Swap exposure rule

A commodity swap has no futures exchange, no margin and no daily settlement. Two counterparties simply agree to exchange a series of cash payments over time, based on a fixed price and a floating price for the same commodity.

Even though nobody in a swap buys or sells the physical commodity, each side still ends up with a real, directional exposure to its price — exactly as if he held a futures position. Knowing which side is which is what lets a trader or hedger use a swap deliberately, instead of by accident.

In a fixed-for-floating commodity swap, one party — the fixed price payer — pays a fixed price agreed at execution, while the other — the floating price payer — pays a price that resets periodically against spot, a nearby futures contract, or an average of either.

The workbook maps out 4 resulting positions. If the commodity's price rises, the fixed price payer gains, because his fixed obligation is now cheaper than the market — so he is indirectly long. The fixed price receiver is on the other side of that same payment, so he is indirectly short. Symmetrically, the floating price payer is indirectly short the commodity, and the floating price receiver is indirectly long. This mapping is what lets a trader or a hedger identify his natural exposure from a swap position and hedge it, or add to it, exactly as he would with a futures position.

A refiner enters a fixed-for-floating swap on crude oil with monthly payments: the refiner pays a fixed price of $75 per barrel, and its counterparty, a trading desk, pays the floating average of that month's spot price, on a notional of 10,000 barrels.

If the average spot price for the month works out to $85 per barrel, the refiner — as fixed price payer — receives $10 per barrel from the trading desk, a payment of $1,00,000, exactly offsetting the extra it now pays for its physical crude purchases at the higher market price. As fixed price payer, the refiner is indirectly long crude oil through this swap, which is precisely why the swap works as a hedge against its real, physical exposure to rising crude prices.

Chapter 1 (Introduction to Commodity Markets), section 1.1, in the introduction to swaps as one of the family of commodity derivative instruments covered in later chapters. Expect a mapping question — given a party's role as fixed or floating, payer or receiver — asking whether that party is indirectly long or short the underlying commodity.

• "Payer" and "receiver" refer to which price a party pays, not which side profits. The fixed price payer pays fixed and, in effect, receives floating — that is what makes him indirectly long.
• The four positions run in two pairs that mirror each other: fixed payer long / fixed receiver short; floating payer short / floating receiver long. Getting one pair right does not guarantee the other is remembered correctly.
• No physical commodity changes hands in a swap — the exposure is entirely in the cash payments, which is what makes the directional mapping worth learning rather than assuming.