Absolute Rate (Interest Rate Swap) - Explained
What is the Absolute Rate on an Interest Rate Swap?
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Table of ContentsWhat is the Absolute Rate?How is the Absolute Rate Used?Academic Research on Absolute Rate
What is the Absolute Rate?
An absolute rate refers to the fixed portion of an interest rate swap that is expressed as a percentage without reference to the interest rate swaps premium or discount. An absolute rate is otherwise known as an absolute swap yield. An absolute rate is determined by calculating the basic rate of interest often called the LIBOR, and the fixed portion on the interest rate swap. The addition of both parts amounts to the absolute rate, this means that the absolute rate represents the total amount accumulated by the two parties involved in an interest rate swap. For example; in an interest rate swap, if the LIBOR is 5% and the fixed portion is 10%, then the absolute rate is 15%.
How is the Absolute Rate Used?
Two parties are involved in an interest rate swap, it is a derivative agreement which entails that both parties agree to exchange interest rates based on the Principal amount. For instance, two parties can consent to the exchange of a fixed-rate interest payments for floating-rate interest payments using a benchmark reference rate. Vanilla swaps are the most common interest rate swaps, although, there are few others. However, absolute rate is realized by the addition of these two interest rates involved in the interest rate swap agreement. It is the addition of the LIBOR rate and the fixed-rate interest. It represents the percentage of yield or total yield accumulated by both parties in an interest rate swap.
Academic Research on Absolute Rate
- Rate of return guarantees for mandatory defined contribution plans, Turner, J. A., & Rajnes, D. M. (2001). International Social Security Review, 54(4), 49-66. The objective of this article is to explore the conceptual basis for an employer-backed minimum rate-of-return guarantee as an option under defined contribution plans. It also presents a prototype model of how the guarantee would work and explains how it may be utilized for a mandatory Social Security defined contribution plan.
- Retirement guarantees in mandatory defined contribution systems, Walliser, J. (2003). The pension challenge: Risk transfers and retirement income security, 238-250. This paper reviews the design of guarantees for retirement income in a large set of countries and discusses the economic rationale and incentive structure resulting from such designs. It also examines the past experiences for various countries and pays special attention to the importance of changes to these guarantees over time and inflation.
- Defined contribution plans with rate-of-return guarantees, Rajnes, D. (2003). This article examines the operation of rate-of-return guarantees in mandatory and voluntary DC Plans throughout the world. The range of guarantee features surveyed suggests a wide variety of conditions and motivating factors at work in the US and also in other countries. Its conclusion links the discussion to the current debate in Congress over limiting investment flexibility in 401(k) accounts of American workers.
- The role of guarantees in defined contribution pensions, Antoln, P., Payet, S., Whitehouse, E. R., & Yermo, J. (2011). This paper investigates the role played by guarantees in DC pension plans and specifically I minimum investment return guarantees during the accumulation phase. The purpose is to determine the cost and benefits of different return guarantees. It utilizes a stochastic financial market model where the guarantee claims are computed as a financial derivative in a financial market framework.
- Exchange rate variability and asset trade, Persson, T., & Svensson, L. E. (1989). Journal of Monetary Economics, 23(3), 485-509. This article discusses the effect of exchange rate variability on capital flows and international portfolio diversification. It also examines how different monetary policies find the risk characteristics of nominal assets and how these risk characteristics determine international portfolio composition and trade in assets when the international asset markets are not complete.