What Is the Absolute Rate?
It is calculated as the sum of the fixed and variable components of the interest rate swap. For example, if an interest rate swap has a fixed rate of 2% and a variable rate of 3%, then the absolute rate would be 5%.
- The absolute rate is the sum of the fixed and variable rates used in an interest rate swap.
- It is also known as the absolute swap yield and is a key metric used by swaps traders along with the swap spread.
- Interest rate swaps are a large and liquid market, useful for parties wishing to hedge or speculate on interest rate movements.
Understanding Absolute Rates
Interest rate swaps are a type of derivative transaction in which two parties agree to exchange, or "swap," one series of cash flows for another over a set period of time.
The most commonly traded type of interest rate swap is a "plain vanilla" swap. In these contracts, one party agrees to exchange a series of cash flows based on a fixed interest rate, in exchange for a series of cash flows based on a variable interest rate, such as the Fed Funds rate.
At the time that the interest rate swap is initiated, the two series of cash flows—one which is based on a fixed interest rate, and the other which is based on a variable interest rate—will be structured so that the two series have the same net present value (NPV). However, depending on how interest rates fluctuate after the contract is initiated, the interest rate swap may end up benefiting one party more than the other.
Users of interest rate swaps will also refer to the "swap spread." The swap spread refers to the difference between the interest rate on the fixed portion of an interest rate swap, as compared to the interest rate given by a sovereign debt security that has a similar maturity period. For example, if a 1-year sovereign bond is yielding 2.00% and the fixed portion of an interest rate swap is set at 3.00%, then the swap spread on that interest rate swap would be 1.00%.
In addition to plain vanilla swaps, there are many other types of interest swap transactions, such as ones in which the counterparties each exchange cash flows based on a variable interest rate. However, plain vanilla swaps comprise the majority of the market.
When initiating a new interest rate swap, one party may provide an upfront premium to their counterparty depending on the market's expectations of future interest rate movements. These expectations are usually gauged by reference to the forward rate curve.
Real World Example of an Absolute Rate
Suppose you are an investor who recently purchased a $1 million 10-year sovereign bond. The bond provides a fixed payment at a rate of 2.00% per year. In the weeks after you purchase the bond, you become convinced that interest rates are likely to rise. As such, you start looking for an opportunity to exchange your fixed interest payments in exchange for variable payments which would rise if interest rates increase.
You find your solution in the derivative market, utilizing an interest rate swap transaction. Your counterparty is in the opposite situation: the owner of a 10-year variable bond with principal value of $1 million, they feel overly exposed to interest risk and would prefer having a predictable fixed rate of interest.
To accomplish your objectives, you and your counterparty agree on an interest rate swap whereby you agree to pay your counterparty 2.00% per year, while your counterparty agrees to pay you a variable rate based on the Fed Funds rate, which is currently 2.00% as well. In this scenario, the absolute rate of the interest rate swap is 4.00%, or the sum of the fixed and variable interest rates.