What does Arrears Swap mean?
An interest rate swap in which the floating payment is based on the time-sensitive interest rate at the end of the period. The payment is made at the end of the time period, which eliminates the time lag between setting the amount and paying it.
Futures Knowledge Explains Arrears Swap
An interest rate swap with a floating interest rate that is set in arrears rather than in advance. For example, the rate may be set two days before payment date, rather than six months in advance. This type of interest rate swap is preferred over a normal interest rate swap for speculation. Speculators use their skill to predict the yield curve. Speculators get payments that reflect the timeliness of their predictions.
Suppose you believe the yield curve, which is flat, is likely to steepen. You can purchase an arrears swap, which will pay you a floating payment each period. The fixed payment will be set to reflect the current market yield. If you prediction comes true, you will receive a higher floating payment, while still making a relatively lower fixed payment.