Traders use commodity swap to hedge against price fluctuations in commodity prices, commonly energy and agriculture commodities
No commodities are exchanged during the ‘swap trade’, cash is exchanged instead.In commodity swaps, exchanged cash flows are dependent on the price (floating/market/spot) of an underlying commodity. It’s more or less similar to a fixed-floating interest rate swap, the difference is the floating leg is based on the price of the underlying commodity insteador EURIBOR.
The advantage of being linked with a commodity swap is that the user can secure a maximum price to the commodity and agree to pay a financial institution a fixed amount. In return, he/she gets payments based on the market price of the commodity. Fixed-floating and commodity-for-interest are the two types of commodity swaps commonly seen.
Let’s think of a practical example, the case of airlines. Airlines, heavy users of oil, will often highly benefit by entering into a swap deal. In swap contracts, airlines companies agree to make a series of fixed payments at a pre-determined frequency, say every three months for two years. In fact, airlines will buy the actual oil from spot market; however they receive payments on agreement dates as determined by an oil price index.
If you're interested in learning more about the commodity market, a good place to start would be to sign up for our mailing list - you'll receive our free essays on gold, silver, crude oil and occasionally on other commodities. Again, it's free and if you don't like it, you can easily unsubscribe..Back