COMMODITY SWAPS

The final class for which we will consider swapping cash flows is commodities. 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.). There are two kinds of agents participating in the commodity markets: end-users (hedgers) and investors (speculators). Indeed, the Chicago exchange breaks out the open interest in the Commitment of Traders Report by hedger and speculator. It is a technical tool used by some market analysts to predict future direction.

Producers need to manage their exposure to fluctuations in the prices for their commodities. They are primarily concerned with fixing prices on contracts to sell their produce. A gold producer wants to hedge his losses attributable to a fall in the price of gold for his current gold inventory. A cattle farmer wants to hedge his exposure to changes in the price of his livestock.

End-users need to hedge the prices at which they can purchase these commodities. A university might want to lock in the price at which it purchases electricity to supply its air conditioning units for the upcoming summer months. An airline wants to lock in the price of the jet fuel it needs to purchase in order to satisfy the peak in seasonal demand for travel.

Speculators are funds or individual investors who can either buy or sell commodities by participating in the global commodities market. While many may argue that their involvement is fundamentally destabilizing, it is the liquidity they provide in normal markets that facilitates the business of the producer and of the end-user.

Why would speculators look at the commodities markets? Traditionally, they may have wanted a hedge against inflation. If the general price level is going up, it is probably attributable to increases in input prices. Or, speculators may see tremendous opportunity in commodity markets. Some analysts argue that commodity markets are more technically-driven or more likely to show a persistent trend.

The futures markets have been the traditional vehicles for participating in the commodities markets. Indeed, derivatives markets started in the commodities field.

Types of commodity swaps

There are two types of commodity swaps: fixed-floating or commodity-for-interest.

Fixed-floating swaps are just like the fixed-floating swaps in the interest rate swap market with the exception that both indices are commodity based indices.

General market indices in the commodities market with which many people would be familiar include the Goldman Sachs Commodities Index (GSCI) and the Commodities Research Board Index (CRB). These two indices place different weights on the various commodities so they will be used according to the swap agent's requirements.

Commodity-for-interest swaps are similar to the equity swap in which a total return on the commodity in question is exchanged for some money market rate (plus or minus a spread).

Valuing commodity swaps

In pricing commodity swaps, we can think of the swap as a strip of forwards each priced at inception with zero market value (in a present value sense). Thinking of a swap as a strip of at-the-money forwards is also a useful intuitive way of interpreting interest rate swaps or equity swaps.

Commodity swaps are characterized by some idiosyncratic peculiarities, though.

These include the following factors for which we must account (at a minimum):

1. The cost of hedging
2. The institutional structure of the particular commodity market in question
3. The liquidity of the underlying commodity market
4. Seasonality and its effects on the underlying commodity market
5. The variability of the futures bid/offer spread
6. Brokerage fees
7. Credit risk, capital costs and administrative costs

Some of these factors must be extended to the pricing and hedging of interest rate swaps, currency swaps and equity swaps as well. The idiosyncratic nature of the commodity markets refers more to the often limited number of participants in these markets (naturally begging questions of liquidity and market information), the unique factors driving these markets, the inter-relations with cognate markets and the individual participants in these markets.

Correlation and basis

Many times when using commodity derivatives to hedge an exposure to a financial price, there is not one exact contract that can be used to hedge the exposure. If you are trying to hedge the value of a particular type of a refined chemical derived from crude oil, you may not find a listed contract for that individual product. You will find an over-the-counter price if you are lucky.

How do the OTC traders hedge this risk?

They look at the correlation (or the degree to which prices in the individual chemical trade with respect to some other more liquid object, such as crude oil) for clues as to how to price the OTC product that they offer you. They make assumptions about the stability of the correlation and its volatility and they use that to "shade" the price that they show you.

Correlation is an unhedgeable risk for the OTC market maker, though.

There is very little that he can do if the correlation breaks down.

For example, if all of a sudden the price for your individual chemical starts dropping faster than the correlation of the chemical's price with crude oil suggests it should, the OTC dealer has to start dumping more crude oil in order to compensate.

It is a very risky business.

The OTC market maker's best hope is to see enough "two-way" business involving end-users and producers so that his exposure is "naturally" hedged by people seeking to benefit from price movement in either direction.

Commodity swaps and commodity derivatives are a useful and important tool employed by most leading energy, chemical and agricultural corporations. For more information about the risk management policies of these companies, consult the footnotes of the Annual Financial Statements of these companies.

Tags: commodity, commodity futures, commodity swap, otc, correlation

Article by Chand Sooran, Principal Victory Risk Management Consulting, Inc.