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Trade Type –
Commodity Swap
An agreement to buy the financial equivalent of a commodity at a time in the future between two counterparties. If the trade is for a single period, the trade is called a ‘Forward’. If the trade is for multiple periods, the trade is called a ‘Swap’. It is common practice to call a trade a Swap even if it is just a single period.
Notes:
1) A ‘Forward’ or ‘Swap’ is always financially settling, meaning that only cash is exchanged, never the physical commodity. Organizations do trade where the actual physical commodity is purchased or sold… that trade type isn’t called a ‘Swap’ or ‘Forward’… that is called a ‘Physical’ trade. In other words, a ‘Forward’ or ‘Swap’ is financially setting by definition.
2) With regard to the timing of the forward/swap trade… by definition the exchange of cash and finalizing the prices are done sometime in the future. That is, the trade is done on the current date, so the trade date is today for an exchange to be made at a future point in time. If you did a trade today for delivery today (physical delivery) then the trade would be called a ‘Physical’ trade (not a forward/swap). Physical trades for immediate settlement are sometimes called ‘cash’ trades and physical trades for delivery in the next month (after the current month) are sometimes called ‘prompt month’ trades.
3) In order for one side to pay the financial equivalent of the commodity, you need an objective/impartial third party to publish prices. These are called ‘settle’ or ‘closing’ prices when the source of the prices is a commodities exchange. For example, a popular commodities exchange is the NYMEX www.nymex.com. Or the prices might just be called ‘published prices’ if the source of the prices is not an exchange. A popular source of commodity prices from a non-exchange is Platts. www.platts.com/
4) A ‘Forward’ or ‘Swap’ is always between two counterparties by definition. Trades between two counterparties are called OTC (Over the Counter). An OTC trade is sometimes called a bilateral trade. If a trade with similar attributes is cleared on an exchange then it is called a ‘Futures’ contract.
5) The typical period is for a month. So… for example, you could have a Jan 2012 forward trade. A commodity ‘Swap’ could be for one month, three months, 12 months or more. A three month swap, e.g., January to March would typically have 3 payments, one for each month. In other words, a Swap is like a series of Forwards. You could alternately have a single payment that is based on the average of the values of three months. Any variation of terms is possible with OTC trades.
Example
One side of the trade, e.g., an oil major (e.g., Shell Oil Company) agrees on Dec
1, 2010 (trade date) to pay the financial equivalent of the price of crude oil
each month for 12 months for periods Jan 2011 to Dec 2011. The oil major agrees to pay whatever price is
published on the NYMEX the day before the last trade date for the contact
(e.g., the Jan-2011 contract). The
volume is 5000 BBL (barrels).
The other side of the trade, an investment bank
will pay a fixed price of $85/BBL, i.e,, 85 dollars per barrel. Note that investment bank is the term in the
For both sides, the payment date will be 5 (five) business days after the date the price is published by the exchange.
Notes:
1) Common price setting for the crude oil market could be
1a) Based on the last trading day of the contract, which would be 20-Dec-2010 for the Jan-11 contract. This type of pricing is sometime called ‘exchange lookalike’ since it mimics the economic characteristics of a futures contract (trade done where one side of the trade is the commodities exchange, e.g., NYMEX).
1b) Based on one business day before the last trading day of the contract, e.g., Friday 17-Dec-2010 for the Jan-11 contract. Why one day before? The volume traded on the very find day of trading tends to be low and low volume means that the final price could be inadvertently skewed one way or another to be too high or too low relative to what people think is a fair value. ‘One day before’ pricing is commonly called ‘penultimate’ pricing.
1c) A very common form of pricing would be to take the average price for the calendar month. So, for example, take the settle price for all of the business days in the month of Jan-2011, add them up, and divide by the total number of business days (to get the average price). Observe from the table below that the ‘Jan-11’ contract actually expires before the calendar month of January, so for the average of the business days in January (i.e., Jan 1 to Jan 31, business days only) you’ll typically get the prices from what is called the ‘first nearby contract’, which is the Feb-2011 contract from Jan 1 to Jan 20, 2011, the expiration date of the Feb contract… and then you get your daily prices sourced from the March-2010 contract from 21-Jan-2011 to 31-Jan-2011.
i.e.,
Jan 1 to Jan 21 – Get the price from the Feb-2011 contract
Jan 22 to Jan 31 – Get the price from the Mar-2011 contract
1d) Another variation would be to shift the date of the ‘contract roll’ to be one day earlier. So the pricing would be the average of the daily settlement /closing prices as follows:
Jan 1 to Jan 20 – Get the price from the Feb-2011 contract
Jan 21 to Jan 31 – Get the price from the Mar-2011 contract
2) The volume in this example is set to be 5,000 BBL per month. So for the fixed payment, which is $85/BBL… we know the exact payment in advance, i.e., we know the payment amount and payment date for the ‘fixed side’ payer. The payment amount is calculated based on a formula of quantity * price, or 5,000 BBL * $85/BBL = $425,000. For the floating side (also called the ‘index side’) we don’t know the amount of the payment as of the trade date… but we do know the formula for calculating the payment… it is the same as for the fixed side of quantity * price… the quantity is the same…5,000 BBL and the price is an unknown as of the trade date… it will be determined at a later time based on the agreed to pricing formula. Note that that total volume for this example is 60,000 BBL, which is 5,000 per month * 12 months.
