Swaps are derivative contracts between two parties that involve the exchange of cash flows. Interest rate swaps involve exchanging interest payments, while currency swaps involve exchanging an amount of cash in one currency for the same amount in another.
Interest Rate Swaps
An interest rate swap is a financial derivative contract in which two parties agree to exchange their interest rate cash flows. The interest rate swap generally involves exchanges between predetermined notional amounts with fixed and floating rates.
For example, assume bank ABC owns a $10 million investment, which pays the London Interbank Offered Rate, or LIBOR, plus 3% every month. Therefore, this is considered a floating payment because as the LIBOR fluctuates, so does the cash flow. On the other hand, assume bank DEF owns a $10 million investment, which pays a fixed rate of 5% every month. Bank ABC decides it would rather receive a constant monthly payment. However, bank DEF decides to take a chance on receiving higher payments. Therefore, the two banks agree to enter into an interest rate swap contract. Bank ABC agrees to pay bank DEF the LIBOR plus 3% per month on the notional amount of $10 million. Bank DEF agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of $10 million.
Conversely, currency swaps are a foreign exchange agreement between two parties to exchange cash flow streams in one currency to another. While currency swaps involve two currencies, interest rate swaps only deal with one currency.
For example, assume bank XYZ operates in the United States and deals only with U.S. dollars, while bank QRS operates in Russia and deals only with rubles. Suppose bank QRS has investments in the United States worth $5 million. Assume the two banks agree to enter into a currency swap. Bank XYZ agrees to pay bank DEF the LIBOR plus 1% per month on the notional amount of $5 million. Bank QRS agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of 253,697,500 Russian rubles, assuming $1 is equal to 50.74 rubles.