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.

Unlock smarter investing with a Demat account

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?

• To hedge against future price changes of a commodity
• To get price stability for budgeting and planning
• To protect profit margins for both producers and buyers

Who Uses Commodity Swaps?

• Oil companies to lock oil selling prices
• Airlines to manage fuel costs
• Farmers and food companies to fix prices of crops
• 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.

• The biscuit company agrees to pay a fixed price of ₹2,000 per quintal (₹2 crore total).
• The trading firm agrees to pay the market price on the settlement date.

At the end of 6 months:

• 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.
• 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

1. Fixed-for-Floating Swap: One party pays a fixed price, the other pays the market price
2. Commodity-for-Commodity Swap: Exchange cash flows based on two different commodities (less common)

Benefits of Commodity Swaps

• Protects against price volatility
• Helps in planning and budgeting
• Useful for industries that rely heavily on commodities
• 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

• Market price predictions may go wrong

• Counterparty risk (if one party defaults)

• 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.

Related Blogs - Options and Swaps