Introduction

In a country like India, where agriculture, metals, and energy are the pillars of growth, price fluctuations create serious problems for businesses and investors. On one hand, sugar prices fluctuate for sugar mills; transport costs are affected by unpredictable oil prices, and fluctuating metal prices impact industries. Managing these and other commodity-related risks is essential. This is where the financial tool of a commodity swap helps, it significantly reduces downside cash flow risk due to market uncertainty. This article put commodity swaps in the spotlight. It describes what they are, how they work, the different types of commodity swaps, their benefits, and their risks.

What are Commodity Swaps?

A commodity swap is a contract between two parties to exchange cash flow based upon the price of a commodity (e.g., oil, wheat, gold, etc.) without the actual commodity delivery. Such contracts are purely financial contracts to the extent that they only focus on and rely on the movement of the commodity's price. Commodity swaps reduce cash flow risk from price fluctuations and can also be used to view prices moving in a specific direction. Commodity swaps ultimately are a hedge against the uncertain nature of commodity prices.

For example, an Indian edible oil manufacturer worried about rising palm oil prices could enter a swap to establish a fixed price, allowing them to control the production cost. Similarly, a cotton farmer in Gujarat might enter a swap to secure a fixed income that does not fluctuate with the changing global price. Theoretically, these swaps can be developed to be as flexible as the party’s desire, typically with minimum customising requirements, as they are usually traded over the counter (OTC).

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How Commodity Swaps Work

Commodity swaps feature the exchange of currencies based on buying, selling, or utilising commodities based on fixed and floating computed prices during a specific period. A three-step process is involved in an exchange of commodity swaps:

• Contract creation: The parties agree upon the commodity (e.g., crude oil), the period, the amount, and the fixed price.

• Settlement periods: Payments are exchanged every period (e.g., monthly) based on the fixed price and the market price of the commodities at the time. If the market price at settlement exceeds the fixed price, the floating-price payer must pay the difference to the counterparty, and vice versa.

• Cash Payments: Settlements are made in cash, with no physical commodity exchange.

Assume that an Indian airline faces fluctuating jet fuel prices. The airline enters a swap agreement with a bank where the airline agrees to pay a fixed price of ₹6,000 per barrel, and the bank will pay the market price on behalf of the airline. If, over the next year, the price of jet fuel rises to ₹6,500 per barrel, then the airline receives ₹500 for every barrel it pays, thereby effectively hedging any additional costs relating to fuel. Conversely, if the market price falls to ₹5,500, then the airline will pay ₹500, but will have the advantage of reduced costs on its fuel purchases.

Types of Commodity Swaps

There are two types of swaps in commodity markets:

• Fixed-for-Floating Swaps

One party pays a fixed price, and the other pays a price related to a market index. A fixed-for-floating swap is a common strategy for hedging since it establishes a secure price for that commodity over a fixed period.

• Commodity-for-Interest Rate Swaps

Payments tied to the price of a commodity are switched for payments linked to the interest rate. These swaps are less common but are still used by financial institutions with double exposure to manage.

• Benefits for Indian Businesses and Investors

Commodity swaps offer significant advantages in India’s commodity-driven economy:

• Price Stability: Commodity swaps reduce the potential for sudden price rises and can support easier budgeting for businesses such as sugar mills or refineries.

• Customisation: OTC contracts can be tailored to fit the required commodity, quantity, and time. This aspect is particularly well suited to India, which has many diverse segments.

• Speculation gains: Investors' ability to benefit from price movements without owning the commodity appeals to traders who trade in these spaces.

• Lower transaction Costs: Because commodity swaps do not require physical delivery, they can lower transaction costs than futures contracts.

While many benefits can come from commodity swaps, there are also dangers and risks to consider:

• Counterparty Risk: If one of the parties to the swap defaults on its obligation, payments to the non-defaulting party can stop. To mitigate this risk, only use SEBI-regulated institutions or clearinghouses.

• Market Risk: A trader can lose money if the price of the underlying contract goes against them; this risk is heightened if the trader speculates.

• Liquidity Risk: OTC (Over the Counter) markets may lack liquidity to enable traders to exit contracts.

• Regulatory Risk: SEBI’s guidelines regarding commodity derivatives can and do change regularly, and this could influence the nature of trading.

Conclusion

Commodity swaps are important for Indian businesses and investors navigating market uncertainty. Their attribute of price stability gives the stakeholder a flexible instrument to help them manage risk in agriculture, energy, and metals. However, there is complexity and risk in the swaps that can affect their use, so one must use caution and plan them out. As the commodity derivatives market in India expands (through MCX (Multi Commodity Exchange of India Ltd. and SEBI), swaps will be essential in obtaining financial resilience within these markets. Those pursuing this instrument should ask for advice from a SEBI-registered advisor. They could also utilize a reliable platform to ensure they make the best-informed decisions for their situation.

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