All About Forex Market In Usa.pdf

foreword

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FOREWORD

Over the past forty years, the Federal Reserve Bank of New York has published

monographs about the operation of the foreign exchange market in the United States.

The first of these reports, The New York Foreign Exchange Market , by Alan Holmes, was

published in 1959. The second, also entitled The New York Foreign Exchange Market ,

was written by Alan Holmes and Francis Schott and published in 1965. The third

publication, Foreign Exchange Markets in the United States , was written by Roger

Kubarych and published in 1978.

Each of these publications presents a lucid

and informed picture of the foreign exchange

market and how it operates, filled with

rich insights and reflecting a profound

understanding of the market and its complex

mechanisms. Roger Kubarych’s report, written

twenty years ago, provided a valuable analysis

of the foreign exchange market that is still read

and widely appreciated by persons interested in

gaining a deeper understanding of that market.

are traded. Chapters 7-8 look at foreign

exchange trading from a micro, rather than

macro, point of view—how an individual

bank or other dealing firm sees things.

Chapters 9-11 comment on some of the

broader issues facing the international

monetary system and how governments,

central banks, and market participants

operate within that system. This is followed by

an epilogue, emphasizing that there are many

unanswered questions, and that we can expect

many further changes in the period ahead,

changes that we cannot now easily predict.

But the foreign exchange market is always

changing, always adapting to a shifting world

economy and financial environment. The

metamorphosis of the 1980s and ‘90s in both

finance and technology has changed the structure

of the market and its operations in profound

ways. It is useful to reexamine the foreign

exchange market from today’s perspective.

Markets go back a long time—in English

law, the concept was recognized as early as the

11th century—and it is interesting to compare

today’s foreign exchange market with historical

concepts. More than one hundred years ago,

Alfred Marshall wrote that “a perfect market is

a district, small or large, in which there are

many buyers and many sellers, all so keenly on

the alert and so well acquainted in one

another’s affairs that the price of a commodity

is always practically the same for the whole of

the district.”

The focus of the present book is once again

on the U.S. segment of the global foreign

exchange market. Chapters 1-3 describe the

structure of the market and how it has

changed. Chapters 4-6 comment on the main

participant groups and the instruments that

1 l The Foreign Exchange Market in the United States

foreword

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Today’s over-the-counter global market in

foreign exchange meets many of the standards

that classical economists expected of a

smoothly functioning and effective market.

There are many buyers and many sellers.

Entry by new participants is generally not too

difficult. The over-the-counter market is

certainly not confined to a single geographical

area as the classical standards required.

However, with the advance of technology,

information is dispersed quickly and

efficiently around the globe, with vast

amounts of information on political and

economic developments affecting exchange

rates. As in commodity markets, identical

products are being traded in financial centers

all around the world. Essentially, the same

marks, dollars, francs, and other currencies

are being bought and sold, no matter where

the purchase takes place. Traders in different

centers are continuously in touch and buying

and selling from each other. With trading

centers open at the same time, there is no

evidence of substantial price differences

lasting more than momentarily.

systems, the price discovery process has

become less exclusive and pricing information

more broadly disseminated—at least for

certain foreign exchange products and

currency pairs. Indeed, by most measures, the

over-the-counter foreign exchange market is

regarded by observers as not only extremely

large and liquid, but also efficient and

smoothly functioning.

Many persons, both within and outside the

Federal Reserve, helped in the preparation of this

book,through advice,criticism,and drafting.

In the Federal Reserve, first and foremost, before

his tragic death, Akbar Akhtar was a close

collaborator on the project over an extended

period, contributing to all aspects of the effort

and helping to produce much of what is here.

Dino Kos and his colleagues in the Markets

Group were exceedingly helpful. Allan Malz

contributed in many important ways. Robin

Bensignor, John Kambhu, and Steven Malin

also provided much valuable assistance, and Ed

Steinberg’s contribution as editor was invaluable.

At the Federal Reserve Board, Ralph Smith

offered very useful suggestions and comments.

Not all features of today’s over-the-counter

market fully conform to the classical ideals.

There is not perfect “transparency,” or full and

immediate disclosure of all trading activity.

