Question

1. Explain using cash flow diagrams how for any commodity it is equivalent to sign several futures contracts or one commodity swap.

2. Explain why a bank is subject to credit risk when it enters into two offsetting swap contracts.

Answer 1

2) At the start of the swap, both contracts have a value of approximately zero. As time passes, it is likely that the swap values will change, so that one swap has a positive value to the bank and the other has a negative value to the bank. If the counterparty on the other side of the positive-value swap defaults, the bank still has to honor its contract with the other counterparty. It is liable to lose an amount equal to the positive value of the swap.

1) What is a Commodity Swap? Like most other swaps, a commodity swap is a legally binding agreement where two counterparties agree to ‘swap’ cash flows, for example, at regular intervals over a specified period (e.g., for one year). One of the cash flows (also known as legs) is based on a floating price that is tied to the price of a commodity, and the other cash flow, or leg, is usually based on an agreed-upon fixed price. The floating price is determined using a specific price series. For example, many commodity swaps use the price of the main physical?delivery futures contract as published by the exchange, but they can also use spot prices as published by a reporting agency (e.g., Platts). These cash flows are generally also based on a fixed amount of the commodity (e.g., 1 million barrels of oil) which is known as the notional. The specified period for the swap is generally known as the tenor of the swap.  

Commodity swap contracts can also be converted into the equivalent set of futures contracts. Essentially, the swap is decomposed into its component parts, and then each part is represented by measures of size, direction, and expiration equivalent to the main physical-delivery futures contract for the commodity. In so doing, futures equivalent positions can be constructed that essentially represent the portfolio of futures contracts that would most closely provide the price exposure of that swap. These positions represent the futures contracts an entity would have to hold for similar economic exposure to the commodity (i.e., the hedge portfolio of futures held by the swap dealer). For example, if a swap contract for WTI crude oil expires in three years but has cash flows each month for the next three years, an entity would have to hold equivalent positions in the NYMEX WTI futures for each of the contract months over the next three years in order to replicate the swap. Therefore, this type of swap could be represented as 36 futures?equivalent positions associated with each of the contract months over the next three years (i.e., 36 monthly values corresponding to the 36 payout dates).

Below is a graphical representation and a more detailed explanation of the concept of futures equivalence for swaps.