Updated for the 2026-2027 CFA® Level II curriculum.
A plain cash-settled commodity swap exchanges fixed-price and floating-price payments over agreed settlement dates. This note focuses on that structure, with physical purchases or sales handled separately. Level II tests whether you can match the swap direction to the exposure an investor or producer actually wants, not just define the structure.
Quick Answer
Commodity swaps transfer an agreed commodity price, index-return, basis, or volatility exposure through contractual payments. In a fixed-for-floating price hedge, a consumer pays fixed and receives floating to offset rising costs; a producer takes the opposite side to offset falling revenue. Return swaps provide benchmark exposure, basis swaps address relative-price differences, and variance or volatility swaps target price variability rather than direction.
Key Takeaways
A fixed-for-floating commodity swap has two legs: one party pays a fixed price, the other pays a floating price tied to a reference index.
Settlement is in cash, based on notional quantity multiplied by the price difference. No principal or physical commodity is exchanged.
A consumer who wants protection from rising prices pays fixed and receives floating.
A producer who wants protection from falling prices receives fixed and pays floating.
Combining the swap's cash flow with the physical purchase or sale cash flow produces the economic hedge.
Basis risk remains if the swap's reference price does not exactly match the price paid or received in the physical market.
What You Need to Know for CFA Level II
The LOS asks you to describe commodity swap structures and explain how swaps obtain, hedge, or modify exposure. It does not require pricing or valuing the swap.
You must identify which party pays fixed and which pays floating, and connect that direction to the party's underlying exposure.
You should be able to compute net cash settlement for one period given quantity, fixed price, and floating price. This is a supporting calculation, not a separate confirmed exam requirement beyond the describe and explain tasks.
You should recognize notional quantity as a reference amount only, never a cash investment.
You should identify basis risk and counterparty risk as structural features of the swap, not defects unique to one party.
Trace Fixed and Floating Legs
A plain commodity swap has four defining features: a fixed price, a floating reference price tied to a published index, a notional quantity, and a settlement interval. At each settlement date, the two legs are netted and one payment moves in one direction. No commodity is delivered.
How Fixed and Floating Swap Payments Work
One counterparty pays the fixed price and receives the floating price. The other pays floating and receives fixed. Calling someone the "floating-price receiver" means that party benefits when the reference price rises above the fixed price.
Net settlement to the floating-price receiver is:
Where:
= net settlement to the floating-price receiver
Q = settlement quantity
= contractual reference price per unit
K = fixed price per unit
This applies to a single cash-settled period with matching units on both legs. The paying-floating counterparty receives the negative of this amount. If the reference price falls below the fixed price, the floating receiver pays the difference instead.
Key Risks and Common Mistakes in Commodity Swaps
Two risks sit inside this structure. Basis risk arises when the index used for settlement does not move identically to the price the investor actually faces in the physical market. Counterparty risk arises because promised payments depend on the other party performing.
Collateral agreements, netting, or central clearing can reduce exposure, but their terms must be checked. A swap is not necessarily unsecured.
Candidates often reverse pay-fixed and receive-fixed exposure. Receiving floating means benefiting from a price increase. Paying floating means benefiting from a price decrease. Confusing the two produces the opposite hedge of what the investor intended.
Match the Swap to the Desired Exposure
The swap direction must match the economic exposure the investor already has, or wants to create.
Swap Positions for Consumers, Producers, and Investors
A consumer of a commodity, such as a manufacturer buying raw material, faces rising input costs. That consumer pays fixed and receives floating. If the reference price rises, the floating receipt increases and offsets the higher cost of the physical purchase.
A producer of a commodity, such as a mining company selling output, faces falling revenue. That producer receives fixed and pays floating. If the reference price falls, the fixed receipt stays constant while the floating payment shrinks, offsetting lower sale proceeds.
An investor with no physical commodity position can use a swap alone to create synthetic exposure. Paying fixed and receiving floating creates a synthetic long position in the commodity, since the investor gains when prices rise, providing price sensitivity without taking physical inventory. The fixed price reflects the agreed contract terms, and swap returns can differ from physical holding returns.
How Swap Settlements Offset Price Risk
The hedge works by combining two cash flows: the physical transaction cash flow and the swap settlement cash flow. The consumer's physical cost rises with the market price. The swap receipt rises with the same market price. Added together, the net cost stays close to the fixed price, which is the economic purpose of the hedge.
Candidates sometimes treat the notional quantity as money invested. Notional quantity is a reference amount used only to calculate settlement. An at-market swap generally has zero initial value before fees, although collateral can be required. Off-market terms may require an upfront payment. Distinguish those amounts from the notional quantity.
