Commodities markets offer investors the chance to purchase contracts that diversify portfolios and help to limit risk. Although commodities, including items such as oil, precious metals and food products, can have volatile prices, commodity swaps allow participants to reduce other risks. Deregulation of financial institutions has made commodity swaps increasingly popular; business executives and other investors who understand the process can therefore gain a competitive advantage.
Commodity swaps involve two participants, called counterparties. Swaps are done through a contract, or agreement to exchange cash flows dependent upon the price of a given commodity. On predetermined "settlement dates," or dates on which the commodity price is recorded, cash-flow exchanges between the parties takes place. The type of commodity swap entered will depend upon the investment strategy, specifically whether a party is an "end-user," such as a producer or consumer of the commodity, or a speculator attempting to make money from price fluctuations.
Different types of commodity swaps have differing significance. For instance, a gas station chain may be an end user of crude oil; the station chain's executive management may want to enter into a swap in order to avoid volatility in the prices of barrels of oil. By contrast, a manager of a fund based on commodities may see an advantage in the difference between oil prices and current money market rates. In addition, both of the above-described situations may offer the chance to "hedge," or limit future risk. The gas station chain sees the opportunity to lock in an oil price at an affordable rate. The fund manager may view a commodity swap as a hedge against future inflation.
In addition to the underlying intent, commodity swaps may be structured to suit each party's specific financial needs. Swaps may be arranged as fixed floating agreements, for example. In such a contract, one party will pay a fixed price for the given commodity on the settlement date, while the counterparty will pay a floating price for the same commodity. The agreed-upon price is determined by an exchange, such as the Commodities Research Board Index. A fixed floating contract is also known as a "simple swap."
By contrast, a swap can be structured to limit the price paid for the commodity. In these cases, a "cap" or "floor" is placed, meaning that one party pays a specified amount up front, while the counterparty pays the difference by which the price exceeds or falls below the contract price as of the settlement date.
Although simple swaps may be the most common type of commodity contract, there are key variations as well. For example, a hedge may involve a commodity price versus a specified money market rate. In this type of contract, called an interest-for-commodity swap, parties are attempting to hedge against movements in interest rates against commodity prices. A commodity producer may therefore lock in both a price for its product and a hedge against the chance of rising variable rates on the company's debt, for instance. Using varying contract types allows a party to reduce risk (or speculate, in the case of investors) on more than one economic variable at a time.
Commodity swaps have additional costs beyond the potential price paid on the settlement date. For instance, swaps may include brokerage fees as well as risk-analysis and internal administrative costs. In addition, legal ramifications of commodity swaps also affect the type of contract. Creditworthiness of counterparties, security (collateral) available and termination rights of the parties all must be considered. Both additional costs and legal issues can affect management's ultimate choice of commodity swap type.