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 parties, both of which are usually firms or financial institutions. While there are several types of plain vanilla swaps, including an interest rate swap, commodity swap, and a foreign currency swap, the term is most commonly used to describe an interest rate swap in which a floating interest rate is exchanged for a fixed rate or vice versa.
Understanding a Plain Vanilla Swap
A plain vanilla interest rate swap is often done to hedge a floating rate exposure, although it can also be done to take advantage of a declining rate environment by moving from a fixed to a floating rate. Both legs of the swap are denominated in the same currency, and interest payments are netted. The notional principal does not change during the life of the swap, and there are no embedded options.
Example of a Plain Vanilla Swap
In a plain vanilla interest rate swap, Company A and Company B choose a maturity, principal amount, currency, fixed interest rate, floating interest rate index, and rate reset and payment dates. On the specified 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. Only the netted difference between the interest payments changes hands.
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 currencies: the U.S. dollar, euro, Swiss franc, Japanese yen, and British pound. Maturities range from overnight to 12 months. The rate is set based on a survey of between 11 and 18 major banks.
The most common floating rate reset period is every three months, with semi-annual payments. The day count convention on the floating leg is generally actual/360, for the U.S. dollar and the euro, or actual/365, for the British pound, Japanese yen, and Swiss franc. The interest on the floating rate leg is accrued and compounded for six months, while the fixed-rate payment is calculated on a simple 30/360 or 30/365 basis, depending on the currency. The interest due on the floating rate leg is compared with that due on the fixed-rate leg, and only the net difference is paid.