Question

(11) Explain the working of a "plain vanilla" swap (also called generic swap). Provide an example of how both counterparties may benefit by using such an instrument.

Answer 1

Plain vanilla swap is simple financial instrument contracted between two private parties to exchange interest rate payments with each other. In interest rate swap one party ie party A agrees to make payment to another country ie party B on the basis of fixed interest rate and party B makes payment to the first party ie party A on the basis of floating exchange rate on a notional principal ,on dates which are specified and for a period of time which is specified.

These exchanges work to the benefit of both the parties.The two parties are trading a fixed rate to a variable interest rate. For eg one party may have a bond that offers the London interbank offered rate(LIBOR) while another party may offer fixed rate of 5% .If the LIBOR is 3% then the party paying the variable interest rate will pay LIBOR plus 2%. In this way both parties will receive similar payment and benefit .