ASX Grain Futures and swaps
You may be familiar with a product called a 'swap'. This page explains the difference between ASX Grain Futures and a swap and highlights a number of ways the products can be applied.
Know about the marketing tools available: A comment often made has been "I don't use ASX, I use swaps", however a growing number of participants are now thinking "I may use swaps and I may also use ASX". Successful marketing, trading and accumulation of grain is about knowing all the tools that are available and how they can be applied under different market scenarios. For example, swap users who grow or trade or accumulate wheat in the underlying port zones for any of the ASX Grain Futures contracts (AWM, WAW, AFB, ASM & ACM) may be interested to know how they can combine swaps as well as participate in the ASX delivery process and thereby benefit from the oversight of ASX Clearing Corporation.
What is a swap?
Swaps are 'over the counter' price risk management products, offered and priced by swap providers. The application of ASX Grain Futures contracts as price benchmarks for the 'over the counter' swaps market is growing considerably. A number of banks currently offer swap products over ASX Grain Futures.
The swap price quoted is made around the price trading for an actual futures contract. That is, the swap provider references underlying futures markets and quotes a market around the underlying futures contract price. For instance, the swap offering in Australia includes grain markets available on ASX as well as North American futures exchanges namely Chicago, Kansas and Winnipeg.
ASX Grain Futures contracts reflect the grain supply and demand equation for Australian grain. It should be noted that swaps priced around North American markets reflect the price traded in those markets and do not primarily reflect the local supply and demand fundamentals determining grain prices trading in Australia.
The contractual terms and conditions governing swaps priced on ASX may differ to the ASX Operating Rules and ASX Clear Operating Rules that govern the ASX Grain Futures contracts. Participants considering their application should understand what these differences are. The most likely areas of difference between the swap offering and ASX contracts may include the exercise, expiry and settlement terms.
Swap Pricing Example
Bank XYZ offers a swap around Chicago Wheat futures that expire in December. If the Chicago wheat market is trading around $200 per tonne (t) a swap provider will make a market around that price. For growers interested in hedging their downside price risk by selling swaps, Bank XYZ may show a bid of $195/t. For end users interested in hedging their upside price risk by buying swaps, Bank XYZ may show an offer of $205/t. The difference between the price at which Bank XYZ buys from growers and sells to end users is the margin made for providing this service. The margin between the underlying futures price and the market quoted in this example is $5 each way but will differ depending on the level of competition in the marketplace. If the swap provider has an unbalanced book they will hedge their exposure using the underlying futures contract that the swap was referenced to.
The key advantage promoted by swap providers is that margins are not required during the life of the hedge as the participation in the underlying futures market is indirect. This is not to say that hedging using swaps is "free". There is obviously a cost for all services provided. For exchange traded products, margins are a necessity to manage the financial integrity of the marketplace. As market participation becomes more direct in nature, cost efficiencies will be realised. The trading rules, restrictions, currency denomination and settlement processes applied for swaps differ between providers. However, at settlement, there are two scenarios that can occur.
If you are a grower
- you have a position that is in the money at maturity (you sold the swap at a price higher than the settlement price) and the swap provider owes you the money, or
- you have a position that is out of the money at maturity (you sold the swap at a price lower than the settlement price) and you owe the swap provider money.
The second point is important in that many growers may be of the understanding that they do not have a production obligation and therefore do not have a wash out exposure. Regardless of what marketing product you use, if you are forward selling a commodity that is yet to be harvested there is a risk that the market may go against you and at the same time you may have no production to offset this cost. This is true for forward physical contracts, swaps and ASX Grain Futures.
Leaving Basis Open (Drought Markets): A key point of promotion (to growers) for swaps priced over North American markets such as Chicago is that if an Australian drought were to eventuate, particularly throughout Australia's eastern seaboard, growers who had sold swaps based on North American markets still had the opportunity to benefit from stronger cash prices (due to the drought) which, in all probability, would reflect a much stronger basis (local cash price less the swap market price). With the successful listing of Western Australia Wheat (WAW) futures (PDF 82KB) on ASX, growers interested in leaving the basis open may be interested to investigate whether a swap over WAW may behave in a similar fashion to swaps over Chicago. This particular strategy assumes a drought in Australia's east rather than Western Australia.
