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.

RELATED FAQS
  1. Can individual investors profit from interest rate swaps?

    Find out how individual investors can speculate on interest rate movements through interest rate swaps by trading fixed rate ... Read Answer >>
  2. What are interest rate swaps on the OTC market?

    Learn about interest rate swaps and how they are traded over the counter, and understand the impact of Dodd-Frank on swaps ... Read Answer >>
  3. How do companies benefit from interest rate and currency swaps?

    An interest rate swap involves the exchange of cash flows between two parties based on interest payments for a particular ... Read Answer >>
  4. What would motivate an entity to enter into a swap agreement?

    Learn why parties enter into swap agreements to hedge their risks, and understand how the different legs of a swap agreement ... Read Answer >>
  5. Do interest rate swaps trade on the open market?

    Learn how interest rate swaps are traded on the OTC and interbank markets, and how these swaps can be used to arbitrage different ... Read Answer >>
  6. Can bond traders trade on interest rate swaps?

    Read about interest rate swaps and why these transactions are performed by institutional actors in the bond market, not individual ... Read Answer >>
Related Articles
  1. Investing Basics

    How Are Interest Rate Swaps Valued?

    When trading in financial markets, higher returns are generally associated with higher risk. Hedge your risk with interest rate swaps.
  2. Investing

    What's an Interest Rate Swap?

    An interest rate swap is an exchange of future interest receipts. Essentially, one stream of future interest payments is exchanged for another, based on a specified principal amount.
  3. Professionals

    Interest Rate and Equity Swaps

    CFA Level 1 - Interest Rate and Equity Swaps. Learn the components of plain vanilla interest rate swaps and equity swaps. Contains sample calculations finding the payments for each swap.
  4. Investing

    How To Read Interest Rate Swap Quotes

    Puzzled by interest rate swap quotes terminology? Investopedia explains how to read the interest rate swap quotes
  5. Investing Basics

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  6. Professionals

    Swaps

    CFA Level 1 - Swaps. Learn how swaps can change the characteristics of assets or liabilities. Discusses the cash flows of interest rate and currency swaps.
  7. Trading Strategies

    Interest Rate Swaps Explained

    Plain interest rate swaps that enable the parties involved to exchange fixed and floating cash flows.
  8. Investing

    What Warren Buffet Calls "Weapons of Mass Destruction": Understanding the Swap Industry

    A full analysis of how the swap industry works.
  9. Professionals

    Currency Swaps

    CFA Level 1 - Currency Swaps. Discusses the features of a currency swap. Learn how comparative advantage affects the payments made during a swap agreement.
  10. Professionals

    Swap Markets and Contracts

    CFA Level 1 - Swap Markets and Contracts. Learn the basics of swaps, including how they are used and settled. Includes various methods for terminating a swap contract.
RELATED TERMS
  1. Swap Rate

    The rate of the fixed portion of a swap as determined by its ...
  2. Delayed Rate Setting Swap

    An exchange of cash flows, one of which is based on a fixed interest ...
  3. Bond Market Association (BMA) Swap

    A type of swap arrangement in which two parties agree to exchange ...
  4. Absolute Rate

    The fixed portion of an interest-rate swap, expressed as a percentage ...
  5. Asset Swap

    Similar in structure to a plain vanilla swap, the key difference ...
  6. Swap

    A derivative contract through which two parties exchange financial ...

You May Also Like

Hot Definitions
  1. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  2. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  3. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  4. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  5. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  6. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
Trading Center