Find our latest analyses and trade ideas on bsic.

it

The Mechanics of Commodity Swaps (BSIC x Dare)

Introduction

Commodity Swaps are a widely used instrument for hedging and speculation in the commodities markets. Like
other swaps, they are an OTC instrument where two counterparties agree on exchanging some cashflows based
on the trend of an underlying security (most often oil, but also other commodities like metals and grains). They
usually anchor themselves on an index, and involve a floating and a fixed payment, where the fixed payer (or
floating receiver) agrees to pay a fixed amount at specified terms (monthly, quarterly etc.) and receives instead a
cashflow based on the average trend of the underlying commodity/index from the counterparty, whose obligations
are the opposite.

They are used by a variety of different market participants, ranging from production companies, to consumers, to
pure speculators of the sector, wishing to gain a particular exposure with a tailor-made contract.

History of the Product

Commodity Swaps are one of the oldest commodity derivatives present in the financial markets. Around since the
mid 1970s (with the first ever oil swap established by Chase in 1986), are mainly used in industries where demand
and supply dynamics tend to face heightened volatility, primarily the energy and agricultural market.

With the earliest instances of futures contracts on commodities being dated as far back as 2000 B.C. in
Mesopotamia, the first ever regulated derivatives exchange still operating today is the Chicago Board of Trade
(CBOT), opened in 1848 and saw the biggest expansion of its traded securities in the early-mid 70s, when,
coincidentally with the collapse of the Bretton Woods Agreements, the advent of computational power and the
advancements made in derivatives pricing by Black and Scholes. Since then, and up to the great revolution in
regulatory laws post the 2008 crisis, derivatives contracts saw a huge expansion, particularly in the agricultural
sector, due to the highly volatile nature of the market.

Definition and Key Features

A commodity swap is a legally binding agreement that guarantees a fixed price level. In this arrangement, one party
commits to paying a 'fixed index rate,' while the other agrees to receive this fixed rate and, in turn, pays the 'floating
rate' determined by the monthly average movement of the same underlying. Notably, the swap doesn't affect the
underlying sale or purchase transaction, which may involve another institution. The sole movement of funds
involves a net transfer of payments between the two parties on predefined dates. However, with oil swaps, there
is an option to link the swap with a specific physical cargo, with cash flows calculated based on an agreed notional
amount, whether or not the cargo is actually delivered.

For instance, if the monthly average price falls below the strike, a shipping company can procure its fuel at a more
favourable market price. Conversely, if the monthly average cost surpasses the strike, an oil company compensates
the shipping company for the excess above the rate. An oil cap, for instance, fixes the shipping company's bunker
fuel costs at a maximum level, providing financial stability in a volatile market.

There are a couple of notable features that make it a versatile financial instrument. Firstly, it offers insurance
protection, enabling counterparties to secure a fixed rate for purchasing or selling a predetermined quantity of oil
or oil products over a specific time frame. Notably, no premium is required for this benefit. Furthermore, oil swaps

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial
recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur
implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information,
opinions, and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change
without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise.
Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © 2023 BSIC | Bocconi Students Investment Club 1

 Find our latest analyses and trade ideas on bsic.it

present the option for cash or physical settlement, where typically, only the index-linked cash flows are exchanged,
leaving the notional cargo quantity untouched. However, parties can arrange for physical settlement in advance if
mutually agreed. Additionally, oil swaps facilitate funding optimization by allowing counterparties to work with
institutions offering the most favourable prices for the underlying oil transactions, effectively decoupling the swap
negotiations from these core dealings. It's imperative to carefully evaluate the credit risk associated with both
counterparties, as each party assumes the other's credit risk. Oil swaps are typically zero-premium instruments,
necessitating a credit line, but in some cases, counterparties may need to collateralize the swap with cash, through
means such as a deposit or a variable letter of credit. These features collectively make oil swaps a powerful tool for
risk management and price certainty.

