A commodity swap (sw or swap) is a contract whereby the two sides exchange a single cash flow that is dependent on the price of the underlying commodity, where the buyer pays a predefined fixed rate and receives a floating rate.
This floating rate is calculated as the average price of the underlying commodity over a series of predefined fixings (the defined observation period). The fixing basis for the swap's underlying commodity depends on the market convention for the specific underlying.
In the market there are exchange swaps as well as OTC swaps.
In SDX Commodities & Energy a swap provides you with additional input flexibility, letting you tailor the swap to the OTC market. For example, if you enter a 3-month swap, it is entered as a single 3-month swap, with only one settlement date.
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In addition, you can enter into a composite or quanto version of this instrument. |
The settlement itself is usually made in cash.
On the settlement date:
If the calculated floating rate is higher than the predefined fixed rate, the buyer receives the difference between the two.
If the calculated floating rate is lower than the fixed rate, the buyer pays the difference between the two.
If the calculated floating rate is equal to the fixed rate, no exchange of cash occurs.
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A Henry Hub natural gas swap is also known as a lookalike future. This is because it is an OTC swap traded off floor but it has the same characteristics as a future. |
Why buy a swap?
A swap:
Offers more flexibility than an exchange traded product such as a future. This is because a swap can be tailored to be an exact hedge for the underlying exposure, and there are no restrictions on contract size.
Can be used to hedge against the price of a commodity. By replacing the floating rate of the underlying commodity with a fixed (and therefore known-in-advance) rate, it lets you manage exposure to any future price movement. That is, the buyer will know the required cash flow up-front.
A buyer of a swap thinks that the market will move adversely and so wants to hedge the cost of the commodity by fixing the outgoing cash flow, while accepting the fact that no profit can occur from a favorable move in the commodity’s price (because its structure does not allow for any participation in a favorable spot movement).