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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Accreting Principal Swap

What it is:

An accreting principal swap is a swap in which the two parties to the contract agree to pay interest on a growing principal amount.

How it works (Example):

In a swap, one party is reducing its exposure to risk while the other party is increasing its exposure to risk in the hopes of getting a higher return.

In most cases, the principal amount of the swap contract, also called the "notional principal" or the "notional amount" stays constant. But in an accreting principal swap, the notional principal grows throughout the life of the swap agreement.

For example, assume that Charlie owns a $1,000,000 investment that pays him LIBOR + 1% every month. As LIBOR goes up and down, the payment Charlie receives changes.

Now assume that Sandy owns a $1,000,000 investment that pays her 1.5% every month. The payment she receives never changes.

Charlie decides that that he wants to lock in a constant payment on his investment and Sandy decides that she wants to take a chance on receiving higher payments on her investment. So Charlie and Sandy agree to enter into an interest rate swap contract.

Under the terms of their contract, Charlie agrees to pay Sandy LIBOR + 1% per month on a $1,000,000 principal amount, and Sandy agrees to pay Charlie 1.5% per month on the $1,000,000 principal amount. [Click here to see the outcome of this example under different scenarios as explained in the interest rate swap definition.]

Charlie and Sandy also agree to make this an accreting principal swap, under which the $1,000,000 principal amount will increase automatically by $100,000 per year. So at the end of year one, the principal amount has grown to $1,100,000, and at the end of year two it's grown to $1,200,000, and so on.

Why it Matters:

An accreting principal swap is often entered into by growing companies in need of increasing amounts of capital. The accreting principal swap allows the company to either reduce or increase its exposure to changes in underlying interest rates as it increases the amount it is borrowing.