What is an absolute rate?

By Chizoba Morah AAA
A:

An absolute rate is easy to understand once you know the basics of an interest rate swap. An absolute rate is the fixed rate portion of an interest rate swap. Interest rate swap is an agreement between two parties to exchange or "swap" interest payment on loans. The most popular form of interest rate swap is the fixed to floating rate swap. (To learn more on this concept, be sure to read An Introduction To Swaps.)

Fixed to floating rate swap is when one party with fixed interest payments, swaps with another party that has floating or variable rate interest payments. Companies engage in interest rate swap as a way to minimize interest rate risk (risk that might occur due to interest rate fluctuations).

The absolute rate is expressed as a fixed percentage and not as a premium or discount to a reference rate. Reference rates are usually based on a moving index like LIBOR, and some interest rates are derived by adding a premium to the reference rate or subtracting a discount from the reference rate. It is sometimes referred to as "absolute swap yield."


The absolute rate is usually determined finding the present value of the fixed portion of the interest rate swap. The present value of the fixed portion of the interest rate swap is calculated by dividing the fixed payments by one plus the maturity rate of a U.S Treasury bond with the same maturity, raised to the maturity date of the swap. In other words, the absolute rate is equal to [Fixed Payments/(1+maturity rate)^maturity date of swap]. (For further reading about present value, see the Bond Pricing Sectionof our Advanced Bond Concepts Tutorial.)

It is important to know the absolute rate if you are planning to be involved in a swap rate. If you have a variable interest payment that you want to exchange or swap for a fixed one, it is very important to know what the fixed or absolute rate is. It would be meaningless to engage in an interest rate swap without knowing what the absolute rate is.

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