# Construction and Valuation of Commodity Swaps

## 17 Seiten, Note: 2,0

Leseprobe

List of Figures

List of Equations

List of Abbreviations

1. Introduction – by M. Schulte

2. Theoretical fundamentals – by V. Vivekanantham
2.1. Commodity
2.2. Swap
2.3. Commodity swap

3. Construction of Commodity swaps – by M. Schulte
3.2. Types of Commodity swaps
3.2.1. Fixed-floating Commodity swaps
3.2.2. Commodity for Interest swaps

4. Pricing and Valuation of Commodity swaps
4.1. The Method for Valuation and Pricing – by V. Vivekanantham
4.2. Valuation of a Crude Oil Commodity Swap – by M. Schulte

5. Conclusion – by V. Vivekanantham

List of Cited Literature

## List of Figures

Figure 1 - Construction of a fixed-floating commodity swap.

Figure 2 - Fictive example of a fixed-floating commodity swap.

Figure 3 - Construction of a commodity for interest swap.

Figure 4 - Payment Schedule

## List of Equations

Equation 1 - Present value of fixed leg

Equation 2 - Present value of floating leg

Equation 3 - Value of swap through Netting

## List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

## 1. Introduction

Findings show that in year 2008 the notional amount of derivative products reached \$516 trillion.1 One of the important derivative products are swaps. The purpose of this research is to describe a special form of swaps: commodity swaps. Providing an overview of the application, construction and valuation of commodity swaps. The organization of the research is structured in five chapters. The next chapter involves theoretical fundamentals of the terms commodity and swap and it defines the meaning of the expression commodity swap. After that, the paper outlines the main trading motives of commodity swaps. Then, two types of commodity swaps, which are the basis of a further modification of commodity swaps, are introduced and their construction is illustrated. In addition to the construction, the following part starts with the theoretical valuation of commodity swaps and gives a fictive instance of a valuation. The paper closes with a conclusion of the main points of the construction and valuation of commodity swaps.

## 2. Theoretical fundamentals

### 2.1 Commodity

A commodity is by definition any product manufactured, grown or created from grown products.2 The term is moreover defined from a financial perspective by the Markets in Financial Instruments Directive (MiFID) as “any goods of a fungible nature that are capable of being delivered, including metals and their ores and alloys, agricultural products, and energy such as electricity" (Article 2(1) of the Regulation (EC) No 1287/2006. The MiFID implies furthermore the tangibility and interchangeability of commodities through the wording of fungible in the definition above. Hence, commodities are often used as inputs in the production of other goods and services. They are basic physical goods that are essentially uniform across producers with only slight quality differences. For example, a barrel of oil is the same raw commodity, regardless of the producer. On the other hand, a produced good from the electronics industry may differ in quality and features depending on the producers.3 Subsequently, individually produced end products should not be counted as commodities.

Strictly speaking, energy resources like electricity or gas could not be counted as commodities, as they are intangible products. Nevertheless, the MiFID handle them also as commodities, since they are capable of being delivered by way of a notification to an energy network.4 For this reason, the range of commodities has been expanded. Apart from traditional commodities like oil and gold (hard commodities) or grains, beef and sugar (soft commodities)5, there are financial commodities, such as foreign currencies and indexes. In recent years, there are also new technological types of commodities, such as cell phone minutes and bandwidth.6 As it can be seen, with increasing globalization and quickly growing technology, the borderline of the conventional conception of commodities has become more flexible.

### 2.2 Swap

A swap is a derivative financial instrument apart from options, forwards and futures. As the name indicates, a swap is an exchange transaction.7 Swap contracts are part of unconditional forward transactions, like forwards and futures. They are traded individually in over-the-counter (OTC) markets via bilateral contracts, as they are non-standardized products. Counterparties that enter a swap contract hope for reducing their financing costs through comparative cost advantages.8 That means, some companies profit from borrowing in fixed-rate markets, whereas other companies see advantages in floating-rate markets.9

