8. Markets for foreign exchange. Hedging techniques.

The foreign exchange markets are among the largest markets in the world, with trading each day in excess of $200 billion. It is essentially an over-the-counter market, with no central tra­ding location and no set hours of trading. Prices and other terms of trade are determined by negotiation over the telephone or by wire, satellite, or telex. The foreign exchange market is informal in its operations; there are no special requirements for market participants, and trading conforms to an unwritten code of rules among active traders.

The largest money center banks headquartered in New York, London, Tokyo, and other financial capitals of the world not only maintain large inventories of key foreign currencies, but trade curren­cies with each other simply through an exchange of deposits. For example, if a major U.S. bank needs to acquire pounds sterling, it can contact its correspondent bank in London and ask that bank to deliver an additional amount of sterling to the U.S. bank's correspon­dent account. In turn, the U.S. bank will increase the dollar de­nominated deposit held with it by the London bank. In this way money never really leaves the country of its origin; only deposits denominated in various currencies have their ownership transferred from one holder to the next.

The central institutions in modern foreign exchange markets are commercial banks with their foreign exchange departments. They routinely keep working balances of foreign currencies with major banks abroad. Transactions affecting a bank's working cur­rency balance (i.e. buying foreign currency, selling of domestic currency to foreign banks, purchase of financial documents, such as bills of exchange or traveler's checks, that are denominated in foreign currencies) are carried out by specialized traders with the aid of telephones, video screens and teletype equipment to keep them in constant touch with other exchange dealers. Foreign exchange dealing is, as its name implies, the exchange of the cur­rency of one country for the currency of another. In an era of floating exchange rates, dealing in foreign exchange can be exceed­ingly risky. Banks typically employ a wide variety of currency-hedging techniques to help shelter their own and their customer's currency risk exposure. Banks trading in foreign currency are themselves exposed to exchange risks, unless the debts and claims neutralize each other. Dealers continually adjust the bank posi­tion in dollars, yen, pounds and other foreign currencies. They try to avoid both having a long position and being short in any foreign currency. As long as the total position balances there is no risk for the bank.

The prices of foreign currencies expressed in terms of other currencies are called foreign exchange rates. There are today three markets for foreign exchange: (1) the spot market, which deals in currency for immediate delivery; (2) the forward market, which involves the future delivery of foreign currency; and (3) currency futures market, which deals in contracts to hedge against future changes in foreign exchange rates.

The basic idea of foreign exchange dealing is making profit on selling and buying currencies. Dealers and brokers usually quote not one, but two exchange rates for each pair of currencies: a bid (buy) price and an asked (sell) price. The bid-asked spread constitutes the dealer's profit, though that spread is normally very small. Thus the spot bid and asked rates on pounds might be quoted as 52/56. It is assumed the customer is aware of current exchange rates and knows, therefore, that the bid price being quoted is $1.5052/£ and the asked price is $1.5056/£. If there is a difference in price between two markets (for example, of pounds in New York and in London) professional traders will take advantage of this arbitrage opportunity. The force of arbitrage generally keeps foreign exchange rates from getting two far out of line in different markets.

The problem of fluctuating currency values is very serious if payment must be made in future.

Settlement for a spot transaction is usually within one or two business days, in contrast, a forward contract is an agreement to deliver a specified amount at a set price on some future date (known as the value date) within 1, 2, 3, 6 or 12 months.

There are several different ways of measuring and quoting forward exchange rate. One is known as the outright rate. Another popular method is to express the forward rate as a premium or discount from the spot rate, known as the swap rate. Forward exchange rates may also be expressed in terms of annualized percentage rate above or below the current spot price.

In the event customers do not know when they will need foreign currency, an option forward contract is frequently used. The recent volatility of foreign exchange rates has given rise to an ever-growing volume of new techniques to deal with currency risk. Among such hedging instruments are currency options, currency futures contracts and currency swaps. Innovative new approaches continue to emerge each year.