An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

3

The Foreign Exchange Market

3.1 CHAPTER OVERVIEW

The foreign exchange market is a global, technology-based marketplace in which banks, corporations, governments, and institutional investors trade currencies around the clock. This chapter explores the structure of the market and the role of foreign exchange (FX) dealers in sustaining liquidity. It considers the changing role of central banks in a world largely based on freely floating exchange rates. It looks at how a spot FX dealer makes two-way quotations and assesses the profitability of deals. The chapter explores the different types of risks that have to be managed in the FX dealing room, such as market risk and settlement risk, and the factors that determine FX rates between currencies. Although the bulk of FX deals are still settled two business days after the deal is agreed (spot transactions) there is also a highly active market in forward FX transactions. The chapter looks at the application of products such as outright forward FX deals and FX swaps in managing currency risks, in matching expected future cash flows, and in switching investments into foreign currency assets.

3.2 MARKET STRUCTURE

In the millennium year 2000 average daily volumes in FX trading around the world exceeded $ 1.5 trillion for the first time. However import and export transactions between countries accounted for only about 3 % of these trades. The bulk of FX deals are made by commercial banks including giants such as JP Morgan Chase, Citigroup, ...