Hedging - Futures vs Swaps

When it comes to hedging commodity exposure, there are distinct differences between utilizing commodity futures
contracts and commodity swaps. Commodity swaps provide a more personalized approach, giving counterparties
the opportunity to secure tailored insurance protection without the burden of a premium. This flexibility also
enables them to optimize their funding by engaging in transactions where the most favourable prices are accessible.
However, it's important to note that commodity swaps come with their share of considerations, including the need
for credit risk assessment and the potential for collateral requirements.

On the other hand, commodity futures contracts serve as more standardized and easily accessible mean of hedging.
They provide a straightforward way to protect against commodity price fluctuations. However, they lack the level
of customization found in swaps, which could limit their suitability for certain situations. Furthermore, commodity
futures contracts often entail higher transaction costs due to initial margin requirements and the need for daily
mark-to-market settlements.

Use Cases

As already discussed, commodity swaps are usually used for hedging by large corporations that wish to have more
predictable cash flows in their cost of inputs or in the revenues coming from their outputs. In such a framework,
we normally see the consumer paying the swap (i.e., paying fixed) and thus hedging on possibly rising costs for
their inputs (a classic example of this would be an airline hedging the price of fuel or crude oil), whereas producers
tend to receive the swap, putting a floor to a possible decrease in the price of the commodity.

To build up on this intuition, we propose a “textbook” example of hedging through commodity swaps:

A prominent US oil refiner is concerned about another potential increase in Brent crude oil prices, due to the
escalating geopolitical uncertainty and seeks to hedge around 120,000 barrels per month for a period of nine
months starting November. To address this risk, the company intends to 'pay the fixed and receive the floating'
rate, mirroring the underlying transaction. The company is content with entering the contract at the prevailing
rates, and a major oil company offers a swap at $87.00 per barrel.

In this scenario the two parties would calculate and offset cashflows on pre-specified reset dates. For the sake of
simplicity let's say that in early December, when calculating the settlements for November, we observe the
following rates:

Fixed: $87.00 per barrel

Monthly average: $90.00 per barrel

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial
recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur
implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information,
opinions, and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change
without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise.
Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © 2023 BSIC | Bocconi Students Investment Club 2

 Find our latest analyses and trade ideas on bsic.it

In that case the oil company would make a net payment of $3.00 per barrel to the refiner, totalling $360,000 for
the initial 120,000 barrels. This effectively offsets the additional $3.00 per barrel that would have been incurred in
the underlying market. Conversely, if the monthly average rate had been $85.00, the refiner would make the
payment, resulting in a net cash settlement of $2.00 per barrel to the oil company.

Source: BSIC

Swaps however, just like other derivatives, also act as a powerful price discovery tool, for traders to set benchmarks
on current prices in the spot market, while also allowing for lower transaction costs and overall increased market
efficiency.

The latter also underscores the role of these derivatives as a means of speculation and as a way to express directional
views on the trends and movements within the underlying markets. As a matter of fact, a second popular kind of
commodity swap is the so-called “commodity-for-interest” swap, where, similarly to equity swaps, one leg pays the
returns associated to a certain underlying commodity, and the other pays a floating interest rate (e.g., SOFR) or a
predefined fixed rate. This type of contract enables counterparties to take on a directional exposure to anticipated
returns of a specific commodity, and thanks to the cash-settled nature of the agreement, it eliminates the need for
unnecessary costs associated with a physical delivery of the product.

