A spread swap 3-leg is similar to a Spread Swap, but whereas the spread swap is a cash settled swap where the fixing basis for the swap's underlying is the price differential (or spread) between two OTC or exchange-traded energy assets, e.g., crude oil, gasoline or diesel commodities, the spread swap 3-leg is a swap on the price differential between any three assets.
The actual spread (which is displayed in the pricing page in the Swap Rate result) is always displayed in the unit of asset 1 and is calculated as follows:
The swap rate of Asset 1 +/- the swap rate of Asset 2 +/- the swap rate of Asset 3
The swap rate of each individual asset is calculated as its weight x its price, where for asset 2 & asset 3 the inclusion of the weight lets SD convert the swap rate of that asset in its own default unit into a swap rate in the default unit of asset 1.
On the settlement date, if the underlying (i.e., the spread) is higher than the fixed rate (which is displayed in the Strike field), then 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.
The spread swap 3-leg 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 weights for each asset.
Why enter into a spread swap 3-leg?
A regular spread swap with 2 legs is generally used to do either of the following-hedge spreads to offload a basis risk or to take a position on a spread, for example, on a distorted price difference. For more information on this, see the Spread Swap topic.
However, you may instead want to lock in (or fix) a spread between the swap rates for a combination of 3 assets.
Why is this ability useful? Many industries combine multiple inputs (or commodities) to produce a single output (or commodity), while some have multiple outputs as a result of their industrial processes. For example, an electricity producer might want to trade the spread between electricity (the asset that is being produced) and a basket containing coal (the asset they need to buy to product the electricity) and emissions (which is a by-product of the electricity-making process and has to be paid for); a mill might want to trade the spread between soybeans, soybean meal and soybean oil, etc.
In such circumstances, fixing the spread lets you lock in your profit level. That is, using a single instrument you can hedge your costs and protect your profits.
Although you can of course do this by building a structure of swaps manually in the Portfolio page, it is easier to do this using SD's spread swap 3-leg. The spread swap 3-leg interface lets you easily and efficiently price and manage the relevant spread, while letting you do so according to market convention, for example, by enabling you to define a single volume defined in units of asset 1.
Defining a spread swap 3-leg in SDX Commodities & Energy
When defining a spread swap 3-leg:
You select the three assets from a list of the OTC or exchange-traded energy commodities supported on the system.
When you define a weight for asset 1, the system automatically defines the weights for asset 2 and asset 3 using its conversion factors. You can then edit the weights for asset 2 and asset 3 individually if required.
The weight of asset 2 and of asset 3 is used to convert the swap rate of that asset in its default unit (as shown in the Strip Price field for that unit) into the swap rate for that asset in the default unit of asset 1.
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If no conversion factor is available, SD uses a weight of 1 by default. |
You must define the term. The actual swap itself is always a calendar month.
As soon as you define the term, in the Strike 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 instrument's present value.
For each asset you must define if the sign of the weight is - or +.
- means that the buyer of this instrument is selling this asset.
+ means that the buyer of this instrument is buying this asset.
These signs also define whether you want to add (+) or subtract (-) its swap rate to the swap rates of the other assets in order to calculate the instrument's actual spread.
You must define if you are buying or selling the instrument. In theory, if you are buying the instrument, you are buying the protection; if you are selling the instrument, you are selling the protection (and exposing yourself).