commodityswaps

Commodity swaps are over-the-counter financial derivative contracts in which two parties exchange cash flows linked to the price of a commodity. The typical swap involves a notional quantity of the commodity, the identity of the commodity, a fixed price or rate, and a floating price benchmark. At each payment date, the party owing the greater cash flow pays the net amount to the other, effectively locking in a price over the term of the contract. Most commodity swaps are cash-settled, and physical delivery of the commodity is uncommon.

Common purposes include hedging price risk for producers and users, budgeting costs, or obtaining exposure to commodity prices without owning the commodity.

Variants include single-commodity swaps, cross-commodity basis swaps (which hedge relative movements between related commodities), and index-based swaps.

Pricing and risk: the value of a commodity swap depends on current forward curves, price volatility, and the correlation between the actual price and the benchmark. There is counterparty risk, liquidity risk, and, in many markets, regulatory clearing and margin requirements.

Regulation and market structure: commodity swaps are traded over-the-counter or, in some cases, cleared through central counterparties. They may be subject to reporting and margin rules under national regimes. In the United States, such activity is affected by rules stemming from the Dodd-Frank Act; in the European Union, EMIR applies.

Example: if one party pays a fixed price of, say, $70 per barrel and the other pays the market price, and the actual price is $75, the net settlement is $5 per barrel times the contracted volume, paid to the party entitled to the difference.