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. 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 >>
  6. When was the first swap agreement and why were swaps created?

    Learn about the history of swap agreements, the first swap agreement between IBM and the World Bank, and how swaps have evolved ... Read Answer >>
Related Articles
  1. Trading

    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. 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.
  3. Trading

    An Introduction To Swaps

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

    Different Types of Swaps

    Investopedia explores the most common types of swap contracts.
  6. 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
  7. Trading

    Interest Rate Swaps Explained

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

    The Advantages Of Bond Swapping

    This technique can add diversity to your portfolio and lower your taxes. Find out how.
  10. Trading

    Hedging With Currency Swaps

    The wrong currency movement can crush positive portfolio returns. Find out how to hedge against it.
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. Asset Swap

    Similar in structure to a plain vanilla swap, the key difference ...
  4. Absolute Rate

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

    A derivative contract through which two parties exchange financial ...
  6. Rate Anticipation Swap

    A type of swap in which bonds are exchanged according to their ...
Hot Definitions
  1. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  2. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
  3. Risk Averse

    A description of an investor who, when faced with two investments with a similar expected return (but different risks), will ...
  4. Indirect Tax

    A tax that increases the price of a good so that consumers are actually paying the tax by paying more for the products. An ...
  5. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  6. Beta

    Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. ...
Trading Center