There has always been a desire to avoid the risk associated with trade and economic activity across currency boundaries. An early form of exchange risk hedging in industrial countries was the use of long bills that constituted an asset or liability in foreign currencies—a practice dating back several centuries. With the improvements in financial techniques in the latter half of the nineteenth century in Europe, genuine forward exchange markets—markets in which currencies were traded for future delivery—emerged. Since that time, official or unofficial forward exchange trading has taken place whenever exchange rates fluctuated or were subject to significant uncertainty, provided that the authorities did not directly suppress the markets.

There has always been a desire to avoid the risk associated with trade and economic activity across currency boundaries. An early form of exchange risk hedging in industrial countries was the use of long bills that constituted an asset or liability in foreign currencies—a practice dating back several centuries. With the improvements in financial techniques in the latter half of the nineteenth century in Europe, genuine forward exchange markets—markets in which currencies were traded for future delivery—emerged. Since that time, official or unofficial forward exchange trading has taken place whenever exchange rates fluctuated or were subject to significant uncertainty, provided that the authorities did not directly suppress the markets.

Forward currency markets in Europe were strictly controlled or suppressed during the two world wars. Trading resumed rather rapidly after World War I in 1919, but was prevented after World War II until the early 1950s in most financial centers other than New York.4

Forward exchange markets reduce the risk associated with foreign trade to the extent that importers’ demand for and exporters’ supply of foreign currency are matched in the market at a given exchange rate, or the risk is shifted to agents (speculators) who are willing to assume it. It is well known by now, and formalized in various capital asset pricing theories, that the required return on any transaction is positively related to its level of risk. A reduction in exchange risk should therefore reduce the profit margins required to conduct foreign trade and should thus lower the cost of imports and exports. In 1922, a time of floating exchange rates and active forward markets, Keynes pointed out that the availability of forward cover in markets enabled traders to avoid speculative activities and to concentrate on the trading business, in which they had expertise.5 He encouraged central banks of countries that did not have a well-functioning forward exchange market to take steps to develop such markets or to provide backup cover to commercial banks in order to get a forward market started. (Specific reference was made to Austria and Romania.) He cautioned, however, that central banks should avoid carrying exchange risk and should cover their open positions in the spot markets.

Capital movements are much larger today than during the interwar period and covering exchange risks related to capital account rather than current account transactions has become a more important function of the forward exchange markets as debtors cover the cash flow of debt service payments and limit their overall liability position in terms of domestic currency. Forward exchange markets encourage potential borrowers and lenders to engage in foreign currency contracts, and improve the access of residents to foreign financing. Forward exchange markets play an especially important role in the management of the foreign exchange exposure of corporations operating internationally.6 From a private investor’s point of view, forward contracts expand the choice of instruments for portfolio investment. As a consequence, investors can improve the risk/return structure of their asset holdings and improve their intertemporal welfare.

On a broad macroeconomic level, forward exchange rates may be seen as allowing interest rates to differ between countries, even under conditions of capital mobility, as the forward differential will tend to compensate for current interest rate deviations. This “covered interest parity condition” expresses the equality between a forward discount on a domestic currency and the corresponding uncovered interest differential in favor of domestic-currency assets when there is neither political risk nor actual or potential credit or exchange controls. In forward markets, covered interest parity will be maintained by riskless arbitrage, apart from a margin of indeterminacy resulting from transactions costs. Empirical evidence shows that the condition holds fairly precisely in the Eurocurrency markets, where these assumptions generally apply. Some forms of political risk may be reflected in interest rates and therefore need not affect adherence to the parity condition.

Furthermore, the forward rate may serve as an indicator of the future movement of the spot exchange rate. Since a frictionless functioning of the forward exchange market depends on the existence of well-functioning spot exchanges and short-term financial markets, and requires a degree of freedom of cross-border capital movements, the forward currency market will also have a catalytic effect on the efficiency and sophistication of other components of the financial system.

