A commodity swap is a type of financial agreement where two parties exchange cash flows based on the price of a commodity. It is mostly used by businesses and investors to protect themselves from price changes in raw materials like oil, gold, wheat, etc.
Let’s understand this in simple terms with examples.
What is a Commodity Swap?
A commodity swap is a contract where one party agrees to pay a fixed price for a commodity, while the other party agrees to pay a floating or market-based price.
The goal is to manage the risk of rising or falling prices. No actual exchange of the physical commodity happens — only the difference in prices is paid or received in cash.
Why Are Commodity Swaps Used?
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To hedge against future price changes of a commodity
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To get price stability for budgeting and planning
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To protect profit margins for both producers and buyers
Who Uses Commodity Swaps?
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Oil companies to lock oil selling prices
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Airlines to manage fuel costs
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Farmers and food companies to fix prices of crops
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Investors looking to trade on commodity price movements
How Does a Commodity Swap Work?
Example:
A large biscuit manufacturing company in India uses wheat as its main raw material. Wheat prices are highly volatile and can impact the company’s profit.
To protect itself, the company enters a commodity swap agreement with a trading firm for 1,000 tonnes of wheat for 6 months.
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The biscuit company agrees to pay a fixed price of ₹2,000 per quintal (₹2 crore total).
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The trading firm agrees to pay the market price on the settlement date.
At the end of 6 months:
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If the market price rises to ₹2,200 per quintal, the trading firm pays the biscuit company the ₹200 difference per quintal — a total of ₹20 lakh.
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If the market price falls to ₹1,900, the biscuit company pays the trading firm ₹100 per quintal — a total of ₹10 lakh.
Result: The biscuit company avoids the risk of sudden price hikes and keeps its costs stable, while the trading firm earns a return based on price movements.
Types of Commodity Swaps
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Fixed-for-Floating Swap: One party pays a fixed price, the other pays the market price
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Commodity-for-Commodity Swap: Exchange cash flows based on two different commodities (less common)
Benefits of Commodity Swaps
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Protects against price volatility
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Helps in planning and budgeting
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Useful for industries that rely heavily on commodities
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No need to physically hold the commodity
How Are F&O and Commodity Swaps Different?
While both F&O (Futures & Options) and commodity swaps are used for managing price risks, they are quite different in structure and purpose:
F&O contracts are ideal for short-term traders, while commodity swaps are better suited for companies that want long-term price certainty on large volumes.
Risks of Commodity Swaps
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Market price predictions may go wrong
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Counterparty risk (if one party defaults)
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Complex contracts need financial understanding
Final Words
A commodity swap is a useful financial tool for businesses that want price certainty. It does not involve buying or selling actual goods but helps manage cash flows based on commodity prices.
If you are a business exposed to commodity risks or an investor looking to learn about advanced trading instruments, understanding commodity swaps is a smart step forward.
For more expert support, trading guidance, and market insights, platforms like Motilal Oswal offer research, tools, and advisory services to help you make informed decisions.
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