TEACHING NOTE 97-08:

PRICING AND VALUATION OF COMMODITY SWAPS

Version date: October 14, 2003 C:\Classes\Teaching Notes\TN97-08.doc

The commodity swap is designed to assist in the management of the risk

associated with the prices of input resources such as energy, precious metals, and
agricultural products. To date, however, commodity swaps are predominantly associated
with energy-related products. The transaction involves the exchange of payments
between two parties at a series of scheduled future dates. At least one set of payments is
determined by the price of a commodity. The other set is usually a fixed rate. For
example, suppose an airline has determined that it must purchase 500,000 barrels of jet
fuel per quarter. It enters into a swap with a dealer in which the airline pays the dealer a
fixed rate for 500,000 barrels of jet fuel on a specific date each quarter. The dealer in
turn pays the airline the price of jet fuel for 500,000 barrels on those same dates. In this
manner, the airline has fixed the purchase price of its fuel for the term of the swap.
Typically the swap is settled in cash, meaning that no physical delivery of the commodity
occurs.
A fairly common procedure used in commodity swaps is to have the variable
payment set at the average price of the commodity over a specific period, rather than the
price of the commodity on the settlement date. This type of arrangement makes
commodity swaps similar in principle to the derivatives known as Asian options, wherein
the payoffs are determined by the average price of the asset during a period over the
option’s life. Asian-style payoffs accomplish two objectives. They structure the payoff
to reflect only the average performance of the asset, which can be useful to firms whose
risks are associated more with the average value of the asset. For example, a firm may
know that it needs to purchase about 100,000 units of a commodity over a six-month
period. Its purchases will be made weekly, but it does not know exactly which amounts
will be purchased from week to week. It knows only that its total purchases are likely to
add up to around 100,000 units. It may, therefore, feel that its exposure is more to the
average price of the asset during the six-month period. An Asian-style swap could better

D. M. Chance, TN97-08 1 Pricing and Valuation of Commodity Swaps

suit its needs than one that pays off based on the final price of the commodity at the end
of the six-month period.
Asian-style settlement is also useful in markets where the commodity is quite
volatile, and particularly when its price is susceptible to distortion or even manipulation.
Oil is a good example of such a market. Extreme events such as tension in the middle
east can lead to sharp increases in the price of oil. In addition, the oil market is
characterized by a fairly small number of producers, many of which belong to OPEC.
Consequently, oil prices can possibly be manipulated by collusive practices of suppliers.
In this Teaching Note, we shall look at how commodity swaps are priced and
valued. Remember that pricing refers to the process of determining the fixed rate that
must be paid at each settlement date in exchange for receiving a payoff tied to the price
of the asset. Valuation means to determine what the swap is worth later during its life.
For presentation purposes we shall refer to swaps that pay off the asset price as standard
swaps and swaps that pay off the average asset price as Asian swaps, although as noted
above, the Asian swap is more common.
We begin by establishing a time framework. Let there be discrete time points
denoted as t = 0, 1, 2, ..., T that are the swap settlement dates. The asset prices on these
dates are S(1), S(2), ..., S(T). For standard swaps the price is denoted as G(0,T), which is
read as the price of a standard swap started at time 0 and ending at time T with
settlements at the discrete equally-spaced time points 1, 2, ..., T. From the perspective of
the party paying the fixed rate and receiving the asset price, who is called the “long,” the
payoffs are S(1) - G(0,T), S(2) - G(0,T), ..., S(T) - G(0,T). Now consider a time j, where
0 < j < T, at which the asset price is S(j). We will want to find the value of the swap at
that time. The risk-free rate per period is r and the asset’s yield per period is δ, which is
essentially the asset’s convenience yield less storage costs. If there are no storage costs,
then δ > 0. Both r and δ are assumed to be non-stochastic.1 Thus, from time t to t+1 the
net cost of carry factor is e(r-δ). When we price the Asian swap, we shall introduce some
additional notations.

