What is a 'Commodity Swap'

A commodity swap is a contract where two sides of the deal agree to exchange cash flows, which are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity, and they have been trading in the over-the-counter markets since the middle of the 1970s.

BREAKING DOWN 'Commodity Swap'

A commodity swap consists of a floating-leg component and a fixed-leg component. The floating-leg component is tied to the market price of the underlying commodity or agreed-upon commodity index, while the fixed-leg component is specified in the contract. Most commodity swaps are based on oil, though any type of commodity may be the underlying, such as precious metals, industrial metals, natural gas, livestock and grains. Considering the nature and sizes of the contracts, typically large financial institutions engage in commodity swaps, not individual investors.

Structure and Example

Generally, the floating-leg component of the swap is held by the consumer of the commodity in question, or the institution willing to pay a fixed price for the commodity. The fixed-leg component is generally held by the producer of the commodity who agrees to pay a floating rate, which is determined by the spot market price of the underlying commodity. The end result is that the consumer of the commodity gets a guaranteed price over a specified period of time, and the producer is in a hedged position, protecting them from a decline in the commodity's price over the same period of time. Typically, commodity swaps are cash-settled, though physical delivery can be stipulated in the contract.

As an example, assume that Company X needs to purchase 250,000 barrels of oil each year for the next two years. The forward prices for delivery on oil in one year and two years are $50 per barrel and $51 per barrel. Also, the one-year and two-year zero-coupon bond yields are 2% and 2.5%. Two scenarios can happen: paying the entire cost upfront, or paying each year upon delivery.

To calculate the upfront cost per barrel, take the forward prices, and divide by their respective zero-coupon rates, adjusted for time. In this example, the cost per barrel would be:

Barrel cost = $50 / (1 + 2%) + $51 / (1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56.

By paying $97.56 x 250,000, or $24,390,536 today, the consumer is guaranteed 250,000 barrels of oil per year for two years. However, there is counterparts risk, and the oil may not be delivered. In this case, the consumer may opt to pay two payments, one each year, as the barrels are being delivered. Here, the following equation must be solved to equate the total cost to the above example:

Barrel cost = X / (1 + 2%) + X / (1 + 2.5%) ^ 2 = $97.56.

Given this, it can be calculated that the consumer must pay $50.49 per barrel each year.

RELATED TERMS
  1. Commodity Price Risk

    Commodity price risk is price uncertainty that adversely impacts ...
  2. Asset Swap

    An asset swap is a derivative contract through which fixed and ...
  3. Commodity Market

    The commodity market is a physical or virtual marketplace for ...
  4. Swap Bank

    A swap bank is an institution that acts as a broker to two unnamed ...
  5. Floating Price

    The floating price is a leg of a swap contract that depends on ...
  6. Reverse Swap

    A reverse swap is an exchange of cash flow streams that undoes ...
Related Articles
  1. Financial Advisor

    When Will it Be Safe to Buy Commodities?

    When will it be safe to buy commodities (and which ones)? A closer look at the commodities markets and how they move.
  2. Trading

    Different Types of Swaps

    Identify and explore the most common types of swap contracts. Swaps are derivative instruments that represent an agreement between two parties to exchange a series of cash flows over a specific ...
  3. Investing

    All About Liquid Commodities

    You might hear 'liquid commodities' and think of an auction, but they're actually a high-volume, fast paced financial product suitable for day traders.
  4. Investing

    3 Reasons to Invest in Discounted Commodities

    Though they're selling at depressed prices, there are several reasons that it could make sense to invest in commodities now.
  5. Investing

    Top 3 Commodities ETFs for 2018

    Commodities ETFs are a great way for investors to jump into the sector while avoiding some of the volatility that tends to befall the individual stocks. Here are three with momentum.
  6. Trading

    Currency Swap Basics

    Find out what makes currency swaps unique and slightly more complicated than other types of swaps.
  7. Trading

    How To Value Interest Rate Swaps

    An interest rate swap is a contractual agreement between two parties agreeing to exchange cash flows of an underlying asset for a fixed period of time.
  8. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  9. Investing

    Why Investing in Commodities Can Be Tricky

    While some exposure to commodities can enhance a portfolio, it is key to understand the investment vehicle you've chosen, or you could be in for a rude awakening.
RELATED FAQS
  1. What is the difference between derivatives and swaps?

    Swaps comprise just one type of the broader asset class called derivatives. Read Answer >>
  2. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
  3. How do companies benefit from interest rate and currency swaps?

    Interest rate and currency swaps help companies manage exposure to rate fluctuations and acquire a lower rate than they would ... Read Answer >>
  4. What is a Debt for Equity Swap?

    Learn why companies issue debt for equity swaps, what they are, and how they impact shareholders and debt holders. Read Answer >>
Trading Center