By definition, a swap contract is an agreement between two parties, the so-called counterparties, to exchange defined cash flows at specific dates in the future.10 Basically, a swap can be interpreted as a portfolio of forward contracts. In contrast to a single forward contract, the counterparties sign up to exchange a series of cash flows at predetermined dates. At least the first of the cash flows is known at the time of initiating the swap contract, influenced by variables, such as interest rates, exchange rates, commodity prices or other market variables.11 Therefore, there are various constructions of swaps transactions. The most common swap types are ‘‘plain vanilla’’ interest rate swaps, currency swaps and commodity swaps (Non-financial swaps).12 In a ‘‘plain vanilla’’ interest rate swap “a company agrees to pay cash flows equal to interest at a predetermined fixed rate on a notional principal for a predetermined number of years. In return, it receives interest at a floating rate on the same notional principal for the same period of time.”13 Similar to this common swap type, for this present study, the definition, construction and valuation of commodity swaps is of essential significance.

### 2.3 Commodity swap

Commodity swaps are a subset of swaps. In contrast to Interest rate swaps, the exchanged cash flows are based on the price or index of the underlying commodity. This type of swaps has become increasingly popular in recent years14, as it is a helpful risk management tool used by financial institutions, corporations, municipalities, and government entities.15 Hedgers, for example a company that consumes 100,000 barrels of oil per year for its production process, could agree to pay a fixed amount of €10 million each year for the next 10 years. Hereby, the company can hedge against inflation and would limit its oil cost at 100€ per barrel. In return, the company receives a variable amount of 100,000*S, where S is the market price of oil per barrel. The counterparty of this transaction, here for example the oil producer, could enter this swap to lock in the price he has realized for his oil at 100€ per barrel, thereby hedging against falls in the price.16 The fixed amount of cash flow is also called fixed leg and the variable amount of cash flow as floating leg, respectively.17

There are two general types of commodity swaps, the Fixed-floating commodity swap and the Commodity for interest swap, that will be outlined and discussed in the next chapter.

## 3. Construction of Commodity swaps

The main trading motives for commodity swaps are hedging and speculation. Commodity swaps provide people and companies the opportunity to hedge expected risks such as the price volatility. Commodity producers are able to hedge expected price drops, whereas commodity consumers hedge the risk of price increases.18

Hedges are classed as either short or long hedges. If a commodity producer plans to sell his commodities in the future and wants to protect himself against decreasing prices, the producer will sell commodity swaps for a specific amount. Due to his short hedge, he has the payer swap, that means that he has to pay the floating price which depends on the future price of the underlying at the coupon date and obtains the fixed settlement price of the commodity future. As a result of a price drop, the producer earns the difference of the settlement price and the commodity price at the payment. If the producer sells the commodity at this time, he will get the delivery price which is equal to the commodity price. Thus, he hedges the risk of a price drop and gets the fixed settlement price.19

In contrast to going short, commodity consumers have the opportunity to hedge an expected rise of the commodity price with a long position in a commodity swap. If the consumer knows, that he will buy commodities at a later date, it is possible to enter a long position in a swap. That means he will pay the fixed price and gets the floating price. Furthermore, the consumer buys the commodity for the spot market price which is equal to the floating price. Consequently, the consumer establishes a fixed commodity price for a later purchase with a long hedge.20

Besides hedging, speculation is another objective for trading commodity swaps. The aim of speculation is generating profit by the difference between spot prices and the prices of derivative products. In spite of reducing the price risk as hedgers do, speculators accept the risk of suffering a loss. Purely speculative trades do not have physical transactions in the spot market. This means speculators are not interested in the commodity as a physical material. Speculators invest in expected price increases or decreases. If the price development is against their expectation, losses will not be offset against a counter deal.21

### 3.2 Types of Commodity swaps

#### 3.2.1 Fixed-floating Commodity swaps

The fixed-floating commodity swaps are similar to interest rate fixed-floating swaps which are also called plain vanilla interest rate swaps. Plain vanilla swaps implicated the periodically exchange of a payment fixed-rate and a floating-rate based on a notional principal between two counterparties. One counterparty pays the predetermined fixed-rate, whereas the other counterparty pays the floating-rate. The floating-rate depends on an interest rate e. g. the London Interbank Offer Rate (LIBOR). The notional principal is never exchanged.22

Abbildung in dieser Leseprobe nicht enthalten25 26

Figure 1 - Construction of a fixed-floating commodity swap. Adapted from: Brigo 2008, p.13; Corb 2012, p.5.

