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Commodity Swaps and Exposure to Commodities

Commodity Swaps and Exposure to Commodities

A commodity swap is a legal contract involving the exchange of payments over several dates as determined by specified reference prices or indexes relating to commodities. Swaps are an alternative to futures when investors want to gain market exposure or hedge commodity risk.

A commodity swap provides risk management and risk transfer while eliminating the need to set up and manage multiple future contracts. It also provides a degree of customization. Note, however, that this is not possible with standardized futures contracts; hence there are many types of swaps as follows:

An excess return swap is made or received based on a return calculated by changes in the index level relative to a benchmark or fixed level. In this case, the net change in the prices of the underlying futures contracts is defined as the “excess” return. The excess return is multiplied by the contract’s notional amount to determine the payments between buyer and seller.

In a total return swap, one party makes payments based on a set rate (either fixed or floating). On the other hand, the other party makes payments based on the return of an underlying asset. When the level of the index increases, the swap buyer receives payment net of the fee paid to the seller. On the other hand, if the level of the index decreases between two valuation dates, the swap seller receives payment (plus the fee charged to the buyer).

For a basis swap, periodic payments are exchanged based on the values of two related commodity reference prices that are not perfectly correlated. Basis swaps are often used to adjust for the difference (called the basis) between a highly liquid futures contract in a commodity and an illiquid but related material.

In variance swaps, the two parties bet on the variance of price levels of commodities. The parties agree to periodically exchange payments. The exchange is done based on the comparative difference between an observed or actual variance in the price levels of a commodity (over consecutive periods), and some fixed amount of variance established at the outset of the contract. If this difference is positive, the variance swap buyer receives a payment. On the other hand, if it is negative, the swap seller receives payment, and often the variance differences (observed versus fixed) are capped to limit upside and losses.

In the case of a volatility swap, the two sides of the transaction speculate on how volatile prices will be versus expectations and not on the level or direction of prices. A volatility seller will post a profit if realized volatility is lower than expectations, whereas the counterparty volatility buyer anticipates higher than expected volatility.

Question 1

In a commodity volatility swap, the direction and amount of payments are most likely determined relative to the observed versus reference to:

  1. The direction in the price of a commodity.
  2. Variance for the price of a commodity.
  3. Volatility for the price of a commodity.

Solution

The correct answer is C.

In a commodity volatility swap, the two sides of the transaction speculate on expected volatility, whereby a volatility seller will profit if the realized volatility is lower than expectations. In contrast, the volatility buyer earns profit from volatility that exceeds expectations.

A is incorrect. A volatility swap is based on price volatility, not direction.

B is incorrect. A volatility swap is based on price volatility as opposed to price variance (price volatility squared).

Question 2

A portfolio manager enters a $100 million (notional) total return commodity swap to obtain a long position in commodity exposure. The position is reset monthly against a broad-based commodity index. At the end of the first month, the index is up by 3%, and at the end of the second month, the index declines by 2%. Which two payments would most likely occur between the portfolio manager and the swap dealer on the other side of the swap transaction?

  1. No payments are exchanged because a net cash flow only occurs when the swap agreement expires.
  2. $3 million would be paid by the swap dealer to the portfolio manager (after Month 1), and $2 million would be paid by the portfolio manager to the swap dealer (after Month 2).
  3. $3 million would be paid by the portfolio manager to the swap dealer (after Month 1), and $2 million would be paid by the swap dealer to the portfolio manager (after Month 2).

Solution

The correct answer is B.

The portfolio manager has a long position in the total return commodity swap and will receive payments when the commodity index rises and make payments when the commodity index declines.

The payment calculations after the first two months are as follows:

$$\text{Month 1}=$100 \text{ Million}\times 3\text{%}=$3 \text{ Million}$$
$$\text{Month 2}=$100 \text{ Million}×-2\text{%}=-$2 \text{ Million}$$

A is incorrect. Swap payments are made periodically (in this case, monthly) and not withheld to the end of the contract.

C is incorrect. The payments would be in the opposite direction for each month.

Reading 37: Introduction to Commodities and Commodity Derivatives

LOS 37 (i) Describe how commodity swaps are used to obtain or modify exposure to commodities.

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