3) This example is sometimes called a ‘fixed for float’ or ‘fixed price for index price’ swap because one side is fixed (meaning known in advance, set as of the trade date as part of the terms of the trade). You could also have a float for float swap were both sides of the swap are based on to-be-determined amounts. For example a float for float swap could be for the price of crude oil versus the price of unleaded gasoline, both expressed in barrels. That particular difference in prices is known as a ‘crack spread’, because ‘cracking’ is the name of one of the popular methods for refining crude oil into unleaded gasoline. Note that any combination of crude oil versus a refined product, such as unleaded gasoline or heating oil) can be called a ‘crack spread’
4) Each side of the swap, i.e., the two counterparties in the trade makes a payment with one side payment a fixed price and the other side paying a floating price, meaning unknown as of trade date, though the payment will be finalized/known by the payment date.
Oil Major:
Pays Floating Payment (volume * floating price)
Receives Fixed Payment (volume * fixed price)
Investment Bank
Receives Floating Payment (volume * floating price)
Pays Fixed Payment (volume * fixed price)
The counterparty that is paying the fixed payment is said to be the ‘buyer’ of the swap and the other side is said to be the ‘seller’ of the swap. In the above example, the Oil Major is the seller of the swap. It can be confusing to people as to which side is the buyer and which side is the seller since both side make a payment (and both sides receive a payment). To remember how this terminology is used… consider a physical trade instead. If the Oil Major were selling oil (the physical commodity) and the other counterparty were paying a fixed price of $85/BBL, then it would be clear that the Oil Major was selling the oil. With the swap example… instead of selling the physical oil, the Oil Major is providing the financial equivalent of the oil instead of the physical commodity.
5) For practical purposes, payments in swap transactions tend to be ‘netted’ such that only one side makes a payment and that payment is the ‘net’ (meaning difference) between the two prices.
So instead of this:
Oil Major Pays $90 * 5,000 = $450,000 (assuming the first floating price winds up being $90/BBL)
Investment Bank Pays $85 * 5,000 = $425,000
You have this in common practice:
Oil Major Pays $5 * 5,000 = $25,000
Investment Bank doesn’t pay anything (they just receive the $25,000)
6) Here is a recap of the trade terms as they might commonly be expressed and details on the expected pricing and payment dates.
Quantity: 5,000 BBL
Fixed Price: $85/BBL
Floating Price: NYMEX Crude Oil penultimate single day (non averaging)
Start Month: Jan 2011
End Month: Dec 2011 (12 monthly periods)
Buyer of the swap (pay fixed): Investment bank
Contract |
NYMEX |
Day Before |
Payment Date |
Volume (BBL) |
Fixed Price
($) |
Fixed Payment
($) |
Floating
Payment |
Jan-11 |
20-Dec-2010 |
17-Dec-2010 |
22-Dec-2010 |
5000 |
85 |
425000 |
??? |
Feb-11 |
20-Jan-2011 |
19-Jan-2011 |
24-Jan-2011 |
5000 |
85 |
425000 |
??? |
Mar-11 |
22-Feb-2011 |
21-Feb-2011 |
28-Feb-2011 |
5000 |
85 |
425000 |
??? |
Apr-11 |
22-Mar-2011 |
21-Mar-2011 |
28-Mar-2011 |
5000 |
85 |
425000 |
??? |
May-11 |
19-Apr-2011 |
18-Apr-2011 |
25-Apr-2011 |
5000 |
85 |
425000 |
??? |
Jun-11 |
20-May-2011 |
19-May-2011 |
24-May-2011 |
5000 |
85 |
425000 |
??? |
Jul-11 |
21-Jun-2011 |
20-Jun-2011 |
27-Jun-2011 |
5000 |
85 |
425000 |
??? |
Aug-11 |
20-Jul-2011 |
19-Jul-2011 |
25-Jul-2011 |
5000 |
85 |
425000 |
??? |
Sep-11 |
22-Aug-2011 |
19-Aug-2011 |
24-Aug-2011 |
5000 |
85 |
425000 |
??? |
Oct-11 |
20-Sep-2011 |
19-Sep-2011 |
26-Sep-2011 |
5000 |
85 |
425000 |
??? |
Nov-11 |
20-Oct-2011 |
19-Oct-2011 |
24-Oct-2011 |
5000 |
85 |
425000 |
??? |
Dec-11 |
18-Nov-2011 |
17-Nov-2011 |
22-Nov-2011 |
5000 |
85 |
425000 |
??? |
Reason to Buy
By buying a commodity swap, a user of the commodity can lock in prices. E.g., a refiner (an organization that converts crude oil into a refined product such as unleaded gas) can buy a supply of crude oil to use in their refining facilities.
With regard to the ‘reason to buy’ a commodity swap, consider the alternatives for a user of the commodity (e.g., a refiner):
1) They could choose to wait until they need the commodity and then buy it at the market price… which could be higher or lower in the future than it is today. Meaning that they buy the commodity they need in the physical market.
