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.