Currency swaps are agreements between two individuals or entities to exchange specified types and amounts of currencies. Along with the initial exchange of a specific amount of one currency for a specific amount of a different currency, the process of a currency swap normally also includes a series of recurring payments based on the cash flow performance of the two currencies. This makes a currency swap somewhat different from a currency exchange, in that the exchange normally involves simply exchanging currency at the most recent rate of exchange.
The recurring payments that compose the second phase of a currency swap normally make use of both fixed and variable rates of interest. One party will agree to pay a fixed interest rate, while the second party will make interest payments based on a floating rate of exchange. However, it is possible to arrange a currency swap agreement where both parties pay recurring payments based on a fixed rate or a floating exchange rate. The final determination of how the interest rate will be calculated is defined in the terms and conditions that govern the swap.
One important aspect of the currency swap that also sets it apart from currency exchanges is the fact that the swapping of the currency is not a permanent component. At the time that the two currencies are swapped, the parties agree to make the recurring interest rate payments for a specific period of time. Once the duration outlined in the agreement is complete, the two currencies are returned to the original owner. However, each party retains all returns that were shared in the form of interest payments.
The transaction of a currency swap is usually utilized when there is some expectation that the two currencies in question have potential to realize a significant amount of return via the rates of interest accrued. As can be expected, both parties usually anticipate realizing a higher return with the currency type that is received in the swap. However, since rates of exchange tend to fluctuate over time, there is usually a reasonable chance that both parties ultimately benefit from the currency swap.