An alternative to futures, Swaps are a hedging tool that involves two parties exchanging or swapping prices. It works by transferring a market price (floating) for a fixed price over a specific timeframe. Unlike futures, swaps do not trade on an exchange and are customizable.
A commodity swap is a derivative contract where two parties agree to exchange cash flows based on the price of the underlying asset. Used to hedge against price movements, they consist of a floating-leg and a fixed-leg.
The floating-leg is tied to an underlying commodity's market price while the fixed-leg is agreed upon by contract. The purpose is to provide the consumer of the commodity with a guaranteed price while the producer has protection from a decline in the commodity's price.
This hedge requires over-the-counter transactions and therefore is only suitable for pro investors.
The risks for this strategy can be low due to the customized nature of the derivatives contract.
Costs of a derivatives contract are variable.
XYZ Airlines needs to purchase 250,000 barrels of oil each year for two years. The forward prices for this oil in year one is $50 and $51 for year two. Also, the one and two-year zero-coupon-bond yields are 2% and 2.5%.
If the company wants to pay upfront, they take the forward prices and divide by the zero-coupon rate, adjusting for time. The calculation is as follows:
Barrel cost = $50 / (1 + 2%) + $51 / (1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56
In this scenario, the company is paying $97.56 x 250,000, or $24,390,536 for 250,000 barrels of oil per year for two years. The only issue is counterparty risk, which means that there is some probability that the oil producer never delivers.
As an alternative, the company can opt to pay two payments, one each year, as the barrels are delivered. The following calculation determines the amounts:
Barrel cost = X / (1 + 2%) + X / (1 + 2.5%) ^ 2 = $97.56 or $50.49 per barrell
© 2020 Todd Moses
The strategies discussed are for illustrative and educational purposes and are not a recommendation, offer, or solicitation to buy or sell any currency or to adopt any investment strategy. There is no guarantee that any strategies discussed will be useful. Todd Moses is not a licensed securities dealer, broker, or US investment adviser or investment bank.