Swaps & Commodity Forwards/Futures R32/33

Question 1

What is the simple equation regarding financial settlement?

Financial settlement of interest rate swaps and commodity swaps are very similar.

Answer 1

settlement = (difference between fixed and market values) x (notional principal)

Question 2

With respect to swap valuation, you are supposed to memorize the following 4 main points.

Answer 2

• Value is the present value of the settlement
• Values at inception are zero (ignoring fees)
• Values change as interest rates change. In addition, the value of a commodity swap changes as commodity prices change.
• Values change as time passes.

Forward contracts can lock in the cash flows, but the changes in the interest rates can change the PV of the CFs, and hence the market value of the swap.

Question 3

From the perspective of the buyer of a prepaid swap, what risks are there?

For financially settled swaps, what are the risks?

Answer 3

Prepaid swap

• credit risk
• market risk
• financial risk

Financially settled swap

Risk from changes in forward prices and interest rates, but credit risk is much less.

Question 4

What is the formula for a forward price on a financial asset?

F_0,T = ?

Answer 4

Question 5

What is the lease rate?

Answer 5

The lease rate on a commodity is the interest rate (i.e., return) the holder of a commodity would require to lend it out, and it is analogous to the dividend yield on a stock that has been loaned out for a short sale.

Question 6

What is the formula if there are storage costs associated with holding the commodity?

What is the formula when including a non-monetary gain from holding the commodity (the convenience yield)?

Answer 6

Note that storage costs act like a negative lease rate. The owner of a storable commodity lends the commodity, he is relieved of paying the storage costs.

The storage costs are being reduced by the convenience yield:

Question 7

Identify and explain how to exploit arbitrage situations that result from the convenience yield of a commodity and from commodity spreads across related commodities.

What is the formula for the range of no-arbitrage prices?

Answer 7

Question 8

Compare the basis risk of commodity futures with that of financial futures.

Answer 8

Basis risk is the risk that the cash price and the futures price will change in an unpredictable way.

In order to minimize it, try and find a futures contract that is highly correlated with the hedged asset. The timing of the delivery should match the expiration of the hedge in both financial/commodity futures.

Extra basis risk for commodity futures vs financial futures

• Timing
• Grade
• Storage costs
• Transportation costs

Question 9

Define contango and backwardation and how the lease rate affects both.

Answer 9

Contango = upward-sloping forward curve, where the lease rate < risk-free rate

Backwardation = downward-sloping forward curve, where lease rate > risk-free rate