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:
- Interest rates: Interest rate swaps facilitate the exchange of payments derived from fixed rate debt obligations for variable rate payments and vice-versa.
- Currencies: Currency swaps enable the interchanging of nominal amounts of foreign currencies. The international debt market, exchange rates and an entity's entrance into a new country or foreign market are a few motivations for this type of transaction.
- Commodities: Commodity swaps are used to hedge against the inherent volatilities facing a specific market or markets. Agricultural and energy products are among the most commonly involved in commodity swaps.
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:
- Principal amount: The amount of capital involved in the debt service.
- Duration: Period of time until the agreement reaches maturity, including the payment schedule.
- Denomination of currency: Type of currency in which the payments are to be made.
- Interest rates: The interest rates by which the trade is bound. Fixed and variable rates are defined by the participants. Reference to an interest rate index, for example the London Interbank Rate (LIBOR), is common practice to define the variable rate.
The transaction commences involving Commercial Bank Z and Company X:
- Company X and Bank Z agree upon a principle of US$100 million, duration of 5 years, with payments due twice per year.
- Bank Z makes payments based upon a fixed 10%, while Company X agrees to make its payments based upon a variable rate of 2% + current LIBOR.
- The payments are processed by an intermediary, with fluctuations in the variable interest rate acting as the primary determinant of success for each party.
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. 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.
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.
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Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…