2) The organization could lock in the price with a physical trade, i.e., one side pays a payment based on a fixed price and the other side delivers the commodity.
Why might an organization want to trade a financially settling trade, a ‘swap’, instead of a physical trade? Suppose they are used to buying the physical commodity they need from local distributers. And suppose those local distributers are not equipped to commit in advance to allow their clients to lock in prices, e.g., they don’t have the trading and risk management in place to make those kind of trades/commitments. The refinery could buy a financially settling commodity agreeing, as in the above example, to pay $85/BBL. Then if the price rises to $90/BBL… they pay the investment bank $85/BLL, get/receive the $90/BBL from the investment bank, and then use the $90 they received to pay their local distributer of crude oil for the physical commodity (in the cash/spot market).
Reason to Sell
As in the above example, where the oil major is selling the swap… a reason to sell a swap would be to lock in prices. An oil major will, literally, get crude oil from the ground, from a well. For the oil it expects to get in the future (i.e., expects to get as of today), it has these main choices:
a) It can wait until it has pumped the oil and then sell the oil at the market price, i.e., whatever it will be in the future.
b) It can lock in a price today for selling the oil. The organization may choose to lock in the prices to avoid losses if the price of oil drops in the future.
There are other possibilities for the oil major for the oil the pump…
c) They can store it (e.g., in tanks on the ground or on ships)
d) They can refine it into unleaded gas or other refined products (if they own the refining facilities)
The point here is that if the oil major does decide to lock in the price that they can sell their future oil at, then they can do so by selling a commodity swap.
MTM Valuation
To get the present value of a commodity swap
1) List out each payment, e.g., 12 payments, one per month from the example above
2) You’ll need to project the prices, i.e., estimate on what the prices will be for the future dates.
3) For each payment date, calculate the discount factor using the appropriate interest rates.
4) Calculate each payment as quantity * price.
5) Then calculate the net payment, i.e., the different between what you are paying versus what you are receiving.
6) Multiply the net payment times the discount factor to calculate the present value for each payment.
7) Sum of the present value of all of the payments to get the MTM (mark to market) of the trade.
For example, the MTM for the below trade is the sum of the values in the final column:
$2,675.00
That is from the point of view of the firm paying the floating price.
The value would be negative of that, it would be $-2,675.00 from the point of view of the other firm, the firm paying the fixed price.
Volume |
Fixed Price
($/BBL) |
Fixed Payment
($) |
Projected |
Projected |
Net Payment
($) |
Payment Date |
Discount |
MTM ($) |
5000 |
85 |
425,000 |
85.00 |
425,000 |
0.00 |
22-Dec-2010 |
0.99 |
0.00 |
5000 |
85 |
425,000 |
85.10 |
425,500 |
(500.00) |
24-Jan-2011 |
0.985 |
(492.50) |
5000 |
85 |
425,000 |
85.20 |
426,000 |
(1,000.00) |
28-Feb-2011 |
0.98 |
(980.00) |
5000 |
85 |
425,000 |
85.30 |
426,500 |
(1,500.00) |
28-Mar-2011 |
0.975 |
(1,462.50) |
5000 |
85 |
425,000 |
85.20 |
426,000 |
(1,000.00) |
25-Apr-2011 |
0.97 |
(970.00) |
5000 |
85 |
425,000 |
85.10 |
425,500 |
(500.00) |
24-May-2011 |
0.965 |
(482.50) |
5000 |
85 |
425,000 |
85.00 |
425,000 |
0.00 |
27-Jun-2011 |
0.96 |
0.00 |
5000 |
85 |
425,000 |
84.90 |
424,500 |
500.00 |
25-Jul-2011 |
0.955 |
477.50 |
5000 |
85 |
425,000 |
84.80 |
424,000 |
1,000.00 |
24-Aug-2011 |
0.95 |
950.00 |
5000 |
85 |
425,000 |
84.70 |
423,500 |
1,500.00 |
26-Sep-2011 |
0.945 |
1,417.50 |
5000 |
85 |
425,000 |
84.60 |
423,000 |
2,000.00 |
24-Oct-2011 |
0.94 |
1,880.00 |
5000 |
85 |
425,000 |
84.50 |
422,500 |
2,500.00 |
22-Nov-2011 |
0.935 |
2,337.50 |
PnL Explained Attributes
# |
Attribute |
Applicable |
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1 |
Impact of New Trades |
Yes |
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2 |
Impact of Amendments |
Yes |
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3 |
Impact of Cancelations |
Yes |
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4 |
Impact of Time |
Yes |
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5 |
Impact of Commodity Prices For the sensitivities approach:
|
Yes |
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6 |
Impact of Interest Rates Note: Interest rate exposure for a commodity swap tends to be very small relative to the commodity price exposure, but it will be non-zero For the sensitivities approach:
|
Yes |
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7 |
Impact of Volatility For the sensitivities approach:
|
No |
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8 |
Impact of Cross Price/Volatility |
No |
||||||||||||
9 |
Impact of Correlations |
No |
Additional PnL Explained
Attributes
Not applicable for this trade type
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