1
The assumption the interest rate is non-stochastic is necessary for pricing the Asian swap but not for the
standard swap.
D. M. Chance, TN97-08 2 Pricing and Valuation of Commodity Swaps
Pricing the Standard Swap
We wish to determine the value G(0,T), which is defined as the fixed payment
such that the present value of the fixed payments equals the present value of the variable
payments, implying an initial value of zero. The present value of the fixed payments is
simply
 1 − e − rT 
G (0, T ) r  .
 e −1 
The present value of the variable payments can be determined by purchasing units
of the asset that will yield these cash inflows. Since the asset accrues value at the rate of
δ per period, we should purchase less than one unit of the asset to produce one unit at a
future date. In other words, at time 0 we purchase e-δt units of the asset for all t = 1, 2, ...,
T. Then at each time t = 1, 2, ..., T we sell one unit of the asset at the price S(t). This
will generate the necessary cash inflow. The number of units of the asset that we must
purchase at time 0 is
T
1 − e − δT
X (0, T ) = ∑ e −δt = .
t =1 eδ − 1
The total cash outlay at time 0 will be X(0,T)S(0). The value of the swap at time
0 must be zero since no money changes hands, so we equate the cash outlay required to
reproduce the variable cash inflows to the present value of the fixed cash outflows:
 1 − e − rT 
X(0, T )S(0 ) = G (0, T ) r  ,
 e −1 
and solving for G(0,T) gives
 er − 1 
G (0, T ) = X (0, T )S(0 ) .
−rT 
1 − e 
The appendix contains a numerical example.
Valuation of the Standard Swap
Now suppose we are positioned during the life of the swap. Let k represent the
number of the previous settlement date, where k can be 0, 1, 2, ..., T-1.2 Then let j be a
fraction, 0 < j < 1, representing the portion of the current settlement that has passed since

2
In the case where k = 0, we are in the first settlement period and there is no previous settlement.
D. M. Chance, TN97-08 3 Pricing and Valuation of Commodity Swaps
time k. Define R = T - k as the number of remaining settlements. We position ourselves
at time kj.3 We wish to find V(kj;0,T) defined as the value of the swap at time j when the
last settlement was at time k, the swap started at time 0 and ends at time T. If we are long
this swap, the remaining cash flows are S(k+1) - G(0,T), S(k+2) - G(0,T), ..., S(T) -
G(0,T). We can now short a swap with the same remaining settlement dates. This new
swap will have no value or cash flow at time kj but will have the cash flows G(kj,T) -
S(k+1), G(kj,T) - S(k+2), ..., G(kj,T) - S(T) where G(kj,T) is the price of the new swap.
The combined cash flows from our two positions are now G(kj,T) - G(0,T) at each time t
= k+1, ..., T. The value of this combined position is obviously the present value of this
stream of cash flows, which, because they are certain, can be obtained by discounting at
the risk-free rate. The value of this position is the value of the original swap minus the
value of the new swap, which equals the value of the original swap. Defining PVFA as
the present value factor at kj for the remaining cash flows, the price of the new swap is,
using the results of the previous section, G(kj,T) = X(kj,T)S(kj)/PVFA where X(kj,T) is
the number of units of the asset that must be purchased at time kj to reproduce the
variable swap payments on the new swap. Then the value of the old swap is
V(kj;0, T ) = [G (kj, T ) − G (0, T )]PVFA
= [X (kj, T )S(kj) / PVFA − G (0, T )]PVFA
= X (kj, T )S(kj) − G (0, T )PVFA.
The interpretation of this formula is that the value of the swap to pay G(0,T) and receive
the asset price at each settlement is the value of a position of X(kj,T) units of the asset
worth S(kj) and a liability of payments of G(0,T) at each remaining settlement date. To
value the swap then requires that we determine X(kj,T) and PVFA. This general
interpretation will apply to each case for any kind of commodity swap.
To find the number of units to purchase at time kj, we step back to time k, the
previous settlement. At time k the number of units to purchase would be
1 − e − δR
.
eδ − 1

