Swaps, Spreads and Safety Nets

Last year took the world's financial markets to the brink. Trillions of dollars of real estate transactions, OTC credit swaps and other derivatives couldn't be valued; managers didn't know what their portfolios were worth, or how to exit their positions.

Grain merchandisers had it easy by comparison. Deep, liquid futures markets let you quickly and easily lay off price and spread risk. Everything is marked to market daily for complete transparency. Hedges are exchange-cleared, where the CME Clearing Corporation becomes your counterparty and adjusts your account daily for gains or losses. With global finance swirling into chaos, agriculture largely conducted business as usual.

But two things were missing before now:

• A way to hedge basis risk
• A way to fine-tune managing spreads

In March 2009 the CFTC authorized clearing of OTC agricultural basis and calendar swaps using the CME Clearport® electronic platform. Approval quickly followed for the June 1 CBOT/CME launch of trading in put and call options on futures spreads in grains and the soy complex (excluding rice and oats).

Now grain merchandisers have additional tools to manage basis, price and spread risks in these turbulent markets while staying within the safety net of exchange-cleared products!

Swaps 101

This all sounds wonderful, but what are swaps and how can we use them? In regulatory talk, a swap is an agreement to use a derivative contract to exchange or "swap" price risks between two instruments and includes an exchange of cash flow.

In plain English, a traditional swap is like a hedge. Two people might agree they will ‘swap' money based on the changing value of some agreed-upon benchmark. An ethanol plant could buy a swap from a financial firm to fix the price of corn for 12 months, using an agreed-upon price of $4.00, based on December 09 CME corn futures, to be settled in monthly increments on an agreed upon day each month. If December corn futures are above $4.00 on that date, the swap seller sends money to the ethanol plant. If December futures are below $4.00, the ethanol plant sends the difference to the financial entity.

The swap protects the ethanol plant's corn cost at $4.00 (futures) plus basis. The plant still needs to buy physical corn at some price/basis; the swap gain or loss determines the final net raw material cost. The major risk to both parties is whether each will be able and willing to meet any financial obligations. The plant is also tied to the original counterparty and cannot exit the swap early unless both sides agree.

Exchange-cleared agricultural swaps

The CME already clears ethanol swaps but now clears ag calendar swaps, which manage price risk, and basis swaps which manage basis risk. These swaps are financial transactions — they are not cash grain contracts. The CME's Clearport platform is used only for the counterparties to enter the details of their trade. From that point the CME becomes the counterparty to each side.

These swaps are not traded in CME pits, nor on Globex. Swap participants work out their terms directly over the phone, via e-mail, or through a third-party broker. CME has standardized some swap terms, however, to facilitate clearing:

• 5,000-bushel increments; 1/4¢ price ticks
• Standardized contract periods and expirations
• Standardized settlement process at maturity.

E-C swaps eliminate some issues and risks of privately held swaps. The benefits include:

• Financial integrity of CME Clearing virtually eliminates counterparty credit risk
• Cross-product margining with your exchange-traded futures and options can reduce capital requirements for initial and ariation margin on other hedges
• Transparency — daily mark to market
• Liquidity — you can exit your swap by finding another party that agrees to the terms
• Parties to the swap don't need to know each other or have any business connection
• Eliminates need for time-consuming ISDA (Int'l. Swap Dealers Assn.) documentation

Getting started: