Rate Anticipation Swap

What Is a Rate Anticipation Swap?

A rate anticipation swap is a bond trading strategy in which the trader exchanges the parts of their bond portfolio in anticipation of expected interest rate developments.

Understanding Rate Anticipation Swaps

Rate anticipation swaps are speculative in nature, since they rely upon anticipated changes to interest rates. The most common form of rate anticipation swap comprises of trading short-maturity bonds in exchange for long-maturity bonds, in anticipation of lower interest rates. Alternately, traders will likewise exchange long-maturity bonds for short-maturity bonds assuming they think interest rates will rise.

Rate anticipation swaps depend on the way that bond prices move the other way as interest rates. As interest rates rise, the price of existing bonds falls since investors are able to purchase new bonds at higher interest rates. Then again, bond prices rise when interest rates fall, on the grounds that existing bonds become higher-yielding than new bonds.

Generally talking, bonds with long maturities, like 10 years, are more sensitive to changes in interest rates. Consequently, the price of such bonds will rise all the more quickly assuming that interest rates fall and will fall all the more quickly assuming interest rates rise. Short-maturity bonds are less sensitive to interest rate developments.

Hence, bondholders who need to conjecture on anticipated interest rate changes can rebuild their portfolios to hold all the more long-maturity bonds (which are more sensitive to rate changes) than short-maturity bonds, or the other way around. Specifically, they can swap their short-maturity bonds for longer-maturity ones assuming that they expect interest rates to fall (making bond prices rise), and do the inverse assuming they expect interest rates to rise.

Rate Anticipation Swap Example

Investors utilize "duration" to allude to the sensitivity of a bond to changes in interest rates. As a general rule, bonds with higher duration will see more quick price declines as interest rates rise, while bonds with lower duration will see less price volatility.

Data with respect to the duration of specific bonds can be handily acquired utilizing online trading platforms. In this way, investors who wish to theorize on interest rate developments in bonds can look for bonds with particularly high or low levels of duration.

Notwithstanding the impact of maturity length as referenced over, one more factor that influences a bond's sensitivity to interest rate changes is the size of the coupon payments associated with the bond. As a general rule, bonds with bigger coupon payments will be less sensitive to changes in interest rates, while bonds with smaller coupon payments will be more sensitive. Subsequently, an investor expecting to purchase bonds with high sensitivity to interest rate developments could search for long-maturity bonds with small coupon payments.

Highlights

• Rate anticipation swap depends on the way that bond prices are conversely connected with interest rates, and that certain sorts of bonds are more sensitive to interest rate changes than others.
• Rate anticipation swap is innately speculative, since it requires the trader to foresee how interest rates will change.
• Rate anticipation swaps comprise of trading bonds to boost or limit their sensitivity to future interest rate developments.