FX Options and Smile Risk

1

The FX Market

The foreign exchange (FX) market is an OTC market where each participant trades directly with the others; there is no exchange, though we can identify some major geographic trading centres: London (the primary centre, where the primary banks’ market makers are located; its importance has increased in the last few years), New York, Tokyo, Singapore and Sydney. This means that trading activity is carried out 24 hours a day, though in practice during London working hours the market has the most liquidity. Needless to say, the FX market experiences fierce competition amongst participants.

Most trades are currently carried out via interbank platforms (EBS is the most important). Anyway, the major market makers offer Internet platforms to their clients for quick trades and for leaving orders. The Reuters Dealing, which was the main platform in the past, has lately lost much of its pre-eminence. Basically, it is a chat system connecting the participants, capable of recognizing the deal implicit in typical conversations between two professional operators, and transforming it into an automatic confirmation for the transaction. Nowadays, the Reuters Dealing is used mainly by option traders.

1.1 FX RATES AND SPOT CONTRACTS

Definition 1.1.1. FX rate. An exchange (FX) rate is the price of one currency in terms of another currency; the two currencies make a pair. The pair is denoted by a label, made up of two tags of three characters each: each currency is identified by its ...