Match Other Swap Structures to the Exposure
Fixed-for-floating price hedges are one structure, not the whole commodity-swap market. Read the return definition, payment terms, and notional before identifying the exposure.
Excess-return swaps provide the specified commodity or futures-index return without its collateral-yield component. Financing charges and other contractual payments still affect the investor's net result.
Total-return swaps reference a total-return benchmark, including its defined collateral-income component. Check the payment leg to avoid counting collateral income twice.
Basis swaps exchange two commodity-linked references, such as different grades or locations. They can modify a relative-price exposure that a single reference-price hedge leaves behind.
Variance swaps exchange realized variance against a fixed variance strike; volatility swaps use realized volatility. They target the size of price variation rather than a simple rise or fall in the commodity price.
Working Example
A manufacturer plans to buy 1,000 units of a raw material at the prevailing market price. The manufacturer wants to lock in a cost near 70 per unit and enters a commodity swap with a dealer. Under the swap, the manufacturer pays a fixed price of 70 per unit and receives the floating reference price, based on a notional quantity of 1,000 units, with one settlement date matching the physical purchase date.
Assumptions. The reference price used for settlement equals the price the manufacturer pays in the physical market. There are no transaction costs and no counterparty default.
Step 1: Determine the swap settlement
On the settlement date, the reference price is 76 per unit.
The manufacturer, as the floating-price receiver, collects 6,000 from the dealer.
Step 2: Determine the physical purchase cost
The manufacturer buys 1,000 units at the market price of 76, paying 76,000 instead of the budgeted 70,000. The physical purchase costs 6,000 more than planned.
Step 3: Combine the cash flows
The swap receipt of 6,000 offsets the 6,000 cost increase. Net cost equals 76,000 physical payment minus 6,000 swap receipt, equal to 70,000, or 70 per unit.
The swap did not change the physical market price the manufacturer paid. It transferred the effect of the price increase from the manufacturer to the dealer through cash settlement, holding the manufacturer's net cost near the fixed price agreed at the start.
Common Exam Traps
Reversing pay-fixed and receive-fixed exposure
A consumer worried about rising prices needs to receive floating, not pay it. Paying floating while facing rising costs doubles the loss instead of hedging it.
Treating notional as a cash investment
Notional quantity sets the scale of settlement payments; it is not principal exchanged at initiation. The derivative itself can have a recognized positive or negative fair value, so notional and balance-sheet value are different measures.
Assuming the reference price perfectly matches the physical purchase price
The index used in a swap may differ from the actual commodity grade, delivery location, or timing an investor faces. This gap is basis risk, and it means a swap rarely produces a perfect hedge even when the direction is correct.
Practice Question
A manufacturer buys a raw material monthly and wants to protect against a rise in the purchase price over the next year. The manufacturer is considering a one-year fixed-for-floating commodity swap with monthly settlement, referenced to the same index used to price its physical purchases. In Options A and B, the notional equals the monthly purchase quantity. Ignore fees and counterparty default. Which swap position best offsets the manufacturer's price risk?
Receive fixed and pay floating
Pay fixed and receive floating
Pay fixed and receive floating on twice the monthly physical purchase quantity
Correct Answer: B
The manufacturer's physical cost rises when the market price rises. Paying fixed and receiving floating means the manufacturer collects a larger settlement as the reference price climbs. That settlement offsets the higher purchase cost, holding the net cost near the fixed price.
Why Other Options Are Wrong
Option A: Receiving fixed and paying floating benefits from falling prices, which matches a producer's hedge, not a consumer's. This position would increase the manufacturer's loss if prices rise.
Option C: Using the appropriate swap direction with twice the physical quantity overhedges the purchase. Twice the physical quantity leaves an additional net long exposure after the purchase cost and swap cash flows are combined. A matching quantity offsets the stated exposure.
Matching swap direction to the underlying exposure, not memorizing a label, is the skill tested here. The manufacturer's risk is rising prices, so the correct position pays fixed and receives floating.
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FAQs About Commodity Swaps and Commodity Exposure
Which swap direction hedges a commodity purchase?
A buyer facing rising costs pays fixed and receives floating. The floating receipt grows as prices rise, offsetting the higher purchase cost.
Why can basis risk remain after a swap?
The swap's reference index may not match the exact price, location, or timing of the physical transaction. Even a correctly directed swap leaves a residual mismatch between the hedge and the actual market exposure.
How does a producer combine a swap with a physical sale?
A producer receives fixed and pays floating on a matching quantity. When the market price falls, the swap receipt offsets lower physical sale proceeds. When the price rises, the swap payment offsets the higher proceeds. A matching reference price and timing are needed for the simplified fixed-price result.