Reviewed by Oct 05, 2020| Updated on
A commodity swap is a kind of derivative contract wherein two parties agree to swap cash flows depending on the cost of an underlying commodity. A commodity swap is typically used to protect against price fluctuations in the market concerning a commodity, such as livestock and oil. A commodity swap will allow the producers of a product as well as buyers to lock in a fixed price for a given commodity.
A commodity swap is not traded on exchanges. Rather, they are personalised agreements that are conducted outside formal exchanges and without the oversight of an exchange regulator. Much of the time, transactions are made by financial services firms.
## How Does a Commodity Swap Function?
The commodity swap comprises a floating leg component and a fixed leg portion. The floating-leg component is related to the market price of the underlying commodity or the agreed-upon commodity index, whereas the fixed-leg component is stated in the contract.
Most commodity swaps are based on oil, although any form of the commodity may underlie swap swaps, such as precious metals, industrial metals, natural gas, livestock, or grains. Due to the complexity as well as the size of the contracts, typically only major financial institutions participate in commodity swaps, not individual investors.
## What is the Objective of a Commodity Swap?
In general, the aim of commodity swaps is to reduce the amount of risk to a particular party within the swap. A party seeking to hedge its risk against the fluctuations of a specific commodity price must enter into a commodity swap and agree, on the basis of the contract set out above, to accept a particular price that it will either pay or obtain over the term of the arrangement.
Airline companies are heavily fuel-dependent for their operations. Oil price fluctuations can be especially challenging for their companies so that an airline could enter into a commodity swap arrangement to minimise their exposure to any volatility in the oil markets.