DEFINITION of 'Arrears Swap'

An interest rate swap in which the floating payment is based on the interest rate at the end of the period. The payment is made at the end of the period, eliminating the time lag between setting the amount and paying it.

BREAKING DOWN 'Arrears Swap'

This type of swap is often used by speculators who attempt to predict the yield curve. It is better suited for speculating than a normal interest rate swap, since it allows speculators to receive payments that reflect the timeliness of their predictions.

For example, let's say speculators believe the current yield curve is too flat. They can purchase an arrears swap, which will pay them a floating payment each period. The fixed payment will be set to reflect the current market yield. If the speculators are correct and the yield curve steepens, they will receive a higher floating payment, while still making a relatively lower fixed payment.

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