The positive effects of forward markets on trade and capital transactions in particular are clearly appreciated by the authorities of many countries. Industrial countries have, therefore, generally kept their forward markets functioning effectively with a minimum of regulation, at least for cover of commercial transactions and debt service payments. When such markets have not existed, forward cover facilities have generally been made available by the authorities. However, nonmarket forward cover schemes, usually provided by the central bank, have been problematic because the exchange risk has often been borne by the central bank, resulting in heavy budgetary losses at times.

Coverage of Transactions

There are three major categories of transactions in forward exchange markets, and some market arrangements provide facilities for only one or two of these. However, comprehensive and free forward markets in which all three forms of transactions may be undertaken by banks and nonbanks exist in many industrial countries (these include Australia, Belgium, Canada, the Federal Republic of Germany, Japan, the Netherlands, New Zealand, Switzerland, the United Kingdom, and the United States).

The most basic market provides cover only for commercial transactions and, in some cases, scheduled debt service payments, as do (largely) arrangements in Austria, Finland, France, Ireland, Norway, Spain, and Sweden, and for access by residents in Italy (see Table 1).7

Table 1.

Industrial Countries: Main Features of Regulations Affecting Forward Exchange Markets, December 31, 19861

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Sources: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions (Washington: IMF, 1987); and national authorities.Note: “Yes” indicates it is a practice under the exchange system; “No” indicates it is not; … indicates that information is not available; and — indicates that the information is not applicable.

For detailed descriptions see Appendix I.

Not necessarily for all transactions in either of the two groups.

Payments on authorized loans and credits may be covered freely.

Restrictions apply to the official market.

Forward cover for financial transactions is substantial.

Restriction applies only to the forward sale of Danish kroner.

Transactions in commodity futures markets may be covered freely.

Currencies admitted to Madrid foreign exchange market plus ECU.

A second form of market also provides cover for interest arbitrage transactions. When transactors wish to move funds from one country to another to maximize yields on financial investments while avoiding exchange risk, they are likely to require cover for their spot exchange transactions. Commercial banks are often permitted to engage in interest arbitrage within some spot-against-forward limits, even in relatively tightly regulated markets, whereas nonbanks are prevented from shifting funds in this manner.

A third type of forward market also enables transactors to take open positions of a purely speculative nature. The main difference between this form of activity and the two described above is that there need not exist underlying commercial or financial transactions.


In a fully developed forward market, the maturity structure should reflect the maturities of other instruments in both the domestic and other major financial markets, operating through arbitrage and the interest parity condition. However, the longer maturities are generally less frequently transacted. In some countries, official limitations are placed on the maturities of forward exchange transactions; in Ireland and Spain the maximum permissible maturity is 12 months; in Austria and Italy it is 18 months; and in Denmark it is 3 years. Forward exchange contracts involving some major currencies (U.S. dollars, pounds sterling, Canadian dollars, deutsche mark, Netherlands guilders, and Swiss francs) are available in the respective countries for maturities of up to ten years. However, forward premiums increase rapidly for maturities over five years. Transactions involving other currencies, or transactions with longer maturities in the major currencies, must be negotiated, although such contracts tend to be quite exceptional (and expensive), even in markets with no official restrictions on maturities. For most currencies, quotations are published for up to one year, with maturities up to six months being the most heavily traded. Pricing in the long-term forward market is also somewhat indeterminate. The techniques used for pricing in the short-term markets are based on arbitrage between Eurocurrencies and foreign exchange markets, and are not fully applicable because there is more than one way of calculating arbitrage in multiperiod situations.8

An alternative way of eliminating long-term and short-term exchange risk is the denomination of export and import contracts in domestic currency. But this is a one-sided solution, relieving uncertainty for the domestic party only. Such an arrangement may not be acceptable to the foreign partner, to whom the risk is transferred. Maintenance of value clauses in contracts and similar methods of allocating currency risk between the parties have the drawback, relative to hedging in forward markets, that the risk is not spread through the banking system to permit lower premiums. While the larger multinational corporations may also hedge risk by spreading their real and financial assets geographically and between currencies, smaller or more locally oriented businesses cannot do this. The decision whether to expand production capacity for export or to establish long-standing customer relationships for imports may suggest a demand for cover extending over many years. In response to this situation, banks have recently begun to offer special swap arrangements to small and medium-sized companies; these swaps can be used to hedge some foreign exchange exposure for up to ten years. It is not clear at this stage, however, whether the market for this type of instrument will develop significantly.

