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Accreting Principal Swap Definition
An Accreting Principal Swap, variously known as accreting swap, accumulation swap, construction loan swap, drawdown swap, or step-up swap is an interest rate swap that involves an exchange of cash flows between two counterparties and that witnesses an increase in the notional principal amount over time. As a convention, an accreting swap is a fixed interest rate swap. However, there are circumstances where such an agreement involves a currency swap. The individual future cash flows that are swapped are known as legs and these are calculated at a fixed rate. Accreting Principal Swaps are most common in the construction industry as well as projects in which costs are expected to inflate during the course of the venture.
A Little More on What is Accreting Principal Swap
Growing businesses often enter into accreting principal swaps in order to increase their capital. Such swaps allow businesses to either increase or decrease their exposure to changes in underlying interest rates as they increase their borrowing amounts. Accreting principal swaps allow investors to set the cost of the funds in advance, while drawing down funds during certain periods of time. Since projections of cost often fluctuate over time, it becomes necessary for investors to match funding by way of swaps.
In general, any swap involves the reduction of a party’s exposure to risk and a corresponding increase in the other party’s exposure to risk in lieu of potentially higher returns. Typically, the notional principal (which is the principal amount involved in the swap) remains constant. However, in the case of an accreting principal swap, the notional principal grows during the entire duration of the swap.
A mainstay of the construction industry, accreting principal swaps allow construction companies to create a predictable structure for the interest costs of projects. Construction companies, as a rule, are able to assess future inflation in costs of key resources such as labour, construction materials and regulations pertaining to construction. Therefore, they need a reliable option at the very outset to finance those future funding requirements. Accreting principal swaps offer such companies the reassurance of getting access to a series of predictable future payments to offset the inflating costs of construction.
Illustration of an Accreting Principal Swap
Let us assume that company C1 owns an investment worth $1,000,000 that brings in payment in the form of LIBOR (short for London Interbank Offered Rate, a globally-accepted key benchmark interest rate) plus an additional 1% every month. Since LIBOR is susceptible to fluctuation, C1‘s monthly payment also tends to fluctuate.
Suppose another company C2 owns a similar investment of $1,000,000 that brings in a fixed payment of 1.5% every month.
Now, let us assume a scenario where company C1 wants to lock in a constant payment on its $1 million investment, whereas company C2 decides to attempt for potentially higher returns on its $1 million investment, notwithstanding the higher risks involved. Therefore, C1 and C2 decide to enter into an accreting principal swap contract.
According to the terms of this new contract, C1 agrees to pay C2 LIBOR + 1% per month on the $1 million principal amount. Similarly, C2 agrees to pay C1 a fixed 1.5% per month on the $1 million principal amount.
Since this is an accreting principal swap, the principal amount of $1,000,000 will increase by $100,000 every year. Therefore, the principal will increase to $1,100,000 at the end of the first year and $1,200,000 at the end of the second year, and so forth.
References for Accreting Swap
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Swaps: Plain and fanciful, Litzenberger, R. H. (1992). Swaps: Plain and fanciful. The Journal of Finance, 47(3), 831-850.The outstanding face amount of plain vanilla interest rate swaps exceeds two trillion dollars. While pricing and hedging of such swaps appear to be quite simple, many existing theories are based on the incorrect characterization of a swap as a simple exchange of a fixed for a floating rate note. This characterization is not consistent with standardized swap contracts and the treatment of swaps in bankruptcy. This paper provides an alternative perspective on swaps.
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A perspective on credit derivatives, Batten, J., & Hogan, W. (2002). A perspective on credit derivatives. International Review of Financial Analysis, 11(3), 251-278.This contribution offers an explanation of credit derivatives as a group of financial instruments having a common purpose being the managing of credit exposures, and thus credit or default risk. This paper explores the links between their economic and financial manifestations and the legal bases for their widespread application. To ensure an understanding of the purposes served by each of the main types of credit derivatives, a detailed scrutiny of individual instruments is undertaken. Issues relating law and economics to trading in this type of derivative are investigated, then pricing issues and empirical evidence are considered. A summary brings together the range of features bearing upon the effective development of a market in these financial instruments.
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The Derivative Products, Shaik, K. (2014). The Derivative Products. In Managing Derivatives Contracts (pp. 21-57). Apress, Berkeley, CA.This chapter surveys at a high level the products traded on the derivatives market outlined in Chapter 1.
IMMUNIZATION The process of protecting an INTEREST RATE-sensitive PORTFOLIO from future market movements so that a future, Banks, E. (2005). IMMUNIZATION The process of protecting an INTEREST RATE-sensitive PORTFOLIO from future market movements so that a future.
Interest Rate Risk Derivatives and Their Use in Managing Financial Risk, Cooper, R. (2004). Interest Rate Risk Derivatives and Their Use in Managing Financial Risk. In Corporate Treasury and Cash Management (pp. 209-237). Palgrave Macmillan, London.An interest rate swap is a legal arrangement between two parties to exchange interest rate payments or receipts on a notional principal amount, for a specific period of time. The interest obligations are in the same currency. There is no exchange or payment of principal under an interest rate swap.
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Swaps, Choudhry, M., Joannas, D., Pereira, R., & Pienaar, R. (2005). Swaps. In Capital Market Instruments (pp. 329-357). Palgrave Macmillan, London.Swaps are off-balance sheet instruments involving combinations of two or more basic building blocks. Most swaps involve combinations of cash market securities, for example a fixed interest rate security combined with a floating interest rate security, possibly also combined with a currency transaction. The market has also seen swaps that involve a futures or forward component, as well as swaps that involve an option component. The main types of swap are interest rate swaps, asset swaps, basis swaps, fixed-rate currency swaps and currency coupon swaps.