How is the floating rate observed in an arrears swap?

In an arrears swap, the floating rate is observed only at the end of the period. This is a common feature of arrears swaps, wherein the payment is made based on the reference rate that is determined at the end of each payment period rather than at the beginning. This means that the counterparties do not know the exact floating rate they will be paying or receiving until the end of the period, which makes this structure distinct from other types of swaps where rates are established at the start.

The concept behind this is that during the period, the market interest rates can fluctuate, and the final rate is only known when the period concludes. Consequently, the party paying the floating rate does not have clarity on their payment until that end point approaches, which adds a dimension of risk associated with interest rate movements during the period of the swap.

In contrast, the other options don't accurately describe how floating rates function in arrears swaps, as they either suggest that the rates are locked in at the beginning, or are implied to have a fixed nature for the duration of the swap, neither of which aligns with the characteristics of an arrears structure.