The Commodity Exchange Arena Shifts to ‘Swaps’

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FACTBOX-Naked swaps and other derivatives terms revealed

April 1 (Reuters) – The proposed overhaul of the country’s regulatory system has introduced a slew of new words into the lexicon of the American public.

Here is a glossary of some of the jargon used by lawmakers, lobbyists, the Commodity Futures Trading Commission and others as they tackle the derivatives portion of financial reform.

Derivatives – contracts that derive their value from commodities, financial instruments, events or conditions. Bought and sold on regulated exchanges or bilaterally through over-the-counter dealers. Used for hedging and speculating — but not generally used to directly buy or sell the products on which they are based. In the United States, on-exchange derivatives are called futures.

Hedging – a position taken to offset exposure to price fluctuations, or risk, in the cash or physical market. Hedging can be done through exchange-traded futures and options, over-the-counter derivatives, or insurance policies.

For example, corn farmers wanting to “lock in” a price for their crop ahead of harvest could sell corn futures that would establish they deliver a fixed number of bushels at a fixed price and a certain date in the future. They would then offset their position by buying futures when they deliver their physical crop.

Over-the-counter – also known as off-exchange, OTC trading is a transaction for bonds, stocks, commodities or derivatives that occurs between two parties with specific details on how the agreement will be settled at some point in the future.

The CFTC estimates the market is worth $300 trillion in the United States alone, but others estimate it at $450 trillion.

The market is not regulated. Congress plans to change that after certain types of OTC derivatives were blamed for helping accelerate the recent financial crisis.

Some have estimated up to 80 percent of OTC derivatives are standardized and could trade on exchanges or public platforms. The rest are highly customized to the particular needs of the buyer.

Swaps – the exchange of one asset or liability for a similar asset or liability for the purpose of lengthening or shortening maturities, or otherwise shifting risks. Swaps, which are usually traded OTC, have grown in popularity as a way to avoid big ticket margin calls on futures exchanges while still obtaining a hedge for bank financing.

Credit default swaps – a type of derivative used to protect against the risk of debt default. The buyer pays the seller an agreed sum each quarter, and in the event of default — such as bankruptcy — is paid the amount of debt insured by the seller.

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One trade group estimated the CDS market was worth $36 trillion last year, an increase from $630 billion in 2001.

The swaps have been blamed for amplifying concerns about corporate and sovereign credit quality, and came under fire in the government bailout of U.S. insurer AIG ( AIG.N ), which took outsized positions on risky assets such as subprime mortgages, without having enough capital to back up the contracts. [ID:nN09238823]

Naked swap – involves selling a call or put option to a buyer who does not hold the underlying security and therefore has no risk exposure to the instrument. A naked CDS contract is typically a bet taken by investment firms such as hedge funds that the bond will end up on the rocks.

Clearinghouses – the middle man between buyers and sellers of exchange-traded derivatives. They guarantee parties can meet their obligations by requiring them to post margin, or collateral.

Clearinghouses are sometimes part of an exchange such as the IntercontinentalExchange ( ICE.N ) and the CME Group Inc ( CME.O ), which handle credit default swaps. Exchanges have sprinted to launch clearinghouses for OTC products, since the crisis. Clearinghouses also can be freestanding entities.

The CFTC’s Gary Gensler has pushed for standard OTC derivatives to be traded on public platforms, such as exchanges, as well as cleared through clearinghouses to reduce risks of failure.

End users – the final recipient of a product, such as utilities, processors and manufacturers. End users that count on using OTC contracts to hedge their risk have been lobbying Congress for exemptions from new clearing requirements because they say posting margin would hurt them. They commonly pledge noncash assets as collateral in their OTC deal-making.

Position limits – a cap or limit on the number of futures contracts that can he held in a particular commodity. The CFTC proposed in January a crackdown on excessive speculation in energy trading by restricting the holdings of big players. [ID:nCFTCREG]. It also is considering similar curbs in the metals arena. [ID:nN25212518]

Gensler, under mounting political pressure, has pledged to be more aggressive on position limits. But the industry has lobbied against them, and some of the five CFTC commissioners are worried limits could push speculators to unregulated or overseas markets.

