Commodity Swaps

Maybe rolling futures contracts over from time to time just isn't your thing. It's a fair amount to manage.

You can get the same exposure with a __commodity swap__, allowing the exchange of payments based on a series of futures contracts over time. If you find a swap dealer and set up a swap that suits you, what is one difference you would expect from using futures contracts?

No. This is the same. Risk is transferred as you need.

That's right! Futures are standardized, and swaps are not. So you get a greater level of customization here. Risk is still managed or transferred as needed, and you can always exit with the dealer or some opposite swap, but the flexibility is the main difference here.

No, there is. You can always close or find a counteracting swap position. Also, swaps end.

The swap dealer takes the opposite side of whatever you need and can do multiple things with it. Suppose you're swapping based on oil prices, paying a fixed rate and getting whatever excess rate is agreed. The swap dealer could open an offsetting swap with someone else, hedge with futures or with a physical contract, or just hold the exposure. Perhaps over the course of the swap, you paid EUR 5,000 as the premium and then received excess rate payments totaling EUR 4,800. Why might you be happy with that?

No, there is. Think about why you would have started the swap.

Exactly! It's not a matter of making money with the swap. The point is risk reduction, unless you're just speculating. If your exposure is excess rates of return on oil, then this swap has done its job in protecting you, even if it didn't have to provide drastic payments in compensation. Consider if returns did spike. You wouldn't really win in total. You just wouldn't lose. The swap payments would cover your spot market losses.

No. A small loss is nothing to be happy about.

Sometimes, instead of an excess return swap, a total return swap is better. It's simple and based on a commodity index. Any change in the index level is multiplied by the notional amount to get the payment between counterparties. For example, an institutional investor has a EUR 1,000,000,000 portfolio with a 9% exposure to commodities. The entire exposure is covered by a one-year swap, and the next week, the commodity index used in the swap rises 1%. That's a payment of EUR 900,000. $$\displaystyle \mbox{EUR } 1{,}000{,}000{,}000 \times 9 \% \times 1 \% = \mbox{EUR } 900{,}000 $$ Who pays?

No, the institutional investor.

Yes.

The 1% increase in commodities is good for the portfolio, but swapping that exposure means that this benefit must be paid, just like a loss would have been compensated. So the institutional investor will pay for gains and get paid for losses in the portfolio.

There are a few other common types of swaps to be familiar with. A basis swap bases the payments on two different reference commodity futures contracts. A commodity variance swap bases the payments on observed variance of prices, subtracting some fixed variance level. A commodity volatility swap is similar to a variance swap, but it's based on the observed vs. expected volatility as time goes on, rather than observed vs. some fixed level. With each type, there's a buyer of the thing (basis difference, variance, volatility) and a seller.

To summarize: [[summary]]

Risk isn't transferred

The contract isn't standardized

There's no way of exiting the position

There's no reason

At least risk was transferred

At least the loss wasn't more than EUR 200

The swap dealer

The institutional investor

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