What it means
Many financial deals are packages of two or more linked parts. An interest rate swap has a fixed leg, where one party pays a set rate, and a floating leg, where the other pays a rate that resets with the market.
An options spread has a long leg, which is bought, and a short leg, which is sold. Breaking a position into legs makes it easier to price, record and manage.
Each leg has its own cash flows, risks and accounting treatment, and the profit or loss on the whole position is simply the sum of the profit or loss on each leg. Traders use the word freely, so a two-legged trade or a four-legged strategy tells you how many parts are involved.
Legs also affect how risk is understood. A strategy such as a spread is designed so that the legs offset one another, limiting the maximum loss.
If one leg is removed, the remaining leg may leave the holder with a larger and different exposure than intended. In corporate finance and treasury, the term appears when a company swaps debt from a fixed to a floating rate or hedges a foreign currency exposure with a forward contract.
In a currency swap, for example, one leg is in dollars and the other in another currency. Finance teams track each leg separately for valuation, collateral and disclosure.
The word has other uses that are worth knowing. In a syndicated or staged deal, a leg may mean a stage, such as the first leg of an investment, and in markets it can also describe a move within a trend, such as the second leg of a rally.
The context always makes clear which meaning is intended.
In practice
Real-world examples.
Example
A treasurer wants to turn floating-rate debt into fixed-rate debt and enters an interest rate swap. One leg pays the fixed rate and the other receives the floating rate. The two legs together fix the net interest cost.
Example
An options trader buys a call option at one strike price and sells a call at a higher strike price. The two legs form a bull call spread with limited loss and limited gain. The risk manager reports the position as a single two-leg strategy.
Example
A manufacturer hedges a euro receivable with a currency swap. The manufacturer uses a foreign exchange swap, where the near leg exchanges euros for dollars today and the far leg reverses the exchange on the date the receivable is due. Finance records both legs in its hedge accounting.
Formula
Calculation
Net swap payment = fixed leg payment - floating leg payment. Position profit or loss = sum of the profit or loss on each leg
A company has an interest rate swap on a notional amount of $10,000,000, paying fixed at 4% and receiving floating, which is currently 3.5%, with quarterly settlements. The fixed leg payment is $10,000,000 x 4% / 4 = $100,000. The floating leg payment is $10,000,000 x 3.5% / 4 = $87,500. The net payment is $100,000 - $87,500 = $12,500 from the company to its counterparty for that quarter, and over a full year at these rates the net would be 4 x $12,500 = $50,000.Case study
Seen in the real world.
Kingfisher Marine Supplies is an illustrative, fictional company with a $20,000,000 floating-rate loan that worried its board. The treasurer arranged a swap in which Kingfisher paid fixed at 5% and received floating, so the floating leg of the swap matched the loan interest and cancelled it out.
In the first year, floating rates rose from 4% to 6%. The loan interest cost went up by about $400,000, but the swap's floating leg paid Kingfisher the same extra amount, leaving it paying only the fixed 5% overall. The illustrative lesson is that understanding each leg shows how the pieces combine to remove a risk.
Watch out
Common mistakes.
- Looking at one leg alone and judging the gain or loss, when the legs are designed to be assessed together.
- Forgetting that each leg may have its own counterparty, credit risk and accounting treatment.
- Assuming the number of legs shows how risky a strategy is, when some multi-leg strategies are used precisely to reduce risk.
Questions
People also ask.
What is a two-legged trade?
It is a transaction made of two linked parts, such as buying one asset and selling another, or the two sides of a swap.
What are the legs of an interest rate swap?
They are the fixed leg, where one party pays a fixed rate, and the floating leg, where the other party pays a rate that changes with the market.
Can a leg be traded on its own?
Often yes, but doing so changes the risk of the position, which is why traders talk about legging in and legging out.
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