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. How are swap agreements financed?

    Learn how swap agreements are now cleared by swap execution facilities and require the use of collateral margin to hold, ... Read Answer >>
Related Articles
  1. Managing Wealth

    An In-Depth Look at The Swap Market

    The swap market plays an important role in the global financial marketplace; find out what you need to know about it.
  2. Trading

    An Introduction To Swaps

    Learn how these derivatives work and how companies can benefit from them.
  3. 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.
  4. Trading

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  5. Trading

    Interest Rate Swaps Explained

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

    CFTC Probes Banks' Use of Interest Rate Swaps

    U.S. regulators are probing banks' trading and clearing of interest rate swaps, which played a central role in the 2008 financial crisis
  7. Investing

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  8. Investing

    PIMCO’s Mutual Fund for Investment Grade Bonds (PTTRX)

    Explore the complicated and often arcane makeup of the PIMCO Total Return Fund, and identify the fund's management style and top five holdings.
  9. Trading

    Introduction To Counterparty Risk

    Unlike a funded loan, the exposure from a credit derivative is complicated. Find out everything you need to know about counterparty risk.
  10. Investing

    Harvard Gets a Failing Grade on Interest-Rate Swaps

    Harvard is among scores of colleges and universities spaying the price for investing in interest-rate swaps that imploded during the financial crisis.
RELATED TERMS
  1. Delayed Rate Setting Swap

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

    A type of swap arrangement in which two parties agree to exchange ...
  3. Swap Rate

    The rate of the fixed portion of a swap as determined by its ...
  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 ...
Hot Definitions
  1. Benchmark

    A standard against which the performance of a security, mutual fund or investment manager can be measured.
  2. Mobile Wallet

    Mobile wallet is a virtual wallet that stores payment card information on a mobile device.
  3. Leverage

    1. The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. ...
  4. Trumponomics

    Trumponomics is a term for the economic policies of President Donald Trump.
  5. Universal Health Care Coverage

    An organized healthcare system that provides healthcare benefits to all persons in a specified region. Many countries, such ...
  6. Davos World Economic Forum

    The annual meeting of the World Economic Forum hosted at Davos—a small ski town in Switzerland—in January each year is among ...
Trading Center