Commodity Swap

Think of an old-fashioned “swap meet” where people get together to trade or sell used goods.

In the world of commodities trading (oil, natural gas, metals, corn, wheat, etc.), a commodity swap happens when two parties exchange cash flows that are dependent on the price of an underlying commodity. Since prices can fluctuate wildly due to natural disasters or market demand, commodity swaps are used as a hedge against these price changes.

There are two parts to a commodity swap: a floating leg that is tied to the market price, or an agreed upon index...and the fixed leg that is the price agreed upon in the contract.

Swaps are generally done by a large institutional investor or a large distributor who holds the floating leg component. The fixed leg is usually held by the producer of the commodity. So if the investor wants to pay a guaranteed price for the commodity for a specific period of time, and the producer is willing to pay a floating rate as a hedge against declining prices, the swap can take place. Commodity swaps are usually done with oil, with its frequent price fluctuations.