What Is a Rate Anticipation Swap?
A rate anticipation swap is a bond trading strategy in which the trader exchanges the components of their bond portfolio in anticipation of expected interest rate movements.
- Rate anticipation swaps consist of exchanging bonds so as to maximize or minimize their sensitivity to future interest rate movements.
- Rate anticipation swap is inherently speculative, since it requires the trader to predict how interest rates will change.
- Rate anticipation swap relies on the fact that bond prices are inversely correlated with interest rates, and that certain kinds of bonds are more sensitive to interest rate changes than others.
Understanding Rate Anticipation Swaps
Rate anticipation swaps are speculative in nature, since they depend on predicted changes to interest rates. The most common form of rate anticipation swap consists of exchanging short-maturity bonds in exchange for long-maturity bonds, in anticipation of lower interest rates. Conversely, traders will also exchange long-maturity bonds for short-maturity bonds if they think interest rates will rise.
Rate anticipation swaps are based on the fact that bond prices move in the opposite direction as interest rates. As interest rates rise, the price of existing bonds falls because investors are able to purchase new bonds at higher interest rates. On the other hand, bond prices rise when interest rates fall, because existing bonds become higher-yielding than new bonds.
Generally speaking, bonds with long maturities, such as 10 years, are more sensitive to changes in interest rates. Therefore, the price of such bonds will rise more rapidly if interest rates fall and will fall more rapidly if interest rates rise. Short-maturity bonds are less sensitive to interest rate movements.
For these reasons, bondholders who want to speculate on anticipated interest rate changes can restructure their portfolios to hold more long-maturity bonds (which are more sensitive to rate changes) than short-maturity bonds, or vice-versa. Specifically, they can swap their short-maturity bonds for longer-maturity ones if they expect interest rates to fall (causing bond prices to rise), and do the opposite if they expect interest rates to rise.
Rate Anticipation Swap Example
Investors use the word "duration" to refer to the sensitivity of a bond to changes in interest rates. In general, bonds with higher duration will see more rapid price declines as interest rates rise, while bonds with lower duration will see less price volatility.
Data regarding the duration of specific bonds can be easily obtained using online trading platforms. Therefore, investors who wish to speculate on interest rate movements in bonds can search for bonds with especially high or low levels of duration.
In addition to the impact of maturity length as mentioned above, another factor that affects a bond's sensitivity to interest rate changes is the size of the coupon payments associated with the bond. In general, bonds with larger coupon payments will be less sensitive to changes in interest rates, while bonds with smaller coupon payments will be more sensitive. Therefore, an investor hoping to purchase bonds with high sensitivity to interest rate movements might look for long-maturity bonds with small coupon payments.