Could someone confirm how a 3-way collar would work for an end user. Essentially, it's a costless collar (buy cap, sell primary floor) but with a secondary floor in between. The only difference between the simple collar and a 3-way seems to be that by selling another floor at a slightly higher price, you can reduce the cap, giving up some more downside for upside protection.Buy Cap (60)Sell Secondary Floor (58) Sell Primary Floor (56)Ignoring the way cash-flows would work to and from dealer:When the market is above the cap, the cost is the cap price (60).When the market is below the primary floor, the cost is the primary floor (56)When the market is between the secondary floor and the cap, the cost is the market price (59)What would the cost be when the market is between the secondary and primary floors?Thanks folks.

This is an unusual set of prices for a three-way collar. But there's a wide variety of contracts under that designation. Given your information, it appears that the notional amount of the cap is equal to the sum of the notionals of the two floors. In that case, if the price ends up between the two floors you will pay something higher than the market price. For example, if the two floors have equal notional, you'll pay the average of $58 and the market price, if the market is between $56 and $58.A more common three way collar has the same notional for all three legs. For example, suppose you could do a costless two-way collar buying a cap at $60 and selling a floor at $56. You might be able to sell a cap at $64, buy a cap at $59 and sell a floor at $55 instead. You have reduced your primary cap and floor by $1, but have no price protection above $64. Or you might buy a second floor at $52, then move your primary cap and floor up to $61/$57. You get the benefit of price declines below $52, at the cost of raising your primary cap and floor. In all these cases, your secondary contract is the opposite buy/sell as the other contract of the same type.

Thanks for your reply.I made up the numbers on the caps and floors in the previous example without giving it too much thought. Here's a set of actual quotes for a 3-way collar: The constraint here is that the end user wants complete upside protection so we can't sell a higher cap.Buy Cap: 57.50Sell Secondary Floor: 53.40Sell Primary Floor: 49.40 Lets assume the market settles at $51.So in this situation, would the cost be the average of 53.40 & 51? If one sells a floor at 53.40 and 49.40, isn't he basically setting a floor at 53.40? I'm definitely not thinking right but why the average between the market and secondary floor?

What are the notional amounts? If the two floors add up to the same notional as the cap then at a price at settlement time of $51 the party would be forced to buy some at $53.40 and would buy the rest at the market price of $51.This is not the same as having the entire floor at $53.40. In that case the entire amount would have to be purchased at that price.Think of it as two caps: a $57.50/$53.40 that the party is paid to take, and a $57.50/$49.40 that the party pays an offsetting amount to take.

I wasn't considering the notionals. I think i get it now. The notionals on both floors add up to the cap notional. So it makes complete sense that you would be forced to buy some at the secondary floor and the rest at market. So just to confirm, if the market settlement was below the primary floor, then the cost would be the average of the primary and secondary floors as one would be forced to buy the notionals at each floor?Thanks.

Almost.If the price is between the two floors, you will be forced to buy some at the primary floor, the rest you will buy at market. If the primary floor is half the total notional, you will execute at the average of the primary floor and the market price. If the primary floor has a different notional, you will have a weighted average.I have not seen contracts like this, although they may be common in some markets. I wouldn't call it a three-way collar myself. It's really two standard two-way collars. There are really only two outcomes, inside or outside the range, except for a minor adjustment if the price ends up between the primary and secondary floor.I'm not trying to split hairs, it's just that the more common (in my experience, anyway) three-way collars are essentially different from this contract. The secondary cap or floor has the opposite optionality as the primary. There really are three different outcomes: inside the (primary) collar, outside but not triggering the secondary cap or floor, and outside and triggering the secondary cap or floor.

