Swaps represent exchanges of payments between two parties. They are financially settled and no physical commodity is delivered or received by either party. They represent a substitute for the futures contracts but rely on NYMEX pricing to establish the financial arrangement for the swap contract. Similar to a NYMEX contract, the elements of a swap contract include the commodity, location, date, and price.
We use the phrase “fixed-for-floating” swap to signify the prices agreed to by both parties in the contract. The “fixed” price is always the current market price. It is the price known at the time the deal is struck. The exchange of payments will occur when the NYMEX settlement price is known. We refer to this settlement price as the “floating” one since it is not known until the contract’s last trading day and “floats” with each day’s trading until then. The difference between the two represents the amount of payment due to one party or the other.
For example, as of this writing, the December 2019 NYMEX crude oil contract is trading $62.69. If I bought a swap, I would be setting my contract price at $62.69. On November 20th, 2019, this contract will settle, and the difference between my $62.69 and the NYMEX Final Settlement price that day, will be the amount exchanged between me and my counterparty. If the contract settles at $63.19, since I bought the swap, I would be selling it back at that price for a profit of $0.50 per contract and, my counterparty would pay me $0.50 per contract (1,000 Bbl), or $500. On the other hand, if the contract settled at $62.19, I would be selling the contracts back at a loss of ($0.50) and I would pay my counterparty $0.50 per contract, or $500. The calculations are the same as those shown in Lesson 7's hedging spreadsheet.
As we learned in previous lessons, Futures contracts are standard contracts. However, swaps can be customized. This is another advantage of swaps that make them popular. The advantage of using swaps for hedging is that you can achieve the same price protection without actually having to buy or sell NYMEX contracts. And you can work with brokers either by phone ("Voice" Brokers) or through an electronic trading platform such as "The Intercontinental Exchange (ICE)".
In a previous lesson and in the textbook, we discussed the fact that physical entities wishing to hedge must take a position in the financial market which is the opposite of their physical position. For instance, a crude oil producer is "long" the commodity. Therefore, in order to execute a proper hedge, they must go "short" in the financial derivative they choose. In Lesson 7, I presented how the physical and financial prices interact in a hedge. The same applies to swaps as to the NYMEX contracts themselves.
Key Learning Points for the Mini-Lecture: Financial Energy Swaps
- “Swaps” are exchanges of payments between two parties. They are strictly financial. No physical exchange of the commodity takes place.
- One party to the transaction agrees to pay a current market price (“fixed”) while the other agrees to pay a price in the future (“floating”).
- They are a simpler and less expensive way to hedge price risk.
- One very important swap is a “basis swap” which is a market-determined value that represents the difference between the NYMEX Henry Hub and other natural gas trading points in North America.
- For basis swaps, the "fixed" price or, "known" is the current market price which can be obtained through electronic platforms such as NYMEX Clearport or ICE. In addition, some brokers will give quotes over the phone. The "floating" price becomes known when the NYMEX contract for the particular month settles and the monthly index ("postings" we addressed in Lesson 5) for the cash location is published. This is known as the "actual" or "settlement" basis and represents the other value in settling the swap.
The following mini-lecture is a summary of the points presented above (3:37 minutes).