Co-location – allows traders to place their computer systems next to exchange servers, giving them the ability to execute strategies at lightning-fast speed through computer algorithms. [ID:nN11252716]

These market participants — sometimes called high-frequency traders — may include banks, hedge funds, and independent proprietary trading firms that are very sensitive to delays in sending orders to the electronic markets.

Critics charge that these traders who co-locate their servers receive an unfair advantage by getting an earlier look at market data, and a speed advantage in submitting orders. Its defenders say there is little evidence of unfair advantages.

Commodity Swap

What Is a Commodity Swap?

A commodity swap is a type of derivative contract where two parties agree to exchange cash flows dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against price swings in the market for a commodity, such as oil and livestock. Commodity swaps allow for the producers of a commodity and consumers to lock in a set price for a given commodity.

Commodity swaps are not traded on exchanges. Rather, they are customized deals that are executed outside of formal exchanges and without the oversight of an exchange regulator. Most often, the deals are created by financial services companies.

Key Takeaways

A commodity swap is a type of derivative contract where two parties agree to exchange cash flows dependent on the price of an underlying commodity.

A commodity swap is usually used to hedge against price swings in the market for a commodity, such as oil and livestock.

Commodity swaps are not traded on exchanges; they are customized deals that are executed outside of formal exchanges and without the oversight of an exchange regulator.

How a Commodity Swap Works

A commodity swap consists of a floating-leg component and a fixed-leg component. The floating-leg component is tied to the market price of the underlying commodity or agreed-upon commodity index, while the fixed-leg component is specified in the contract. Most commodity swaps are based on oil, though any type of commodity may be underlying the swap, such as precious metals, industrial metals, natural gas, livestock, or grains. Because of the nature and sizes of the contracts, typically only large financial institutions engage in commodity swaps, not individual investors.

Generally, the floating-leg component of the swap is held by the consumer of the commodity in question, or the institution willing to pay a fixed price for the commodity. The fixed-leg component is generally held by the producer of the commodity who agrees to pay a floating rate, which is determined by the spot market price of the underlying commodity.

The end result is that the consumer of the commodity gets a guaranteed price over a specified period of time, and the producer is in a hedged position, protecting them from a decline in the commodity’s price over the same period of time. Typically, commodity swaps are cash-settled, though physical delivery can be stipulated in the contract.

In addition to fixed-floating swaps, there is another type of commodity swap, called a commodity-for-interest swap. In this type of swap, one party agrees to pay a return based on the commodity price while the other party is tied to a floating interest rate or an agreed-upon fixed interest rate. This type of swap includes a notional principal–a predetermined dollar amount on which the exchanged interest payments are based–a specified duration, and pre-specified payment periods. This type of swap helps protect the commodity producer from the downside risk of a poor return in the event of a downturn in the commodity’s market price.

In general, the purpose of commodity swaps is to limit the amount of risk for a given party within the swap. A party that wants to hedge their risk against the volatility of a particular commodity price will enter into a commodity swap and agree, based on the contract set forth, to accept a particular price, one that they will either pay or receive throughout the course of the agreement. Airline companies are heavily dependent on fuel for their operations. Swings in the price of oil can be particularly challenging for their businesses, so an airline company may enter into a commodity swap agreement to reduce their exposure to any volatility in the oil markets.

Example of a Commodity Swap

As an example, assume that Company X needs to purchase 250,000 barrels of oil each year for the next two years. The forward prices for delivery on oil in one year and two years are $50 per barrel and $51 per barrel. Also, the one-year and two-year zero-coupon bond yields are 2% and 2.5%. Two scenarios can happen: paying the entire cost upfront or paying each year upon delivery.

To calculate the upfront cost per barrel, take the forward prices, and divide by their respective zero-coupon rates, adjusted for time. In this example, the cost per barrel would be:

Barrel cost = $50 / (1 + 2%) + $51 / (1 + 2.5%) ^ 2 = $49.02 + $48.54 = $97.56.

