los 35b requires “hedging strategies that rely on swaps”. schweser touched on risk exposures of commodity swaps without giving any details on hedging. can someone help me out with using interest rate swap to hedge interest rate exposure of a commodity swap? i have been thinking all day long. but it’s still as clear as mud.
Well if you’ve entered a commodity swap to say pay LIBOR and receive return on Crude Oil, then enter into a Interest Rate Swap to Receive LIBOR and Pay a FIXED rate, if you expect Interest rates to increase in the near future, thus you are paying a Fixed rate adn receving the return on Crude. Does that help?
what if i pay fixed instead of libor for crude oil?
Well if you expect Interest rates to go down you would do the reverse, Pay Fixed, receive LIBOR. If you expect Interest rates to increase and you’re paying Fixed, you would do nothing.
bigwilly Wrote: ------------------------------------------------------- > Well if you expect Interest rates to go down you > would do the reverse, Pay Fixed, receive LIBOR. > If you expect Interest rates to increase and > you’re paying Fixed, you would do nothing. let me try to understand this, if interest rate goes down, the swap rate of the commodity may go up because the forward price of the commodity will be discounted at a lower rate. so, i making money in commodity swap, but lossing money in interest rate swap; if interest rate goes up, the swap rate of the commodity may go down because the forward price of the commodity will be discounted at a higher rate. so, i lossing money in commodity swap, but making money in interest rate swap; okay, i am good now, even though it’s opposite to yours. next question, how much do i hedge?
You would hedge the principle when they are both SWAPS.
bigwilly Wrote: ------------------------------------------------------- > You would hedge the principle when they are both > SWAPS. okay, i take your words for it cause i am still very fuzzy.
I mean if you were long a commodity, say Oil, and you wanted to hedge your exposure you could enter into a swap to PAY the Total Return on Oil and RECEIVE a FIXED or LIBOR, most likely LIBOR. So You receive the commodity return via the underlying and then Pay it to the counterparty so they “cancel” each other out, plus you receive a fixed or variable interest rate from the counterparty.
no, that’s not what i am aiming for. i have been thinking of someone who has view on commodity. he enters into a commodity swap by paying fixed swap rate (say $1000 for gold for the next two years in an annual swap). he might believe the forward prices of the commodity is under valued. however, he does not have any view on interest rate. so he likes to hedge that off. given this scenario, do you still think he should hedge the nominal amout?
I could be totally wrong, but if you dont’ have a view on interest rates, you will only be hurt if Interest Rates Decrease since you are fixed on the upside, so you might enter into an Receiver SWAPTION to Receive the Fixed Rate (since you are Currently Paying the Fixed Rate) and Pay LIBOR. So if Interest rates do decline, you could Exercise the Receiver Swaption, so you Receive Fixed Rate (plus pay out Fixed rate on commodity Swap), and then Pay LIBOR and Receive teh Commodity REturn. So your Profit will be Commodity Return - Libor. Now remember if Commodity return is negative you have to pay the return plus still pay libor. Does that make sense? I hope so b/c I’ll be heading out of here soon :), meaning work.
Entering into a swaption in addition sounds like you are making a bet on interest rate vol to me and that’s probably not what the gold swap was about. If you are interested in betting on gold, you probably shouldn’t be making a two-year interest rate bet as well (although gold vol >> two year bond vol). Swap it out, but of course you don’t have to because whoever is on the other side of that gold swap probably wants floating rate swap too.