Importantly, this is a robust conclusion that holds for any pairing of fixed rate instruments with plain vanilla interest rate swaps, irrespective of the length or duration of the bonds accrual periods. These swaps are made between corporations with differing. In this type of swap, two parties decide to exchange periodic payments with one another according to specified parameters using interest rates as. As you can see in the above diagram, party a is paying floating rate on its obligation, but wants to pay fixed rate. Interest rate swapderivative pricing in excel rvarb. A plain vanilla swap is one of the simplest financial instruments contracted in the overthecounter market between two private parties, both of which are usually firms or. The parties to a currency swap will exchange principal amounts at the beginning and end of the swap.
Companies engage in swaps in order to benefit from an exchange of comparative interest rate advantage. The pricing of these swaps requires a spread often quoted in basis points to be added to one of the floating legs in order to. The swap market has spawned numerous policy issues, especially as cases involving large. For example, if the interest rate in the market is rising, then an investor can take advantage of this rising interest rate if he has invested in stepup bonds or bonds with the callable feature.
Lets walk through an example of a plain vanilla swap, which is simply an interest rate swap in which one party pays a fixed interest rate and the other pays a floating interest rate. Asset swaps are used to alter the cash flow profile of a bond. At inception, the value of an interest rate swap is zero. Of or relating to the uncomplicated version of a particular type of security. For example, a plain vanilla derivative is typically exchangetraded and void of bells and whistles. An interest rate swap is a financial derivative instrument in which two parties agree to exchange interest rate cash flows based on a notional amount from a fixed rate to a floating rate or from one floating rate to another floating rate. An interest rate swap is a contract between two counterparties consisting in exchanging interest flows at regular dates agreed in advance calculated on an amount called notional plain vanilla swaps consist in exchanging floating to fixed interest flows on a fixed notional amount, without any. Normally, swap contracts allow for payments to be netted against each other. Vanilla swap is also often used to describe a plain swap. Jul 03, 2018 importantly, this is a robust conclusion that holds for any pairing of fixed rate instruments with plain vanilla interest rate swaps, irrespective of the length or duration of the bonds accrual periods. An interest rate swap is a customized contract between two parties to swap two schedules of cash flows. The swap contract in which one party pays cash flows at the fixed rate and receives cash flows at the floating rate is the most widely used interest rate swap and is called the plain vanilla swap or just vanilla swap. Reference to an interest rate index, for example the london interbank rate.
Most likely, the value of a plain vanilla interest rate swap will only equate to zero at initiation, as interest rates will change over the life of the swap. However, interest rate swaps can come in many different flavors. The mechanics of a plain vanilla interest rate swap are fairly straightforward and similar to those involving currencies and commodities. An interest rate swap is a contract which commits two counterparties to exchange, over an agreed period, two streams of interest payments, each calculated using a different interest rate index, but applied to a common notional principal amount. For example, one company may have a bond that pays the london interbank offered rate libor, while the other party holds a bond that provides a fixed payment of 5%. Another important class of derivative security are swaps, perhaps the most common of which are interest rate swaps and currency swaps. For example, one company may have a bond that pays the london interbank offered rate libor, while the other party holds a bond that provides a fixed payment of 5 %. Expected exposure and pfe simulation with quantlib and python 08042015 16042015 matthias groncki in this post i will show how to use the python bindings of the quantlib library to calculate the expected exposure ee for a netting set of interest rate swaps in a ipython notebook. Modeling vanilla interest rate swaps using quantlib python g b. In the plain vanilla swap a floating interest rate is swapped for a fixed rate. A growing number of community banks have recently taken the step to add swaps and caps to their interest rate risk management toolkit. Mar 21, 2019 if the layman understands how fras work, sure. A swap is any type of financial contract in which two investors swap one stream of payments for another.
As shown in figure 1, the counterparties in this example, a financial institution and. Swap dealers avoid interest rate risk by entering into the swap, housemann bank, the swap dealer, has assumed the risk that the interest rate it pays to goyco corp. For the fixed leg of the interest rate swap, the given r c. They are for illustrative purposes in this example. The most common type of interest rate swap is one in which party a agrees to make payments to party b based on a fixed interest rate, and party b agrees to make payments to party a based on a floating interest rate. Plain vanilla interest rate swap specifically refers to a fixedfloating. A plain vanilla interest rate swap has two legs a fixed leg and a floating leg. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Plain vanilla interest rate swap specifically refers to a fixedfloating agreement. 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. With the building blocks in place, it outlines the determinants of swap prices.
