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Addressing Client Challenges  |  Swaps
Other Exotic Financial Instruments  |  Structured Products

Swaps

Swaps are the most common of all price risk management tools. The simplest way to think of a swap is the ability to ‘lock-in’ prices on either the purchase or the sale side. The physical relationships that exist between industry members do not change and will enable companies to maintain their existing customer/supplier relationships. The swap allows either the producer or the consumer to lock in what it considers an advantageous price for a fixed period of time. However, locking in prices does not imply that these structures are without risk.

For example: A consumer, after evaluating its risk exposure, decides to fix a portion of his prices for a six-month period and buys a swap from Koch Steel Trading at a negotiated price. A month later, if the market prices were lower, the consumer would lose on the portion of the exposure covered by the swap. If the prices were higher, the consumer would gain on the portion of the exposure covered by the swap.

By buying a swap from Koch Steel Trading, the consumer will lose on the swap if prices decline, but gain on the swap if spot price rises. The imbalance of payments is settled monthly to ensure that the swap effectively dovetails into the overall corporate cash flow. To gain price protection, the ability to participate on future beneficial price moves is sacrificed.

The typical swap transaction locks in a price relative to a market index. Settlement is purely financial – cash changes hands – but the physical product does not. Each month, during the life of the contract, cash will change hands depending on the swap price relative to the market index price.

Swap: Producer Example

Note: The following example is a partial illustration only and does not constitute an offer. The relevant products will not be available to everyone.

A steel mill is concerned that market conditions could cause steel prices to decline and squeeze margins to the point of jeopardizing future earnings. To mitigate part of this risk, the mill decides the volume they would like to hedge is 20 percent of its annual exposure. The mill negotiates and enters into a swap with Koch Steel Trading that locks in the price of commercial grade hot-rolled steel at $340/short ton on 10,000 tons per month. (The actual price will be a function of current market conditions.) This transaction ensures that the customer will, in effect, receive a fixed price for 20 percent of its steel regardless of market conditions.

Here are a few of the things that could happen during the tenure of the swap:

• The mill continues to sell physical steel to customers of its choice, at current market prices.
• On a monthly basis, the mill and Koch Steel Trading exchange payments equal to the difference between the fixed price of $340/ton and the prevailing index price. For example, if the index price is $320/ton in a given month, the mill will receive from Koch Steel Trading $20/ton on 10,000 tons. However, if the index price is $350/ton, the mill will pay $10/ton on 10,000 tons to Koch Steel Trading.

Swap: Consumer Example

Note: The following example is a partial illustration only and does not constitute an offer. The relevant products will not be available to everyone.

A white goods manufacturer has announced its new line of refrigerator and is preparing to set prices for the following year. It knows that about 25 percent of the cost of its final product is based on the prevailing market price of cold-rolled steel. If the price of steel rises above its forecast, the manufacturer’s profit margins erode. To service its customers while hedging its steel price exposure, the manufacturer enters into a one-year swap, which effectively fixes the price of cold-rolled steel at $270/ton on a monthly volume of 5,000 tons, or 25 percent of anticipated monthly usage.

Here are a few of the things that could happen during the tenure of the swap:

• The manufacturer continues to purchase cold-rolled steel from their existing suppliers at current market prices. They can negotiate payment terms, quality, inspection, extras and service as always.
• On a monthly basis, the manufacturer or Koch Steel Trading makes payments equal to the difference between the fixed price of $270/ton and the index price for cold-rolled steel. For example, if the index price for hot-rolled steel is $290/ton in a given month, the manufacturer will receive from Koch Steel Trading $20/ton on 5,000 tons. However, if the index price is $260 ton, the manufacturer will pay $10/ton to Koch Steel Trading. The net effect of combining the swap cash flows with actual purchases of cold-rolled steel is a fixed price of $270/ton.
• The swap helps the manufacturer protect the margin on a portion of its sales from fluctuating steel prices.