By definition a Swap is a derivative agreement where you exchange one financial instrument for another between you and the other party concerned. This exchange takes place at a predetermined time, as specified in the contract.
Swaps can be used to hedge risk of various kinds which includes interest rate risk and currency risk. Interest rate swaps and currency swaps are the two most common kinds of swaps traded in the market.
An interest rate swap is an instrument that allows you to change your variable interest rate to a fixed rate.
By entering into a swap rate exchange you will be paying the fixed interest rate during the full swap agreement lifetime no matter how much the base rate (or the variable rate) will be or become.
It is important to understand that the fixed rate offered by the bank moves independently from the base rate. As the market sentiment changes so does the rate, where you will fix your swap upon it.
Waiting for the lowest base rate does not guarantee you the lowest fixed rate, quotes will change from day to day, however when you accept the fixed rate, it will not change for the duration of the agreement.
A currency swap is an agreement to exchange principal and fixed interest in one currency for principal and fixed interest in another currency.
It is a long term financing or hedging technique and it helps in managing both interest and exchange rate risk. It can be interpreted as a series of forward contracts. It is not a loan and therefore does not change the liability structure of the parties’ balance sheets.
Unlike the interest rate swap, during the currency swap an exchange of principal occurs.