Question

Advantages and Disadvantages of commodity swaps

Answer 1

Meaning of Swap: A swap is an agreement between two or more people/parties to exchange sets of cash flows over a period in future.The needs of the parties in a swap transaction are diametrically different

Swaps are of different types: Interest swaps, currency swaps, Equity swap, Commodity swap.

commodities include gold, silver, wheat, rice, coffee beans, sugar, salt, etc

Commodity swaps are used for protect as fluctuations in commodity prices.

How commodity swaps work: For example:

Let us now work through an example. A business man  has entered into a contract with farmer to pay a fixed rate of 25.00 $ for 100 Kg wheat. If at the payment period, the price of wheat increased 30$ , how much has the businessman  saved, given the contract is for100 Kg  of wheat.

Here we see that the businessman  wants to pay a fixed rate of $25  of 100 kg wheat. At this point in time, the difference would be: $30 – $25gallon = $5 per 100 kg

In total, the other party would pay the farmer at new rate 100  x 30$ = 3000$

This $50 would offset the increase in the price of wheat paid by the businessman. If the businessman had to pay $30 for 100kg of wheat, this would cost them $3000. However, due to the swap contract the net amount is: 100*25=2500

increased price 100*30=3000

So total saved price due to swap is 3000-2500= 500$

We can see that through the swap contract, the businessman  is able to ensure a price of 25$ per 100 kG wheat for

Thus it has several advantages of commodity swaps:

1.Diversification — Diversification is when you invest in a variety of industries that give results differently to changes in the market. It will keep your annual profit stable and also avoid big losses. investing in commodities can be the right option for you manage risk in the market. it can be relate with above example.

2. Higher growth opportunities. A rapidly increasing demand for a commodity can see increases in prices significantly time to time. It provides a lot of opportunities to make quick income through commodity investment.

Disadvanatges of Commodity swaps:

1.Sometimes no income generation. — Just like another asset as stock and bonds, Investment in commodities doesn’t generate large income for the investor.

2. Highly volatile market — Commodities are most volatile security among other assets. According to one study commodities are almost double as stocks and four times as volatile as bonds. This volatility makes commodities very risky for some traders. This one is a negative point of commodity trading.Volatility often refers to the amount of uncertainty or risk related to a security's value.

Conclusion: Thus we can say commodity market is effective to save a money if price increase . But if there are advanatges some disdavanatges are also there.