# Plain Vanilla Interest Rate Swap

### Merke

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{*LOSnr37*}

Define, calculate, and interpret the payments of currency swaps, plain vanilla interest rate swaps, and equity swaps.

In a plain vanilla interest rate swap, one party pays a floating rate and the other pays a fixed rate, both based on the notional amount. A plain vanilla swap is a fixed-for-floating swap.

$$\text {Fixed rate payment} =$$
$$\text {(swap fixed rate - LIBORt-1)} \cdot {\text {number of days} \over 360}\cdot \text {notional principal}$$

### Beispiel

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Example:

Your bank’s assets have an average fixed rate of 10% with an average maturity of 5 years. Bank liabilities are composed of short-term deposits that are pegged to LIBOR. You would like to hedge against the possibility of rising interest rates by entering into a plain-vanilla interest rate swap. A swap dealer has offered you the following quarterly swap – 8% fixed for LIBOR floating with a notional principal value of \$50 million for 5 years. The cash flows that apply to this example are the following: • The bank’s LIBOR-based payments to depositors are offset by the swap dealer’s LIBOR payment to the bank. • The bank is receiving 10% from its loan portfolio and is paying 8% fixed to the swap dealer. The net inflow to the bank is a fixed 2% annually on a$50 million basis. ### Beispiel

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Example:

XYZ, Inc. has entered into a "plain-vanilla" interest rate swap on \$5,000,000 notional principal. XYZ company pays a fixed rate of 8.5% on payments that occur at 180-day intervals. Platteville Investments, a swap broker, negotiates with another firm, SSP, to take the receive-fixed side of the swap. The floating rate payment is based on LIBOR (currently at 7.2%). At the time of the next payment (due in exactly 180 days), XYZ company will: A. pay the dealer net payments of$65,000.

B. pay the dealer net payments of $32,500. C. receive net payments of$32,500.

The answer is B. The net payment formula for the fixed-rate payer is:

$$\text {Fixed Rate Payment} =$$
$$\text {(Swap Fixed Rate - LIBORt-1)} \cdot {\text {number of days in term} \over 360} \cdot \text {Notional Principal}$$

If the result is positive, the fixed-rate payer owes a net payment and if the result is negative, then the fixed-rate payer receives a net inflow. Note: We are assuming a 360 day year.

Fixed Rate Payment = (0.085 - 0.072) * (180 / 360) * 5,000,000 = \\$32,500

Since the result is positive, XYZ owes this amount to the dealer, who will remit to SSP.