Accreting Principal Swap - Explained
What is an Accreting Principal Swap?
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Table of ContentsWhat is an Accreting Principal Swap?How does an Accreting Principal Swap Work?Illustration of an Accreting Principal SwapAcademic Research on Accreting Principal Swap
What is an Accreting Principal Swap?
An Accreting Principal Swap, variously known as accreting swap, accumulation swap, construction loan swap, drawdown swap, or step-up swap is an interest rate swap that involves an exchange of cash flows between two counterparties and that witnesses an increase in the notional principal amount over time. As a convention, an accreting swap is a fixed interest rate swap. However, there are circumstances where such an agreement involves a currency swap. The individual future cash flows that are swapped are known as legs and these are calculated at a fixed rate. Accreting Principal Swaps are most common in the construction industry as well as projects in which costs are expected to inflate during the course of the venture.
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How does an Accreting Principal Swap Work?
Growing businesses often enter into accreting principal swaps in order to increase their capital. Such swaps allow businesses to either increase or decrease their exposure to changes in underlying interest rates as they increase their borrowing amounts. Accreting principal swaps allow investors to set the cost of the funds in advance, while drawing down funds during certain periods of time. Since projections of cost often fluctuate over time, it becomes necessary for investors to match funding by way of swaps. In general, any swap involves the reduction of a partys exposure to risk and a corresponding increase in the other partys exposure to risk in lieu of potentially higher returns. Typically, the notional principal (which is the principal amount involved in the swap) remains constant. However, in the case of an accreting principal swap, the notional principal grows during the entire duration of the swap. A mainstay of the construction industry, accreting principal swaps allow construction companies to create a predictable structure for the interest costs of projects. Construction companies, as a rule, are able to assess future inflation in costs of key resources such as labour, construction materials and regulations pertaining to construction. Therefore, they need a reliable option at the very outset to finance those future funding requirements. Accreting principal swaps offer such companies the reassurance of getting access to a series of predictable future payments to offset the inflating costs of construction.
Illustration of an Accreting Principal Swap
Let us assume that company C1 owns an investment worth $1,000,000 that brings in payment in the form of LIBOR (short for London Interbank Offered Rate, a globally-accepted key benchmark interest rate) plus an additional 1% every month. Since LIBOR is susceptible to fluctuation, C1s monthly payment also tends to fluctuate. Suppose another company C2 owns a similar investment of $1,000,000 that brings in a fixed payment of 1.5% every month. Now, let us assume a scenario where company C1 wants to lock in a constant payment on its $1 million investment, whereas company C2 decides to attempt for potentially higher returns on its $1 million investment, notwithstanding the higher risks involved. Therefore, C1 and C2 decide to enter into an accreting principal swap contract. According to the terms of this new contract, C1 agrees to pay C2 LIBOR + 1% per month on the $1 million principal amount. Similarly, C2 agrees to pay C1 a fixed 1.5% per month on the $1 million principal amount. Since this is an accreting principal swap, the principal amount of $1,000,000 will increase by $100,000 every year. Therefore, the principal will increase to $1,100,000 at the end of the first year and $1,200,000 at the end of the second year, and so forth.