What is a rate anticipation swap?
Key points to remember
- Interest rate swaps consist of exchanging bonds in order to maximize or minimize their sensitivity to future changes in interest rates.
- The interest rate anticipation swap is inherently speculative, as it forces the trader to predict the evolution of interest rates.
- The interest rate swap is based on the fact that bond prices are inversely correlated to interest rates and that certain types of bonds are more sensitive to changes in interest rates than others.
Understanding interest rate swaps
Rate anticipation swaps are speculative by nature, since they depend on the expected evolution of interest rates. The most common form of interest rate swap is to swap short-dated bonds for long-dated bonds in anticipation of falling interest rates. Conversely, traders will also swap long-dated bonds for short-dated bonds if they believe interest rates will rise.
Interest rate swaps are based on the fact that bond prices move in the opposite direction to interest rates. When interest rates rise, the price of existing bonds falls because investors can buy new bonds at higher interest rates. On the other hand, bond prices rise when interest rates fall, as existing bonds become higher yield than new obligations.
Generally speaking, bonds with longer maturities, such as 10 years, are more sensitive to changes in interest rates. Therefore, the price of these bonds will rise faster if interest rates fall and fall faster if interest rates rise. Short-term bonds are less sensitive to interest rate fluctuations.
For these reasons, bondholders who want to speculate on the forecasts interest rate changes can restructure their wallets hold more long-dated bonds (which are more sensitive to rate changes) than short-dated bonds, or vice versa. Specifically, they can swap their short-dated bonds for longer-dated bonds if they expect interest rates to fall (causing bond prices to rise), and do the opposite if they don’t. expect interest rates to rise.
Example of a rate anticipation swap
Investors use the word “durationto refer to a bond’s sensitivity to changes in interest rates. In general, bonds with a longer duration will see their prices fall faster as interest rates rise, while bonds with a shorter duration will see less price volatility.
Data regarding the duration of specific bonds can be easily obtained using online trading platforms. Therefore, investors wishing to speculate on bond interest rate movements may seek bonds with particularly high or low durations.
In addition to the impact of the length of maturity mentioned above, another factor that affects a bond’s sensitivity to changes in interest rates is the size of the bond. coupon payments associated with the link. 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 buy bonds that are very sensitive to interest rate fluctuations might look for long-dated bonds with small coupon payments.