Understanding Swap Agreements

For our final installment in the series on contracting agreements, we will turn our attention to the world of swaps. While perhaps not as widely used or well understood as futures and forward agreements, swaps are really not much different in many respects and provide agricultural hedgers with another valuable tool in their arsenal to manage forward profit margins. Swap agreements are certainly more common in the financial markets where they originated, and are used extensively by many different types of businesses and government entities.

One of the most popular examples in this realm is probably the interest rate swap. This involves an agreement between two parties where a variable rate is exchanged for a fixed rate of interest over a certain period of time. Many businesses borrow money on variable rate notes and in an environment of historically low interest rates, have preferred to “swap” this out for a fixed rate over the life of their borrowing term. This obviously gives them greater control and forward visibility on their debt payments over time, which may be a priority for their management teams.

Another example would be a currency swap which is widely used by importers and exporters who either source raw materials or sell finished goods overseas and have input costs paid or revenues received in a foreign currency. Here too, they may wish to “swap” unknown exchange rates in the future for known exchange rates today such that their margins are secured and they protect the risk against rising input costs or falling revenue value based solely on negative foreign currency translations following an unfavorable move in exchange rates.

In the agricultural markets, swaps have also become more commonplace in providing hedgers another vehicle to manage their risks. While there are different examples of swaps in the ag markets, they essentially can be thought of as a hybrid or cross between a forward agreement and a futures contract in that they share elements of each. First, swaps can either be customized to meet the particular needs of the contracting parties as to the size of the contract and term of the agreement, or they can be standardized to mimic a futures contract with identical exchange specifications. Many of the swap agreements typically found in the agricultural markets are of this latter form where their terms are standardized to be lookalike or copycat contracts of exchange equivalency. The benefit of this approach for the issuing party of the swap agreement is that they have an equivalent vehicle by which to hedge their risk against the contracts they commit to with counterparties.

To explore an example of a swap agreement in the agricultural market, let’s consider a contract on hogs that is a futures equivalent of the CME Group specifications. The issuer of the contract might be an entity such as financial institution or brokerage firm, with the contracting party being a hog producer exposed to the risk of lower prices before the hogs are ready to be marketed to a packer. For this example, let us assume that it is early December and the hog producer wishes to protect their risk on hogs that will be marketed next spring and priced against the June 2016 futures contract with the packer. As an alternative to selling a futures contract on the exchange, or entering into a forward agreement directly with the packer, the hog producer elects to use a swap agreement with a financial counterparty.

The mechanics of the contract will function very similarly to that of a futures or forward agreement, although there are some differences. Similar to having a pre-established relationship with a packer prior to forward contracting or with a brokerage firm prior to trading futures, the hog producer will need to establish a formal relationship with the counterparty providing the swap agreement. This consists of a “master agreement” that spells out the exact terms of contracting between the two parties, and will also involve submission of financials to establish creditworthiness as there will be financial obligations between the parties. Once the relationship has been established and formalized, the hog producer can place an offer to execute a swap agreement at a certain price, such as $76.00/cwt. for example against the June 2016 futures.

If the reference CME June futures price were to reach this level such that the offer is accepted, the hog producer would formally enter into a swap agreement with the issuing counterparty. While the execution of the contract in this sense is very similar to how a forward agreement or futures contract would work with a packer or brokerage firm, moving forward with the contract is where they would differ. With a forward agreement, there would be a physical settlement of the contract whereby the hog producer would be required to deliver hogs to the packer upon settlement to fulfill the agreement. With the swap, there is a financial settlement instead upon termination of the contract, with no requirement on the part of the hog producer to deliver physical animals in the cash market.

In this respect, the financial settlement of the swap agreement is similar to how a futures contract functions, although the settlement procedure may be different. With a futures contract, there is a daily settlement procedure where the contract is “marked-to-market” every day, with any gains or losses from the previous day’s settlement paid out or paid in to an account with performance bond requirements that must be maintained as mandated by the exchange. While a swap agreement may also function this way, what is more common is that there is simply a single settlement procedure upon termination of the agreement. What this means is that once the hogs reach a target weight and are sold to the packer in the cash market, the hog producer will terminate their swap agreement with the counterparty and they will settle up one time based on the terminal value of the June 2016 hog futures on that particular day in the future.

This single settlement procedure is therefore very similar to the way a forward agreement would work in the cash market. Either the hog producer will be indebted to the swap issuer if the market goes up between the time the contract is executed and once it is finally settled, or the swap issuer will be indebted to the hog producer should the market instead move lower during that interim. To financially settle the agreement upon termination of the contract, either the hog producer or the swap issuer will need to pay the other party the difference between where the contract was executed at $76.00/cwt., and where the market is actually trading on the day the contract is finally closed.

This is why financials will be required when initiating a relationship with a swap provider as debt gets built up in these agreements unlike the account margining process and daily settlement procedure that regulates futures contracting. Also, because the swap issuer may have to margin the position on behalf of their counterparty over the life of the contract, they typically will charge more in execution costs relative to what it would cost to simply trade futures.

A swap contract may be an attractive alternative for an agricultural hedger depending on their specific circumstances. In a situation where the producer may not want to have the supply commitment and physical delivery requirement of a forward contract, a futures or swap agreement becomes a viable alternative. Because however contracting with futures can be capital intensive based on how the market moves after a hedge is initiated, the swap agreement may prove attractive if it does not include the daily margining requirement that is a feature of using futures.

As with any contracting alternative, there are advantages and disadvantages associated with each. There is no absolute right or wrong way to protect a particular risk exposure around forward margins, but understanding the features of various contracts and considering your particular circumstances, you can make a more informed choice on what type of contract may work best for your operation in a given situation.