LIBOR-in-Arrears Swap

What Is a LIBOR-in-Arrears Swap?

A LIBOR-in-arrears swap is like a customary or vanilla swap yet the floating rate side is set toward the finish of the reset period instead of the beginning. That rate is then applied retroactively.

The quick definition is that a vanilla swap sets the rate in advance and pays later (in arrears) while an arrears swap sets and pays later (in arrears).

This swap has several different names, including arrears swap, reset swap, back-set swap, and delayed reset swap.

Understanding a LIBOR-in-Arrears Swap

The LIBOR-in-arrears structure was introduced during the 1980s to empower investors to exploit possibly falling interest rates. It is a strategy utilized by investors and borrowers who are directional on the interest rates and who accept they will fall.

Swap transactions exchange the cash flows of fixed-rate investments for those of floating-rate investments. The floating rate is generally based on an index, like the London Interbank Offered Rate (LIBOR), plus a predetermined amount. Ordinarily, all rates set toward the beginning of the swap, and, if applicable, toward the beginning of subsequent reset periods until the swap develops.

The definition of "arrears" is money that is owed and ought to have been paid before. In the case of a LIBOR-in-arrears swap, the definition leans more toward the calculation of the payment, as opposed to the actual payment.

In a standard or plain vanilla swap, the floating rate is set toward the beginning of the reset period and paid toward the finish of that period. For an arrears swap, the major difference is the point at which the swap contract tests the LIBOR rate and determines what the payment ought to be. In a vanilla swap, the LIBOR rate toward the beginning of the reset period is the base rate. In an arrears swap, the LIBOR rate toward the finish of the reset period is the base rate.

As of December 2020, plans were in place to phase out the LIBOR system by 2023 and replace it with different benchmarks, for example, the secured overnight financing rate (SOFR).

Using a LIBOR-in-Arrears Swap

The floating rate side of a vanilla swap, in this case, LIBOR, resets on each reset date. In the event that the three-month LIBOR is the base rate, the floating rate payment under the swap happens in 90 days, and afterward the then-current three-month LIBOR will determine the rate for the next period. For an arrears swap, the current period's rate sets in 90 days to cover the period just ended. The rate for the second three-month period sets six months into the contract, etc.

Assuming an investor accepts that LIBOR will fall throughout the next couple of years and just needs to take advantage of this possibility then they anticipate that it should be lower toward the finish of each reset period instead of toward the beginning. The investor could enter a swap agreement to receive LIBOR and pay LIBOR-in-arrears over the life of the contract. Note, the two rates are floating, in this case.