Foreign Exchange Basics
I start with some basic knowledge about foreign exchange that the reader will want to have before tackling currency options.
THE FOREIGN EXCHANGE MARKET
An exchange rate is a market price at which one currency can be exchanged for another. Exchange rates are sometimes called pairs because there are always two currencies involved. If the exchange rate for Japanese yen in terms of U.S. dollars is 90.00, it is meant that yen can be traded for dollars—or dollars traded for yen—at the rate of $1 for 90.00 yen.
A spot foreign exchange transaction (or deal)1 is an agreement to exchange sums of currencies, usually in two bank business days' time. This transaction is the core of the foreign exchange market. A forward transaction is a deal done for settlement, or value, at a time beyond spot value day. There are two kinds of forwards. Forward outrights are similar to spot deals. The exchange rate is agreed when the deal is done on the trade date, but currencies settle at times in the future further out on the settlement calendar, say in a week, or a month, or in many months. A forward swap is the combination of a spot deal and a forward deal done in opposite directions. Forward outrights and forward swaps will be covered in detail later in this chapter.
It is well known that the foreign exchange market is a very large market, but exactly how large is hard to say. Our single best source as to the size and structure of the worldwide foreign exchange market ...