A swap is an agreement between two parties to exchange two different cash flows, i.e., exchange of a variable cash flow for a fixed cash flow or vice – versa. Swaps are typically OTC traded.
To understand commodity swaps, let us take an example:
Suppose there is an airline company which is worried about the fluctuation in the prices of one of its commodities, i.e., oil. The company is expecting that the prices of oil will go up. The airline company goes to an investment bank and agrees to pay a series of fixed payments and in turn, will receive variable payments. These payments will be based on the current prices of oil which can be then paid to the oil manufacturer. This is an effective way to hedge future price uncertainty of a commodity.
Commodity Swaps are generally OTC traded and are complex instruments. Only large institutions and investment bankers generally enter into a swap, because the value of these contracts are really high.