Structured Solutions using Commodity Swaps
(All prices in this case are hypothetical but can be easily applied to real prices today's market)

A Korean chemicals manufacturer uses 250,000 barrels of oil every three months. The firm has contracted to sell its output at a fixed price for seven years and would like to fix its input costs for the same period. Its largest expenditure is for oil. Now, in the world markets oil is priced in US Dollars and of late its price has been displaying remarkable volatility. Also, there is a great fluctuation in the FX rate of US Dollar with Korean Won, the manufacturer's base currency. The manufacturer is, thus exposed to two forms of risk: 1) commodity price risk of oil and 2) USD/KRW risk in the FX rate. The firm would like to engineer a structure that would fix the price of oil in KRW. The current USD/KRW rate is 1,161 and the seven year USD swap rate is 6% and the Korean rate is 8%. Also, the spot price of oil is US$26.00 a barrel. Also, all seven year swaps are quoted against 3 month USD LIBOR.

Solution:

The solution for the Korean chemicals manufacturer is to enter into three simultaneous swaps: 1) USD interest rate swap 2) KRW for USD currency swap and 3) commodity swap involving oil. It is assumed that the commodity swap dealer’s mid price for oil swaps is $26.00 a barrel. Structuring the swap is a six step process:

• Step 1: Determine the number of US Dollars the Korean firm will need every three months to the pay the fixed-price leg of its commodity swap. This is 250,000 barrels times $26.00 and is equal to $6,500,000.
  
• Step 2: Determine the notional principal required on a USD interest rate swap for the fixed rate side to generate $6,500,000 every three months using the current 6% qtr for USD interest rate swap. This is found out by dividing the quarterly cash flow of $6,500,000 by a periodic rate of 1.50%.
  
• Step 3: Calculate the Present Value of the cash flows on the fixed rate side of the interest rate swap using the current 6% rate. The periodic payments are $6,500,000 and there are 28 periods (seven year swap – quarterly payments) with a rate of 1.50%. The PV turns out to be $147,723,659.
  
• Step 4: Translate the PV of the dollar annuity to its equivalent in Korean Won (KRW) using the spot FX rate. This gives us a value of KRW 171,507,167,652.
  
• Step 5: Determine the KRW cash flow on the fixed rate side of KRW-USD currency swap having a PV of KRW 171,507,167,652. Again there are 28 periods, but the discount rate is quarterly equivalent of seven year Korean swap rate of 8%. The quarterly cash flow comes out to be KRW 8,059,065,491.
  
• Step 6: Last, we need to determine the KRW notional principal that would generate the quarterly payments of KRW 8,059,065,491. The procedure in step 2 is repeated here to generate a notional principal of KRW 402,953,274,571.

Thus the above portfolio of swaps ensures for the manufacturer that his cost of oil will be fixed at KRW 32,236 per barrel (this is obtained by dividing KRW 8,059,065,491 by 250,000 barrels).

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