Commodities are tangible products such as cattle, natural gas, metals, wheat and crude oil. Commodity swaps involve an agreement between speculators or investors and the end-user, sometimes called the hedger. The investor naturally seeks to make a profit from the deal, and the hedger is hoping to control future costs of the products necessary for business operations. There are two basic types of commodity swaps: commodity-for-interest swaps and fixed-floating swaps. It is helpful to understand the advantages of commodity swaps to both parties.
Commodity Swap Basics
In simple terms, a swap is an exchange of cash flows. End-users want to reduce or eliminate the risk that prices for necessary commodities will fluctuate too greatly. For example, an oil refinery might want to secure a hedge against crude oil prices skyrocketing, or a company that produces canned vegetables might want to lock in a price on next season's corn crop.
Commodity for Interest Swaps
In an equity swap, two parties agree to a trade in which one or both is an equity index, such as the Dow Jones Industrial Average, the Standard and Poor's 500 or a similar index. Commodity for interest swaps bear much similarity to equity swaps. The commodity's total return is swapped for a money market interest rate. Typically, the rate contains a spread, such as plus or minus 0.5 percent.
Fixed-Floating Commodity Swaps
Interest rate swaps most often involve a trade of a fixed-rate cash flow for a floating-rate cash flow. A cash flow comprises a predetermined index, swap dates and the face value, called the notional amount. A fixed-floating commodity swap is similar, except each asset carries a commodity-based index, such as the Goldman Sachs Commodities Index.
Options on Swaps
Derivatives derive their value from an underlying security. Futures, structured notes, swaps and options are all types of derivatives. In some cases, derivatives are viewed as a type of insurance, much like paying a premium to protect against potential loss. A swap can be combined with an option to allow further hedging. By purchasing an option, the buyer does not obligate himself to execute a swap agreement, but he retains the right to do so if he so desires.
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