Commodity Swaps
A commodity swap is a financial contract between two parties to exchange cash flows based on the price of a specific commodity or basket of commodities. The cash flows are usually determined by the difference between the agreed-upon price and the actual market price of the underlying commodity.
Commodity swaps are commonly used by businesses and investors to manage their exposure to commodity price fluctuations, allowing them to hedge against price risk. For example, a producer of a commodity may enter into a commodity swap with a counterparty to lock in a fixed price for their future production. This protects the producer from price fluctuations and provides certainty around future revenues.
In a commodity swap, one party agrees to pay a fixed price for the commodity, while the other party agrees to pay the floating market price of the commodity. The payments are made periodically, such as monthly or quarterly, and are based on the difference between the fixed price and the market price of the commodity at the time of payment.
Commodity swaps are typically customized contracts that are negotiated between the two parties, allowing them to tailor the terms to their specific needs. The contract can specify the commodity, delivery location, delivery period, and other terms that are relevant to the parties.
Commodity swaps can be settled physically or financially. Physical settlement involves the physical delivery of the underlying commodity, while financial settlement involves cash payment based on the difference between the fixed price and the market price of the commodity.
Commodity swaps are typically traded over-the-counter (OTC) between two parties, rather than on an exchange. This allows for greater flexibility in terms of contract customization, but also carries counterparty risk. To mitigate this risk, parties may use collateral or credit support agreements to secure the transaction.
In summary, commodity swaps are a financial contract used to manage exposure to commodity price fluctuations. They allow parties to lock in a fixed price for the underlying commodity, providing certainty around future revenues or costs. Commodity swaps are typically customized contracts negotiated between two parties, and can be settled physically or financially. They are typically traded over-the-counter and carry counterparty risk, which can be mitigated through collateral or credit support agreements.