A spread swap (ss) is similar to a Basis Swap, i.e., it is a cash settled swap where the fixing basis for the swap's underlying is the price differential (i.e., the spread) between two predefined commodities.
The difference is that whereas in SDX Commodities & Energy the basis swap is a swap on the price differential between the Henry Hub Natural Gas asset and a US natural gas asset traded at a different location (or hub), the spread swap is a swap on the price differential between two OTC or exchange-traded energy assets, e.g., crude oil, gasoline or diesel commodities. Accordingly the spread swap is tailored to the energy market, which can be seen in the fact that the fixing frequency is set to daily and that you can define different volumes for each asset.
The actual spread is displayed in the pricing page in the Swap Rate result and is calculated as follows:
The swap rate of Asset 2 (presented in the unit of the base asset) - the swap rate of Asset 1 (i.e., the base asset)
On the settlement date, if the underlying (i.e., the spread) is higher than the fixed rate (i.e., the traded rate), the spread swap buyer receives the difference between the two from the spread swap seller. If the underlying rate is lower, the spread swap buyer pays the spread swap seller the difference.
Why enter into a spread swap?
A spread swap is generally used to do either of the following:
Hedge spreads to offload a basis risk
The distinction between what an exchange-traded instrument can be used to hedge and what the user actually needs to hedge is often the source of Basis Risk. Accordingly, if you use for example an exchange-traded futures contract to hedge a position based on a different commodity, you will then often need something to manage your basis risk. For example, a refiner who is exposed to Sing 180 may choose to hedge this exposure using a Brent crude oil futures contract. However, choosing that hedge will expose the refiner to the basis risk between the Sing 180 and Brent and the refiner will then need to also hedge this resultant risk factor.
There are a number of contracts available in the OTC market that can be used to cover your basis risk, i.e., the risk associated with imperfect hedging arising from using exchange-traded futures to hedge instruments based on a different commodity. One of these instruments is the Spread swap, which basically closes the gap between the exchange-traded futures contract's price and the price of the other asset to give you price certainty.
Take a position on a spread
You can use a spread swap to take a position on a spread, for example, on a “distorted” price difference—where the price differential seems over or under priced.
For example, a trader may not have a view on the Dec 2010 absolute values of either the Brent crude oil asset or of the gasoline asset, USG FOB Reg Unl 87. However, that same trader may have the view that the Dec 2010 spread between these two assets will be above the current value of the spread between them. If that is the case then this trader would enter into a buy order for this spread.
Pricing a spread swap in SDX Commodities & Energy
When defining a spread swap:
You select the two assets from a list of the OTC or exchange-traded energy commodities supported on the system.
If you define one volume, by default the system then automatically updates the other volume accordingly. It does this using the conversion factors as displayed in the Conversion Factors window (accessed by clicking Conversion Factors on the left hand side of the pricing page). Alternatively, if you uncheck the Link Volume checkbox you can define a separate volume for each commodity.
For each asset you must define if the sign of the volume is - or +.
- means that you selling the asset.
+ means that you are buying the asset.
You must define if you are buying or selling the spread swap. In theory, if you are buying the instrument, this means you are selling Asset 1 (the base asset) and buying Asset 2; if you are selling the instrument, you are buying Asset 1 and selling Asset 2.
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Toggling the Buy <> Sell button simply affects the sign of the volume set for each asset. |
You must define the term.
The actual swap itself is always a calendar month, as noted by the Begin Date and End Date fields.
As soon as you define the term, in the Traded Rate field the system displays the fixed rate that will give a zero cost instrument (i.e., it is defined to be the same as the calculated swap rate). You can then manually change the fixed rate and recalculate the instrument. However, if you do change the fixed rate note that this action will affect the present value of the spread swap.