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The Basics of Commodity Swaps


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Features of Commodity Swaps

commodity swaps

Commodity swaps are contractual agreements to trade one cash flow for another. These swaps are not listed or traded on exchanges , but rather have an OTC (over-the-counter) market which creates trades among dealers. These swaps deal with physical assets such as crops, oil, livestock, and precious metals. They are helpful to hedge against market fluctuations for these assets. Most commodity swaps involve oil, but they are also commonly found in the agricultural sector.

Types of Commodity Swaps

Commodity swaps come in two formats—interest rate and currency. An interest rate swap, also known as plain vanilla, is the most basic and straightforward swap to make. These deals follow a standard structure with varying contract details. A currency swap, meanwhile, involves trading principal and interest payments in one currency for principal and payments on a different currency.

Ending a Swap Early

If a swap is not working out and you want to cancel it before the agreed upon termination date, there are four options that you can take.

•             Buy out- If you can afford to buy the counter party’s share by paying market value, this may work. This must be specified in advance in the contract, however.

•             Enter a Swap to offset the previous swap.

•             Sell it to somebody else.

•             Use an option. A swaption is an option that allows you to set-up an offsetting swap at the time you enter the initial swap. This reduces market risk when entering the offsetting swap.

Commodity swaps can be very confusing for beginners. Entering this investment field takes time and knowledge. There is also risk involved in these trades because they are over-the-counter. Your counter party could default, so great care must be taken before entering a swap. Although they are tricky early on, these commodity swaps can be great tools for hedging your investments.

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