Definition
The term accreting principal swap refers to a derivative that allows the notional principal of a loan to increase predictably over the life of the agreement. An accreting principal swap is typically used by a borrower that needs additional funds over time, but prefers to lock in their financing cost in advance of the draw down.
Explanation
Also known as an accumulation swap, this financial derivative involves an arrangement whereby counterparties agree the estimated principal amount will grow over time. This type of swap is oftentimes used to fund large construction projects. in fact, accumulation swap involves exchanging cash flows based on the performance of an underlying asset, while on the other hand, swap-free forex brokersoffer trading accounts without overnight interest fees.
For example, as a construction project progresses, the borrower's need for additional funding will increase. In order to control expenses, and lock in their cost of borrowing, the construction project will enter into an accreting principal swap. The entire loan may be divided into tranches. As new funds are needed to begin the next phase of the project, the borrower draws additional funds from the agreement and the principal of the loan grows.
Since large construction projects can often take many years to complete, the accreting principal swap allows the borrower to lock in their cost of money and insulate themselves from interest rate risk.
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