VOLUME 1, NUMBER 19/July 17, 1995
***************************************************************** DERIVATIVES 'R US is a weekly non-profit publication on the Internet user group misc.invest.futures that provides a simple non-technical treatment of various topics in derivatives. DRU is written by Don M. Chance, Professor of Finance at the Center for the Study of Futures and Options Markets at Virginia Tech. He can be contacted at dmc @ vt.edu or by phone at 540-231-5061 or fax at 540-231-4487. DRU is for educational purposes only and does not provide trading advice.Back issues of DRU are available by anonymous ftp from fbox.vt.edu/filebox/business/finance/dmc/DRU or can be accessed using a Web browser at http://fbox.vt.edu:10021/business/finance/dmc/DRU. The file contents.txt can be viewed to see a list of old filenames and topics available for reading or downloading. *****************************************************************
COMMODITY SWAPS
This week's topic is the fourth in a series of articles on swaps. There are essentially four classes of swaps based on the generic class of the underlying instrument. We have already covered interest rate swaps, currency swaps and equity swaps. This week we look at commodity swaps.
A commodity swap is an agreement between two parties in which each party promises to make a series of payments to the other - the standard definition of a swap - and of which at least one set of payments is determined by the price of a commodity. The payments could be made by delivering actual units of the commodity but typically there is simply a cash payment determined by the commodity price.
Commodity swaps are becoming increasingly common in the oil industry. Heavy users of oil, such as airlines, will often enter into contracts in which they agree to make fixed payments, say every six months for two years, and receive payments on those same dates determined by an oil price index. Computations would likely be based on a specific number of tons of the oil. This locks in the price the airline pays for a specific quantity of oil, purchased at regular intervals over the two year period. The airline will buy the actual oil it uses in the spot market.
This kind of hedge, while likely to be reasonably effective if properly designed, will still probably contain a fair amount of basis risk. The exact type of oil it uses may not be represented perfectly by the oil price index on which the swap payments are made. More importantly, however, the quantities and the timing of its spot market purchases may not correspond to the swap payments. There is considerable uncertainty in their spot market needs so the hedge will often be far from ideal. That does not mean they should not be hedging. On the contrary, hedging is likely to play a major role in keeping them alive in days of turbulent oil prices.
One interesting feature in oil swaps is the manner in which the variable payment is calculated. In most standard interest rate, currency and equity swaps, the variable payment is based on the price or rate on a specific day. In oil swaps it is fairly common to base the variable payment on the average value of the oil index over a defined period of time. For example, let us say the next settlement date is August 15. Then the variable payment owed on August 15 might be based on the average of the daily index values for each business day from August 1 to August 14. This feature removes the effects of an unusually volatile single day and insures that the payment will more accurately represent the value of the index in early-August. Such single day volatility could arise from a number of sources, including the possibility of manipulation by a large institution, country or trader. Such volatility - though not necessarily from manipulation - often characterizes markets dominated by a small number of large and powerful participants. Oil is one such market.
Another way in which the averaging could be done is over the entire period between settlements. This could be done daily (though not likely), weekly, monthly or quarterly. This would assure that the payment would be representative of an average price over the period. For an airline purchasing oil steadily over the entire period, this is often an acceptable, if not preferable, arrangement.
These average-price payoff structures are found in other derivatives, especially in options. They are called Asian options, a topic we covered in the May 30 issue called "Geographic Options."
One might reasonably wonder why standard forward or futures hedges wouldn't be preferable. Without rehashing the debate over which is preferable, forwards or futures, let us simply recall that swaps are equivalent to a series of forward contracts each with the same price. The swap structure could be far more efficient that a package of individual contracts. Also, as I heard a treasurer for the Britain's White Star line state in Risk magazine that it is difficult to determine when to set your futures expirations. Using an average-price oil swap worked a lot better for them.
I predict that commodity swaps will become increasingly used in the energy and agricultural areas, where demand and supply are both subject to considerable uncertainty.