Commodity Price Swap

Definition of "Commodity Price Swap"

A proposed arrangement for Islamic financial market involving swap of commodities. A basic commodity price swap entails two counter parties exchanging cash flows at various points in time, with specifics agreed in advance. In the standard case, the two counter- parties agree to periodically exchange a given quantity of a commodity for a specified period of time. Example: An airline company wants to achieve more certainty in its cost of fuel and at the same time an oil refiner would like to position itself to get fixed revenues. Both can enter into swap agreement via an Islamic bank who facilitates the agreement. Oil refiner: the oil refiner goes to a swap arranger, the Islamic bank, who pays the refiner a fixed price over a period of time and, in return, the refiner pays the bank the average market price (spot) for the refined oil products. Over the same period of time, the oil refiner sells refined oil products in market at spot prices. Airline company: the airline company with an objective of fixing the cost of fuel goes to the Islamic bank and arranges a swap. The company pays the Islamic bank its predetermined price over the same period of time and receives an average market (spot) price from the bank. The airline company continues purchasing the fuel from oil market at the prevailing spot price. Swap arrangement: The Islamic bank receives a fixed price from the airline company and passes it on to the refiner. During the same period, it receives average (spot) price from the refiner which it passes on to the airline company. The airline company and the oil refiner have locked in prices at their desired level since any gains or losses in the spot market will be offset by gains and losses in the swap arrangement. The Islamic bank earns fees and also makes a profit equal to differences between the refiner’s target price and airline company’s target price.