Handbook of Exchange Rates

23.1 Introduction

This chapter provides an overview of the markets for foreign exchange (FX) futures, forwards, and swaps. In contrast to the FX spot market where traded currencies are settled immediately (within 2 days after the transaction in practice), FX futures, forward, and swap contracts involve transactions to buy or sell currencies that are settled on a future date.

FX derivatives markets have been regarded as one of the most well-developed, liquid, and efficient markets. In its Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, the Bank for International Settlements (BIS) reported that as of end-April 2010, the global daily turnover of FX swaps and outright forwards amounted to $1765 billion and $475 billion, respectively, while that of FX spot stood at $1490 billion. The turnover of FX swaps and outright forwards combined increased more than 2.5 times from 1998 through 2010. Such significant growth of FX derivatives markets has provided investors and bond issuers with much greater flexibility in accessing hedging, speculative and arbitrage opportunities with regard to foreign currency-denominated assets and liabilities.

How efficiently these FX derivatives markets function can be gauged by examining the so-called the covered interest parity (CIP) conditions, which correspond to no arbitrage conditions between domestic and foreign interest rates when the associated cash flow is covered by FX forwards. Empirical research on the CIP conditions ...