Forex Investment and Currency Trading

Description

An In Arrears Swap is an Interest Rate Swap where the fixing of one floating leg occurs at the end of each period, usually 0,1, or 2 business days before the payment date depending on the currency convention. This is a common variation on the vanilla Interest Rate Swap, which re-fixes the floating rate at the beginning of the period, like a conventional bank loan. In arrears Swaps are also known as Delayed Swaps.

Application

The “arrears” feature enables a company to monetize a view that short term rates will not increase to the extent implied by the yield curve. In this example, the company uses an In Arrears Swap to pay a lower margin over 6 month JPY LIBOR, by pushing their fixing rate further along the curve.

• The company will pay 6 month JPY LIBOR set in arrears plus 21bp, and receive 6 month JPY LIBOR set in advance plus 40bp – the arrears feature is thus worth 19bp per annum as an initial benefit.
• Put simply, the difference between each two consecutive 6-month JPY LIBOR forward interest rate is, on average, expected to be 19bp over the term of the swap.
• The company will benefit from this hedge if the pace of any rise in 6 month JPY LIBOR is slower than predicted by the market over ach fixing period; it will lose if the 6 month JPY LIBOR increases at a faster pace than that expected by the market on the trade date.
• The effect of the change in the fixing mechanism is particularly relevant in a steep curve environment since it can create a significant difference in the rate paid by the company (a “positive carry”) – the steeper the curve, the higher the initial (and the potential) benefit relative to a vanilla swap.
• Similarly, the benefit will usually increase with the tenor of the observation index (e.g. usually 12 month LIBOR > 6 month LIBOR > 3 month LIBOR) and with higher cap volatilities, due to higher convexity adjustment.

Variations

• An In Arrears Swap can have either two floating legs, as in this example, or one fixed leg vs an in arrears floating leg.
• Most basic interest rate derivatives can be adjusted to include an in-arrears fixing mechanism.
• “Quanto Swaps” (where the payment currency is different from the currency of the underlying index) are often structured to include an in arrears feature. This transfers some benefit from a steep curve in one market to a flatter curve in another market.