Plain-vanilla interest rate swap

Have you ever flip through the newspapers and see this term known as the "Plain-vanilla interest rate swap"? When I first heard of this, I thought it was kind of cute and interesting. I was asking myself, why plain vanilla? Why not chocolate or strawberry? Hmm.., anyone know why?

Anyway, what is a plain-vanilla interest rate swap then? A plain-vanilla interest rate swap is an exchange of a series of fixed interest payments for a series of floating interest payments, fluctuating with LIBOR (London interbank offer rate). The fixed rate of interest is often quoted as a spread over the current US Treasury security of the desired maturity and is called the swap rate. Normally, the floating rate paid at the end of each period is based on LIBOR at the beginning of the period. The times at which the floating rates are established are called the “reset dates.” The two sides of the swap are called the “fixed leg” and “floating leg”; and the life of a swap is called its tenor. In this case, only the cash flows, not the principals, of the two types of debt are exchanged. So the size of the swap is measured by its notional principal.

For example, for five years, one counterparty (“the buyer”) agrees to pay a fixed rate of interest, say the coupons that would be received on $1,000,000 of principal of the current five-year Treasury note plus 65 basis points (.65%) in exchange (from “the seller”) for five years of semiannual floating rate payments equal to $1,000,000 paying LIBOR with six-month resets. Here, the notional principal is $1,000,000 and the tenor of the swap is five years. The spread over treasuries allows the swap to be quoted “flat”, similar to a forward contract, so that no money need change hands at inception.

Swap financing is normally adopted by companies which operate globally and can be used as a hedge against foreign rate exchange risk.