Commodity Swaps Research Articles

Do agricultural swaps co-move with equity markets? Evidence from the COVID-19 crisis

Using proprietary data reported by swap dealers to the Commodity Futures Trading Commission, we first present new evidence on the size and composition of 13 over-the-counter agricultural swaps markets. We then utilize our novel dataset to show the existence of linkages with the equity markets. We use the spike in the Chicago Board Options Exchange Volatility Index in early 2020 to show that swaps trader positions were significantly impacted by the financial market volatility created by the COVID-19 pandemic. Following similar methods as Cheng et al. (2015), we find index swaps traders reduce their net long positions in response to tightening financial conditions, while commercial swaps traders absorb some of this risk by decreasing their net short positions. This internal swap market netting occurs in three of the four largest agricultural markets: corn, soft red winter wheat, and sugar. Concurrently, we observe a limited swap dealer hedging response in the futures market, especially when compared to other financial traders, consistent with swap market netting. Our results confirm that equity market shocks can affect financial traders in both commodity swaps and futures markets.

METHODOLOGICAL APPROACHES TO THE ASSESSMENT OF THE GLOBAL COMMODITY MARKET SEGMENTS FINANCIALIZATION LEVEL

Abstract. The purpose of the study is to fi nd out which of the approaches to the assessment the various world commodity market segments’ financialization levels that are developed in modern economics is the most appropriate for use in the process of evaluating the macro- and microeconomic consequences of financialization. The methods of analysis and synthesis (studying the structure of commodity derivatives market participants), classification (assignment of investors in the commodity derivatives market to the appropriate categories depending on the motives of their trade), comparison (identifying the market strategy features of each category of investors) are applied in the study. The results of the research confirmed that the majority of modern scientists associate financialization with changes in the participants structure of the commodity derivatives markets and in this regard, they assess the level of financialization on a particular commodity market by evaluating the size of the net position belonging to the certain investors category or its share in an open position (the size of swap dealers net position, commodity index traders net position, hedge funds and swap dealers net position, managed money net position, the speculative index etc.). It can be concluded that in connection with the peculiarities of the various markets conjuncture, in order to simulate the impact of financialization on such economic parameters as the commodity derivatives prices volatility, price volatility of its underlying assets, the cost of hedging, the inflation rate, economic growth, it is the most appropriate to use as an exogenous variable the ratio of commercial traders net position to non-commercial traders net position, as it enables the comparison between the different segments of the global commodity market. Keywords: financialization, commodity markets, commodity derivatives, commodity index traders, commodity futures, over-the-counter commodity swaps.

Selected Issues In The Taxation Of Swaps, Structured Finance and Other Financial Products

This article is based on a paper presented by the author to the Tax Review of New York City on November 16, 1992.The last decade has seen an explosive growth in the use of swaps and other derivative products as part of the asset and liability management strategies of corporations and other institutional investors. Beginning with interest rate and currency swaps, the menu of swap products has expanded to include commodity swaps, equity index swaps, equity swaps, total return swaps, basis swaps, and interest rate caps, floors and collars. According to industry sources, the market for interest rate swaps has grown in notional principal amount from an estimated $3 billion in 1982 to over $3.065 trillion by the end of 1991 (the most recent figures available). Similarly, the outstanding aggregate notional principal amount of currency swaps has grown from $182 billion in 1987 to $807 billion by the end of 1991.At the same time as the swap market has been expanding, the structured finance market, including mortgage and asset securitization, has seen similar growth. Beginning in the 1970s, U.S. government-backed enterprises such as the Government National Mortgage Association ("Ginnie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") sponsored transactions in which pools of residential first mortgages were bundled into pass-through certificates that were then sold to thrifts, banks and other institutional investors. In 1983, Freddie Mac introduced collateralized mortgage obligations ("CMOs"). CMOs, which divided up the cashflows from an underlying pool of mortgages into separate debt securities having different maturity, interest rate and credit characteristics, dramatically broadened the market for mortgage-backed securities. With the enactment of the "Real Estate Mortgage Investment Conduit" ("REMIC") provisions as part of the 1986 Tax Reform Act, the taxation of mortgage pass-through and pay-through securities became subject to a new, self-contained set of rules. Moreover, since the mid-1980s, structured finance techniques originally employed in securitizing mortgages have been applied to a broad range of other financial assets, including stocks, credit card receivables, auto loans, lease receivables, home equity loans, commercial and industrial loans and trade receivables.

Integrated structural approach to Credit Value Adjustment

This paper proposes an integrated pricing framework for Credit Value Adjustment of equity and commodity products. The given framework, in fact, generates dependence endogenously, allows for calibration and pricing to be based on the same numerical schemes (up to Monte Carlo simulation), and also allows the inclusion of risk mitigation clauses such as netting, collateral and initial margin provisions. The model is based on a structural approach which uses correlated Lévy processes with idiosyncratic and systematic components; the pricing numerical scheme, instead, efficiently combines Monte Carlo simulation and Fourier transform based methods. We illustrate the tractability of the proposed framework and the performance of the proposed numerical scheme by means of a case study on a portfolio of commodity swaps using real market data.

How Enron Used Accounting for Prepaid Commodity Swaps to Delay Bankruptcy for One Decade: The Shadowy Relationships With Big Banks

Accounting standards for prepaid commodity swaps did not exist until 2003. This absence of regulation gave Enron the opportunity to have its own homemade accounting. Two actions facilitated this task for Enron: (a) The Securities and Exchange Commission granted Enron in January 1992 a unilateral privilege to use mark-to-market valuation for energy contracts. This private communication was made at a time when viable markets did not exist. (b) Big banks colluded with Enron’s top executives to design structured finance contracts that allowed Enron to report at least US$8.7 billion of loans as cash flow from operations. Seventy-one percent of the cash flow from operations reported in the last 5 years of Enron’s existence came from these loans. JPMorgan Chase and Citigroup effectively made it easy for Enron to carry out this fraud. The two banks established their own special purpose entities to give these loans the appearance of legitimate trade transactions using prepaid commodity forwards and swaps. This article outlines some of the schemes that the two banks devised to help Enron appear financially healthy when in reality it was near bankruptcy for years.

Exploring Commodity Trading Activity: An Integrated Analysis of Swaps and Futures

This paper presents an analysis of new, regulatory data on commodity swaps, focused on West Texas Intermediate (WTI) crude oil. We find that commercial end-users have a much larger footprint in the WTI swaps space than financial end-users do. Commercials have a much larger exposure in swaps than in futures and are net short in both markets. Financial end-users are smaller in swaps than in futures and are net long in both markets. Swap Dealers perform a substantial amount of intermediation among WTI longs, WTI shorts, and index investors; consequently, net dealer exposure to hedge in futures markets is far less than the gross swap exposure.

How Enron used Accounting for Prepaid Commodity Swaps to Delay Bankruptcy for One Decade: The Shadowy Relationships with Big Banks

This study addresses two important, but less known, factors that contributed to Enron’s collapse. (a) The SEC’s granting Enron in January 1992 a unilateral privilege to use mark-to-market for energy contracts. Enron had a full discretion to estimate the market values of its contracts and reported the changes in these values as a steady increase in profits without disclosing the source. (b) The role of big banks in conspiring with Enron’s top executives to design structured finance contracts that allowed Enron to loans as cash flow from operations for nearly one decade. More than 24 contracts of prepaid commodity swaps and prepaid commodity forward contracts were executed on paper through special purpose entities established by JPMorgan Chase and Citigroup. Enron borrowed a total of ($8.7 Billion between 1992 and 2000 using these structured finance contracts disguised as commodity swaps. The absence of accounting guidance for prepaid commodity swaps gave Enron the way to manipulate its financial statements with impunity to satisfy management goals at the expense of investors.

How Enron Used Accounting for Prepaid Commodity Swaps to Delay Bankruptcy for One Decade: The Untold Story

This study addresses two important, but less known, factors that contributed to Enron’s collapse. (a) The SEC’s granting Enron in January 1992 a unilateral privilege to use mark-to-market for energy contracts. Enron had a full discretion to estimate the market values of its contracts and reported the changes in these values as a steady increase in profits without disclosing the source. (b) The role of big banks in conspiring with Enron’s top executives to design structured finance contracts that allowed Enron to loans as cash flow from operations for nearly one decade. More than 24 contracts of prepaid commodity swaps and prepaid commodity forward contracts were executed on paper through special purpose entities established by JPMorgan Chase and Citigroup. Enron borrowed a total of ($8.7 Billion between 1992 and 2000 using these structured finance contracts disguised as commodity swaps. The absence of accounting guidance for prepaid commodity swaps gave Enron the way to manipulate its financial statements with impunity to satisfy management goals at the expense of investors.

Speculators, commodities and cross-market linkages

We use a unique, non-public dataset of trader positions in 17 U.S. commodity futures markets to provide novel evidence on those markets' financialization in the past decade. We then show that the correlation between the rates of return on investible commodity and equity indices rises amid greater participation by speculators generally, hedge funds especially, and hedge funds that hold positions in both equity and commodity futures markets in particular. We find no such relationship for commodity swap dealers, including index traders (CITs). The predictive power of hedge fund positions is weaker in periods of generalized financial market stress. Our results support the notion that who trades helps predict the joint distribution of commodity and equity returns. We find qualitatively similar but statistically weaker results using a proxy for hedge fund activity based on publicly available data.

