A swap is an exchange of financial flows between two companies or financial institutions. Money is not directly exchanged, but financial instruments like interest rates are. Here’s an example: Both you and your friend buy a $100,000 home. You get a fixed rate of 2% and he gets a variable rate that ends up being 1.6% for the first year. You say, “Shoot! I should have taken a variable rate!” He says, “Shoot, what have I got myself into if next year my rate increases to 3%?”
You both agree to exchange (swap) your rates because you both think that it’s better for you. As a result, your friend pays the 2%, and in exchange, you pay the value of the variable rate. If the variable rate stays below 2% for a long time you will come out on top, however if it quickly climbs above 2% you will lose. You have swapped the risk with your friend, since each of you thought your initial choices were riskier than the other’s.

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