In a commodity index swap, what is one of the cash flows based on?

• A. The fixed interest rate of a bond
• B. The price of a specific commodity or index
• C. The performance of a mutual fund
• D. The historical volatility of the market

Answer: (B)

In a commodity index swap, one of the cash flows is indeed based on the price of a specific commodity or index. This financial instrument allows investors to gain exposure to fluctuations in commodity prices without having to take physical delivery of the commodities themselves. In this arrangement, one party typically agrees to pay a cash flow tied to the price movement of an underlying commodity index, while receiving a fixed cash flow in return.

The focus on the price of a specific commodity or index is crucial because it directly reflects changes in supply and demand dynamics in the commodity markets. As the price of the underlying commodity fluctuates, the cash flows exchanged in the swap will also vary, reflecting the economic conditions and market factors that influence those prices.

This structure enables investors to hedge risk, speculate on price movements, or gain commodity exposure in a more liquid format than direct investment in physical commodities would allow.