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Subject 7. Commodity Swaps and Indexes PDF Download
Commodity Swaps

A commodity swap is a contract where the two sides of the deal agree to exchange cash flows, which are dependent on the price of an underlying commodity or agreed-upon commodity index.

Why? A commodity swap provides both risk management and risk transfer while eliminating the need to set up and manage multiple futures contracts. Swaps also provide a degree of customization not possible with standardized futures contracts.

There are many types of swaps.

  • In an excess return swap, payments are made or received based on a return calculated by changes in the level of the index relative to a benchmark or fixed level.
  • In a total return swap, one party makes payments based on a set rate (either fixed or floating), while the other party makes payments based on the return of an underlying asset.
  • In a basis swap, periodic payments are exchanged based on the values of two related commodity reference prices that are not perfectly correlated.
  • In variance swaps the two parties bet on the variance of price levels of commodities.
  • In a volatility swap, the two sides of the transaction are speculating on expected volatility.

Commodity Indexes

Commodity indexes can be used as a benchmark, for macroeconomic or forecasting purposes, and as an investment vehicle. There are five primary commodity indexes based on assets. They all have been highly correlated with each other.

The key differentiating characteristics of commodity indexes are:

  • the breadth and selection methodology of coverage (number of commodities and sectors) included in each index.
  • the relative weightings assigned to each component/commodity and the related methodology for how these weights are determined.
  • the rolling methodology.
  • the methodology and frequency for rebalancing the weights of the individual commodities and sectors.
  • the governance that determines which commodities are selected.

Commodity indexes have very low correlation with traditional asset classes (stocks and bonds).

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