There are several possible reasons why longer maturities have not been available in forward exchange markets to the extent generally envisaged at the outset of generalized floating, despite the very long-term nature of some investment decisions. The first lies in the purchasing power parity view of long-run exchange rate determination. Importers and exporters with longer-term contracts or investments may rely implicitly on movements in the spot exchange rate to offset prospective changes in the domestic purchasing power of their foreign receipts. Another reason may be that many of the longer-term trade, international investment, and financing decisions are undertaken by large multinational corporations, which because of the diversity of their transactions may be able to balance their real and financial portfolios to minimize exchange rate risk internally. The dearth of longer maturities may also stem from the character of institutional arrangements in the long-term forward market; transactions tend to be of a barter nature, owing to the increased risks associated with longer maturities. Barter-type arrangements may not be conducive to rapid market growth because, as the maturities lengthen, the possibilities for matching future bilateral transactions with any accuracy become more limited. Banks may face considerably higher costs if they no longer act as brokers only. Yet another possible reason is the intrinsically smaller volume of long-term trade transactions. Trade financing, which accounts for a large proportion of activity in forward markets, is typically short term, in the range of 60–120 days. The bulk of interest arbitrage and speculative activity may have an even shorter time horizon.

Limitations on Transactors, Currencies, and Rates

Entry limitations for transactors generally distinguish among three groups: banks, nonbank residents, and nonresidents. Cover for commercial transactions is not, by its nature, restricted in any country to interbank transactions. However, cover for some financial transactions in Finland, France, Spain, and Sweden is limited to transactions between resident banks. As for the currency coverage of forward transactions, this is generally restricted in practice to the exchange of domestic for convertible foreign currencies. The reason is that, where currencies are subject to restriction, future delivery becomes uncertain because it may be blocked by the authorities. A further possible reason is that the existence of restrictions on flows of the foreign currency may make it difficult to ascertain the appropriate forward discount or premium, because the interest parity condition will no longer hold with any precision.

At present no industrial country sets the forward exchange rate directly, although rates are subject in some to intervention to affect supply and demand in the market.9 Australia, Finland, Ireland, and New Zealand managed forward rates prior to liberalizing forward markets in recent years. As noted above, in the more regulated markets the most common restriction on entry refers to the need for underlying commercial transactions. Where the forward rate was managed in the past, this was almost always accompanied by restriction to commercial transactions. Management of the rate was seen as dampening speculative influences on the market from abroad. It was also consistent with participation on the part of the central bank in the forward market, by which it assumes some of the administrative and other costs, and therefore might see the provision of cover to some extent as a “benefit” to be kept to the real sector.

Effects of Financial Sector Regulation

Exchange controls are an important impediment to the development of forward markets. Where transactors are unable to substitute assets on a spot basis in response to expected exchange rate movements, the supply of and demand for assets in the forward market may be distorted. This may tend to result in disequilibrium in the forward market and a consequent drying up of two-way transactions. As can be seen from Table 2, exchange controls remain in a number of industrial countries, and there is a close correspondence between the existence of exchange controls on current or capital transactions, and regulations on forward market operations (in Austria, Denmark, Finland, France, Ireland, Italy, Norway, Spain, and Sweden both types of transactions are restricted). There is also a correspondence between such controls and arrangements for determining exchange rates. Members with floating rates and those participating in the European Monetary System (EMS) are more likely to be free of forward market restrictions. At one end of the spectrum, Iceland, which has no forward exchange market, maintains exchange controls on current and capital transactions.

Table 2.