3
Time kj is not the product of k time j.
D. M. Chance, TN97-08 4 Pricing and Valuation of Commodity Swaps
At time kj, this would be found by compounding the above factor at the rate δ for the
period j to obtain
 1 − e − δR  δj
X ( kj, T ) =  δ e .
 e −1 
The present value factor for an annuity at time k would be
1 − e − rR
.
er − 1
At time kj this would be found by compounding at the rate r for the period j to obtain
 1 − e − δR  rj
 δ e .
 e −1 
Thus, we have the value of the swap as
 1 − e − rR  rj
V(kj;0, T ) = X (kj, T )S(kj) − G (0, T ) r e .
 e −1 
Asian Swap Pricing
Now we wish to determine the price of the Asian swap, which we denote as
GA(0,T). This is the fixed rate that would equate the present value of the cash inflows to
the present value of the cash outflows. The present value of the outflows is
 1 − e − rT 
G A (0, T ) r  .
 e −1 
Each inflow is defined as the average of N prices observed on specific dates during the
settlement interval. The settlement inflows are denoted as A(1), A(2), ..., A(T). We
define each settlement interval as consisting of times n = 1, 2, ..., N, which we call price
observation dates. A price, denoted as S(tn) where t is the upcoming settlement, is
observed and recorded at time n. The average at t is
N
A(t ) = ∑ S((t − 1)n ) / N .
n =1

Each price observed in recording the average is denoted as S((t-1)1), S((t-1)2), etc.,
which will appear as S(01), S(02), or S(11), S(12), etc.
To reproduce a cash inflow at time t equivalent to the average price as defined
above, we must undertake at time 0 a set of transactions as follows:
D. M. Chance, TN97-08 5 Pricing and Valuation of Commodity Swaps
 To produce the value A(1) at time 1, we
buy e-(δ/N)(1/N)e-(r/N)(N-1) units. At time 01, this will accrue to [e-(δ/N)(1/N)e-
(r/N)(N-1)
]e(δ/N) = (1/N)e-(r/N)(N-1) units. We sell the units at price S(01) and
invest the proceeds in riskless bonds maturing at time 1. A time 0 The
accrued value at time 1 will then be (1/N)e-(r/N)(N-1)S(01)e(r/N)(N-1) =
(1/N)S(01). We also buy e-(δ/N)2(1/N)e-(r/N)(N-2) units. At time 02, this will
accrue to [e-(δ/N)2(1/N)e-(r/N)(N-2)]e(δ/N)2 = (1/N)e-(r/N)(N-2) units. We sell these
units at the price S(02) and invest the proceeds in riskless bonds maturing
at time 1. The accrued value at time 1 will be (1/N)e-(r/N)(N-2)S(02)e(r/N)(N-2)
= (1/N)S(02). Additional transactions following this pattern are also
conducted at time 0 so that at time 1, the accrued value will be (1/N)(S(01)
+ S(02) + ... + S(0N)). The total number of units to purchase at time 0 to
create this cash flow is
N
(1 / N )∑ e −(δ / N )n e −(r / N )(N −n ) .
n =1

These transactions have reproduced only the first cash inflow, A(1). To reproduce the
second cash inflow, we do a set of similar transactions. In general we purchase enough
units of the asset so that when the price observation date is reached, we sell off the
appropriate number of units, invest the proceeds in riskless bonds so that at the next
settlement the amount accrued will be (1/N) times the price recorded for averaging.
Doing this for all price observation dates reproduces the average at the next settlement
date. Doing this for all settlement dates reproduces the swap’s entire cash inflows.
The total number of units to be purchased at time 0 is

X A (0, T ) = (1 / N )∑∑ {e −(δ / N )[(t −1)N + n ]e −(r / N )( N − n ) }.

