Commodity Swaps and Fixed-for-Floating
A commodity swap lets a producer or consumer lock in a fixed price against a floating market price for months or years at a time, without ever touching futures contracts, margin calls, or physical delivery.
Prerequisites: Commodity Futures Basics, Interest Rate Swaps
An airline wants to know its jet fuel cost for the next two years so it can price tickets with confidence. Buying two years of monthly futures contracts would work, but it means constant rolling, margin calls that swing with the market, and operational overhead the airline's treasury team may not want. A commodity swap solves the same problem in one over-the-counter contract: the airline pays a fixed price per barrel each month, and a bank counterparty pays it the floating market price — the two sides simply net the difference in cash.
In a fixed-for-floating commodity swap, one side pays a pre-agreed fixed price each period and receives the floating market price, while the other side takes the opposite; only the difference is exchanged, no commodity is delivered, and the fixed-price payer has effectively locked in its cost regardless of where the market goes.
How the netting works
At each settlement date — commonly monthly — the two sides compare the fixed price written into the swap against the floating price, usually an average of a published index over that period (to reduce the ability of either side to game a single day's price). Whichever side owes money based on that comparison pays the other in cash. If the floating price rises above the fixed price, the fixed-price payer comes out ahead — they are still paying only the fixed rate while the market has moved against the other side — so the floating-price payer (the bank, typically) owes them the difference. If the floating price falls below the fixed price, money flows the other way.
Worked example
An airline enters a 12-month swap on jet fuel, agreeing to pay a fixed $85 per barrel on a notional 10,000 barrels a month, receiving the floating monthly average market price. In a month where the floating index averages $95, the swap dealer owes the airline (95 − 85) x 10,000 = $100,000. The airline separately still buys its actual physical fuel at the prevailing $95 market price, so its net cost after the swap payment is $95 minus the effective $100,000/10,000 = $10 per barrel gain, landing back at $85 — exactly the fixed price it locked in. In a month where the index falls to $75, the airline instead pays the dealer (85 − 75) x 10,000 = $100,000, again netting back to an effective $85 per barrel regardless of which direction the market moved.
What this means in practice
Swaps are popular with commercial hedgers precisely because they can be customized — tenor, notional, settlement frequency, even the specific reference index — in ways a standardized exchange-traded future cannot be, and they avoid daily mark-to-market margin calls, though that convenience comes with counterparty credit risk to the dealer that an exchange-cleared future would not carry.
A commodity swap hedges price risk, not the underlying physical purchase itself — the airline in the example still has to go out and buy real jet fuel at the market price every month. The swap is a purely financial overlay that offsets the cost of that purchase; if the airline's physical supplier defaults or fuel becomes unavailable at any price, the swap does nothing to solve that separate problem.
Related concepts
Practice in interviews
Further reading
- Hull, Options, Futures, and Other Derivatives (ch. on swaps)