Two questions:With the three-way collars that you are suggesting and are more common, what would be the notionals on the caps/floors?Secondly, have you come across participating swaps? They seem quite popular with marketers in the commodity markets. They are set at a cap/floor price and with a certain percentage of participation on the upside/downside. So for example, if a producer were to enter into a 50% participating swap with a floor of $50, they would receive $50 if the market was below $50 and if the price was above $50 (e.g. $52), they would receive 50% of the difference between the floor and the market ($1 in this case). It seems to be a mix of a fixed price swap and a call/put option (the weights depend on the participation required). The premium for the floor is built into the floor price of the swap. One could probably replicate this structure by entering into a fixed price swap and purchasing a floor. Am I correct? If i was trying to price this structure , would the floor strike price of the participating swap be 50%* the a fixed price swap plus 50%* the ATM put option?Thanks.

In the three-way collars I have seen, all three legs have the same notional. There are two flavors, the buyer either gets a better collar by accepting some downside if the price goes far outside the collar in the bad direction; or the buyer gets a worse collar, but participates in some upside if the price goes far outside the collar in the good direction.For example, suppose a gold producer can get a zero-cost two-way collar to sell 1,000 troy ounces at a price between $400 and $450. That means buying a put at $100 and selling a call at $450, each for 1,000 ounces.It might be willing to give up protection if gold falls below $350, on the grounds that it will close down its mine at that point. In that case, it might sell a put for 1,000 ounces at $350, buy a put for 1,000 ounces at $410, and sell a call for 1,000 ounces at $460.Alternatively, it might decide it wants to participate in price increases above $500. So it might buy a put at $390, sell a call at $440 and buy a call at $500; all for 1,000 ounces.A participating swap is just an option, renamed for marketing reasons.

Thank Aaron. Greatly appreciated. One last question:How would a "Particpating Swap" be priced? As in how would one determine the floor/cap and the level of participation.

You would price the participation call or put, then adjust the swap to make the total value zero.In your example, a producer wants the maximum of $50 or the average of $50 and the market price, say on two barrels of oil. What that amounts to is buying a $50 put on one barrel of oil and a forward contract to sell one barrel of oil for $50. If the forward price of oil is $55 a barrel, the forward contract has a negative value of the present value of $5; that should equal the premium on the put.A "participating swap" sounds better than "playing with derivatives."

Thanks Aaron. Greatly appreciated.

Here's an actual quote by a dealer for a 50% Particpating Swap, a Cap and a Fixed Price Swap. The deal date would be November 4'04 and the expiry date is February 28 (~116 days). Fixed Price Swap: $9.41Cap: Strike $9.41 Premium $0.82650% Participating Swap: Cap @ $10.03Based on my calculations, the Cap on the particpating Swap should be ~$9.83. Either i'm missing something in the calculation, or there is a siginifcant premium built in the quote. It's probably the former so any comments would be appreciated.

I think your logic is that a participation on half the notional is worth $0.826/2 = $0.413. The future value of that is about $0.42. Adding this to the execution price gives $9.41 + $0.42 = $9.83.That's a good calculation if the participation were triggered at $9.41. That is, the counterparty gets to buy half the notional at $9.83 and the other half at the lower of $9.41 or the market price. But the participation typically starts at the execution price, a cap at $9.83 should be worth about $0.65 instead of $0.826. So by this logic the swap is even more overpriced.I suspect the actual deal is the counterparty gets a put option at $10.03. That makes the price about right. A simple calculation gives $9.95 as the fair price, but that uses the at-the-money volatility. The smile could easily account for the extra $0.08.Without more information on the deal and the underlying, I can't say more.

Put option or Call option? It's a 50% participating swap to hedge against price increases, so wouldn't the participating swap be 50% units of a long fixed price swap and 50% units long cap (Calls)?Here are the deatails:Underlying notional is for 10000 units. The Dec'04 - Mar'05 forward strip is @ $9.41Quotes for Caps for Dec'04 - Mar'05 are:Strike: $9.41Premium: $0.826Strike: $10.09Premium: $0.60The Partcipating Swap is being offered at a Cap of $10.03, with 50% participation prices below $10.03.

So on half the notional you have a forward at $10.03 when the market price is $9.41, that amounts to paying $0.62 on 5,000 units.On the other half of the notional, you have a cap at $10.03. A cap at $10.09 sells for $0.60 so $0.62 seems close to a fair price on the $10.03 cap.