Managing your risk
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How to make a swap contract work for you and your business
By James M. Burr
Last month we discussed the basics of futures contracts. This month, we are going to discuss the basics of swaps.
For the purposes of this article, we will assume that the terms ‘swaps contract,” ‘derivatives” and ‘over-the-counter contracts (OTCs)” are all interchangeable.
A swap contract is a privately negotiated contract in which the terms and conditions are agreed to by both parties.
If ‘Your Company” contacted ‘Acme Oil” and said, ‘Gulf Heating Oil is trading at $1.30 per gallon. How about we strike a deal, at the end of the month, if Gulf Heating Oil is above $1.30 per gallon, you pay me the amount it is above $1.30. If at the end of the month Gulf Heating Oil is below $1.30 per gallon, I will pay you that amount?” This is a swap; two firms privately negotiating a contract that will ultimately be settled not by physical delivery, but with their checkbooks.
A swap contract is a hybrid between a futures contract and a contract for physical delivery. It is like a futures contract in that it has a financial gain or loss based on the index stipulated in the contract. It is similar to a contract for physical delivery in that each transaction is accompanied with a conformation of trade and both sides are expected to review for correctness, sign and return.
A generic swap transaction would include all the terms and conditions of the contract, including:
