3. The Foreign Exchange Market The foreign exchange market provides the physical and institutional structure through which the money of one country is exchanged for that of another country, the rate of exchange between currencies is determined, and foreign exchange transactions are physically completed. A foreign exchange transaction is an agreement between a buyer and a seller that a given amount of one currency is to be delivered at a specified rate for some other currency. 3.1 Geographical Extent of the Foreign Exchange Market Geographically, the foreign exchange market spans the globe, with prices moving and currencies traded somewhere every hour of every business day. The market is deepest, or most liquid, early in the European afternoon, when the markets
of both Europe and the U.S. East coast are open. The market is thinnest at the end of the day in California, when traders in Tokyo and Hong Kong are just getting up for the next day. In some countries, a portion of foreign exchange trading is conducted on an official trading floor by open bidding. Closing prices are published as the official price, or 'fixing' for the day and certain commercial and investment transactions are based on this official price. 3.2 The Size of the Market In April 1992, the Bank of International Settlements (BIS) estimated the daily volume of trading on the foreign exchange market and its satellites (futures, options, and swaps) at more than USD 1 trillion. This is about 5 to 10 times the daily volume of international trade in goods and services. The market is dominated by trading in USD, DEM, and JPY respectively. The major markets are London (USD 300 billion), New York (USD 200 billion), and Tokyo (USD 130 billion). 3.3 Functions of the Foreign Exchange Market The foreign exchange market is the mechanism by which a person of firm transfers purchasing power form one country to another, obtains or provides credit for international trade transactions, and minimizes exposure to foreign exchange risk. Transfer of Purchasing Power: Transfer of purchasing power is necessary because international transactions normally involve parties in countries with different national currencies. Each party usually wants to deal in its own currency, but the transaction can be invoiced in only one currency. Provision of Credit: Because the movement of goods between countries takes time, inventory in transit must be financed. Minimizing Foreign Exchange Risk: The foreign exchange market provides "hedging" facilities for transferring foreign exchange risk to someone else. 3.4 Market Participants The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail market. Individual transactions in the interbank market usually involve large sums that are multiples of a million USD or the equivalent value in other currencies. By contrast, contracts between a bank and its client are usually for specific amounts, sometimes down to the last penny. Foreign Exchange Dealers: Banks, and a few nonbank foreign exchange dealers, operate in both the interbank and client markets. They profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price. Worldwide competitions among dealers narrows the spread...
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