Individual traders know about the orders and

the flow of trading activity in their own firms,

but that information may not be known to

everyone else in the market. However,

transparency has increased enormously in

recent years. With the growth of electronic

dealing systems and electronic brokering

Outside of the Federal Reserve, Michael

Paulus of Bank of America contributed

profoundly and in many ways to the entire

project, both in technical matters and on

questions of broader philosophy. Christine

Kwon also assisted generously. Members of the

trading room staff at Morgan Guaranty were

also very helpful. At Fuji Bank, staff officials

provided valuable assistance. Richard Levich

provided very helpful comments.

The Foreign Exchange Market in the United States l 2

table of contents 1 of 3

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CHAPTERS

w FOREWORD

ONE- Trading Foreign Exchange:

A Changing Market in a

Changing World

1. How the Global Environment Has Changed

2. How Foreign Exchange Turnover Has Grown

p. 3

w TWO- Some Basic Concepts:

Foreign Exchange, the Foreign

Exchange Rate, Payment and

Settlement Systems ä p. 9

1. Why We Need Foreign Exchange

2. What “Foreign Exchange” Means

3. Role of the Exchange Rate

Bilateral and Trade-Weighted Exchange Rates

4. Payment and Settlement Systems

Payments via Fedwire and CHIPS

THREE- Structure of the

Foreign Exchange Market

1. It Is the World’s Largest Market

2. It Is a Twenty-Four Hour Market

p. 15

3. The Market Is Made Up of an International Network of Dealers

4. The Market’s Most Widely Traded Currency Is the Dollar

5. It Is an “Over-the-Counter” Market With an “Exchange-Traded” Segment

FOUR- The Main Participants

in the Market

1. Foreign Exchange Dealers

2. Financial and Nonfinancial Customers

p. 23

3. Central Banks

Classification of Exchange Rate Arrangements, September 1997

4. Brokers

In the Over-the-Counter Market

Voice Brokers

Automated Order-Matching or Electronic Broking Systems

In the Exchange-Traded Market

FIVE- Main Instruments:

Over-the-Counter Market

1. Spot

There Is a Buying Price and a Selling Price

p. 31

How Spot Rates Are Quoted: Direct and Indirect Quotes,

European and American Terms

There Is a Base Currency and a Terms Currency

Bids and Offers Are for the Base Currency

Quotes Are in Basis Points

Cross Rate Trading

Deriving Cross Rates From Dollar Exchange Rates

2. Outright Forwards

Relationship of Forward to Spot—Covered Interest Rate Parity

Role of the Offshore Deposit Markets for Euro-Dollars and Other Currencies

How Forward Rates Are Quoted by Traders

Calculating Forward Premium/Discount Points

Non-Deliverable Forwards (NDFs)

The Foreign Exchange Market in the United States

table of contents 2 of 3

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CHAPTERS

w FIVE- Main Instruments:

Over-the-Counter Market

( continued from last page )

3. FX Swaps

Why FX Swaps Are Used

Pricing FX Swaps

Some Uses of FX Swaps

Calculating FX Swap Points

4. Currency Swaps

Purposes of Currency Swaps

5. Over-the-Counter Foreign Currency Options

The Pricing of Currency Options

Delta Hedging

Put-Call Parity

How Currency Options Are Traded

Options Combinations and Strategies

Foreign Exchange Options Galore

w SIX- Main Instruments:

Exchange-Traded Market

ä p. 59

1. Exchange-Traded Futures

Development of Foreign Currency Futures

Quotes for Foreign Currency Futures

2. Exchange-Traded Currency Options

3. Linkages

Linkages Between Main Foreign Exchange Instruments in Both

OTC and Exchange-Traded Markets

SEVEN- How Dealers Conduct

Foreign Exchange Operations

1. Trading Room Setup

2. The Different Kinds of Trading Functions of a Dealer Institution

p. 67

3. Trading Among Major Dealers—Dealing Directly and Through Brokers

Mechanics of Direct Dealing

Mechanics of Trading Through Brokers: Voice Brokers and Electronic

Brokering Systems

4. Operations of a Foreign Exchange Department

5. Back Office Payments and Settlements

w EIGHT- Managing Risk in

Foreign Exchange Trading

ä p. 77

1. Market Risk

Measuring and Managing Market Risk

Va l u e a t R i s k

7 8

2. Credit Risk

Settlement Risk—A Form of Credit Risk

Arrangements for Dealing with Settlement Risk

Sovereign Risk—A Form of Credit Risk

Group of Thirty Views on Credit Risk

3. Other Risks

The Foreign Exchange Market in the United States

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