Commodities are physical assets such as precious metals, base metals, energy stores (such as natural gas or crude oil) and food (including wheat, pork bellies, cattle, etc.). Commodity swaps were first traded in the mid-1970's, and enable producers and consumers to hedge commodity prices. Swaps involving oil prices are probably the most common; however, swaps involving weather derivatives are increasingly popular. The floating leg of a commodity swap is tied to the price of a commodity or a commodity index, while the fixed leg payments are stipulated in the contract as in an interest rate swap. It is common for a commodity swap to be settled in cash, although physical delivery is becoming increasingly common. The floating leg is typically held by a commodity consumer, who is willing to pay a fixed rate for a commodity to guarantee its price. The fixed leg is typically held by a commodity producer who agrees to pay a floating rate which is set by the market price of the underlying commodity, thereby hedging against falls in the price of the commodity. In most cases, swap rates are fixed either by commodity futures, or by estimating the commodity forward price.
There are two main types of commodity swaps:
- Fixed-floating commodity swaps are similar to the interest rate fixed-floating swaps except that both legs are commodity based. These are used by commodity producers and consumers to lock in commodity prices.
- Commodity for interest swaps are similar to equity swaps, in which a total return on the commodity is exchanged for some money market rate (plus or minus a spread).
To value the swap, the present value of the cash flows of each leg of the transaction must be determined.
The fair value of the swap is calculated as well as cash flows for floating and fixed legs of a fixed-floating commodity or commodity for interest swap including discount factors and present values.
FINCAD analytics return fair value and risk statistics for commodity and equity swaps.
- Generic and non-generic commodity and equity swaps
- Fixed and floating legs
- Fair benchmark price to use for the fixed leg of a generic commodity swap
To evaluate an FINCAD product that can price commodity swaps, contact a FINCAD Representative