investments, 14(1), 40-49. Some policymakers and market contributors believe that the spike in the future prices of the commodity in 2007 to 2008 was because of index funds investment. One empirical evidence is presented as there was an effect of commodity index investment on the future prices level. However, the methods and data used have been criticized on the ground of limiting the confidence a person can place in his results. Another group of researchers find that there is no systematic evidence of relation in commodity future prices level and index funds positions. The lack of direct statistical connection in these two factors makes the belief considerably doubtful that index funds caused a price bubble.

Speculative influences on commodity futures prices 2006-2008, Gilbert, C. L. (2010, March). Geneva, Switzerland: United Nations Conference on Trade and Development. This article analyses the possible price effect of actively index-based investment and speculative bubbles on commodity future prices from 2006 to 2008. The author especially views the crude oil, 3 agricultural commodities (soybeans, wheat and corn) and 3 nonferrous metals (nickel, aluminium and copper). He also specifies a bubble in the market of soybeans. However, the evidence for the bubble behaviour of nickel and crude oil is weaker. Wheat, aluminium and corn are bubble free. He also evaluates the impacts of index-based investment on the markets of the same commodities. The index-based investment contributes to the increase in the prices of metals and oil.

Swap Transactions under the Commodity Exchange Act: Is Congressional Action Needed, Young, M. D., & Stein, W. L. (1987). Geo. LJ, 76, 1917. Nowadays, swaps are acting as a growing force in the global financial network. Swaps are basically main bilateral contractual arrangements which involve a commitments’ mutual exchange. The swap market participants are large financial organizations and business concerns depending on swaps to control the risk of adverse variations in the exchange rates of currency or interest rates. The Commodity Exchange Act states that all future contracts should be traded on exchanges only but it doesn’t particularly define what is meant by future contracts. In Dec 1987, the CFTC (Commodity Futures Trading Commission) offered to take no action on specific swaps types. Consequently, swap markets may shift to secured regulatory havens.

Commodity speculation and commodity investment, Gilbert, C. L. (2010). Market Review, (28), 26. This paper finds the difference between index-based investment and speculation in commodity futures emphasizing on differing motivations of the 2 groups and differing tools, they use. The author provides information about the amount of money spent on these activities. He provides evidence of extrapolation in the prices of metal consistent with speculation influencing prices and demonstrates that in minimum one market, say soybeans market, there is persistent and significant price effect.

Commodity index investing and commodity futures prices, Stoll, H. R., & Whaley, R. E. (2015). Commodity index investing has met an attack recently. The staff of the United States Senate Permanent Subcommittee on Investigation (SPSI) report states that such commodity index traders proved to be one of the main reasons of unwarranted changes (here, increase in wheat price). This article evaluates commodity index investing as a disruptive force, particularly, in the future market of wheat and generally in the commodity futures market. The findings are that the commodity index investing is definitely not speculation having little impact on future prices. The commodity index investing does not lead future prices to change. The future price of wheat cannot converge to cash price at the expiry of the contract.

Commodity index investing: speculation or diversification?, Stoll, H. R., & Whaley, R. E. (2010).  Recently, there were simultaneous price spikes in many apparently unrelated commodities. Congress examined the rise in prices and remarked that the increase in price was attributed to commodity index investing. The objective of this paper is to investigate that the commodity index investing is leading to disruptions in the commodity futures market. The findings are that because of its long-only passive nature, commodity index investing has no speculation and index flows of the commodity, whether because of rolling over active future positions or making new ones, have little effect on future prices.

Does futures speculation destabilize spot prices? New evidence for commodity markets, Bohl, M. T., & Stephan, P. M. (2013). Journal of Agricultural and Applied Economics, 45(4), 595-616. The authors investigate the increasing market shares of future speculators spot prices of the destabilizing commodity. They estimate conditional volatility and examine how the speculative open interest affects it. The authors divide their sample into 2 equally long sub-periods and observe the speculative impact increases on conditional volatility or not. They find no robust evidence with respect to 6 heavily traded energy and agricultural commodities. So, the findings are that the raw material markets financialization has nothing to do with their volatility any more.

tures speculation destabilize spot prices? New evidence for commodity markets, Bohl, M. T., & Stephan, P. M. (2013). Journal of Agricultural and Applied Economics, 45(4), 595-616. The authors investigate the increasing market shares of future speculators spot prices of the destabilizing commodity. They estimate conditional volatility and examine how the speculative open interest affects it. The authors divide their sample into 2 equally long sub-periods and observe the speculative impact increases on conditional volatility or not. They find no robust evidence with respect to 6 heavily traded energy and agricultural commodities. So, the findings are that the raw material markets financialization has nothing to do with their volatility any more.

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