Question

6. Demonstrate how a plain vanilla interest rate swap can be constructed to be mutually beneficial to both parties. Support your analysis with a numerical example.

Answer 1

Plain vanilla transactions refer to the transactions which are commonly made in the financial instruments by the respective participants.

An Plain Vanilla Interest Rate Swap generally refers to exchange of the fixed payments made with the floating payments and vice-versa. Floating payments are based on a variable interest rate which resets after a specified time period. They are usually based upon LIBOR (London Inter bank Offered rate) or any other benchmark i.e. reference rate with respect to a particular currency. LIBOR refers to unsecured money market (short term) rate between top rated banks worldwide. Then, Floating rate will be, let's say LIBOR rate Plus All in Cost Ceiling. All in cost ceiling refers to the expenses which a borrower incurs.  

Let's say companies A and B both enter into an interest rate swap for 12 months. Company A is more creditworthy than Company B i.e. A has a higher credit rating than B. Due to this A will be charged lower interest rate in fixed loans than B. A is currently paying floating interest payments @ 9% Libor (let's say) + One percent (All in cost ceiling) i.e.10 percent per annum (p.a.). Libor is reset annually. Company B is currently paying fixed interest payments @ 10.75% per annum (p.a.). Now, if both the companies switch their payments, then company B will now pay floating rate of 10% p.a. and company A will pay fixed interest payments @ let's say 9.25% on the same principal at which B pays 10.75% due to its higher credit rating. Thus net benefit to A will be 10% paid earlier by it - 9.25% paid by it now i.e. 0.75% respectively. Net Benefit to B will be 10.75% paid earlier by it - 10% paid by it now i.e. 0.75% respectively.

The total savings in the form of costs to both A and B will be the total benefit accrued due to the Plain Vanilla Interest Rate Swap transaction. Hence, total benefits will be 0.75% (A's benefit) + 0.75% (B's benefit) i.e. 1.5% respectively in the swap transaction.   

Note- A plain Vanilla Interest Rate Swap can also be in floating payments where the benchmarks are different and it's mutually beneficial for both the parties to switch to the other's respective benchmark for their respective costs savings.