I am modelling a vanilla interest rate swap using the rquantlib package. Pricing and valuing a plain vanilla interest rate swap. In this swap, party a agrees to pay party b a predetermined, fixed rate of interest on a notional principal on specific. These derivative contracts, which typically exchange or swap fixedrate interest payments for floatingrate interest payments, are an essential tool for investors who use them in an effort to hedge, speculate, and manage risk. After doing so, there are a number of strategies utilizing a plain vanilla swap that yield a winwin solution for both bank and borrower. Other types of swaps include equity and commodity swaps. Both legs of the swap are denominated in the same currency, and interest payments are netted. 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.
Interest rate swaps definitions, examples and applications. The most common type of swap is referred to as a plain vanilla interest rate swap, and this involves one investor paying a series of fixed in. In this example, the use of an interest rate swap unlocks the fixed interest expense associated with the debt and creates interest rate expenses that vary with the market rate the company will benefit if the market interest rate declines. An interest rate swap is an agreement to exchange one stream of interest payments for another, based on a specified principal amount, over a specified period of time. Here we will consider an example of a plain vanilla usd swap with 10 million notional and 10 year maturity. Academic explanation of the concepts of interest rate swaps. These convert floating interest payments into fixed interest payments and vice versa. Simplified accounting for a perfect fair value hedge. The floating rate is tied to a reference rate in almost all cases, the london interbank offered rate, or libor. They are used to illustrate how the payments are determined and not the likely results. Plain vanilla swaps consist in exchanging floating to fixed interest flows on a fixed notional amount, without any capital exchange at the conclusion nor at maturity the fixed rate, called the swap rate or par swap rate, must be set contractually in order to have a fair contract for both parties otc market of swaps. The terms of the swap are typical in other words, the swap is what is generally considered to be a plainvanilla swap, and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap. Valuation of plain vanilla interest rate swap t332.
Most swaps are based on bonds that have adjustable rate interest payments that change over time. The most common reason to engage in an interest rate swap is to exchange a variable rate payment for a fixed rate payment, or vice versa. Swaps are like exchanging the value of the bonds without going through the legalities of buying and selling actual bonds. The simplest type of swap is known as a plain vanilla interest rate swap. The plain vanilla swap contract does not involve the principal exchange. Vanilla swaps are the most common type of interest rate swaps. For example, a swap with a payment based on libor and a receipt with a fixed rate of 6. The basic forms are called plain vanilla or generic swaps. The above description refers to a plain vanilla irs. Companies may use the shortcut method for their perfect hedge programs if certain criteria are met. Plain vanilla swaps basis swaps wiley online library. The focus of this paper is on plain vanilla swaps, which constitute the vast majority of the otc swap market. Likewise, a plain vanilla bond is not convertible and cannot be called. Brief illustration of a fixedforfixed currency swap e.
The party paying the floating rate leg of the swap believes that interest rates will go down. Interest rate swaps have become an integral part of the fixed income market. This would be considered a plain vanilla interest rate swap because one party pays interest at a fixed rate on the notional principal amount and the other party pays interest at a floating rate. Normally, swap contracts allow for payments to be netted against each. Jul 30, 2019 an interest rate swap is a contract between two parties to exchange all future interest rate payments forthcoming from a bond or loan.
Swaps allow investors to offset the risk of changes in future interest rates. An interest rate swap is a contractual agreement between two parties to exchange interest payments. This combination of libors on the above dates represents only one of an infinite number of possible outcomes to the swap. Thus, a company that has only been able to obtain a flo. Interest rate swap with journal entries intermediate accounting. Modeling vanilla interest rate swaps using quantlib python. Generally, the two parties in an interest rate swap are trading a fixed rate and variable interest rate. You can think of an interest rate swap as a series of forward contracts. For interest rate swaps, the relationship between swap rates and interest rate futures contracts is examined. A plain vanilla fixedforfloating swap involves the. A plain vanilla interest rate swap is often done to hedge a floating rate. If they do, the partys interest payments will go down as well.
A plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Value and price of swaps derivatives cfa level 1 exam. Fixed for floating swap interest rate swap the exchange of interest rates for the mutual benefit of the exchangers. A plain vanilla interest rate swap is often done to hedge a floating rate exposure, although it can also be done to take advantage of a declining rate environment by moving from a fixed to a floating rate. A plain vanilla swap usually involves one party swapping a series of xed level payments for a series of variable payments. Plain vanilla swaps exchange fixed and floating interest rate products whereas asset swaps exchange fixed rate investments such as bonds which pay a guaranteed coupon rate with floating rate investments such as an index. Interest rate swap contract an interest rate swap commits two counterparties to exchange, over an agreed period, two streams of coupon payments, each calculated using a different interest rate index, but applied to a common notional principal amount. A plain vanilla swap can include a plain vanilla interest rate swap in which two parties enter into an agreement where one party agrees to pay a fixed rate of interest on a certain dollar amount on specified dates and for a specified time period. Thats what a plain vanilla swap is a series of fras as long as both legs are paidreceived at the same time periodicity.
What is the difference between a swap and a swaption. If the investor holds plain vanilla bonds in such a market than he is actually at a loss. In this chapter, we will study the four basic types of swaps. In a plain vanilla interest rate swap, company a and company b choose a maturity, principal amount, currency, fixed interest rate, floating interest rate index. There are several types of plain vanilla swaps, including an interest rate swap, commodity swap, and a foreign currency swap. Lets do an example to show you how plain vanilla interest rate swaps work. A borrower is locked into fixed rate debt and anticipates that interest rates will.
Expected exposure and pfe simulation with quantlib and. We will study how the swaps market is organized, how to price swaps, and how to use swaps. With this type of swap, party a agrees to pay party b a fixed rate of interest, determined in advance, on a notional principal on specified dates for a certain length of time. Apr 16, 2018 the swap contract in which one party pays cash flows at the fixed rate and receives cash flows at the floating rate is the most widely used interest rate swap and is called the plain vanilla swap or just vanilla swap. Is it better to explain plain vanilla interest rate swap as a. Jul 06, 2019 the most common and simplest swap is a plain vanilla interest rate swap. On february 1st, 2014, parties a and b enter into a fiveyear swap with the following terms. The terms of the swap are typical in other words, the swap is what is generally considered to be a plain vanilla swap, and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap. The price of a plain vanilla interest rate swap is quoted as the fixed rate side. Using a floating for fixed interest rate swap to hedge out cash flow risk entity a issued 5 year bonds on 1 january 2010 for r1 million. Plain vanilla swap financial definition of plain vanilla swap. As in most financial transactions, a swap dealer is in between the two parties taking a commission on the trade.
In order to value the swap, an analyst will need to value corresponding fixed and floating rate bonds based on current market place interest rates. The value of the swap is derived from the underlying value of the two streams of interest payments. Afterthefact payments in plain vanilla interest rate swap. A treasury bond is often used as a benchmark because its rate is considered riskfree. Afterthefact payments in plain vanilla interest rate swap note.
Generally, the two parties in an interest rate swap are trading a fixedrate and variableinterest rate. An interest rate swap in its most basic form, often called a plain vanilla swap, is a financial contract in which two parties agree to simultaneously lend from, and borrow to, each other a certain amount of money in the same currency for the same duration but using different interest rates, generally a fixed rate and a floating rate. Depending on whether you are lending or borrowing, it can be viewed as a. The two legs of the swap are a fixed interest rate, say 3. I am following the example given in the cran paper rquantlib.
The plain vanilla swap is an agreement to exchange interest rate payments on nominally identical principal. Another notable case is harvard universitys termination of a subset of its libor pegged ir swaps in 2004. The mechanics of a plain vanilla interest rate swap are fairly straightforward and. Treasuries with the same maturity as the swap is called the swap spread. The exchangers take advantage of interest rates that are only available, for whatever reason, to the other exchanger by swapping them. A plain vanilla swap, also known as a generic swap, is the most basic type of such transaction.