Pricing

The most common way to think about commodity swaps is as being very similar to a fixed-for-floating interest
rate swap, and a useful abstraction to build on this from a pricing perspective would be to imagine it as a series of
forward contracts, just like IRSs are often associated to a bundle of FRAs (Forward Rate Agreements). However,
a few additional elements typical for Commodity Swaps should be considered, the most notable ones being:

● Cost of Hedging
● Institutional structure of the commodity
● Liquidity of the underlying and its seasonality
● Credit risk

We can describe the pricing of a commodity swap simply by using the futures’ term structure of our underlying
commodity to price the floating leg at origination, and then we can find the fixed rate in the following fashion:

We start by imposing the value of the contract to be 0 at inception, that is: [𝐹(𝑡, 𝑇) − 𝐾]𝑃(𝑡, 𝑇) = 0

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial
recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur
implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information,
opinions, and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change
without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise.
Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © 2023 BSIC | Bocconi Students Investment Club 3

 Find our latest analyses and trade ideas on bsic.it

Where 𝐹(𝑡, 𝑇) is the forward price at time 𝑡 with delivery at 𝑇, 𝐾 is price paid on the fixed leg and 𝑃(𝑡, 𝑇) is the
relative discount factor.

This is also equivalent to saying that the present value of all our future payments ought to be 0:
𝑛
∑𝑛𝑖=1 𝐹(𝑡, 𝑇𝑖 ) ⋅ 𝑃(𝑡, 𝑇𝑖 )
∑ [𝐹(𝑡, 𝑇) − 𝐾]𝑃(𝑡, 𝑇𝑖 ) = 0 ⇒ 𝐾 =
∑𝑛𝑖=1 𝑃(𝑡, 𝑇𝑖 )
𝑖=1

It follows that, immediately after origination, one can value the swap simply as 𝑉𝑠𝑤𝑎𝑝 = 𝑉𝑓𝑙𝑜𝑎𝑡𝑖𝑛𝑔 − 𝑉𝑓𝑖𝑥𝑒𝑑 or vice
versa, depending on what side of the trade one has picked. This is because these swaps are linear contracts that
involve no optionality.

In order to choose the appropriate forward prices/discount factors, dealers tend to look at market prices in the
term structure and price the swap accordingly. In some instances, however, market prices tend not to be present
or are highly unreliable. For instance, some commodities like grains or cattle, do not have futures contract expiring
in every month of the year, but can display irregular patterns, which are often connected to the cycles of the
underlying:

Term Structure of Lean Hog Futures as of Nov. 4 th

Source: OpenBB, BSIC

Similarly, in some specific contracts with longer maturities, like 5+ years, data from the market might be scarce or
unreliable, as often the most traded section of the curve is the front end, with the back end often being crowded
only by a few players, mainly big producers hedging their exposures. In such cases, modelling the forward curve

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial
recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur
implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information,
opinions, and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change
without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise.
Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © 2023 BSIC | Bocconi Students Investment Club 4

 Find our latest analyses and trade ideas on bsic.it

might be necessary to model the fair value of the commodity far into the future and thus pricing longer maturity
contracts.

Over the years, financial literature has proposed variety of possible quantitative models for such problems, which
rely on one pivotal concept: “The scarcer the resource, the higher the volatility”. We can model forward curve
changes, generally speaking, as translations (i.e., parallel shifts) and rotations (although some models also consider
“twists” and seasonality).

For the sake of completeness, we will mention two of the more relevant models, although a more thorough analysis
of their features, is outside the scope of this article:

Heath-Jarrow-Morton Model

The HJM model proposes the following two factors to explain the change in forward prices:
𝐾
𝑑𝐹𝑡,𝑇 𝑖
= 𝛼(𝑡, 𝑇 )𝑑𝑡 + ∑ 𝜎𝑡,𝑇 𝛿𝑡𝑖
𝐹𝑡,𝑇
𝑖=1

Where (𝛿𝑖 )𝑖∈1,…,𝐾 are centred and possibly correlated shocks, 𝛼(𝑡, 𝑇) describes the term structure of futures prices
drift and 𝜎𝑖 scales with the volatility. Note that we assume the “Samuelson effect”, which considers volatility a
decaying factor of time to maturity, given mean-reversion.

