How to make a swap contract work for you and your business
By James M. Burr
Last month we discussed the basics of futures contracts. This month, we are going to discuss the basics of swaps.
For the purposes of this article, we will assume that the terms “swaps contract,” “derivatives” and “over-the-counter contracts (OTCs)” are all interchangeable.
A swap contract is a privately negotiated contract in which the terms and conditions are agreed to by both parties.
If “Your Company” contacted “Acme Oil” and said, “Gulf Heating Oil is trading at $1.30 per gallon. How about we strike a deal, at the end of the month, if Gulf Heating Oil is above $1.30 per gallon, you pay me the amount it is above $1.30. If at the end of the month Gulf Heating Oil is below $1.30 per gallon, I will pay you that amount?” This is a swap; two firms privately negotiating a contract that will ultimately be settled not by physical delivery, but with their checkbooks.
A swap contract is a hybrid between a futures contract and a contract for physical delivery. It is like a futures contract in that it has a financial gain or loss based on the index stipulated in the contract. It is similar to a contract for physical delivery in that each transaction is accompanied with a conformation of trade and both sides are expected to review for correctness, sign and return.
A generic swap transaction would include all the terms and conditions of the contract, including:
• Transaction date
• Period of time the contract covers
• Structure (swap, option, basis contract, etc.)
• Index the contract is to be based on
• Settlement type (Asian, European)
• Commission charges
Why should I use swaps?
There are several advantages to using swaps as your risk management tool.
1. Indices. The swap settlement pricing is based on an “index” that both parties agree to. The primary indices used for refined fuels and propane are:
Distillates and Gasoline
• Group III-Platts
• N.Y. Harbor-Platts
• Los Angeles-Platts
• Mont Belvieu-OPIS
Since you can take a position in the same market that you have physical risk, you can virtually eliminate basis risk (basis risk will be covered in detail in a future article). This means that you can take a hedge position in the market that most closely correlates with the market in which you have physical risk.
2. Specific Commodity. A swap contract can be executed on any commodity that both parties agree to and that there is a posted index on which to settle the transaction. This can be high- or low-sulfur diesel, No. 6 oil, jet fuel, regular unleaded gasoline and reformulated gasoline, to name a few. The ability to design your hedging tool to use the commodity that most closely matches the commodity in which you have risk allows you to design a hedging strategy that uses the tools that will most closely match your risk.
Settlement style. Swaps provide the ability to structure the settlement style of a transaction that most closely correlates with the risk you have in the physical market. The two most common swap settlement types are for Asian and European settlement.
An “Asian Settlement” swap is settled on the average price of an index during the time agreed to in the terms of the contract. Most Asian-settled contracts are settled on the average price over a calendar month, but it can be any duration both parties agree to.
A “European Settlement” swap is settled on the index price on a specific date. This can be any date that both sides agree to.
Futures or swaps?
The correct answer is that the most profitable hedging program will use both. A hedge should never be considered a “permanent” position; rather it should be reviewed and assessed if the current hedging tool (futures or swaps) is currently the correct choice. This is as simple as asking yourself, “If I was to put the hedge on today as a new position, would I use the tool that I am currently using?” If the answer is no, then you are using the wrong tool.
What this allows you to do is move your hedging tool back and forth between futures and swaps to take the greatest advantage of basis moves (basis will be covered in detail in an upcoming article).
For example, if you owned inventory in Texas and hedged this by selling NYMEX futures and the Gulf price increased in value relative to the NYMEX price and you thought that the Gulf price would now decline in value as compared to the NYMEX price you would buy back your NYMEX position and sell an equal amount of a Gulf swap (this is called rolling). This will now allow you to keep from giving back any basis increase you have made and lets you make more money than if you had simply remained hedged in the NYMEX.
This is just the very basics of swaps. Next month we will discuss the basics of options.
James M. Burr is the vice president of FCStone. You can reach him at (816) 457-6217.