Source: Google Books
The word swap has been around for 100 plus years, however its use has grown in popularity over the last 30 years. And in the last 10 years the word swap has gotten a LOT of press.
If you ask 10 people in the agriculture industry what they think of when they hear the term “swap”, you’ll probably get 10 different answers.
Some people see a swap as a highly sophisticated financial term—too technical to understand.
Yet others will think back to 2008 and credit default swaps.
By and large, many people have a negative view of swaps—or, at the very least, are reticent to use them. But why? My guess is because swaps are just misunderstood.
Let’s start with a simple definition from Merriam-Webster: //www.merriam-webster.com/dictionary/swap.
‘To swap is to make an exchange or give in a trade.”
The International Swaps and Derivatives Association (ISDA) defines a commodity swap as a cash-settled agreement in which two parties agree to a series of cash flows based on an agreed (notional) quantity of a commodity (http://www2.isda.org/about-isda/).I would probably have a simpler definition: a commodity swap is the act of exchanging a fixed price for a floating price. And, as it relates to the ag business, I like to think of a swap this way: A commodity swap means exchanging the commodity risk in your business in exchange for a fixed price over a set period of time. Allowing you to stabilize your P&L outcomes for a more predictable and hopefully profitable future.
The commodity swap allows you to have a more known outcome for your business—which is extremely valuable.
Let’s look at this yet another way. Essentially, a swap is a forward-price agreement. As you may know, these financial tools allow you to lock in a price and settle in cash. I would venture to guess many of you who might be reading this post have used forward-price contracts in the cash market in the past.
A swap is similar. The swap allows you to lock in on a price, and settle in cash at the end of a defined period of time. It gives your business more flexibility, since you’re settling in cash; and leaving you open to negotiate basis, logistics, timing and delivery.
Does that make sense?
Let’s use an example from the ag industry to bring this to life. Let’s say you’re a corn farmer like me and you are purchasing inputs (seed/chemicals/fertilizer) this fall on the crop you will plant in the spring. As a result, your farm is exposed to downside risk if the corn market should move lower, having a direct impact on profitability. To remain profitable you need to ensure you can sell all that corn for the best price possible next fall/winter. By using a commodity swap, you could exchange this financial risk for a fixed price for a set period of time. In other words, you would agree to sell 100,000 bushels of corn at a fixed price of $3.90 for the next 12 months, protecting you from downward moves in the corn market. When it comes time to harvest the crop in the fall, you simply un-wind your swap (settle the swap in cash) and sell your crop in the cash market. The effective price for your corn will be your swap price less your local basis. That means, all season long your risk will be limited to moves in local basis and you’ll remain in control, allowing you to optimize other parts of your business; knowing your commodity price risk is managed.
So, is a “swap” really a bad four-letter word?
My take is…..it’s simply misunderstood. In fact, I would argue “swap” is actually a good four-letter word—when used properly, it can effectively manage price risk.
Jeremy Barron is a managing director with Cargill Risk Management and owns Jeremy Barron Farms, a first generation corn and soybean farm in Indiana