What is an Arrears Swap
An arrears swap is similar to a regular or vanilla swap but the floating rate side is set at the end of the reset period, instead of the beginning. That rate is then applied retroactively.
The quick definition is that a vanilla swap sets the rate in advance and pays later (in arrears) while an arrears swap sets and pays later (in arrears).
This swap has several other names including reset swap, back-set swap and delayed reset swap. If the floating rate is based on LIBOR then it is called a LIBOR-in-arrears swap.
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.
The "in-arrears" structure was introduced in the mid-1980s to enable investors to take advantage of potentially falling interest rates. It is a strategy used by investors and borrowers who are directional on the interest rates and who believe they will fall.
Swap transactions exchange the cash flows of fixed rate investments for those of floating rate investments. The floating rate is usually based on an index, such as the London Interbank Offered Rate (LIBOR) plus a predetermined amount. LIBOR is the interest rate at which banks can borrow funds from other banks in the Eurocurrency market. Typically, all rates set at the start of the swap, and, if applicable, at the start of subsequent reset periods until the swap matures.
The definition of "arrears" is money that is owed and should have been paid earlier. In the case of an arrears swap, the definition tilts more towards the calculation of the payment, rather than the payment itself.
In a regular or plain vanilla swap, the floating rate is set at the start of the reset period and paid at the end of that period. For an arrears swap, the major difference is when the swap contract samples 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 reset period is the base rate.
Using an Arrears Swap
The floating rate side of a vanilla swap, LIBOR or some other short-term rate, resets on each reset date. If three-month LIBOR is the base rate, the floating rate payment under the swap occurs in three months, and then the then-current three-month LIBOR will determine the rate for the next period. For an arrears swap, the current period's rate sets in three months, to cover the period just ended. The rate for the second three-month period sets six months into the contract, and so forth.
If an investor believes that LIBOR will fall over the next few years and only wants to exploit this possibility. He/she necessarily expects it to be lower at the end of each reset period than at the beginning. The investor could enter a swap agreement to receive LIBOR and pay LIBOR-in-arrears over the life of the contract. Note, both rates are floating, in this case.
The steepness of the yield curve plays a large role in pricing.