DEFINITION of Absolute Rate
The absolute rate, sometimes also referred to as an absolute swap yield, is the fixed portion of an interest rate swap, expressed as a percentage rather than as a premium or a discount to a reference rate. It is therefore calculated as the sum of two parts of the contract: the fixed rate component as well as the variable bank rate of a swap. The absolute rate represents the total yield accrued by both parties in an interest rate swap.
The absolute rate can be thought of as a combination of the reference rate and the premium or discounted fixed percentage. For example, if the LIBOR is 3% and the fixed interest portion of the swap is at a 7% premium, then the absolute rate would be 10%.
BREAKING DOWN Absolute Rate
An interest rate swap is an over the counter (OTC) financial contract agreed upon by two counterparties to exchange one stream of cash flows such as interest payments for another, over a predetermined period of time.
The most commonly traded and liquid type of interest rate swaps are known as “plain vanilla” swaps, where one counterparty agrees to exchange fixed-rate interest payments for floating-rate interest payments based on LIBOR or some other benchmark reference rate. While several other types of swaps exist and are used for various purposes, such as one which exchanges one floating rate for another floating rate, plain vanilla swaps comprise the majority of the market.
Vanilla swaps will therefore always have a fixed leg as well as a variable, or floating, leg. The swap rate is the fixed interest rate that the swap receiver gets in return for the uncertainty of having to pay out a variable, floating rate to the other counterparty as it changes over time. At the time that a swap agreement is entered in to, the net present value (NPV) of the swap’s fixed rate cash flows will be set equal to the net present value of the expected floating rate payments as indicated by the forward LIBOR curve. Swap contracts are usually priced in terms of this fixed rate, or else they can be quoted in terms of the swap spread, which is calculated as the difference between the fixed rate and that of the yield on a domestic government bond with the same maturity.
The absolute rate, on the other hand, adds together these two rates instead of subtracting them to come to the swap spread. Thus, if the LIBOR rate is 2.5% and the fixed rate is 4.5%, the swap spread would be 2% and the absolute rate would be 7%.