What is an arrears exchange?
An arrears swap is an interest rate swap that is similar to a regular or simple swap, but the floating payment is based on the interest rate at the end of the readjustment period, rather than the beginning, and then applied retroactively.
- An arrears swap is an interest rate swap in which the floating payment is based on the rate at the end, rather than at the beginning, of the readjustment period.
- The slope of the yield curve plays an important role in the price of an arrears swap.
- Speculators often use an arrears swap that attempts to predict the yield curve.
Understanding Arrears Swaps
A quick way to differentiate between a vanilla swap and an arrears swap is that the former sets the interest rate in advance and pays later (in arrears) while the latter sets the interest rate and pays later (in arrears). ). A backlog swap goes by several other names, including the reset swap, the back-set swap, and the deferred restart swap. If the floating rate is based on the London Interbank Offer Rate (LIBOR), then it is called a LIBOR lag rate swap.
The definition of “arrears” is money that is owed and should have been paid earlier. In the case of a late payment swap, the definition leans more toward calculating the payment than the payment itself. The “past due” structure was introduced in the mid-1980s to allow investors to take advantage of potentially falling interest rates.
An arrears swap is a strategy used by investors and borrowers who are directional in interest rates and believe they will fall. A key point is that the slope of the yield curve plays an important role in the price of an arrears swap. As such, it is often used by speculators trying to predict the yield curve. It is more suitable for speculating than a normal interest rate swap, as it rewards (pays) speculators based on the timeliness and accuracy of their predictions.
Swap transactions exchange cash flows from fixed-rate investments for floating-rate investments. The floating rate is generally based on an index, such as LIBOR plus a predetermined amount. LIBOR is the interest rate at which banks can borrow funds from other banks in the euro currency market. Generally, all rates are predetermined prior to entering into the swap contract and, if applicable, at the start of subsequent reset periods until the swap expires.
In a regular or simple swap, the floating rate is set at the beginning of the reset period and paid at the end of that period. For a late payment swap, the main difference is when the swap contract shows the floating rate and determines what the payment should be. In a vanilla swap, the floating rate at the beginning of the reset period is the base rate. In an arrears swap, the floating rate at the end of the adjustment period is the base rate.
Using an Arrears Exchange
The floating rate side of a vanilla, LIBOR, or other short-term swap, is reset on each reset date. If the three-month LIBOR is the base rate, the payment of the floating rate under the swap occurs in three months, and then the three-month LIBOR in effect at that time will determine the rate for the next period, three months in this example. For an arrears swap, the current period rate is set at three months to cover the period just ended. The rate for the second three-month period states six months in the contract, and so on.
For example, if an investor has a strong opinion that LIBOR will fall in the next few years and believes that it will be lower at the end of each reset period than at the beginning, then they can sign an arrears swap agreement to receive LIBOR. and pay back LIBOR during the term of the contract. If your opinion is correct, then you will have benefited from this transaction. It should be noted that, in this case, both types are floating.