A commodity swap is a type of swap agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period. The vast majority of commodity swaps involve

oil An oil is any nonpolar chemical substance that is composed primarily of hydrocarbons and is hydrophobic (does not mix with water) and lipophilic (mixes with other oils). Oils are usually flammable and surface active. Most oils are unsaturate ...

. Many airline and rail companies enter oil commodity swap deals in order to secure lower oil costs in the long term.

Concept

A commodity swap is similar to a fixed-floating

interest rate swap In finance, an interest rate swap (IRS) is an interest rate derivative (IRD). It involves exchange of interest rates between two parties. In particular it is a "linear" IRD and one of the most liquid, benchmark products. It has associations with ...

. The difference is that in an interest rate swap, the floating leg is based on standard interest rates such as

LIBOR The London Inter-Bank Offered Rate (Libor ) was an interest rate average calculated from estimates submitted by the leading Bank, banks in London. Each bank estimated what it would be charged were it to borrow from other banks. It was the prim ...

and

EURIBOR The Euro Interbank Offered Rate (Euribor) is a daily reference rate, published by the European Money Markets Institute, based on the averaged interest rates at which Eurozone banks borrow unsecured funds from counterparties in the euro wholes ...

. However, in a commodity swap, the floating leg is based on the price of underlying commodity like oil, sugar, and precious metals. No commodities are exchanged during the trade. In this swap, the user of a

commodity In economics, a commodity is an economic goods, good, usually a resource, that specifically has full or substantial fungibility: that is, the Market (economics), market treats instances of the good as equivalent or nearly so with no regard to w ...

would secure a maximum price and agree to pay a

financial institution A financial institution, sometimes called a banking institution, is a business entity that provides service as an intermediary for different types of financial monetary transactions. Broadly speaking, there are three major types of financial ins ...

this fixed price. Then, in return, the user would get payments based on the market price for the commodity involved. On the other side, a producer wishes to fix the income and would agree to pay the market price to a financial institution, in return for receiving fixed payments for the commodity.

References

Swaps (finance) Commodity markets {{econ-term-stub