Commodity swaps are derivatives; the value of a swap is tied to the underlying value of the commodity that it represents. Commodity swap contracts allow the two parties to hedge pricing by fixing the effective price of the asset being traded. Many commodity swaps are run through financial service companies that don't actually swap commodities -- they just tie the security to the price of the commodity. Swaps may be behind the stable performance of the stock of a commodity-producing or commodity-using company that you own, or they could be a way for you to invest in the commodities market.
A fixed-floating commodity swap is similar to interest rate swap contracts, but using commodities instead of bonds as the vehicle. The party that owns the fixed portion will make payments to the floating party when the commodity's value drops. When the value goes up, the floating party pays the fixed party the difference, allowing it to buy the commodity at the set price. These payments cancel out what it will cost to buy and sell the products in the open market at fluctuating prices.
Commodity for Interest Swaps
In a commodity for interest swap, the commodity get swapped for fluctuations in interest rates. The swap contract's return is set up to create an equivalency between the commodity and the chosen interest rate. Given that interest rate increases can produce swings in the prices of some commodities, hedging against this risk can be useful for commodity producers and consumers.
One commonly swapped commodity is jet fuel. Airlines frequently hedge fuel prices to provide them with some predictability in what it will cost them to fly their planes. For instance, as of July 23, 2013, jet fuel sold for approximately $2.94 per gallon. If an airline took the fixed portion of a swap contract for one million gallons of jet fuel and the price dropped to $2.50, it would pay $440,000 to the holder of the floating portion. The airline could then buy a million gallons for $2.50, and, with the 44 cents it paid on the swap contract, it would end up at a price of $2.94 per gallon. If jet fuel went up to $4.00 per gallon, the floating-portion holder would pay the airline $1.06 million. The airline could then buy the fuel at $4 per gallon, subtract the swap payment it received, and end up with a net price of $2.94 per gallon.
Risks of Swaps
Commodity swaps have some built-in risks. First, the banks that set up swap contracts have fees that get built into the price. Second, the nature of a swap is that you give up risk while also giving up any upside; hedging locks a low price in when prices are high, but it also locks in a high price when prices are low. Swaps are also based on financial market prices that might not always track the cost of a product in the real market. The biggest risk in a swap is the risk that the party on the other side of the swap, sometimes referred to as the counterparty, defaults. For instance, if jet fuel prices went to $10 per gallon on a swap at $2.94, the owner of the floating leg would have to come up with $7.06 per gallon. If that party doesn't have the money, the swap could become worthless.
Swaps and Individual Investors
For individual investors, commodity swaps are an alternative to investing in the commodity futures market. Since a swap is a purely financial instrument, individual investors don't end up actually having to take delivery of the commodities that swaps represent. While commodity swaps can be less liquid than other types of commodity investments, they're also more private.
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