Introduction

Swaps are essential financial instruments that allow market participants to manage their interest rate and currency risks effectively. This chapter delves into the mechanics of a plain vanilla interest rate swap, a fundamental type of swap in the financial world. We will explore how these swaps work, their components, and how cash flows are computed within such transactions.

Mechanics of a Plain Vanilla Interest Rate Swap

A plain vanilla interest rate swap involves the exchange of fixed-rate and floating-rate cash flows between two parties. Typically, one party agrees to pay a fixed interest rate, while the other agrees to pay a floating interest rate based on a reference rate, such as the London Interbank Offered Rate (LIBOR). The principal amount is not exchanged, and the cash flows are calculated based on the notional amount, which represents the underlying value of the swap.

Computing Cash Flows in a Plain Vanilla Interest Rate Swap

The cash flows in a plain vanilla interest rate swap are calculated at regular intervals, such as quarterly or semi-annually, over the life of the swap. The fixed-rate payer pays a fixed amount, while the floating-rate payer’s payment is based on the current reference rate.

Example: Consider Party A and Party B entering a plain vanilla interest rate swap. Party A agrees to pay Party B a fixed rate of 4% on a notional amount of USD 10 million while Party B agrees to pay Party A a floating rate based on 3−month LIBOR on the same notional amount.

If the fixed payment interval is semi-annual, Party A will pay Party B USD 200,000 $(0.04 \times 10,000,000 / 2)$ every six months. On the other hand, Party B’s payment will vary based on the prevailing 3-month LIBOR rate.

To compute Party B’s payment at each interval, you’d use the formula:

$$\text{Floating Payment = Notional Amount} \times \text{(Current LIBOR + Spread)}$$

Suppose the spread is 0.5%. If the 3-month LIBOR rate is 2.75% at the payment date, Party B’s payment would be:

$$\text{Floating Payment = } 10,000,000 \times (0.0275+0.005)= \text{USD 282,500}$$