Rate Anticipation Swap Definition
Rate anticipation swap refers to a trading strategy where bonds are swapped based on varying maturity dates. In other words, the bonds are swapped according to their present period, and their movement rate prediction. It is mostly done to take full advantage of predicted changes in interest rates. This means that an investor would want to take part in this type of swap in order to maximize returns from the interest rates changes while minimizing losses.
A Little More on What is a Rate Anticipation Swap
Rate anticipation swaps are naturally speculative. Meaning they depend on the results of expected interest change rates. Various types of bonds react differently to falling or rising interest rates. For this reason, those investors who take part in this kind of swap, select bonds depending on how they are faring on in the market to be able to capitalize on the yields.
We can draw a conclusion that the negative relationship between the two financial instruments is as a result of their response to market movement. This is because the two have a reverse market movement. Inversely here means that when the interest rates fall, it causes the bond price to rise, and vice versa, hence the term negative correlation.
Basic Interest Rate Anticipation Swap Strategies
There are two types of basic interest rate anticipation swap strategies that traders use. They include:
- Long-term bonds
These are bonds that take longer to reach maturity. They are also referred to as long-term government bonds.
- Short-term bonds
These are bonds that take a short time to mature. They are also referred to as short-term treasury bills.
It is important to note that the difference in bond maturity duration has an influence on interest rates. For instance, long term bonds costs are highly sensitive to interest rate changes. For this reason, investors who wish to maximize their profits are, therefore, obligated to increase their bond portfolio period. This way, they will be able to utilize their investment fund in return for a higher profit.
However, the most declines in price are mostly experienced in long-term bonds. Therefore, sometimes investors would prefer to hold Treasury bills whose durations are very short because they do not change much in value even as the interest rates rise. The securities also have fixed coupons meaning that their price is depended on new issues and their market value.
How Rate Anticipation Swap Works
For an investor who believes that interest rates are likely to go down, a resolution to swap out the short term bonds in exchange for long-term bonds is appropriate. This is because the long-term bonds have a better duration in which they can increase their value to achieve desired returns. An investor, on the other hand, may also swap long-term bonds in exchange for short-term bonds only if he or she foresees the likelihood of interest rates increasing within a short period of time.
Uses of Rate Anticipation Swap
Rate anticipation swap helps an investor to decide on which type of bond he or she can trade in so as to maximize profits from his or her investment. Using this tool, an investor will be able to do proper timing to ensure that there are higher investment returns.
Rate Anticipation Swap Risks
Interest rates are known to expose its users to several risks. Predominantly, they put traders to market risks, particularly interest rate risks. Value of an interest rate swap will decline as market interest rates move down. In market terms, this is often known as delta risk.
Conclusion Regarding Rate Anticipation Swaps
Though the rate anticipation swap helps investors to utilize their investment on the best bonds in the market, the decisions are typically speculative. This is because no one knows what the future has to offer as interest rates can move against an investor who mispredicted the interest rates. This means that an investor should not rely on this financial tool alone to make investment decisions. It is important to use it along with other relevant financial metrics to ensure favorable results.
Reference for Rate Anticipation Swap
Academic Research on Rate Anticipation Swap
Inside the Yield Book, Tuttle, D. L. (1974).
Bund Market Mathematics and Trading Techniques, Corrigan, D., & Pohlmann, M. (1991). In Bunds and Bund Futures (pp. 49-68). Palgrave Macmillan, London.