The institution of foreign exchange has evolved over many centuries to enable people in one country to carry on financial relations with those in other countries. As old barriers to international trade disappear and as new ones develop, the foreign exchange market must adapt itself to the changed conditions. In this chapter we shall see what use the foreign trader makes of foreign exchange.

The domestic trader expects the money market to assist him in two ways: to provide the instruments and the clearing facilities by which money payments may be transferred from buyer to seller; and to provide credit if buyer or seller is unable or unwilling to “carry” the transaction until the goods are sold to the ultimate consumer. The foreign trader calls on the foreign exchange market to perform the same two services, transfer and credit.

The broad, ever-present difference between the functions of these two markets, of course, is to be found in the fact that every foreign exchange transaction involves not only a transfer of funds from one person to another and from one place to another but also from one currency to another. 1 The similarity of the services rendered by the two markets emphasizes the fact that the foreign exchange market is simply a specialized section of the larger money market.

Currency options are a valuable tool for managing exchange risk, and their scope is really quite broad since they make it possible to eliminate much of the risk that treasurers deem excessive. They are also effective at ensuring wealth protection while avoiding many costly and useless transactions. Although options markets are essentially different from the traditional futures and forwards markets, they are, at least, auxiliary to them. Besides hedging risk, currency options are useful as highly levered investment vehicles for those who anticipate short-term currency movements better than the average. In this sense, the options markets attract a clientele of speculators whose activity allows hedgers to offset their risk. Nevertheless, hedging should not be confused with speculation, although they are both often present in a single transaction. In what follows, we will present the different intervention strategies of hedging and speculation, conscious of the fact that for a given level of risk, some strategies will interest hedgers and other speculators, but that in any single transaction, both can be present.

Imports, exports, foreign investments, and loans raised in other currencies are some of the most common transactions that require currency hedging. The positions can be long or short and the options to hedge them can be traded on either a domestic market or a foreign market. Finally, the hedge can be constructed by buying an option, by selling an option, or by a combination of both. In this section, we will consider the basic strategies.

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