Plain Vanilla Swap

What Is a Plain Vanilla Swap?

A plain vanilla swap is one of the simplest financial instruments contracted in the over-the-counter market between two private gatherings, the two of which are generally firms or financial institutions. There are several types of plain vanilla swaps, including a interest rate swap, commodity swap, and a foreign currency swap. The term plain vanilla swap is most commonly used to portray an interest rate swap in which a floating interest rate is exchanged for a fixed rate or vice versa.

Grasping a Plain Vanilla Swap

A plain vanilla interest rate swap is frequently finished to hedge a floating rate exposure, in spite of the fact that it should likewise be possible to exploit a declining rate environment by moving from a fixed to a floating rate. The two legs of the swap are named in a similar currency, and interest payments are netted. The notional principal doesn't change during the life of the swap, and there are no embedded options.

Types of Plain Vanilla Swaps

The most common plain vanilla swap is a floating rate interest rate swap. Presently, the most common floating rate index is the London Interbank Offered Rate (LIBOR), which is set daily by the International Commodities Exchange (ICE). LIBOR is posted for five monetary standards — the U.S. dollar, euro, Swiss franc, Japanese yen, and British pound. Maturities range from overnight to 12 months. The rate is set in view of a survey of somewhere in the range of 11 and 18 major banks.

The Intercontinental Exchange, the authority responsible for LIBOR, will stop distributing one-week and two-month USD LIBOR after Dec. 31, 2021. Any remaining LIBOR will be discontinued after June 30, 2023.

The most common floating rate reset period is at regular intervals, with semi-annual payments. The day count convention on the floating leg is generally real/360 for the U.S. dollar and the euro, or real/365 for the British pound, Japanese yen, and Swiss franc. The interest on the floating rate leg is accrued and compounded for a long time, while the fixed-rate payment is calculated on a simple 30/360 or 30/365 basis, contingent upon the currency. The interest due on the floating rate leg is compared with that due on the fixed-rate leg, and just the net difference is paid.

Illustration of a Plain Vanilla Swap

In a plain vanilla interest rate swap, Company An and Company B pick a maturity, principal amount, currency, fixed interest rate, floating interest rate index, and rate reset and payment dates. On the predefined payment dates for the life of the swap, Company A pays Company B an amount of interest calculated by applying the fixed rate to the principal amount, and Company B pays Company A the amount derived from applying the floating interest rate to the principal amount. Just the netted difference between the interest payments changes hands.

Features

• Generally, the two legs of the swap are designated in a similar currency, and interest payments are netted.
• A plain vanilla swap is the simplest type of swap in the market, frequently used to hedge floating interest rate exposure.
• There are different types of plain vanilla swaps, including interest rate, commodity, and currency swaps.