Proposal of using SWAPs by hard coal mining companies in Poland

Running a business entails various risks which can significantly impact the economic and production results achieved by a given enterprise. One way of hedging certain risks is to use appropriately designed derivatives. This article presents the newest group of these contracts, i.e. swaps, and focuses on how these contracts can be used by Polish mining companies from the hard coal mining sector selling a part of their output on the global market.This article briefly characterises and presents types of swaps as well as the Polish swap market, pioneered by Polski Bank Rozwoju S.A. with the first FX swap of 1992. Since then, other types of transactions have also been included in the offering of domestic banks (assets swaps, cross-currency interest rate swaps).Mining companies producing hard coal have not been active on the swap market yet because of their poor activity on derivative markets. This article proposes a swap as an derivative hedging the hard coal price for a mining company exporting a part of its production to the global market.In the presented example, a mining company, by concluding a forward and an appropriately structured commodity swap, was able to both protect itself from a fall in the price and use additional gains due to prices rising in the global market.Apart from commodity swaps, mining companies can use FX swaps, IRS and other swaps described in the literature and commonly applied in practice by various economic entities, depending on the type of risk that needs hedging. A significant advantage of this kind of contract is that there is no need to freeze funds in security deposits, nor are there fees of other kinds (premiums) like those payable for other derivatives (futures, options).

Pricing Commodity Swaptions in Multifactor Models

The menu of swaps available in the market today ranges far beyond the basic fixed-for-floating interest rateswap. Commodity swaps specifying a series of future cash flows, whereby one counterparty pays a fixed dollar amount and the other pays the price appreciation on some underlying commodity, are a prime example. And if commodity swaps become popular, commodity swaptions will naturally be introduced. But valuing commodity swaptions involves modeling the behavior of both future interest rates and future commodity prices for all of the payment dates. The standard approach is Monte Carlo simulation, which is complicated and time consuming. Here, Larsson introduces an approximation that is quite mild in terms of the error it introduces and for which the execution time for a given level of accuracy is improved by several orders of magnitude.

Future trends in the structured credit market

In recent years, credit markets have been characterised by the strong growth of credit derivatives and structured credit, not only in terms of the volume of derivatives traded, but also the number of underlying reference entities and the complexity of the payoffs involved. The subprime turmoil, however, might be the turning point for the structured credit market. While there are apparent consequences for the future of credit derivatives, in the long run the crisis will also highlight the more subtle deficiencies in the existing market structure. The obvious conclusions are: (1) in the medium term, investors will avoid complex structures, and (2) trade in plain-vanilla credit default swaps will increase, as these have been the only instruments to remain fairly liquid during the crisis and provide a hedging tool for investors. In addition, there is a structural change in the credit market which is largely independent of cyclical aspects. The trend towards imposing credit derivatives technology on other asset classes continues, with collateralised debt obligations on equity default swaps, commodity swaps and foreign exchange markets having already been established. In the long term, the so-called collateralised asset obligations regime is expected to replace old-fashioned risk-return optimisation.

Hybrid securities and commodity swaps; tools to hedge risk in emerging stock markets: Theoretical approach

This study presents hybrid securities and commodity swaps as a diversification channel in emerging stock markets, in particular, Gulf Cooperation Council (GCC). It is evident that derivative markets play a crucial part in the global financial system. The use of hybrid securities as a tool to hedge risk in emerging stock markets has, however, not been closely examined. Hybrid securities can play a vital role in the future of emerging stock markets. It may be considered a key capital management tool. The paper attempts to apply the appropriate mechanism of hybrid securities in emerging stock markets. Credit derivatives have many uses and provide flexibility to transfer and price credit risk more efficiently. The expected defaults in the GCC markets are expected to continue growing at a high rate. Credit derivatives are likely to be used more extensively in those situations where buying or selling in cash markets is cumbersome and less efficient.

Fundamentals, Trader Activity and Derivative Pricing

We identify and explain a structural change in the relation between crude oil futures prices across contract maturities. As recently as 2001, near- and long-dated futures were priced as though traded in segmented markets. In 2002, however, the prices of one-year futures started to move more in sync with the price of the nearby contract. Since mid-2004, the prices of both the one-year-out and the two-year-out futures have been cointegrated with the nearby price. We link this transformation to changes in fundamentals, as well as to sea changes in the maturity structure and trader composition of futures market activity. In particular, we utilize a unique dataset of individual trader positions in exchange-traded crude oil options and futures to show that increased market activity by commodity swap dealers, and by hedge funds and other financial traders, has helped link crude oil futures prices at different maturities.

