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A commodity swap is an agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period.
A Commodity swap is similar to a Fixed-Floating Interest rate swap. The difference is that in an Interest rate swap the floating leg is based on standard Interest rates such as LIBOR, EURIBOR etc. but in a commodity swap the floating leg is based on the price of underlying commodity like Oil, Sugar etc. No Commodities are exchanged during the trade.
In this swap, the user of a commodity would secure a maximum price and agree to pay a financial institution this fixed price. Then in return, the user would get payments based on the market price for the commodity involved.
On the other side, a producer wishes to fix his income and would agree to pay the market price to a financial institution, in return for receiving fixed payments for the commodity.
The vast majority of commodity swaps involve oil.
- Understanding Derivatives: Markets and Infrastructure Federal Reserve Bank of Chicago, Financial Markets Group
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