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 a swap, and what is a s...50 Views
Finance allah shmoop what is a swap And what is
a swap Shin Um can we just say it's an
option to swap You know like microsoft is a micro
computer software thing or like the electrocution is electricity and
execution or the bromance is you know brother and romance
which is something totally different when dealing with gerbils Anyway
one day a guy was holding a swap turned a
corner wasn't looking where he was going then glam o
he ran into an option What came of it was
a super hybrid type of security were in a slop
like i swap you so many dollars for so many
euros is tacked onto an option You want the ability
to pay off your loan either in us dollars or
in euros assuming they still exist when your loan comes
due That whole brexit thing that issue have the option
to swap the flavor of payments you're making for the
hundred grand You borrowed no it's houses play out well
When the bond was issued one dollar bought you one
euro and the interest rate was eight percent So you
paid eight grand a year to rent that hundred for
ten years at which point you're going to pay it
all off simple but after five years the exchange rates
have drifted massively Magic fairy dust was sprinkled by wizards
all over europe They beat back the thirty two hour
work week Corruption unions and economic misery wrought by not
being able to compete with china russia in africa and
now amazingly the euro is a much stronger currency than
the u s dollar that's kind of a fictional story
here that we'll make enough In fact one euro buys
you two u s dollars like it when the euro
was first put out there So if you holding the
swap shin on the interest payment flavor of the hundred
grand you borrowed if you so choose you can pay
that eight grand in euros that is instead of the
eight thousand dollars a year in interest you can pay
for thousand euros It's almost a ziff your interest rate
was cut in half That's not really it's a value
is the same it's just the number of units were
cut have theirs You know that works And if you
live in europe and work in europe and we're paid
in euros Well it really is like a roman holiday
of interest rates of just want to focus on the
numbers But the values of the same there's No free 00:02:15.938 --> [endTime] lunch here even in swap shen lang
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