By paying $97.56 x 250,000, or $24,390,536 today, the consumer is guaranteed 250,000 barrels of oil per year for two years. However, there is a counterparty risk, and the oil may not be delivered. In this case, the consumer may opt to pay two payments, one each year, as the barrels are being delivered. Here, the following equation must be solved to equate the total cost to the above example:

Barrel cost = X / (1 + 2%) + X / (1 + 2.5%) ^ 2 = $97.56.

Given this, it can be calculated that the consumer must pay $50.49 per barrel each year.

Derivatives vs. Swaps: What’s the Difference?

Derivatives vs. Swaps: An Overview

Derivatives are contracts involving two or more parties with a value based on an underlying financial asset. Often, derivatives are a means of risk management. Originally, international trade relied on derivatives to address fluctuating exchange rates, but the use of derivatives has expanded to include many different types of transactions.

Swaps are a type of derivative that has a value based on cash flows. Typically, one party’s cash flow is fixed while the other’s is variable in some way.

Derivatives

A derivative denotes a contract between two parties, with its value generally determined by an underlying asset’s price. Common derivatives include futures contracts, options, forward contracts, and swaps.

The value of derivatives generally is derived from the performance of an asset, index, interest rate, commodity, or currency. For example, an equity option, which is a derivative, derives its value from the underlying stock price. In other words, the value of the equity option fluctuates as the price of the underlying stock fluctuates.

A buyer and a supplier, for example, might enter into a contract to lock in a price for a particular commodity for a set period of time. The contract provides stability for both parties. The supplier is guaranteed a revenue stream, and the buyer is guaranteed supply of the commodity in question.

However, the value of the contract can change if the market price of the commodity changes. If the market price goes up during the contract period, the derivative value goes up for the buyer because he is getting the commodity at a price lower than market value. In that case, the derivative value would go down for the supplier. The opposite would be true if the market price dropped during the time period covered by the contract.

Swaps

Swaps comprise one type of derivative, but its value isn’t derived from an underlying security or asset.

Swaps are agreements between two parties, where each party agrees to exchange future cash flows, such as interest rate payments.

The most basic type of swap is a plain vanilla interest rate swap. In this type of swap, parties agree to exchange interest payments. For example, assume Bank A agrees to make payments to Bank B based on a fixed interest rate while Bank B agrees to make payments to Bank A based on a floating interest rate.

Assume Bank A owns a $10 million investment that pays the London Interbank Offered Rate (LIBOR) plus 1 percent each month. Therefore, as LIBOR fluctuates, the payment the bank receives will fluctuate. Now assume Bank B owns a $10 million investment that pays a fixed rate of 2.5 percent each month.

Assume Bank A would rather lock in a constant payment while Bank B decides it would rather take a chance on receiving higher payments. To accomplish their goals, the banks enter into an interest rate swap agreement. In this swap, the banks simply exchange payments and the value of the swap is not derived from any underlying asset.

Both parties have interest rate risk because interest rates do not always move as expected. The holder of the fixed-rate risks the floating interest rate going higher, thereby losing interest that it otherwise would have received. The holder of the floating rate risks interest rates going lower, which results in a loss of cash flow since the fixed-rate holder still has to make streams of payments to the counterparty.

The other main risk associated with swaps is counterparty risk. This is the risk that the counterparty to a swap will default and be unable to meet its obligations under the terms of the swap agreement. If the holder of the floating rate is unable to make payments under the swap agreement, the holder of the fixed-rate has credit exposure to changes in the interest rate agreement. This is the risk the holder of the fixed-rate was seeking to avoid.

Legislation passed after the 2008 economic crisis requires most swaps to trade through swap execution facilities as opposed to over the counter and also requires public dissemination of information. This market structure is intended to prevent a ripple effect impacting the larger economy in case of a counterparty default.

The Commodity Exchange Act:

GGD-97-50: Published: Apr 7, 1997. Publicly Released: Apr 7, 1997.

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GAO reviewed the legal and regulatory issues surrounding the Commodity Exchange Act (CEA), focusing on: (1) the extent to which the Commodities Futures Trading Commission (CFTC) has reduced the legal risk surrounding the enforceability of over-the-counter (OTC) derivatives under the CEA; and (2) issues related to the appropriate regulation for exchange-traded futures and OTC derivatives contracts, including their markets and market participants.

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