Going OTC with forwards and swaps

Continuing our series of risk management tutorials, this month Dan Rowe look at swaps and forward contracts in the over-the-counter market

This month’s tutorial article looks at the over-the-counter (OTC) market, focusing on swaps and forwards. The OTC market is an organised, but mostly unregulated market, in which transactions take place directly between counterparties or through a broker.

In general, there is no central arena – whether an exchange or open-outcry – for trading OTC contracts. While there are proprietary electronic exchanges for trading OTC instruments, like the Atlanta, Georgia-based Intercontinental-Exchange, they are just another mechanism for transacting OTC instruments, providing a service like that of a broker.

Trading takes place over the telephone and involves traders locating their own counterparty. As we will see, you have probably entered into an OTC contract at some time or another and did not even realise it.

As OTC is an unregulated market and no formal reporting of transactions is required, judging the size – or monetary value – of it is difficult. It is widely estimated that this market is worth more than $20 trillion a year.

Swaps and forwards are just two of the various types of instrument in the OTC market-place, which covers both financial and physical transactions. To the extent that they are financial, swaps are settled through an exchange of money. Forwards are separate contracts, settled with the actual delivery of a physical commodity.

Later in this article we will draw some parallels between the two and even throw in a futures contract for good measure.

Defining swaps...

A swap is a financial tool designed to transfer, or swap, one type of pricing mechanism/rate for a different pricing mechanism/rate between a buyer and a seller (see figure 1). The buyer and the seller are direct contractual counterparties to one another.

As a swap is a financial – rather than physical – tool, the agreement is for the exchange of cash only. The agreement is to swap, at some later date, the difference in value between the two prices agreed on today.

The world of finance calls an instrument such as a swap a ‘contract for difference’ (CFD). The contract is settled on the basis that the full value of the two prices is not being exchanged, but netted out between the two values.

While there are many different ways to structure a swap, the most basic is what we call a plain-vanilla swap. It consists of one fixed value settled against one floating value, hence the name fixed-for-floating swap.

The floating portion of the swap is based on a readily available, published and verifiable mechanism, such as the London interbank offered rate (Libor), a Treasury Bill or an industry pricing publication. The fixed-value portion of the swap is derived as a result of the floating price.

...and forwards

A forward contract is an agreement directly entered into between a buyer and a seller, calling for delivery of a specified amount of a specified asset at a specified future date. It is also an agreement on a specific price for the commodity.

The seller agrees to deliver a specific commodity to a buyer at some point in the future. The buyer and the seller are direct contractual counterparties to one another. There is no daily settlement. At the end of the life of the contract, one party buys the asset for the agreed price from the other party. The specified price in the contract is called the forward price.

If you have ever sold something that sets the price today, with delivery occurring at some future date, you have entered into a forward agreement. For many people, buying a house would be one example of a forward agreement. When buying a house, you will typically agree on the price to be paid for the house today and take possession at a later date.

A forward contract defines very specific parameters on which the contract is based. All the parameters must be determined before the agreement is entered into, and include:

• the forward price – that is to say, the future delivery price;
• the underlying commodity the contract is based on – for example, crude oil, natural gas or electricity;
• the number of units covered by the agreement – in barrels, cubic feet or megawatts, for instance;
• the date the contract ‘matures’; and
• delivery location and how delivery will be made at time of maturity.

And with so many items to be negotiated, such contracts often take some time to be executed.

Forwards are typically created with no payment or margin upfront. Simply, an estimate of the future value is made. As a result, the contract has no initial value. The parties will not know until much later what the ‘intrinsic’ – or actual – value of the agreement really is.

Yet we must still mark-to-market these transactions for financial reporting, with the understanding that we have unrealised profit or loss on our books

OTC characteristics

OTC instruments offer a tailor-made solution to the problem of hedging products for which there is no active futures market or when a company does not allow for direct dealing in the futures market. In addition, they bridge the gap between the short-term futures market and the longer-term requirements of consumers.

‘Tailor-made’ implies that virtually everything is negotiated with the contract, unlike a futures contract, which – apart from the price – is almost completely standardised by an exchange (see box, "Mistaken identities" below).

Moreover, OTC instruments tend to have high fixed costs as a result of participants having to find their own counterparty. Due to lack of standardisation, these contracts also tend to be illiquid.

While OTC contracts allow us to create a tool tailored to precise specifications, because there is no regulation in this market we introduce an element of risk in the form of credit/default risk. Bear in mind that such an agreement can be for any period of time, assuming a counterparty will agree to it. As a result, when settlement of the instrument occurs, it would be helpful if the counterparty is there to exchange via the CFD or deliver the physical commodity.

So how do we minimise such risk? As the size of the OTC market grew, so the need for standardisation increased – not in the futures contract sense, but standardisation in the form of contract lingo. As a result, the International Swaps and Derivatives Association (Isda) was formed. Isda is the global trade association that serves to represent participants in the OTC industry.

Using forwards

The buyer is the party that receives the actual physical commodity and pays a fixed price. The seller is the party that delivers the physical commodity and collects a fixed price.

The primary use of forward contracts is as a hedge. For example, let us assume a utility needs to purchase coal in three months’ time. Worried about rising coal prices, it decides to lock-in a fixed price today for delivery in three months’ time.

