There's more to swaps than interest rates.
One alternative used by some municipal issuer, primarily transportation authorities, is the commodity swap -- an exchange of payments based on the value of a set amount of a commodity, such as 1,000 gallons of oil or two million pounds of pork bellies.
One side agrees to value the commodity at a set price for the life of the swap. The other side values the commodity at a floating market rate. At each payment date, the side that is valuing the commodity at the lower price pays the other side the difference.
For example, an issuer may enter a two-year swap on a million barrels of oil. The issuer agrees to value the oil at a set price of $15 a barrel while the counterparty agrees to value the oil at the market price.
At the first payment date, the market price is $16 a barrel. Since the market price is higher than the set price, the counterparty will pay the issuer the difference of $1 per barrel. Multiply that by the million barrels involved, and the counterparty will pay the issuer $1 million.
Sometimes the swap is based on an average price. Instead of basing the swap on the price of oil on the payment exchange date, the swap may be based on the average price of oil over the previous six months.
Nonetheless, the issuer and the counterparty still face significant changes of fortune as the price of oil goes up and down.
Few issuers would want to gamble on the price of oil or any other item, but a swap can actually reduce risk for issuers that depend on a particular commodity.
For example, an issuer may have to buy 10,000 gallons of gasoline each month for its fleet of cars and trucks. So the issuer budgets for 120,000 gallons of gasoline a year, usually with an estimate of the average price the issuer expects to pay during the year.
If the price of gasoline drops below the average, the issuer comes out ahead. But if the price rises above the estimate, the issuer risks a budget deficit.
Instead, the issuer can use a commodity swap to lock in one price for the entire year.
The issuer enters a gasoline swap for one year on 120,000 gallons. The issuer agrees to pay a fixed price of $1.05 per gallon, and the swap counterparty agrees to pay the average market price for gasoline over the year.
The issuer then includes the $1.05 per gallon price in its annual budget.
During the year, the issuer buys its gas at the market price. At the end of the year, that may mean a surplus or a shortfall.
But the swap is settled at the same time. if the average price of gas during the year was higher than $1.05, creating a budget shortfall, the swap counterparty's payment will cover the shortfall.
And if the price of gasoline was below the average, the issuer will have to turn over its budget surplus to the swap counterparty.