T N

t =1 n =1

This expression can be simplified. The term in braces can be written as e-(r-δ)e-δten(r-δ)/N.
Putting this expression back into the summation gives
 T  N 
X A (0, T ) = (1 / N )e −(r −δ )  ∑ e −δt  ∑ e n (r −δ ) / N  .
 t =1  n =1 

D. M. Chance, TN97-08 6 Pricing and Valuation of Commodity Swaps

 = Y (1 − Y N ) / (1 − Y ) , the above expression can be
N
Using the mathematical rule that ∑Y
j=1
j

written as
 1 − e − δT  e − (r −δ ) − 1 
X A (0, T ) = (1 / N ) δ  −(r −δ ) / N .
 e − 1  e − 1 

To price the swap we set its value at time 0 to zero. This is done by setting the
value of the assets purchased to the value of the cash outflows:
 1 − e − rT 
X A (0, T )S(0) = G A (0, T ) r  .
 e −1 
Solving for the swap price, we have
 er − 1 
G A (0, T ) = X A (0, T )S(T ) .
−rT 
1− e 
Valuation of the Asian Swap
Now suppose the last settlement date was time k (k = 0, 1, ..., T). We are
currently at time ki where i is the integer number representing the ith price observation
recorded for the next settlement. A total of i prices, which includes the current price,
have been observed and recorded during the current settlement. There are N - i prices
remaining to be observed and recorded in the current settlement and R = T - k settlements
remaining. In this case we are on a price observation date. Later in this section we shall
look at the case where we are not on a price observation date. We wish to find the value
of the swap, which is denoted as VA(ki;0,T). Recall that in general the value of this swap
is the number of units of the asset we would need to purchase today to replicate the
variable payments times today’s price minus the present value of the remaining fixed
payments. To replicate the variable payments, we must determine the number of units of
the asset to purchase today, but we will also have to purchase bonds in an amount
sufficient to grow at the riskless rate to the value (1/N)(S(k1) + S(k2) + ... + S(ki)), which
reflects the prices already observed and recorded in the current settlement period and
which will be used, along with the future prices S(k,i+1), ..., S(kN), in computing the
average at the next settlement date.

D. M. Chance, TN97-08 7 Pricing and Valuation of Commodity Swaps

 The number of units of the asset to purchase at time ki can be found by first
determining the number of units to purchase at time k to reproduce all of the swap’s cash
inflows starting at time k and subtracting the number of units needed to reflect the price
observation dates from time 1 time i.4 In other words, we have already passed i price
observation dates, so we do not need to purchase assets to produce (1/N) times the sum of
the prices already observed on those dates; we shall, however, have to purchase bonds in
an amount to reflect these already-observed prices, as noted above. At time k the number
of units to purchase is found by using the formula we previously obtained and treating it
as though the swap starts at time k. This formula would be
 1 − e − δR  e − ( r − δ ) − 1 
X A (k, T ) = (1 / N ) δ  −(r −δ ) / N .
 e −1  e − 1 

Now we need to determine how many of these units would have been purchased to
produce at the next settlement the amount (1/N)(S(k1) + S(k2) + ... + S(ki)), which are
the previously recorded prices. In deriving the above formula in an earlier section, we
used a more general formula involving summations:

(1 / N )e −(r −δ )  ∑ e −δt  ∑ e n (r −δ )/ N  .

T N

 t =1  n =1 
We need a special case of this formula, specifically that t goes from 1 to 1, since we are
looking only at the upcoming settlement, and that n goes from 1 to i. This gives us

(1 / N )e −(r −δ )e −δ  ∑ e n (r −δ )/ N 
i

 n =1 
i
= (1 / N )e − r ∑ e n (r −δ ) / N .
n =1

Using again the rule for summation of a finite series of the above form and after some
further algebraic rearrangements, we have
i ( r −δ ) / N
(1 / N )e −r  1−−(r −eδ )/ N 
.
e − 1 

Now the total number of units necessary at time k is

4
One further adjustment will be needed, which we shall get to shortly.
D. M. Chance, TN97-08 8 Pricing and Valuation of Commodity Swaps
   e − ( r − δ ) − 1  − r  1 − e i ( r − δ ) / N  
− δR
(1 / N ) 1 −δ e
 −(r −δ ) / N  − e  −(r −δ ) / N   .
 e − 1   e − 1   e − 1 
This is still not quite what we need, which is the quantity required at time ki and not at
time k. We can obtained the desired value, however, by simply compounding the above
quantity by the factor e(δ/N)i. Thus,
 1 − e −δR  e − ( r − δ ) − 1  − r  1 − e i ( r − δ ) / N  
X A (ki, T ) = (1 / N )e (δ / N )i  δ  −(r −δ ) / N  − e  −(r −δ ) / N  .
 e − 1  e − 1  e − 1  

