HOW THE FOREIGN-EXCHANGE MARKET WORKS
HOW THE FOREIGN-EXCHANGE MARKET WORKS
Basic Spot and Forward Markets
With a basic understanding of exchange rate quotations, we can now exam-
ine how foreign exchange is traded,
The majority of foreign-exchange transactions are carried out by com-
mercial banks, with the rest conducted by foreign-exchange brokers. Brokers are specialists who facilitate transactions between banks and replace direct contact between banks.
58 percent of all foreign-exchange trading in the United States is conducted in the spot market, primarily the interbank market.The next-largest category is the swap market. A swap is a simultaneous
spot and forward transaction. For example, a U.S. firm might need British
pounds for 30 days, so it enters into a spot transaction to exchange dollars for pounds and enters into a simultaneous forward transaction to exchange the pounds for dollars in 30 days when the need for British pounds is completed.
The other major foreign-exchange transactions are outright forwards, options, and futures. The outright forward is a forward contract that is not connected to a spot transaction. For example, a firm might be receiving British pounds in 90 days and thus enter into a forward contract to trade pounds for dollars in 90 days. An option is the right to trade foreign currency. It is a relatively new instrument that is gaining in importance. A firm that buys an option pays a brokerage fee and a premium to have the right to buy or sell foreign currency within a certain time period. For example, let's assume that a firm enters into an option to buy Japanese yen at 130 yen per dollar ($0.00769 per yen). The firm would have to pay the premium and the brokerage fee for the right to enter into the option. If the rate is 140 yen per dollar ($0.00714) when the firm wants to buy the yen, it would not exercise the option, because it would not cost as much to buy the yen at the market rate as it would at the option rate. If the market rate is 120 yen per dollar
($0,008), the firm would exercise the option, since it would be cheaper to buy at the option rate than it would be to buy at the market rate. The option provides the firm some flexibility, but the firm must also pay the brokerage fee and the premium whether it exercises the option or not.
The futures contract is similar to the forward contract in that it specifies an exchange rate in advance of the future exchange of currency. The futures contract is not as flexible as a forward contract, because the futures contracts are for specific amounts of currency and for specific maturity dates, whereas forward contracts can be tailor-made to fit the size of the transaction and the maturity date. Forward contracts depend on a client's relationship with the bank of the trader, but the futures contract is entered into by anyone through a broker on the exchange floor.
Basic Spot and Forward Markets
With a basic understanding of exchange rate quotations, we can now exam-
ine how foreign exchange is traded,
The majority of foreign-exchange transactions are carried out by com-
mercial banks, with the rest conducted by foreign-exchange brokers. Brokers are specialists who facilitate transactions between banks and replace direct contact between banks.
58 percent of all foreign-exchange trading in the United States is conducted in the spot market, primarily the interbank market.The next-largest category is the swap market. A swap is a simultaneous
spot and forward transaction. For example, a U.S. firm might need British
pounds for 30 days, so it enters into a spot transaction to exchange dollars for pounds and enters into a simultaneous forward transaction to exchange the pounds for dollars in 30 days when the need for British pounds is completed.
The other major foreign-exchange transactions are outright forwards, options, and futures. The outright forward is a forward contract that is not connected to a spot transaction. For example, a firm might be receiving British pounds in 90 days and thus enter into a forward contract to trade pounds for dollars in 90 days. An option is the right to trade foreign currency. It is a relatively new instrument that is gaining in importance. A firm that buys an option pays a brokerage fee and a premium to have the right to buy or sell foreign currency within a certain time period. For example, let's assume that a firm enters into an option to buy Japanese yen at 130 yen per dollar ($0.00769 per yen). The firm would have to pay the premium and the brokerage fee for the right to enter into the option. If the rate is 140 yen per dollar ($0.00714) when the firm wants to buy the yen, it would not exercise the option, because it would not cost as much to buy the yen at the market rate as it would at the option rate. If the market rate is 120 yen per dollar
($0,008), the firm would exercise the option, since it would be cheaper to buy at the option rate than it would be to buy at the market rate. The option provides the firm some flexibility, but the firm must also pay the brokerage fee and the premium whether it exercises the option or not.
The futures contract is similar to the forward contract in that it specifies an exchange rate in advance of the future exchange of currency. The futures contract is not as flexible as a forward contract, because the futures contracts are for specific amounts of currency and for specific maturity dates, whereas forward contracts can be tailor-made to fit the size of the transaction and the maturity date. Forward contracts depend on a client's relationship with the bank of the trader, but the futures contract is entered into by anyone through a broker on the exchange floor.
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