If you are an end user
- you have a position that is in the money at maturity (you bought a swap at a price lower than the settlement price) and the swap provider owes you the money, or
- you have a position that is out of the money at maturity (you bought a swap at a price higher than the settlement price) and you owe the swap provider money.
ASX Grain Futures compared with 'Over The Counter' (OTC) swaps
|Domestic Contracts||Yes||Yes - if swap priced on ASX||ASX Grain Futures and Options reflect the local supply and demand fundamentals for Australian grain. Swaps priced on ASX contracts reflect the ASX price. Swaps priced on North American markets do not. For end users looking for drought price protection this is of vital importance. It is also of importance for growers looking to maximise their revenue stream during seasons of poor yield. The benefit delivered is reduced basis risk.|
|Public Marketplace||Yes||No||The prices that trade on ASX are determined by the industry and thereby deemed to be 'fair value'. Any industry participant has the ability to access the prices that trade on ASX without the need for a login or password, for example you can subscribe to receive the ASX Daily Activity Report. Swap prices are created by the swap provider and may not be as transparent as ASX prices.|
|Brokered Market||Yes||No||If you are dealing in an exchange traded market directly such as ASX your broker is the only person who has an understanding of any existing positions and which direction you are looking to trade, the market does not. If you are dealing in an over the counter market such as swaps, the swap provider will have access to the same information but is also the counterparty to your trade and is making the price.|
|Transparent Cost Structure||Yes||No||The cost of trading futures is the commission paid to your broker, as well as the applicable ASX fee (PDF 70KB) . All market participants can transparently see and calculate what the hedge costs to execute. On the otherhand, swaps are priced around an underlying market that may be priced a number of ways. The margin charged for the swap service is less transparent than the cost of executing directly on an exchange. While there may not be a transparent "brokerage" charge for swap business it should be realised that it is not a "free" service.|
|Novation||Yes||No||Although a lesser point in respect of the banks and larger agribusiness companies, it should be noted that there is a counterparty credit exposure when dealing in swaps. ASX Clearing Corporation is the counterparty to all ASX market positions and manages the financial integrity of the market by performing a daily mark to market function. Since the Global Financial Crisis there has been a worldwide trend for OTC business to now be centrally cleared by clearing facilities such as that offered by ASX Clearing Corporation.|
|Margins||Yes||No||To effectively manage counterparty credit risk, ASX Clearing Corporation charges margins (Initial ~ deposit) (Variation ~ mark to market) throughout the life of all open contract positions. Swaps remove the need for daily margin calls however the Global Financial Crisis highlighted that this benefit (not having to post margins) is not without risk.|
|Standardised Contract||Yes||Maybe||ASX Grain Futures contracts are exchange traded and are therefore of a standardised form known as contract specifications. Swaps are over-the-counter instruments that may be tailored to meet specific needs.|
|Physical Delivery||Yes||Via EFP into ASX||
Regardless of what marketing product you use, if you are forward selling a commodity that is yet to be harvested there is a risk that the market may go against you and at the same time you may have no production to offset this cost. This is true for forward physical contracts, swaps and ASX Grain Futures.
ASX Grain Futures are ultimately deliverable contracts (if open positions are held through to expiry - physical delivery must be made or taken). It follows there is a production risk associated with selling ASX Grain Futures contracts prior to crop harvest. This risk can be managed through the use of ASX Grain Options.
The reason ASX contracts can be delivered against, is to keep the futures market true to the underlying physical market at expiry. Swap positions may be rolled into a futures position through the Exchange For Physical (EFP) (PDF 57KB) process. Hedgers who initially used a swap over an ASX contract may ultimately decide they would like to participate in the ASX delivery process managed by ASX Clearing Corporation. This flexibility is not possible for swaps written over offshore exchanges.