What it means
Imagine you buy a lot of diesel, and you would like to know your cost next year even though the market price moves daily. A price swap lets you agree a fixed price with a bank.
Each period, the bank pays you if the market price is above the fixed price, and you pay the bank if it is below. The physical purchase carries on as normal at whatever the market price is.
The swap runs alongside it as a separate financial contract, so the gain or loss on the swap offsets the change in the physical price. The net result is an effective price close to the fixed price in the swap.
The key terms are the underlying commodity, the notional quantity, the fixed price, the floating reference price, the settlement dates and the contract length. The floating price is usually an agreed published index or an average over the settlement period, so that nobody can argue about it afterwards.
Settlement is in cash, normally monthly or quarterly. Producers and consumers sit on opposite sides.
A consumer such as an airline or a factory pays the fixed price and receives the floating price, while a producer such as a miner or an oil company receives the fixed price and pays the floating price. Banks and trading houses usually stand in the middle and manage the resulting risk.
The trade-off is that a swap removes the downside and the upside together. If the market price falls well below the fixed price, the buyer pays out on the swap and is stuck with an above-market effective price.
Swaps also carry counterparty risk, which is the risk that the other side fails to pay, and accounting rules often require hedge documentation before gains and losses can be matched in the profit statement.
In practice
Real-world examples.
Example
A regional bus operator pays a fixed price on a diesel swap for the coming year. Ticket prices are set in advance by the city, so knowing fuel costs in advance lets the finance team commit to its budget with confidence.
Example
A copper miner receives a fixed price and pays the floating price on part of next year's production. If copper falls, the swap gains offset the weaker sales revenue, which protects the cash needed to service its loan.
Example
A food manufacturer fixes sugar at $600 per tonne on 500 tonnes a month. When the market price reaches $650, the swap pays it (650 - 600) x 500 = $25,000 for the month, which offsets the higher invoice from its sugar supplier.
Formula
Calculation
Net settlement per period = (Floating price - Fixed price) x Notional quantity, received by the fixed-price payer when the result is positive and paid by them when it is negative.
A haulage firm agrees a swap to fix diesel at $2.50 per gallon on a notional 100,000 gallons per month. In one month the floating reference price averages $2.90. The settlement is ($2.90 - $2.50) x 100,000 = $0.40 x 100,000 = $40,000, received by the haulage firm.
At the pump it buys the 100,000 gallons at the market price of $2.90, which costs $290,000. After the $40,000 swap receipt, its net cost is $290,000 - $40,000 = $250,000, which is $250,000 / 100,000 = $2.50 per gallon. If the floating price had instead been $2.30, the firm would pay ($2.50 - $2.30) x 100,000 = $20,000 on the swap, while buying the fuel for $230,000. The net cost is $230,000 + $20,000 = $250,000, which is again $2.50 per gallon, so the swap gives the same cost whichever way the market moves.Case study
Seen in the real world.
Brightwater Foods is a fictional snack maker whose main cost is vegetable oil. In an illustrative year of rising prices the finance director asked a bank for a twelve-month swap covering about 60% of expected oil purchases, leaving the rest unhedged so the company would still benefit if prices fell.
Prices did rise, and the swap payments covered most of the higher invoices. The sales team was able to hold shelf prices for its retail customers through the year, which won shelf space from a competitor that had to raise prices.
The following year prices fell, so the swap cost money while unhedged competitors enjoyed cheaper oil. The board accepted this because the purpose of the swap had been certainty, not speculation, and the fictional finance director had written that purpose into the hedging policy.
Watch out
Common mistakes.
- Treating a swap as a way to make money, when its job is to fix a price and remove uncertainty.
- Hedging more than you actually use, which turns part of the swap into a speculative bet.
- Forgetting the counterparty and basis risks, such as the other side failing to pay or the swap's reference index not matching the price you really pay.
Questions
People also ask.
Do I have to take delivery of the commodity under a price swap?
No, swaps are settled in cash, and you keep buying your physical supply from your usual supplier.
Is a price swap the same as a futures contract?
They are similar in effect, but a swap is a private contract tailored to your dates and volumes, while a futures contract is a standardised exchange product.
What happens if the market price ends up below my fixed price?
You pay the difference on the swap, and your net cost still comes out close to the fixed price you agreed.
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