The utility contacts the coal producer and locks-in at $30 a ton for 100,000 tons. The coal producer is willing to lock-in at $30 to eliminate the risk of prices falling between now and delivery three months down the road. No money changes hands now. In three months, the producer delivers the 100,000 tons to the utility and collects $3 million.

But what if the utility no longer needs the coal during the three-month period between contracting and delivery? The utility could either hold on to the contract and speculate on the price of coal, or else they could sell this agreement to another party.

If the utility were to sell the forward contract, it would pocket the money from the sale and the new owner would then take delivery of the coal at the contracted delivery point. The utility would never see, smell or touch the coal. The utility will have made money on the deal and still have provided the coal producer with a guaranteed price and buyer for the coal. As such, the utility will have helped to make a market in forward contracts.

We should bear in mind that the market price of coal at the time of delivery is irrelevant. The producer and the utility locked in a price for coal. For better or worse, the price is $30/ton. If the coal producer failed to fulfill its obligation, the utility would have to take the coal producer to court over delivery.

Alternatively, what if the producer could only deliver 80,000 tons? It would have to buy the shortfall of 20,000 tons at the then current market price and deliver them to the utility, at a potential loss if it had to pay more than $30/ton.

Using swaps

From a contractual standpoint, the buyer of a swap will always be the party paying the fixed value. Alternatively, it is the party receiving the floating price. Likewise, the seller is the party who is paying the floating value of the agreement, or receiving the fixed price (see figure 2).

This is often confusing because you might be the one looking to purchase a swap to accomplish a certain end result and yet be considered the seller of the swap.

Let us look at the practical use of a swap in a hedging application, keeping in mind that the end result is to lock-in a price.

In this example, we assume a natural gas producer has price risk exposure on the daily spot price of his natural gas sales. The assumption is that the producer is being paid based on an index value – such as Natural Gas Intelligence or Gas Daily – for its gas sales (see figure 3). In other words, the producer is being paid based on a published, verifiable publication.

As the producer is selling gas on a daily basis and is being paid based on an index, it is exposed to earnings fluctuations. On some days it may be paid more for the gas than on others, depending on the index.

If the producer is interested in stabilising prices, it has two choices: to enter into fixed-price contracts with the companies it is selling the physical commodity to, or to continue to sell the physical gas at the daily index price and enter into a swap with a third party. The former can be very time-consuming, while the latter only requires a little time and a few phone calls.

To enter into the swap, the producer would only need to contact a swap dealer – typically a bank, financial institution, or physical market participant. The producer’s goal is to transfer the floating price it has in the physical market (see figure 3) to the swap dealer. We agree to swap the floating price it is getting in the physical market for a fixed price. The financial portion of the swap is shown in figure 4, and figure 5 combines the physical and financial aspects of the transaction.

The fixed price the producer receives from the bank is determined partly based on how the floating value is to be determined. We should bear in mind that the floating price has to be a verifiable, published value. In our case, the floating-price portion of the swap will be based on the Gas Daily index for deliveries into Chicago. Ideally, this index will coincide directly with the index for which the producer is being paid for the physical commodity.

However, you may have noticed that our natural gas producer is really taking in a floating price from the physical market and passing it along to the bank. If we cancel the items that are common to the producer – that is to say, receiving a floating payment from the physical market and ‘paying’ a floating value to the swap provider – the producer is left with what is shown in figure 6.

The end result is, then, exactly what the producer wanted – to lock-in a fixed price. This has been accomplished without ever contacting the physical market. It just took two steps, one physical and the other financial.

Now in reality, the physical market transaction – the vertical portion of the swap – and the swap are treated as separate items. When we net everything out – that is, cancel all common elements – we end up selling our physical commodity into the market at a floating price and being paid a fixed price by the swap provider (see figure 6).

The swap is then a CFD, in this case settled on only the difference between the fixed price and the floating value, once it is known.

Case study

Inserting figures into the example may clarify the example further.

Let’s say the swap is for 30 days. That is, the price we are locking in will cover a 30-day period. We must also negotiate the notional volume. In our case, it is 10,000 million British thermal units (mmBtu) of natural gas. At the time the swap is entered into we also agree on the fixed price. Here, the fixed price will be $2.35/mmBtu. Figure 7 shows how the swap appears on day one.

Upon settlement, the index value can be determined. In this example, the index averages out for the month at $2.20/mmBtu (see figure 8).

As the producer was guaranteed a price of $2.35/mmBtu and only collected $2.20, the producer is to be paid the difference of $0.15 by the swap provider. The $0.15 added to the $2.20 collected from the physical market add up to the $2.35 guaranteed by the swap on day one.

We can extend swaps to cover any length of time, as long as we have a willing counterparty. Instead of a 30-day period, we could extend the term to 10 years – a long time to wait for payment. Indeed, there is even a risk that the counterparty won’t be around that long.

So we could instead settle every month or quarter on just that portion of the swap. This way we are never overextended and can maintain some cashflow from the hedge, without having to worry about default.

Dan Rowe is senior energy consultant at The Oxford Princeton Programme, Princeton, New Jersey
e-mail: drowe@fame.com

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