Accrual swaps refer to a type of discrete time-switch option in which interests only accrue or build up on one side when some conditions are adhered to. They are a form of derivatives whereby interest is received and given out on one side under stipulations established through the level or range of the index rate. As such, this definition clearly points out that accrual swaps takes place between two parties. That is, the primary party is giving out the swap while the counter party is receiving the swap.
It is of essence to note that accrual swaps are perpetually entwined with the concepts of LIBOR (London Interbank Offered rate) or EURIBOR (Europe Interbank Offered Rate) reference rates. These are basically the interest rates at which financial institutions in the United Kingdom or the European Union lend money to one another, and payment of interest in the accrual swap is made when the reference rate is above or below a certain level.
There are several modes of accrual swaps that can be found in the foreign exchange market. First, is the range accrual swaps that are largely used by institutional traders and it refers to the accrual swaps wherein the coupon rate is earned only on a day when a different rate from the same coupon slips within a certain reference rate range. Second, callable range accrual swaps are accrual swaps, which can be either fixed rate accrual or floating rate accrual, and they provide the party giving out the accrual the choice of revoking the accrual swap on any coupon date following an initial period stipulated as the lock-out period. Lastly, binary accrual swaps are accrual swaps in which every additional potential for accrual is called off once the reference rate move out of the pre-defined range limits.
There are several advantages of investing in accrual swaps. Primarily, they endow investors with the choice of desisting from paying the principal amount in the loan deal. Further, they act as protective measures to shield both the parties from excessive exposure to the rise and fall of interest rates. Accrual swaps are also beneficial in assisting organizations access reduced interest rate payments on loans.
On the flipside, accrual swaps are a risky form of investment and one can lose a substantial portion of his or her investment when investing in them. This is because there is limited guarantee that the counter parties will be able to accomplish their initial obligations.