CHAPTER 2 The Foreign Exchange Market

  Learning  objectives  

After studying this chapter, you should be able to:

  1. Explain the structure of the global foreign exchange market, its participants, and how it operates.
  2. Understand how exchange rates are set, the impact of interest rates, capital flows, and international investment.
  3. Understand the method of quotation, including two-way quotation, sell/buy spread, and cross-rate quotation.
  4. Describe the forward market, including various types of outright contracts and the pros and cons of each.
  5. Analyse the ways to hedge foreign exchange exposure, measure such exposure, and use hedging tools.

Introduction

Banks are among the key players in the foreign exchange market as they trade on their own account and for their clients to hedge risks and make trading profits. In this chapter, we discuss the structure, operations, and various products on the foreign exchange market.

Although banks everywhere are active participants in the foreign exchange (forex) market, Hong Kong banks place particular emphasis on foreign exchange for two reasons. One is the ease with which multiple currencies flow through the city’s banking system. Another reason that is related to the first is the fact that Hong Kong is one of the world’s key foreign currency trading centres along with London, New York, Tokyo, and Singapore.

Understanding the functioning of the foreign exchange market is of great importance. A wrong bet or a failed hedging strategy can cost ...

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