FXCM Insights

What Is A Plain Vanilla Swap?

A swap is a financial derivative product that helps firms and institutions manage risk. A plain vanilla swap, also known as a generic swap, is the most basic type of such transaction. Similar in function to standardised futures and forward contracts, a plain vanilla swap is an agreement between two parties that specifies an exchange of periodic cash flows arising from an asset class or debt instrument.

Corporations, high net worth investors and institutions are the most common purveyors of plain vanilla swaps. Typically, this form of transaction is executed in relation to the following assets:

Plain Vanilla Swap: Parameters And Mechanics

The mechanics of a plain vanilla interest rate swap are fairly straightforward and similar to those involving currencies and commodities. In this type of swap, two parties decide to exchange periodic payments with one another according to specified parameters using interest rates as the basis for the agreement.

For instance, Commercial Bank Z and Company X agree that it may be beneficial to trade payments with one another based upon their own specific circumstances. In order to structure the swap, the following parameters are defined and agreed upon:

The transaction commences involving Commercial Bank Z and Company X:

The swap itself may have many results and be either helpful or detrimental to the participants involved. For instance, Company X may enjoy the value of having a constant stream of revenue generated by the payments from Bank Z. Conversely, Bank Z may benefit from rising interest rates and larger payments received from Company X.

Ultimately, the motivation for entering into the agreement depends upon the individual participants involved. Common reasons for engaging in a plain vanilla swap range from managing risk to capitalising upon fluctuations in various markets.

Summary: The Swap Debate

Although an integral part of the global derivatives market, many kinds of swaps remain controversial. During the credit crisis of 2008, credit default swaps (CDS) pertaining to the U.S. real estate market were deemed to be one of the primary culprits responsible for the meltdown. The subsequent failure of numerous investment banks and insurance companies were attributed to these activities, giving the term “swap” a somewhat negative connotation.

However, the swap has a history dating all the way back to 1981, originating with a trade of currency yields and debt obligations between IBM and the World Bank.1)Retrieved 13 February 2017 http://www.sjsu.edu/faculty/watkins/swaps.htm Since then, swaps have become an enormous over-the-counter (OTC) marketplace. For the year-end 2015, swaps accounted for 75% of the total interest rate derivatives market, a value of US$320 trillion.2)Retrieved 13 February 2017 http://www.bis.org/publ/otc_hy1511.pdf

In general, there are many distinct varieties of swaps, each with its own degree of complexity and popularity. Plain vanilla swaps are the most commonly executed type of swap, and often a viable method of actively managing risk while securing profit.

Additional Reading

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References   [ + ]

1. Retrieved 13 February 2017 http://www.sjsu.edu/faculty/watkins/swaps.htm
2. Retrieved 13 February 2017 http://www.bis.org/publ/otc_hy1511.pdf