Now we must deposit enough cash to produce (1/N)(S(k1) + S(k2) + ... + S(ki)) at
the upcoming settlement. This is easily obtained by depositing the amount
 i 
B A (ki, T ) = (1 / N )e −(r / N )( N −i )  ∑ S(kn ) .
 n =1 
This amount will grow by the interest factor e(r/N)(N - i) and produce the desired total at the
upcoming settlement.
Thus, the purchase of XA(ki,T) units of the asset at price S(ki) and the purchase of
riskless pure discount bonds worth BA(ki,T) will produce the cash inflows over the
remaining life of the swap. The present value of the cash outflows is simply the present
value of the remaining payments of GA(0,T),
 1 − e − rR  (r / N )i
G A (0, T ) r e .
 e −1 
Recall that the swap value is simply the value of the assets required to replicate
the cash inflows minus the present value of the remaining cash outflows on the swap.
Thus,
 1 − e − rR  (r / N )i
VA (ki;0, T ) = X A (ki, T )S(ki ) + B A (ki, T ) − G A (0, T ) r e .
 e −1 
Now suppose that we are between two of the price observation dates. Let k be the
previous settlement date, k = 0, 1, 2, ..., T, and i be the previous price observation date.
Now position ourselves at time h which is a fraction of the period from i to i + 1, the next
price observation date. Note that 0 < h < 1 and represents the elapsed time in the period,
not the remaining time. We first solve for the number of units we would need to

D. M. Chance, TN97-08 9 Pricing and Valuation of Commodity Swaps

purchase at this time to produce the cash inflows on the swap. We denote this value as
XA(kih,T). By definition,
X A (kih, T ) = X A (ki, T )e (δ / N )h .
The amount of cash we must invest in riskless bonds is
 i 
B A (kih, T ) = (1 / N )e −(r / N )( N −i − h )  ∑ S(ki ) ,
 n =1 
which will grow by the interest factor of e(r/N)(N - i - h). The investment required to produce
the cash inflows is S(kih)XA(kih,T) + BA(kih,T). The present value of the remaining
outflows is
 1 − e − rR 
G A (0, T )e (r / N )(i+ h )  r  .
 e −1 
The value of the swap is, therefore,
 1 − e − rR 
VA (kih;0, T ) = S(kih )X A (kih, T ) + B A (kih, T ) − G A (0, T )e (r / N )(i + h )  r  .
 e −1 
Appendix
This appendix provides numerical examples for each of the cases developed in the
above sections. We shall work with a swap with four settlement dates. The asset yield is
.03, the risk-free rate is .09, and the current asset price is 5.2630. For an Asian swap
there will be three price observation dates. Thus, T = 4, δ = .03, r = .09, S(0) = 5.2630,
and N = 3. Other inputs will be provided as needed.
Let us price the standard swap. We first compute X(0,4), the number of units we
must purchase to produce the cash inflows of the swap, as
1 − e −0.3(4 )
X (0,4 ) = = 3.7131 .
e 0.3 − 1
Then the swap price is found as
 e .09 − 1 
G (0,4 ) = 3.7131(5.2630 )  = 6.0874 .
−.09 ( 4 ) 
 1 − e 
Thus, payments of 6.0874 at each of the four settlement dates is a fair exchange for
receiving the price of the asset on those settlement dates. Note that the swap price is

