Posted in Finance, Accounting and Economics Terms, Total Reads: 289
Definition: Plain Vanilla Swap
A Plain Vanilla Swap refers to the most basic type of forward that is traded between 2 parties. These can be of different types depending on the underlying variable for the swap. The variable could be foreign currency exchange rate, it could be commodity prices, it could be interest rate swaps (IRS) which is most common.
A swap essentially tries to meet 2 parties with relative advantages in their line of business. An example could be in a scenario where there are 2 companies – A and B.
Company A can borrow at 7% fixed or LIBOR+20 BPS while the company B might be able to borrow at 7.5% fixed or LIBOR + 30BPS. If company A wants to borrow on LIBOR rate and company B wants to borrow at fixed, they can get into a swap i.e. a sort of a mutual understanding. In this case, the company A can agree to pay B a Floating LIBOR and receive fixed payments at 7.2%. The company B would agree to receive Floating LIBOR and pay fixed payments at 7.2%. Eventually, Company A would borrow at 7% fixed from banks in its own region and company B would borrow at Libor+30BPs in its own region. This leads to overall, a better payoff for both the companies whereby they could meet the objective of either paying in fixed or LIBOR as their company may decide.