1
$\begingroup$

I am just trying to understand that if commodity forwards are available, what is the use of a commodity swap. If a farmer wants to hedge his risk, he can do it via entering into a commodity forward, why is the commodity swap required at all ?

$\endgroup$
2
$\begingroup$

The commodity swap allows the farmer to enter into a series of forwards all at once: so one contract, instead of (say) five separate contracts. Also, the Swap strike will be (approximately) the average of the individual forwards: so from cash-flow perspective, it gives the farmer consistent prices over a prolonged period of time (and some farmers might prefer this). The individual Forwards would all have different strikes, whereas the Swap will have one strike for every month.

| improve this answer | |
$\endgroup$
  • $\begingroup$ I understand that instead of many contracts a swap is all in one and farmer does not have to negotiate with the counterparty at all, but is there anything more advantageous in terms of margins which favors swap over forwards, or both use SIMM model and therefore margins are also the same. Also how is swap giving a series of cashflows if the farmer agrees to a physical delivery at year end. Say he initiates the agreement in Jan-2021 and agrees physical delivery in Dec-2021. So will there be not just a one time cashflow ? $\endgroup$ – userx Jun 8 at 15:44
  • $\begingroup$ Commodity derivatives tend to be OTC (unless traded on the CME directly, but those would be futures and options, rather than forwards and swaps). So I'd say that both the Swap and Forward will get the same SIMM treatment. I think the Swap would have physical delivery every month and cash-flow every month. Even if it was customized swap with physical delivery in arrears (only at year end), I believe the Swap cashflows would have to be settled every month still. $\endgroup$ – Jan Stuller Jun 8 at 15:47
  • $\begingroup$ Interesting, your last point, so are you saying that even if the physical delivery in Jan 2021- Dec-2021 swap happens only in Dec-2021, the cashflows are settled every month which means he has a series of cashflow payments in or out and suppose every month he pays the rent of say tractor or a drone he uses at farm, swap can be a risk management tool for him to keep paying his rent provided the MTM is his side positive. $\endgroup$ – userx Jun 8 at 15:51
  • $\begingroup$ Did I understand your last sentence correctly as per my comment above ? $\endgroup$ – userx Jun 8 at 16:02
  • $\begingroup$ @userx: yes, exactly. Ps: if you feel that my answer has addressed your question, could I pls ask you to click on the "check mark" next to my answer: that way your question will be marked as "answered". $\endgroup$ – Jan Stuller Jun 8 at 16:10

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.