Exponential Two and Three-factor Model

A special case of the abovementioned HJM model, in the exponential variation volatility terms are chosen to
account for level and slope changes:

𝑑𝐹𝑡,𝑇
= 𝑒 −𝑘(𝑇−𝑡) 𝛿𝑡𝑋 + 𝛿𝑡𝑌
𝐹𝑡,𝑇

Note that the rotation factor, 𝜎1 (𝑡, 𝑇) = 𝑒 −𝑘(𝑇−𝑡) decays with time to maturity, whereas the shift factor is constant:
𝜎2 (𝑡, 𝑇) = 1

If we also incorporate the twist, we have: 𝜎1 (𝑡, 𝑇) = 𝑒 −𝑘1(𝑇−𝑡) , 𝜎2 (𝑡, 𝑇) = 𝑘2 (𝑇 − 𝑡)𝑒 −𝑘2(𝑇−𝑡) and 𝜎3 (𝑡, 𝑇) =
1.

The Futurization of Swaps

In 2012, the Intercontinental Exchange (ICE) announced plans to transition all cleared OTC products listed on
ICE’s OTC energy market to futures contracts. The move from swaps to futures was particularly impacted by Title
VII of the Dodd-Frank Act, which sought to lower the levels of risk inherent to such transactions.

The new clearing mandates guaranteed that any financial losses arising from a defaulting counterparty are borne
by sizable, autonomous institutions. This lessens the systemic risk associated with OTC derivatives trading and
fosters greater market stability.

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial
recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur
implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information,
opinions, and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change
without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise.
Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © 2023 BSIC | Bocconi Students Investment Club 5

 Find our latest analyses and trade ideas on bsic.it

Trading shops can take advantage of the increased liquidity and transparency of futures markets to arbitrage
between swaps and futures contracts. For example, a trader might buy a swap contract and then sell an offsetting
futures contract on an exchange. If the price of the underlying asset moves in favour of the trader, they will make
a profit on the futures contract and be able to offset any losses on the swap.

Developing an Edge - Trading

As swap products are not standardised in the same way as futures, their price is more open to speculation. For oil
derivatives, the following products have standard pricing formulas for swap contracts:

● Brent Swaps
● Dubai Swaps
● Low Sulphur Gas Oil (LSGO/Ice Gas) Swaps
● Heating Oil Future Swaps
● RBOB Swaps
● WTI Swaps

The above products are priced based on a formula of the current futures value which also determines the settlement
value at roll-off. For the swap contract of any given month, the price is determined by the arithmetic average of
two forward month future prices which is heavily weighted to the first forward month.

All products with a standardised swap contract share a similar calculation strategy which varies slightly depending
on product and month. This formula is also used to calculate the futures equivalent position of a swap contract as
all risk is associated with the volatility of the front-month futures equivalent of these swap contracts.

For all other products – such 3.5% Fuel Oil Barges, Jet fuel etc. – there exist no standardised pricing formulae for
swap contracts since the price offered is semi-subjective and opaque. In this case, a trader’s edge lies in their ability
to best estimate the true value of the non-standardised product.

References

[1] Abumustafa, Naser I. "Hybrid securities and commodity swaps." 12 Dec. 2006.

[2] Taylor, Francesca. Mastering the Commodities Markets. PEARSON, 2013.

TAGS: Commodities, Swaps, Markets, Pricing, Hedging

All the views expressed are opinions of Bocconi Students Investment Club members and can in no way be associated with Bocconi University. All the financial
recommendations offered are for educational purposes only. Bocconi Students Investment Club declines any responsibility for eventual losses you may incur
implementing all or part of the ideas contained in this website. The Bocconi Students Investment Club is not authorised to give investment advice. Information,
opinions, and estimates contained in this report reflect a judgment at its original date of publication by Bocconi Students Investment Club and are subject to change
without notice. The price, value of and income from any of the securities or financial instruments mentioned in this report can fall as well as rise.
Bocconi Students Investment Club does not receive compensation and has no business relationship with any mentioned company.

Copyright © 2023 BSIC | Bocconi Students Investment Club 6