Arrears Swap
We won't even get into funny alternatives for what "arrears swap" could mean, because suggestions would pretty quickly get either inappropriate or gross, even for Shmoop. So let's just move on to the actual definition...
A swap is a type of derivative contract where two parties agree to exchange different cash flows. We know that comes off as complicated, so here's a real-life example from a galaxy far, far away:
In the late 1970s, George Lucas was making Star Wars and Steven Spielberg was making Close Encounters Of The Third Kind. Things were going well for Spielberg, coming off the success of Jaws a few years earlier. Lucas was having trouble on Star Wars.
The two directors, who were close friends, were commiserating one day when the two decided to make the equivalent to a swap. Lucas would give Spielberg 2.5% of the Star Wars box office and Spielberg would give Lucas 2.5% of Close Encounters.
A deal like that represents the essence of a swap.
Most traders don't have classic movies to speculate with. Instead, in the day-to-day grind of business, swaps are used for things like currencies and interest rates.
So one company (Lucas Corp.) might offer a fixed interest rate (say 5%), while a second company (Spielberg Inc.) might offer a floating rate (say prevailing interest rates + 1%). In this swap, Lucas Corp. gets to play the interest market a little, hoping that the amount they are paying out is less than what they bring in. Meanwhile, Spielberg Inc. gets some stability, guaranteeing a certain income and lowering its exposure to changes in interest rates.
Okay, so much for swaps in general. On to the arrears swap.
The "arrears" part of the "arrears swap" simply refers to when the interest rate (like the one used in the example above) gets set. In an arrears swap, the rate sets in arrears, or behind (See: Arrearage for Nicki Minaj joke), meaning it gets set before the payment date, rather than in advance.
An arrears swap is often used to speculate about the direction of interest rates.
Related or Semi-related Video
Finance: What is Imputed Interest Rate?1 Views
Finance allah shmoop What is imputed interest rate Imputed guest
at or presumed based on x y and z that's
the foundation of an imputed interest rate and its chief
cheerleader Yep It's the i r s the tax people
those guys you just love to hear from Why Well
because taxes need to be collected Right We have pork
to buy for politicians Come on people Get with it
So we have a zero coupon bond here We bought
for five hundred bucks which comes do or pays off
in ten years for a thousand dollars on lee Remember
Zero coupon bonds don't pay any interest along the way
They just pay a one time end of period amount
which includes interest and principal The irs taxes Bondholders imputed
interest Yes like gains based on whatever interest rate is
imputed by the terms of the deal So in this
case remember that rule of seventy two thing so many
years to doubled about it into seventy two and all
that Yeah So in this case the money takes ten
years to double that's ten into seventy two paying seven
point two percent interest per year Compound it So the
irs would take as an imputed interest Five hundred box
times seven point two which is thirty six dollars of
taxable imputed interest games And they would take that each
year and you'd pay that each year on your taxes
So if you owned this bond and we're living in
a forty percent marginal tax bracket blue state which you
livin bitterly even though you got no cash interest from
this bond will you'd suffer a cash tax hit of
forty percent of thirty six or a bit under fifteen
dollars each year as you went along So that's the
bad news you pay the cash up front The good
news is that when the bond finally came do that
decade later for that grand well you have already paid
the taxes along the way And when taxes are already 00:02:01.504 --> [endTime] paid well we impute you'll be a happier camper
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