An FX Swap, or a Foreign Exchange Swap, is the simultaneous sale and purchase of one currency for another. In theory, at a later date the sale and purchase will be reversed. The first transaction is conducted at one price, and the second is conducted at another – a futures price. As the two transactions are agreed at the same time, they are designed to offset each other.
In addition, as each party carries the repayment obligation to its counterpart as collateral on the agreement, some people view FX swaps as risk free collateralised borrowing/lending.
FX swaps are often used by institutions to help fund their foreign exchange balances, they are also frequently used by investors to hedge their positions.
Here is a good example of why a company might undertake an FX swap:
You have €1m in a company account in Germany, and a requirement to fund $900,000 of operations in the US over a six month period. You want to use your surplus of Euros to fund this requirement, but don't wish to take a risk on the forex markets.
Accordingly, you make an agreement with your bank to sell your Euros for a spot rate of 0.90 Euros, and to buy them back in three months at a forward rate of 0.8912. The spot rate and the forward rate is worked out as:
900,000 / 1,000,000 = 0.90 (spot rate)
Theoretical 5% interest on €1,000,000 for 6 months = €25,000
Theoretical 3% interest on $900,000 for 6 months = $13,500
913,500 / 1,025,000 = 0.8912 (future rate)
Therefore, you can fund your US requirement for three months, and on the future date the bank would return you your €1m in return for a payment of $891,200 (with the $8,800 'profit' being the monetised differences between the exchange rate – 2% on €1m for six months translated back into dollars).