In-Arrears Swaps
In-arrears swap
Also known as a delayed reset swap, an in-arrear swap is an interest rate fixed for floating swap that has its floating leg that pays at the regular payment date a rate that has just reset (usually that has reset two business day ago for Euro JPY and USD swap and that has just reset for GBP swap). In the case of swap paying every six months, the reset rate at the payment date would be fixed six months and two days ago in a regular swap only two days ago in the in-arrear version. In an in-arrear, since the reset rate paid is not paid after its reference period as in a standard swap, the floating leg cannot be valued as the sum of the forward Libors but has to take into account the volatility of the forward rates via an adjustment called the convexity correction. We will give more details when examining the pricing of in-arrear swaps.
MARKETING OF IN-ARREAR PRODUCTS In-arrear swaps are popular products in a steep yield curve environment to a fix rate receiver who thinks that short term rates will not rise as fast as the yield curve predicts, pocketing up the difference between the fix rate of the standard swap and the one of the in-arrear swap known as the pick up, while still paying low Libor resets.
Usually, clients (corporates or financial institutions) receive fix and pay floating. In a steep yield curve environment, because of the delayed resets, an in-arrear swap has a fixed coupon much higher than the corresponding swap, making it attractive. It can be as high as 50 basis points in certain situation. If
the investor/trader thinks that rates will not rise as fast as the yield curve predicts, in an-in arrear swap, he will monetize the difference between the expected rise of the short term rates (reflected by the high fixed rate) and the real movements of these rates.
PRICING The pricing can be done either by using standard arguments of forward neutral pricing measure or by using static replication with a set of caplets. Let us
Also known as a delayed reset swap, an in-arrear swap is an interest rate fixed for floating swap that has its floating leg that pays at the regular payment date a rate that has just reset (usually that has reset two business day ago for Euro JPY and USD swap and that has just reset for GBP swap). In the case of swap paying every six months, the reset rate at the payment date would be fixed six months and two days ago in a regular swap only two days ago in the in-arrear version. In an in-arrear, since the reset rate paid is not paid after its reference period as in a standard swap, the floating leg cannot be valued as the sum of the forward Libors but has to take into account the volatility of the forward rates via an adjustment called the convexity correction. We will give more details when examining the pricing of in-arrear swaps.
MARKETING OF IN-ARREAR PRODUCTS In-arrear swaps are popular products in a steep yield curve environment to a fix rate receiver who thinks that short term rates will not rise as fast as the yield curve predicts, pocketing up the difference between the fix rate of the standard swap and the one of the in-arrear swap known as the pick up, while still paying low Libor resets.
Usually, clients (corporates or financial institutions) receive fix and pay floating. In a steep yield curve environment, because of the delayed resets, an in-arrear swap has a fixed coupon much higher than the corresponding swap, making it attractive. It can be as high as 50 basis points in certain situation. If
the investor/trader thinks that rates will not rise as fast as the yield curve predicts, in an-in arrear swap, he will monetize the difference between the expected rise of the short term rates (reflected by the high fixed rate) and the real movements of these rates.
PRICING The pricing can be done either by using standard arguments of forward neutral pricing measure or by using static replication with a set of caplets. Let us