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Stock Market Operations

Notes Banks and Other Financial Institutions

In addition to central banks and governments, some of the largest participants involved with
forex transactions are banks. Most individuals who need foreign currency for small-scale
transactions deal with neighbourhood banks. However, individual transactions pale in
comparison to the volumes that are traded in the interbank market.
The interbank market is the market through which large banks transact with each other and
determine the currency price that individual traders see on their trading platforms. These banks
transact with each other on electronic brokering systems that are based upon credit. Only banks
that have credit relationships with each other can engage in transactions. The larger the bank,
the more credit relationships it has and the better the pricing it can access for its customers. The
smaller the bank, the less credit relationships it has and the lower the priority it has on the
pricing scale.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the
bid/ask price. One way that banks make money on the forex market is by exchanging currency
at a premium to the price they paid to obtain it. Since the forex market is a decentralized market,
it is common to see different banks with slightly different exchange rates for the same currency.

Hedgers

Some of the biggest clients of these banks are businesses that deal with international transactions.
Whether a business is selling to an international client or buying from an international supplier,
it will need to deal with the volatility of fluctuating currencies.
If there is one thing that management (and shareholders) detests, it is uncertainty. Having to
deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose
that a German company orders some equipment from a Japanese manufacturer to be paid in yen
one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German
company has no way of knowing whether it will end up paying more euros at the time of
delivery.
One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go
into the spot market and make an immediate transaction for the foreign currency that they need.
Unfortunately, businesses may not have enough cash on hand to make spot transactions or may
not want to hold massive amounts of foreign currency for long periods of time. Therefore,
businesses quite frequently employ hedging strategies in order to lock in a specific exchange
rate for the future or to remove all sources of exchange-rate risk for that transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay
in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the
European company will realize a financial loss. As such, it could enter into a contract that locked
in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could
be either forwards or futures contracts.

Speculators

Another class of market participants involved with foreign exchange-related transactions is
speculators. Rather than hedging against movement in exchange rates or exchanging currency
to fund international transactions, speculators attempt to make money by taking advantage of
fluctuating exchange-rate levels.

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