An interest rate swap which allows a firm to pay a fixed rate and receive a floating rate with an “option” to have the floating rate set either up front or in arrears. No doubt, the firm will choose to receive the more favorable rate, but in return for this option, it will have to pay a higher fixed rate than that in an ordinary swap. For example, if on the first reset date, the floating rate is 5%, while the arrears reset rate is 5.2%, a fixed rate payer in an arrears option swap, would prefer to receive 5.2%. As long as the floating rate is increasing over the life of the swap, the fixed rate payer is always at an advantage. But if the floating rate is relatively steady or stable over the term of the swap, the fixed rate payer would be worse off, having to pay more than in the first scenario.
Investors could also choose to receive higher fixed rate payments against giving a fixed rate payer the option to choose between setting the floating rate up front or in arrears. This strategy fits short term investment requirements and is advantageous (for the float rate payer) if short term floating rates are constant or declining.
The arrears option swap is also called a chooser swap.
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