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 the difference between ...6 Views
Finance allah shmoop what's the difference between a fixed and
a floating rate All right well we'll just start this
one out with your favorite time Donald and melania need
to borrow money to buy a building here's the history
of ten year t bill costs for the last few
decades Well rates were almost ten percent in the nineteen
seventies and then they fell all the way to being
almost free in two thousand eighteen Well if donald had
borrowed money nineteen eighty to buy a building with us
fixed rate he'd have had to pay about ten percent
interest for all this time That raid in nineteen eighty
was fixed and you know i'd be paying ten percent
for thirty five years very expensive rent on that money
It's not like a dog who can't you know have
pups different kind of fixed you know it's fixes in
he won't move Position is just a set number fixed
in place All right well donald would have overpaid massively
in his loans by paying ten percent interest when he
could have been paying seven percent here and four percent
here And maybe like two percent change here if the
loan he'd taken out in nineteen eighty was floating well
it would have floated downward along the way like that
Well most for floating loans have a preset set of
terms which move along with the rates of the fed
charges to loan money to banks who then mark up
the loans a bit and resell the money to really
borrowers like donald and kill you and me That is
the floating rate might be set at quote the average
federal funds rate plus ah hundred faces points over the
trailing six month period to be reset every month Unquote
Yeah something like that So in this case his rate
would have floated downward And obviously things can go the
other way as well Joe six pack it's a mortgage
for a home he can barely afford today Eight hundred
grand mortgage at four percent Well it cost him thirty
two grand a year to rent that money just the
interest and he has to make principal payments as well
So is total payments or something like forty grand a
year in year one of thirty Well if rates go
back up and they easily could and become say seven
Percent instead of that four percent a few years later
three four five years later Well then all of a
sudden his cost of renting that money goes from thirty
two grand a year in interest costs too something like
fifty or sixty grand a year in interest costs And
joe six pack because he didn't fix his raid at
that four percent figure when he borrowed it let things
float and well he ended up you know living in
his car when he couldn't afford paying The mortgage owns
home anymore and had to sell it And so yeah
he's living in his suv down by the river But 00:02:45.5 --> [endTime] luckily for him that suv floats
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