Ledger provision in hog marketing contracts

Price‐dependent loan agreements at low interest rates have sometimes been included in North American hog sector long‐term marketing contracts. We show that a general form of this stipulation can be viewed as a hybrid between a forward rate agreement and a bundle of commodity spot options. In some cases, the provision amounts to a commodity swap. These observations provide an approach to valuing the provision. Historical data are used to estimate expected payouts to the producer under the contract feature.

Financial engineering in Islamic finance

AbstractThe objective of this article is to examine the scope of financial innovation and engineering within an Islamic financial system. The article concludes that, contrary to common belief, Islamic finance provides the basic building blocks that can be used to construct more complex instruments that will enhance liquidity and offer risk management tools. With the introduction of asset securitization and swap transactions conforming to Islamic principles, the issues of secondary markets and risk management can be addressed. The first section discusses the significance of innovation in Islamic financial markets. The second section discusses the process of introducing new products in the market and their scope. The third section illustrates an Islamic form of asset securitization as an example of financial engineering. The fourth section evaluates the structure of a commodity swap transaction to determine its validity. And finally, the fifth section concludes the discussion. © 1999 John Wiley & Sons, Inc.

Risk Profile Modification of Energy Projects: The Impact of Controlling Financial Risk Utilizing Swaps

Summary The commodity futures and swaps markets are thought to be the invention of speculators, the bane of the oil business, or possibly something confined to finance departments of major corporations. In actuality, they should be considered more as an insurance vehicle and can be used at the project level to modify the risk profile of a property. In this context, an increased familiarity with them can be useful for an engineer. Either futures or swaps can be used to guarantee or modify product prices. While this does not necessarily maximize cash flow or present worth, it can protect a project or company for several years from downside price risk, thereby reducing the risk of the venture. This can be particularly important if lower product prices would cause unacceptable cash flows or net incomes. Reducing risk by limiting downside price exposure could alter budgeting decisions, allow continued or expanded operations of a particular property, or increase debt capacity. Introduction As commodity markets have increasingly assumed the role of discovering near-term prices for oil and are beginning to affect natural gas prices similarly, several financial products have been developed that can reduce product pricing risk. Risk can be reduced directly in the futures market or in the over-the-counter market with financial institutions and trading companies using hedging products like swaps. The role that these products play and the importance of understanding it are increasing as price volatility becomes more pronounced. Their impact is highest and their cost is lowest over the immediate future (1 to 5 years). This may also be the period of maximum producing rate, highest present worth, and maximum uncertainty concerning price; thus, they can provide substantial risk protection. Futures and swaps markets exist for crude oil, natural gas, and several refined hydrocarbon products. While gas futures and swaps can be executed, that market is less well-developed than the oil market, and the relative prices in the two markets do not necessarily correlate. This paper is limited to crude oil transactions to avoid those complications and to concentrate on the risk-modification aspects of hedging. Most comments and all concepts are equally valid for natural gas production. This paper briefly outlines how oil futures and swaps function and then concentrates on demonstrating the effect of swaps on risk management at the project level through specific examples. An attempt is made to focus on the basic fundamentals of altering project risk rather than dealing with the infinite variability of swaps or the mechanical complexities of executing futures contracts.

The Commodity Exchange Act and Other Bucket Shop Laws: The Future of Commodity Swaps Without Preemption

The Commodity Exchange Act and Other Bucket Shop Laws: The Future of Commodity Swaps Without Preemption

Hedging long term commodity swaps with futures

In the past decade the financial community has developed an assortment of risk management techniques. The most successful tool has been the swap. Interest rate and currency swaps have grown into a three trillion dollar market (notional principal outst~ding). Corporations have been able to manage their exposures to fluctuating financial markets. This has facilitated the planning process and allowed corporations to focus on their primary business. Now these same techniques can be applied to commodity price risk. The commodity swap market differs from the rate swap market in two ways. First, the commodity swap user is more likely to be the purchasing manager than the corporate treasurer. Second, the instruments available to the commodity swap dealer to use for hedging are typically limited to futures contracts that cover a period of up to one year at best, whereas the rate swap dealer has a large variety of instruments including 30 year bonds. In this paper we describe the commodity swaps market. We start with a description of the product and the marketplace. Then we discuss the difficulties of hedging a commodity swap from the dealer’s perspective and develop a hedging model for the strategy of replicating long-dated forwards with only short futures contracts. The techniques described in this paper are applicable to any commodity that has a liquid futures market, but most of the discussion uses the oil market as an example. Currently, expanding the swap market into petroleum products has been the focus of major commercial and investment banks.