Simple English definitions for legal terms
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A generic swap is an agreement between two parties to exchange interest payments or obligations. This is usually done to manage risk, speculate on interest rate changes, or convert an instrument from a fixed to a floating rate or vice versa. The parties involved are called counterparties. A plain-vanilla swap is a typical interest-rate swap where one party pays a fixed interest rate while the other assumes a floating interest rate based on the principal amount of the underlying debt. The notional amount of the swap, which is the underlying debt, does not change hands, only the interest payments are exchanged.
A generic swap is a type of interest-rate swap where two parties agree to exchange interest receipts or interest-payment obligations. This is usually done to adjust one's risk exposure, speculate on interest-rate changes, or convert an instrument or obligation from a fixed to a floating rate or vice versa. The parties involved in this agreement are called counterparties.
A plain-vanilla swap is a typical interest-rate swap that involves one counterparty paying a fixed interest rate while the other assumes a floating interest rate based on the amount of the principal of the underlying debt. The underlying debt, called the "notional" amount of the swap, does not change hands, only the interest payments are exchanged.
For example, let's say Company A has a loan with a fixed interest rate of 5%, while Company B has a loan with a floating interest rate based on the LIBOR rate. Company A may want to convert their fixed interest rate to a floating rate, while Company B may want to do the opposite. They can enter into a plain-vanilla swap agreement where Company A pays Company B a fixed interest rate of 5%, and Company B pays Company A a floating interest rate based on the LIBOR rate. This way, both companies can achieve their desired interest rate structure.