A range accrual swap is similar to an interest rate swap, with the main difference being in how the interest rate paid by the range accrual leg is determined.
Unlike a regular swap where the floating rate is compared to the defined strike on a single fixing date in every payment period, in a range accrual swap the coupon of the range accrual leg (which can be either a fixed coupon or a floating coupon) is conditional on some event happening. That is, on how many days an observation rate (usually the LIBOR index) is within a predefined range, set using an upper and a lower barrier.
The actual interest rate used to calculated the payment on each payment date is then calculated as follows:
n/N * predefined rate
Where:
n is the number of fixing days in the payment period that the specified option rate (whether a defined fixed rate or a defined reference rate such as 3-month USD LIBOR) lies within a specified range.
The range can remain the same throughout the life of the swap, or it can be changed according to a preset schedule. For example, for a 2-year swap it can be 0-3.7% for the first year, and 1-3.7% for the second year.
N is the total number of fixing days in the payment period.
Predefined rate is either a fixed rate or an interest rate index.
So if the observation rate fixes within the predefined range on every fixing day in the monitoring (or accrual) period, then 100% of the predefined rate is paid out. If the observation rate fixes within the predefined range on half of the fixing days then only 50% of the predefined rate is paid out.
The observation rate is typically monitored on a daily basis within the coupon period, but it can also be monitored weekly or monthly.
In addition, you can also define a minimum coupon rate (defined either as a fixed percentage or as a floating rate) that is to be paid on the payment date. Having a defined minimum coupon rate means that if on the payment date the calculated interest rate is less than the minimum coupon rate set, you will then use the minimum coupon rate to work out the amount to be paid.
You can choose whether the rate of each of the legs is fixed or floating. If both legs are set to a floating rate, you will have to include a floating spread to ensure a preferable interest rate.
There are two styles of range accrual swap, the difference between them being in whether the swap can be terminated (or called). In a:
Non-callable style range accrual swap the swap cannot be called.
Bermudan style of range accrual swap (also known as a callable range accrual swap), one of the parties has the right but not the obligation to terminate the range accrual swap on any of the predefined fixing (or termination) dates during the life of the swap.
In a callable range accrual swap the right to cancel the swap early always belongs to the payer of the range accrual leg.
Typically a swap market maker or dealer will pay the range accrual leg, while an investor and/or bond issuer will receive the range accrual leg.
Advantages of a Range Accrual Swap
If you enter into a callable and non-callable range accrual swap, then the rate you receive or pay will be better than the rate set in the equivalent non-callable range accrual swap and of course the equivalent vanilla swap (especially as the probability that the underlying index will fix within the defined range decreases).
So if you are:
Receiving the rate determined by n/N * interest rate:
The fixed rate received will be higher than the market rate of the equivalent vanilla swap.
The floating rate will be enhanced by a spread to reflect the risk of fixing outside the range.
The preferential rates received are in exchange for the risk that the other party will cancel the swap at the time when the swap is most beneficial to you.
Paying the rate determined by n/N * interest rate:
The fixed rate paid will be lower than the market rate of the equivalent vanilla swap.
The floating rate payment will be reduced by a spread to reflect the risk of fixing outside the range.
Although there is no penalty for terminating the swap on any of the predefined dates, the rate you pay will be higher than that of a regular range accrual swap.
Pricing a Range Accrual Swap in SDX Interest Rates
When pricing a range accrual swap in SDX Interest Rates, in addition to the standard fields for a swap the following must also be defined:
The fixed rate or the floating coupon that the range accrual leg will pay for each fixing on which the observed interest rate falls between the specified barriers.
The observed index, which does not have to be the same index used for specifying the floating rate to be paid.
The observation frequency.
The high and low barriers between which the observed index must fall for interest to be paid for that day. In the Cash Flow and Dates page, you can edit the high and low barriers for each coupon individually.
Minimum coupon to be paid on each payment date.
Whether the range accrual swap is a Bermudan or non-callable style.
By default the system sets the call dates to match the start dates of the underlying coupons using the call frequency.
In the Callable Dates and Fees window (accessed by clicking the Call Dates button in the pricing page) you can then edit the notice dates, and also cancel any of the automatically scheduled call dates. For more information on working in this window, see Working in the Callable Dates and Fees Window.