Sometimes known as an absolute swap yield, an absolute rate is the fixed portion of an interest rate swap. The amount is usually written as a percentage instead of a discount or premium that is applied to a reference rate. The actual rate involves combining that reference rate with the fixed portion of the swap to yield that percentage.
One of the easiest ways to understand the calculation of an absolute rate is to assume that the reference rate involved in the assessment comes to 4%. Assuming that the fixed portion of the interest rate swap amounts to a premium of 9%, this would mean that the absolute rate would amount to 13%. The source of the reference rate will vary, based on the nation in which the investment is taking place. For example, if the interest rate swap is structured using loans that are written in the United Kingdom, there is a good chance the current LIBOR rate will serve as that reference rate.
While the concept behind the absolute rate can sometimes be confusing, the process becomes easier to grasp when it is understood what is meant by an interest rate swap. Essentially, this type of swap is a commitment between two parties to swap or exchange interest payments on two specific loans. The loans may both carry fixed or variable rates, but a more common strategy is for one loan to carry a fixed rate while the other carries a floating or variable rate. Depending on what occurs with the average interest rate as the economy shifts in various directions, this type of swap can be very lucrative.
With this background in mind, it is easier to see the absolute rate as a calculation that helps to provide some insight into the possible yield associated with this type of swap. Investors can project movements in the average rates and how those changes will impact the floating or variable rates associated with the loans in the swap. From there, it is somewhat easier to determine if a given combination of loans constitutes an opportunity to benefit from the anticipated shifts in the economy and the resulting effects on average rates. Failing to identify the absolute rate as part of the consideration of this type of swap makes it almost impossible to accurately project the yield, and thus distinguish an advantageous swap from one that is likely to carry more risk and less potential to generate profits.
