What is a commodity swap?
A commodity swap is an agreement between two parties linked to the market price of a commodity such as oil, livestock or a precious metal. One party exchanges their exposure to a floating (market) price for a fixed price over a set period of time.
Where have you heard about commodity swaps?
The majority of commodity swaps involve oil. Airlines and rail companies are known for entering into commodity swap deals to lock in their fuel costs as they’re big consumers of oil.
What you need to know about commodity swaps...
No commodities are actually exchanged in a commodity swap. Instead, buyers and sellers 'swap' cash flows with each other to hedge against price fluctuations.
A company that uses commodities might find its profits threatened if commodity prices become volatile so can benefit by entering into a swap agreement.
A commodity swap involves a floating-leg component and a fixed-leg component. The floating leg is linked to the market price of the commodity or commodity index, while the fixed-leg value is specified in the contract. Because of the complexity and size of the contracts, it’s normally large financial institutions that use commodity swaps rather than individual investors.