DEFINITION of Accrual Swap
An accrual swap is a type of interest rate swap in which the interest on one side accrues only if certain conditions are met. Payment of interest in the accrual swap occurs if the reference rate, such as the London Interbank Offered Rate (LIBOR) or Euro Interbank Offer Rate (EURIBOR), is above or below a certain level. One party pays the standard floating reference rate and, in turn, receives the reference rate plus a spread. Interest payments to the counterparty will only accrue for days in which the reference rate stays within a certain range.
Most accrual swaps use one month, two month, six month or 12 month LIBOR for the reference rate, although accrual swaps can be done using treasury rates like the 10 year. The range itself must be determined in advance and may be fixed for the life of the swap. However, depending on the type and terms of the accrual swap, the rate range can be reset after set periods of time, usually on the coupon date. Accrual swaps are also referred to as corridor accrual swaps or range accrual swaps.
BREAKING DOWN Accrual Swap
An accrual swap is sometimes described as a combination of an interest rate swap and a pair of binary options that set a floor and a cap, as no interest accrues if the reference rate is above the cap or below the floor. Investors and companies utilizing accrual swaps are essentially betting that the reference rate will stay in a certain range. As long as the reference rate stays in the predefined range, interest is not accrued. The broader the lower floor and upper cap, the greater the chances that the reference rate will fall within this range.
Types of Accrual Swaps
Accrual swaps come in a variety of types that are tailored to the type of protection and exposure the two parties are looking for. A callable range accrual swap, for example, can be called on any coupon date by the party paying the accrual coupon after an initial lock-out period has passed. In a floating rate accrual swap, the reference range floats in that it is set anew at each accrual period, moving up or down with the reference rate. There are even one-touch accrual swaps - or binary accrual swaps - where any movement outside of the set range cancels all future accruals.
In addition to interest rate accrual swaps, there are other range bound derivatives that can use equity indexes, commodity prices and other reference rates in addition to interest rates. These trading products with wider or even multiple reference rates are usually referred to as range accruals.