Accrual Swap - Explained
What is an Accrual Swap?
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Table of ContentsWhat is an Accrual Swap?How does an Accrual Swap Work? Types of Accrual SwapUses of Accrual SwapThe Bottom Line Academic Research on Accrual Swap
What is an Accrual Swap?
The accrual swap refers to a type of interest rate swap where interest accrues and is paid to one counterpart (one side) as long as the reference rate stays within the determined index rate range. In this kind of rate, one counterpart meets the cost of the standard floating reference rate, and he or she gets the reference rate with the addition of a spread. Interest payment for counter counterpart accrues for days only if the reference rate remains with a predetermined range. Other terms used to refer to an accrual swap include range accrual swaps or corridor accrual swap.
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How does an Accrual Swap Work?
Accrual swaps use different time intervals such as a month, two months, six months or even twelve months London Interbank Offered Rate (LIBOR) for the reference. However, the ten years period is also applicable when treasury rates are used. Note that the range must always be predetermined and in some cases, it may be permanently fixed throughout a swaps life. Nonetheless, this does not mean that the reference rate cant be reset. It can be reset but depending on various swap factors such as the kind of the accrual swap as well as the accrual swaps terms one is dealing with. The resetting is done at a fixed date though in most cases, it takes place during the coupon date.
Types of Accrual Swap
- Binary accrual swaps
The binary accruals swaps refer to binary cap and binary floor. The two are financial instruments used by investors to offset any unfavorable investment risk resulting from price movement. Besides accrual swap having an element of interest rate swap, it is also binary in nature as it includes a set of binary options. The price movement, in this case, can be upward or downward. The binary cap and floor, therefore, help investors to guard against unfavorable up and down price movement that is likely to affect their investment. For instance, if the interest rate happens goes higher beyond the floor, payment will be initiated. On the other hand, if the rate of interest passes the cap, then payment will not be necessary. In other words, any price movement that does not stay within the preset range annuls any accruals in the future. This means that in accrual swap, payment may or may not be paid depending on the binary prevailing circumstance. The best way an investor may use the binary option to offset the risk of price movement is to invest in two bonds which are negatively associated.
- A callable range accrual swap
In this type of an accrual swap, one of the parties paying the accrual coupon is given the right with no obligation to revoke the swap. The cancellation of the swap can be done on any given coupon date but usually before the deadline period. Note that it is only the party with the obligation to pay the range accrual leg that has the right to cancel the swap before maturity. Also, this swap pays the purchaser a coupon that accrues only if a preset index is able to meet a specific condition that is decided on the trading date. This means that the payment can only be done if the preset index meets the conditions put in place. Generally, the accrual swap awards the investor a higher coupon which makes it popular. This is so because, when the cap moves to a high level, it increases the likelihood of the index moving beyond the range. This, therefore, results in an investor getting a high coupon. Similarly, when the range narrows, the coupon becomes larger.
- Fixed rate accrual swap
Fixed rate accrual swap refers to where the payoff of a fixed accrual coupon is dependent on the length of time the reference rate stays within a set range. In this case, the accrual coupon rate remains fixed throughout a swaps life.
- Floating rate accrual swap
Floating rate accrual swap represents a reference rate which is not stable. Meaning, that the reference rate does not stay in the required preset range. Due to its floating habit, a fresh reference rate is put in place whenever the accrual time is reached. This ensures that they move alongside each other during the reference rate movement.
Uses of Accrual Swap
An accrual swap may be used in the following two ways:
- For investment purposes
- For liability management purposes.
The Bottom Line
Generally, the investors and the firms who make use of accrual swaps are usually optimistic that the reference rate will remain in a given range. According to them, the wider the binary floor and upper cap is, the better. When it is wide, it enables the reference rate to stay within the range. This way there will be no accrued interest.