What Is 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 is above or below a certain level. A reference rate is the benchmark interest rate against which other interest rates are pegged.
- An accrual swap is a kind of interest rate swap banks, corporations, and investors use to hedge against loss, earn interest, and manage risk.
- An investor in an accrual swap is betting that a benchmark interest rate will stay within a specified range.
- Accrual swaps come in a variety of types designed to provide the parties with a specific type of protection or exposure.
- Types of accrual swaps include callable range accrual swaps, floating rate accrual swaps, and binary accrual swaps.
Understanding Accrual Swap
Parties in an accrual swap will commonly use the London Inter-bank Offered Rate (LIBOR) or Euro Inter-bank Offer Rate (EURIBOR) as their reference rates. Accrual swaps are also referred to as corridor accrual swaps or range accrual swaps.
The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one-week and two-month USD LIBOR after Dec. 31, 2021. All other LIBOR will be discontinued after June 30, 2023.
In an accrual swap, 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. Financial institutions, corporations, and investors will use interest rate swaps to manage credit risk, hedge potential losses, and earn interest through speculation. Accrual swaps are derivative contracts that trade in the over-the-counter (OTC) market.
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 other rates, such as the 10-year treasury rate. The counterparties involved in the accrual swap must determine the range in advance and the range 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, which is the date on which a holder will receive an interest payment.
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 kind of protection and exposure the two parties are seeking to achieve.
Callable Range Accrual Swap
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 essence, the party paying the coupon has the right (but not the obligation) to cancel or call back the swap to end the contract before the expiration date.
Floating Rate Accrual Swap
For many accrual swaps, the coupon rate remains fixed for the life of the swap. However, in a floating rate accrual swap, the reference range floats. It is set anew at each accrual period, moving up or down with the reference rate.
Binary Accrual Swaps
There are even one-touch accrual swaps—or binary accrual swaps—where any movement outside of the set range cancels all future accruals. For instance, the range will consist of a binary cap and floor. If the interest rate goes beyond the cap, then no payment will be made.
In addition to interest rate accrual swaps, there are other range-bound derivatives that can use equity indexes, commodity prices, and other reference rates. These trading products with wider or even multiple reference rates are usually referred to as range accruals.
A disadvantage of accrual swaps is that they can be complicated to set up and require knowledge about interest rate movements. However, they do allow large financial institutions and corporations a valuable opportunity to manage debt and risk.
Private parties interested in using interest rate swaps will often use the plain vanilla swap, which is the most basic type of swap where an investor will exchange a fixed interest rate for a floating interest rate, or vice versa. Investors can trade these swaps in the over-the-counter (OTC) market. An interest rate swap is just one type of plain vanilla swap; others include commodity swaps and foreign currency swaps.