Question

1. Describe the structure of a plain vanilla swap and describe how long and short positions can be used to hedge risk for a firm. Be complete and support your answer with a graph.

Answer 1

Plain vanilla swap are the simple interest rate swaps. In this person A agrees to pay person B a predetermined, fixed rate of interest on the notional principal on specified dates for a specified period of time. Whereas, person B agrees to make payments based on the floating insterest rate to person A on the same notional principal on the specified dates and time period.

Let's take future contacts to undertand hedging.

The long positions in the market implies the action of purchasing futures and anticipating its value will increase over time.

And short position implies anticipating a fall in the price.

Heding is a process where therisk is offset. The investors use short and long position to hedge their risk.

For eg, an investor is in long position and the price of the future contract today is $100. He will expect the price to increase in future to $ 150, so he can earn a profit of $50. Howvever, if the price decreases to $50, then the investors incurs a loss of $50.

Now suppose, the investors is in short position, and futures price at $100. He anticipates the price will lower ta $50, so he could earn a profit. However, if the price increases, he will suffer losses.

In both these cases the opposite is beneficial to the other. Therfore, to hedge the risk, when the investor is in long position, he enters into a similar short position to offset the risk and vise versa.

The graph below justifies the above stated example of hedging through long and short position.