DEFINITION of Rate Anticipation Swap
A rate anticipation swap is a bond trading strategy in which bonds of different maturities are exchanged according to their current duration based on predicted interest rate movements. A rate anticipation swap is often made in order to take advantage of interest rate changes where more profitable bond opportunities can be found elsewhere. Rate anticipation swaps are speculative in nature, since they depend on the outcome of the expected interest rate change. Various bond types respond differently to rising or falling interest rates and those who participate in rate anticipation swaps generally choose bonds based on performance.
For instance, a trader who believes that interest rates are going to fall would seek to swap out short term bonds for longer term bonds since in this long-term bonds have a greater duration and would increase in value by a greater degree. Conversely, investors may swap longer-term bonds for short-term bonds if interest rates are expected to rise (bond prices and interest rate moves are negatively correlated).
BREAKING DOWN Rate Anticipation Swap
Rate anticipation strategies are employed by bond (or other fixed income) traders in order to speculate on how they believe interest rates will move in the near future. Since bond prices move inversely with interest rates, falling interest rates will lead to rising bond prices in the market (and vice versa). If a trader wants to maximize their profitability on making the correct all about interest rates, they would see to increase their bond portfolio's duration, where duration is the change in bond price given a 1% change in interest rates. Longer maturity bonds have greater durations, while short term bonds have much smaller durations. This means that long term bond prices are far more sensitive to changes in interest rates, and their prices will move higher by a greater percent than short term bonds if interest rates do fall.
In order to capitalize on that fact, a trader who believes that interest rates will fall soon are motivated to swap out short term bonds in their portfolio for long term bonds. The opposite will be true given a rising interest rate environment. Long term bonds will fall the most in price and so a trader would want to hold bonds such as treasury bills (T-bills), which have very short durations and so do not change very much in value as interest rates rise.
These decisions are speculative in nature, however, since nobody can know the future for sure, and so interest rates may move against a trader who has incorrectly anticipated interest rates.