The structure of the commodity swaps follows the plain vanilla swaps. The fixed payment is the commodity price today and the floating payment is linked to the commodity index. The two counterparties agree on a specified amount of commodity, which will also never be exchanged during the trade.23

The over-the-counter traded commodity swaps have individual agreements of the elements of the term sheet. Moreover, the requirements for commodity swaps are a given price volatility and liquidity on the spot market.24 The following fictive instance illustrates the main points the two counterparties have to agree on.

Abbildung in dieser Leseprobe nicht enthalten

Figure 2 - Fictive example of a fixed-floating commodity swap. Adapted from: Flavell 2010, p.139; Gay/Venkateswaran 2010, p.14.

S&P Dow Jones Indices LLC (2017)

Firstly, the counterparties have to fix the specific commodity and the notional amount of commodity, which is the basis of the swap. Next, the commodity price index, that represents the floating price, has to be decided. Typically, the arithmetic daily average of the reference price over each period will be used.27 The fix price is defined as the price per unit of the commodity. The term reflects the length of the swap. The cash settlement is the future exchange of payment flows. That means the counterparty with a higher outflow will pay the difference of the floating and the fixed price to the other one. The settlement takes place semi-annual and the payment has to be on the fixed dates.

#### 3.2.2 Commodity for Interest swaps

Commodity for interest swaps is another type of commodity swaps which is similar to equity swaps. An equity swap is a cross-market swap, because it regards to both, the equity and the interest market. Equity swaps are used e. g. if an investor has an asset that pays him the LIBOR on a notional principal and he expects the equity market to rise whereas the interest market falls. Therefore, he could enter in an equity swap, where he has to pay the LIBOR and receives the return on an equity index. All in all, the investor profits from his asset and the swap in the amount of the return on the equity index.28

[...]

1 Cf. Gay/Venkateswaran 2010, p.1.

2 Cf. Hull 2012, p.748; Dictionary 2017.

3 Cf. Investopedia 2017a.

4 Cf. Emissions-euets 2017.

5 Cf. Investopedia 2017b.

6 Cf. Investopedia 2017a.

7 Cf. Harder 2015, p.15.

8 Cf. ibid.

9 Cf. Hull 2012, p.156.

10 Cf. McCaffrey 2016.

11 Cf. Hull 2012, p.148.

12 Cf. Rudolph/Schäfer 2010, p.131.

13 Cf. Hull 2012, p.148.

14 Cf. Hull 2012, p.744.

15 Cf. Gay/Venkateswaran 2010, p.1.

16 Cf. Hull 2012, p.744.

18 Cf. Buljevich/Park 1999, p.73-74.

19 Cf. Ibid.; Bellalah 2010, p.79; Brigo 2008, p.13.

20 Cf. Buljevich/Park 1999, p.73-74; Bellalah 2010, p.79-82; Lyuu 2002, p.225.

21 Cf. Madura 2015, p.411; Bellalah 2010, p.84; Lyuu 2002, p.225.

22 Cf. Cob 2012, p.3-6; Hull 2012, p.148-149.

23 Cf. Neftci 2008, p.122.

24 Cf. Buljevich/Park 1999, p.73.

25 Cf. S&P Dow Jones Indices LLC, 2017.

26 Cf. Finanzen.net GmbH, 2017.

27 Cf. Flavell 2010, p.139.

28 Cf. Flavell 2010, p.136-137.

Ende der Leseprobe aus 17 Seiten

Details

Titel
Construction and Valuation of Commodity Swaps
Hochschule
Frankfurt University of Applied Sciences, ehem. Fachhochschule Frankfurt am Main
Note
2,0
Autor
Jahr
2017
Seiten
17
Katalognummer
V509899
ISBN (eBook)
9783346087744
ISBN (Buch)
9783346087751
Sprache
Deutsch
Schlagworte
construction, valuation, commodity, swaps
Arbeit zitieren
Vivethinyi Vivekanantham (Autor), 2017, Construction and Valuation of Commodity Swaps, München, GRIN Verlag, https://www.grin.com/document/509899

Kommentare

• Noch keine Kommentare.