What it means
In an ordinary interest rate swap, two parties swap a fixed rate for a floating rate on an agreed notional amount (the sum used to calculate payments, which is never exchanged). The floating rate is normally set at the beginning of each period and paid at the end, which is known as setting in advance.
In an arrears swap, the rate is observed and paid at the end of the same period, so the payment depends on where rates are when the period closes. This change matters because it affects pricing.
A rate set in arrears has an extra element of uncertainty, because its payment timing and the rate level are tied together. Traders adjust the fixed rate for what is called a convexity adjustment, a small correction that reflects the way the payment value moves with rates.
Companies might use an arrears swap to match a cash flow that is itself set in arrears, such as a loan where interest is based on the rate prevailing at the end of the period. They might also use it to express a view on how rates will move during the period.
It is a specialised product and is mainly used by banks, corporate treasuries and hedge funds. The risks are similar to those of any swap, namely market risk and counterparty risk (the chance that the other side does not pay).
The exposure is also less intuitive than for a standard swap, so a business should model it carefully before trading. Valuation usually relies on a bank's pricing model, and the result can differ between providers.
For a non-specialist, the key idea is simple. The floating rate is not known until the end, so the amount that changes hands is only known when it is due.
Because the product is specialised, many companies ask an independent adviser or their auditor to review the pricing before they trade. The questions to ask include how the convexity adjustment was calculated, which model was used and how the swap will be valued at each reporting date.
Clear answers help the finance team explain the position to the board and to lenders.
In practice
Real-world examples.
Example
A property company has a loan whose interest rate resets using a rate observed at the end of each quarter. Its treasurer enters an arrears swap on $20,000,000 so that the swap payments follow the same timing as the loan. This removes a mismatch between the loan and the hedge.
Example
A trading desk at an investment bank believes short-term rates will rise sharply within the coming quarter. It enters an arrears swap as the floating receiver to benefit if that happens. If rates stay flat, the trade makes little money.
Example
A pension fund analyst reviews a derivative contract and finds the floating leg is set in arrears. She asks the bank to confirm the convexity adjustment, because it affects the fixed rate the fund is being quoted. She also asks how the swap will be valued at each reporting date.
Formula
Calculation
Net payment = Notional x (Floating rate set at period end - Fixed rate) x Period length in years
Suppose a company pays fixed at 4.00% and receives floating on a notional of $10,000,000, with quarterly periods. At the end of one quarter the floating rate is observed at 4.60%. Net payment received = 10,000,000 x (0.0460 - 0.0400) x 0.25 = 10,000,000 x 0.006 x 0.25 = $15,000. In a standard swap the rate would have been set at the start of the quarter, for example at 4.20%, giving 10,000,000 x 0.002 x 0.25 = $5,000. The difference arises because the arrears swap reflects the rate that applies at period end.Case study
Seen in the real world.
Marlowe Shipping is an illustrative, fictional company with a $50,000,000 fleet loan on which interest is based on the floating rate prevailing at the end of each six-month period. Its treasurer wanted to hedge the exposure but found that a standard swap set rates at the start of each period, leaving a gap.
The treasurer asked two banks to quote an arrears swap with the same timing as the loan. The quotes differed by 0.04% on the fixed rate, which on a $50,000,000 notional is worth roughly $20,000 a year, so the company chose the cheaper bank after confirming the convexity adjustment it used.
The hedge worked as intended in this illustrative case, but the treasurer also warned the board that the accounting and valuation of the swap were more complex than for a plain product. The board approved the hedge on the condition that the treasurer would report its fair value and the net payments to the audit committee each quarter.
Watch out
Common mistakes.
- Assuming an arrears swap is the same as a standard swap, when the timing of the rate setting changes how the contract is priced.
- Ignoring the convexity adjustment, which can make a quoted fixed rate look cheaper or dearer than it really is.
- Believing the notional amount is exchanged, when only the net interest difference moves between the parties.
Questions
People also ask.
Why is it called an arrears swap?
Because the floating rate is set in arrears, meaning at the end of the period to which it applies, rather than at the start.
Who uses arrears swaps?
Mostly banks, corporate treasuries and hedge funds that need to match a rate set in arrears or want to take a view on rates.
Is it riskier than a standard swap?
It can be harder to value and hedge, so it requires more careful modelling, though the basic risks of rate movement and counterparty failure are the same.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related