D. M. Chance, TN97-08 10 Pricing and Valuation of Commodity Swaps

considerably higher than the current asset price. This is because the cost of carry, r - δ, is
relatively high at .09 - .03 = .06. Recall that in forward contracts the excess of the
forward price over the spot is directly related to the cost of carry. Since a swap is just a
combination of forward contracts, that relationship continues to hold.
Now let us move forward past the first settlement date and 1/3 of the way into the
second. The current price is now 5.2852. Let us find the new number of units that we
would have to purchase to produce the remaining cash inflows:5
 1 − e −.03(3)  .03(1 / 3)
X (11 / 3,4 ) =  .03 e = 2.8545 .
 e −1 
Then the value of the swap is
 1 − e −.09 (3)  .09 (1 / 3)
VA (11 / 3;0, T ) = 2.8545(5.2852 ) − 6.0874 .09 e = −.6743 .
 e −1 
Now let us price the Asian version of this swap. With N = 3 prices in the average,
the number of units required at time 0 to replicate the cash inflows is
−.03( 4 )
1− e  e − (.09−.03) − 1 
X A (0,4 ) = (1 / 3) .03   = 3.6431 .
 e − 1  e −(.09−.03) / 3 − 1 

Solving for the swap price, we obtain

 e .09 − 1 
G A (0, T ) = 3.6431(5.2630 )  = 5.9677 .
−.09 ( 4 ) 
1 − e 
Now let us value the Asian swap during its life. We first value it on a price
observation date, the first such date after the first settlement; thus, k = 1, i = 1. Using the
appropriate formula, we have
 1 − e −.03(3)  e −.06 − 1  −.09  1 − e .02 (1)  
X A (11,4 ) = (1 / 3)e .01(1)  .03  −.02  − e  −.02   = 2.4846 .
 e − 1  e − 1   e − 1 
We must invest enough cash in riskless bonds to reflect the prices already observed in the
average. There is only one previous price so we invest
(1 / 3)(5.2852)e −.03(3−1) = 1.6591 .

5
The notation below in the expression X(11/3,4) is not 11/3 or 1 1/3 but simply indicates that k is 1 and j is
1/3.
D. M. Chance, TN97-08 11 Pricing and Valuation of Commodity Swaps
in riskless bonds expiring in two periods. This amount will earn interest and grow to a
value of (1/3)(5.2852) = 1.7617 at the next settlement. The value of the swap is
 1 − e −.09 (3)  .03(1)
V(11;0,4 ) = (2.4846 )(5.2852 ) + 1.6591 − 5.9677 .09 e = −0.6603 .
 e −1 
Now suppose we are not on a price observation date. Let us be 4/10 of the way
between price observation dates 1 and 2, where the last settlement was at time 1. Thus, k
= 1, i = 1, and h = .4. The current price is S(11.4) = 5.3648.6 The number of units of the
asset we must buy is
X A (11.4,4 ) = X A (11,4 )e .01(.4 ) = 2.4846e.01(.4 ) = 2.4946 ,
which makes use of the fact that we computed XA(11,4) in the previous problem. We
must invest enough money in riskless bonds to reflect the prices already observed in the
current settlement period. This will be
(1 / 3)(5.2852)e −.03(3−1−.4 ) = 1.6792 .
The value of the swap is then,
 1 − e −.03(3)  .03(1.4 )
VA (11.4;0,4 ) = 5.3648(2.4946 ) + 1.6792 − 5.9677 .03 e = −2.5268 .
 e −1 
References
This teaching note borrows from

Chance, D. M. and D. R. Rich. “Asset Swaps with Asian-Style Payoffs.”

The Journal of Derivatives 3 (Spring, 1996), 64-77.

Chance, D. M. and D. R. Rich. “Price the Average.” Energy and Power

Risk Management 1 (December, 1996/January, 1997), 22-25.

Other work on commodity swaps, though not accounting for the averaging effect, is in

Das, S. “Forward March.” Risk 6 (February, 1993), 41-49.

Jarrow, R. and S. Turnbull. Derivative Securities. Cincinnati: South-

Western (1996), pp. 444-447.

A good article discussing the corporate use of commodity swaps is

6
Again, the notation S(11.4) does not refer to time 11.4 but rather time h = .4 after time i = 1 after time k = 1.
D. M. Chance, TN97-08 12 Pricing and Valuation of Commodity Swaps
Schap, Keith. “Jet Fuel Swaps Ground Risk.” Futures 15 (February, 1993), 44-46.

D. M. Chance, TN97-08 13 Pricing and Valuation of Commodity Swaps