3. The Foreign Exchange MarketThe foreign exchange market provides the physical and institutional structure throughwhich the money of one country is exchanged for that of another country, the rate ofexchange between currencies is determined, and foreign exchange transactions arephysically completed.A foreign exchange transaction is an agreement between a buyer and a seller that a givenamount of one currency is to be delivered at a specified rate for some other currency.3.1 Geographical Extent of the Foreign Exchange MarketGeographically, the foreign exchange market spans the globe, with prices moving andcurrencies traded somewhere every hour of every business day.The market is deepest, or most liquid, early in the European afternoon, when the marketsof 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 andHong Kong are just getting up for the next day.In some countries, a portion of foreign exchange trading is conducted on an officialtrading 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 officialprice.3.2 The Size of the MarketIn April 1992, the Bank of International Settlements (BIS) estimated the daily volume oftrading on the foreign exchange market and its satellites (futures, options, and swaps) atmore than USD 1 trillion. This is about 5 to 10 times the daily volume of internationaltrade in goods and services.The market is dominated by trading in USD, DEM, and JPY respectively. The majormarkets are London (USD 300 billion), New York (USD 200 billion), and Tokyo (USD130 billion).3.3 Functions of the Foreign Exchange MarketThe foreign exchange market is the mechanism by which a person of firm transferspurchasing power form one country to another, obtains or provides credit forinternational trade transactions, and minimizes exposure to foreign exchange risk.Transfer of Purchasing Power:Transfer of purchasing power is necessary because international transactions normallyinvolve parties in countries with different national currencies. Each party usually wants todeal 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 mustbe financed.Minimizing Foreign Exchange Risk:The foreign exchange market provides "hedging" facilities for transferring foreignexchange risk to someone else.3.4 Market ParticipantsThe 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 aremultiples 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 downto the last penny.Foreign Exchange Dealers:Banks, and a few nonbank foreign exchange dealers, operate in both the interbank andclient markets. They profit from buying foreign exchange at a bid price and reselling it ata slightly higher ask price.Worldwide competitions among dealers narrows the spread between bid and ask and socontributes to making the foreign exchange market efficient in the same sense assecurities markets.Dealers in the foreign exchange departments of large international banks often functionas market makers. They stand willing to buy and sell those currencies in which theyspecialize by maintaining an inventory position in those currencies.Participants in Commercial and Investment Transactions:Importers and exporters, international portfolio investors, multinational firms, tourists,and others use the foreign exchange market to facilitate execution of commercial orinvestment transactions.Some of these participants use the foreign exchange market to hedge foreign exchangerisk.Speculators and Arbitragers:Speculators and arbitragers seek to profit from trading in the market. They operate intheir own interest, without a need or obligation to serve clients or to ensure a continuousmarket.Speculators seek all of their profit from exchange rate changes.Arbitragers try to profit from simultaneous exchange rate differences in different markets.Central Banks and Treasuries:Central banks and treasuries use the market to acquire or spend their country's foreignexchange reserves as well as to influence the price at which their own currency is traded.In many instances they do best when they willingly take a loss on their foreign exchangetransactions. As willing loss takers, central banks and treasuries differ in motive andbehavior form all other market participants.Foreign Exchange Brokers:Foreign exchange brokers are agents who facilitate trading between dealers withoutthemselves becoming principals in the transaction. For this service, they charge a smallcommission, and maintain access to hundreds of dealers worldwide via open telephonelines.It is a broker's business to know at any moment exactly which dealers want to buy or sellany currency. This knowledge enables the broker to find a counterpart for a client quicklywithout revealing the identity of either party until after an agreement has been reached.3.5 Transactions in the Interbank MarketTransactions in the foreign exchange market can be executed on a spot, forward, or swapbasis.Spot Transactions:A spot transaction requires almost immediate delivery of foreign exchange.In the interbank market, a spot transaction involves the purchase of foreign exchangewith delivery and payment between banks to take place, normally, on the secondfollowing business day.The date of settlement is referred to as the "value date."Spot transactions are the most important single type of transaction (43 % of alltransactions).Outright Forward Transactions:A forward transaction requires delivery at a future value date of a specified amount ofone currency for a specified amount of another currency.The exchange rate to prevail at the value date is established at the time of the agreement,but payment and delivery are not required until maturity.Forward exchange rates are normally quoted for value dates of one, two, three, six, andtwelve months. Actual contracts can be arranged for other lengths.Outright forward transactions only account for about 9 % of all foreign exchangetransactions.Swap Transactions:A swap transaction involves the simultaneous purchase and sale of a