Arrears Swap: What It Means, How It Works

What Is an Arrears Swap?

An arrears swap is an interest rate swap that is similar to a regular, or plain vanilla swap, but the floating payment is based on the interest rate at the end of the reset period, instead of the beginning, and is then applied retroactively.

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 both sets the interest rate and pays later (in arrears). An arrears swap has several other names, including reset swap, back-set swap, and delayed reset swap. If the floating rate is based on London Interbank Offered Rate (LIBOR), then it is called a LIBOR-in-arrears swap.

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. The "in-arrears" structure was introduced in the mid-1980s to enable investors to take advantage of potentially falling interest rates.

An arrears swap is a strategy used by investors and borrowers who are directional on interest rates and believe they will fall. A key point is that the steepness of the yield curve plays a large role in pricing an arrears swap. As such, it 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 rewards (pays out) speculators based on the timeliness and accuracy of their predictions.

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 LIBOR plus a predetermined amount. LIBOR is the interest rate at which banks can borrow funds from other banks in the euro-currency market. Typically, all rates are predetermined before entering the swap agreement and, if applicable, at the start of subsequent reset periods until the swap matures.

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 another short-term rate, resets on each reset date. If the 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, three months in this example. 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.

For example, if an investor has a strong view that the LIBOR will fall over 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 enter an arrears swap agreement to receive LIBOR and pay LIBOR-in-arrears over the life of the contract. If their view is correct, then they will have profited from this transaction. It must be noted that, in this instance, both rates are floating.