What is an arrears swap?
An arrears swap is a type of interest rate swap. In an interest rate swap, two people or companies agree to exchange, or “swap,” interest payments. Usually, one side pays a fixed interest rate while the other pays a floating interest rate that can go up and down.
The critical aspect of arrears swaps is setting the floating interest rate. In a regular swap, the rate is set before payment. But in an arrears swap, the rate is set very close to when the payment needs to be made. This is called setting the rate “in arrears.”
How a regular swap works
Imagine two companies do a “vanilla” interest rate swap where they swap payments every 6 months:
- Company A agrees to pay a fixed rate of 5%
- Company B agrees to pay a floating rate based on LIBOR + 2%
The floating LIBOR rate changes constantly. Let’s say today is January 1st, and the next swap payment is due on June 30th.
In a normal swap, they look at the 6-month LIBOR rate on January 1st and add 2% to it. That becomes the floating rate Company B has to pay on June 30th.
So, Company B knows what interest rate it will pay. The rate is “set in advance” or “set forward”. If 6-month LIBOR on January 1st was 3%, then on June 30th:
- Company A pays 5%
- Company B pays 3% + 2% = 5%
The rates were set and locked in 6 months ahead of time. Even if LIBOR changes significantly between January and June, Company B still pays that 5% rate on June 30th.
How an arrears swap is different
In an arrears swap, the floating rate isn’t set so far ahead of time. Instead, it’s set very close to the payment due date, usually just a few days before.
Let’s use the same example as above. It’s an arrears swap, and today is still January 1st, with payment due June 30th.
This time, we don’t care what LIBOR is on January 1st. We just wait. When June rolls around, a couple of days before the 30th, we look up the LIBOR rate.
If 6-month LIBOR on June 28th is 4%, then on June 30th:
- Company A still pays that fixed 5% like always
- But now Company B pays 4% + 2% = 6%
The floating rate was set “in arrears” just a couple of days before payment was due, based on the latest LIBOR.
Why use arrears swaps?
Arrears swaps are less common than regular swaps, but they have some advantages in some instances.
Better matching of assets and liabilities
Some companies get income that’s based on floating rates set in arrears. For example, many corporate loans charge an interest rate of LIBOR + a spread, where the LIBOR rate is set right before each interest payment is due.
If that company borrows at a floating rate set in arrears and then does a regular swap where they pay fixed and receive a floating set in advance, there could be a mismatch. The company’s loan payments depend on LIBOR set in arrears, but their swap income depends on LIBOR set in advance. The two floating rates might not line up.
An arrears swap solves this. The company’s swap income is based on LIBOR set in arrears, matching their loan payments. Their floating-rate assets and liabilities are in sync.
Capturing the latest rates
Another advantage is that arrears swaps use the most up-to-date interest rates.
If a company thinks rates are going up, an arrears swap will let them benefit from those higher rates sooner. With a normal swap, they’re stuck with whatever the rate was six months ago, even if rates have risen significantly since then.
Potential accounting benefits
Arrears swaps can also have some accounting advantages. Under certain accounting rules, using arrears swaps can make it easier to match the timing of income and expenses for hedges, reducing earnings volatility.
Drawbacks of arrears swaps
While arrears swaps have benefits, they also have some disadvantages compared to regular swaps.
Less certainty on payments
The main drawback is more uncertainty. With a regular swap, you know precisely what payment you’ll make or receive. You can budget for it and plan around it, and there’s very little risk of a surprise.
With an arrears swap, you don’t know what the payment will be until right before it’s due. If rates move against you at the last minute, your payment could be much higher than expected, making cash flow planning harder.
Not as widely available
Arrears swaps are also less common than regular swaps. Not all banks or counterparties offer them, and there may be less liquidity and market depth.
Since they’re not the “standard” structure, more legal and operational work could be involved in setting up an arrears swap. The contracts may be less standardized.
Not a perfect hedge
While arrears swaps can better match assets or liabilities that also use rates set in arrears, it’s still not a perfect match. There’s often still a tiny mismatch of a few days.
For example, a company’s loan payments might be based on a 1-month LIBOR set 2 business days before the payment date. However, their arrears swap might use a 1-month LIBOR set 5 calendar days before the payment date. The rates will be very close but not the same. Some basis risk remains.
