Commodity Swap Agreement
Commodity Swap Glossary Agreement
A swap in which at least one set of payments is based on the price of a commodity, such as oil. The other set of payments can be either fixed or determined by some other floating price or rate. While payments could be made by delivering actual units of the underlying commodity, in practice cash is exchanged instead. Commodity swaps are becoming increasingly common in the energy and agricultural industries, where demand and supply are both subject to considerable uncertainty. For example, heavy users of oil, such as airlines, will often enter into contracts in which they agree to make a series of fixed payments, say every six months for two years, and receive payments on those same dates as determined by an oil price index. Computations are often based on a specific number of tons of oil in order to lock in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two-year period. However, the airline will typically buy the actual oil it needs from the spot market.
In most interest rate, currency and equity swaps, the variable payment is based on the price or rate on a specific day. However, in oil swaps it is common to base the variable payment on the average value of an oil index over a period of time, which could be weekly, monthly, quarterly, or the entire period between settlements. This feature removes the effects of an unusually volatile single day and ensures that the payment will more accurately represent the value of the index. Average-price payoff structures are also found in other derivatives, particularly options.
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