Basic definition of a vanilla interest rate swap?

[ivorystraws]

I'm just wondering if anyone could provide a link or an explanation in layman's term's of what a vanilla interest rate swap is?

I've found some useful info on wikipedia and some other sites but some of the examples provided are filled with abbreviations and specific financial terms.

Basically, I know that it's where one party agrees to swap cash flows with another. Example, a business may have a fixed-rate loan, while another business may have a variable-rate loan; each of the businesses would prefer to have the other type of loan. Rather than cancel their existing loans (if this is possible, it may be expensive), the two businesses can achieve the same effect by agreeing to "swap" cash flows: the first pays the second based on a floating-rate loan, and the second pays the first based on a fixed-rate loan (in practice, the two will net out the amounts owing). By swapping the cash flow, each has "converted" or "swapped" one type of loan into another.

But why would you use them and how are they valued (in layman's terms)?

 

[CCOVICH]

Why would you use them? To hedge your cash flows.

If you have a steady cash flow, you would be comfortable paying fixed, and vice versa.

How are they valued? By discounting the future cash flows against the swap curve.

 

[ivorystraws]

Thanks CCOVICH!

Sorry if my questions seem basic but how do I discount the future cash flows against the swap curve? I think I need to do some background reading on swap curves.

 

[CCOVICH]

The swap curve will give you the future discount rates-but I'm not sure how this relevant to someone in business-are you looking to mark-to-market swaps on a daily basis? Why?

FWIW, Anglo Irish Bank [broken link removed] (the cost to exchange fixed for floating) on their website each day.

 

[ivorystraws]

That's perfect thanks! No sorry, I won't be using swaps at any stage.. thanks so much for the information.