Industrial Countries: Main Features of Exchange Systems, December 31, 19861

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Sources: International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, 1987; and national authorities. Note: “Yes” indicates that it is a practice in the exchange and trade system; “No” indicates that it is not.

Classification as per Annual Report on Exchange Arrangements and Exchange Restrictions.

Restrictions (that is, official action directly affecting the availability, use, or cost of exchange as such, or involving undue delay) on payments to member countries, other than restrictions imposed for security reasons under Executive Board Decision No. 144, adopted August 14, 1952.

Specific restrictions on spot and forward transactions vary widely in scope and severity. Details on forward market restrictions are provided in Appendix I; detailed information on spot arrangements is contained in the Annual Report on Exchange Arrangements and Exchange Restrictions.

The nature of domestic money markets will also affect the efficiency of an unregulated forward market since interest rate differentials influence the equilibrium forward rate. The activities of arbitrageurs ensure considerable interdependence between foreign exchange markets and domestic money markets in the process of interest rate determination. Where there is insufficient interest rate flexibility or credit rationing in the domestic market, or in a major competing money market abroad, forward premiums and discounts may not be realistic indicators of future spot exchange movements. In such circumstances, as in the presence of exchange restrictions, the market will tend to become inefficient.

Market Instruments

A survey in 1982 by the Group of Thirty established that the cost of doing international business was perceived by bankers as having been raised by exchange rate instability under floating rates.10 However, pegging or even allowing a sticky float of the spot exchange rate of a smaller currency would not avoid the effects of this instability, partly because other major currencies will fluctuate in the short run against the domestic currency. Moreover, differential inflation developments in domestic and foreign markets, also in the short run, create another form of instability as expectations of realignments are aroused by variations in purchasing power or asset revaluation resulting from underlying contracts or otherwise unalterable arrangements. Consequently, the survey found volume in forward exchange markets had increased with their maturation in industrial countries, coinciding with the onset of greater exchange rate instability in the mid-1970s, and a wide number of instruments have evolved.

Outright Forward Contracts

The outright forward foreign exchange market enables market participants to enter into agreements on foreign exchange transactions, to be effected at specified times in the future. The core of a forward market is an interbank market for forward transactions, with a substantial proportion of contracts intermediated by brokers operating on commission. The size and maturity of a forward contract are negotiated between the buyer and seller, and forward exchange rates are generally quoted for 30, 60, or 90 days, or 6, 9, or 12 months from the date the forward contract is written. The forward contract stipulates the exchange rate at which the transaction is to be carried out at maturity and thus covers the parties against exchange rate changes intervening until maturity. Since participants in the interbank market usually maintain credit lines with each other, no upfront margin deposits are required against the risk involved in the liability associated with a forward contract.

Commercial customers generally do not have direct access to the interbank forward market and obtain forward cover from a bank, although large corporations with well-established credit ratings may be able to enter the interbank market directly through a brokerage firm or a bank acting as a broker. Because of the risk of nonperformance, banks usually require established relationships with a customer before entering into a forward contract. They may charge the customer an open commission or set a wider spread between buying and selling rates. Because forward contracts do not generally require payments before maturity (except where a commission is due at the outset), market participants do not experience any initial loss in liquidity.

An agent can, as an alternative to purchasing foreign exchange forward at the current forward rate, purchase foreign exchange in the spot market and deposit the amount of foreign exchange proceeds for the same period as the forward contract with a bank. Such possibilities for arbitrage should, as noted above, ensure that the deviation of the forward rate from the spot rate is, in the absence of exchange controls, taxes, or political risks, equal to the interest differential between the respective currencies—apart from a margin for transaction costs. Thus, if the domestic interest rate exceeds the foreign interest rate, the domestic currency will be at a forward discount, and conversely. However, restrictions on financial capital movements or surrender requirements may prevent agents from holding foreign currency deposits or obligations, and thus distort the “covered interest parity” relationship. Transaction costs for the banks and dealers providing the services, taxes, and political risks also cause deviations from covered interest parity (relatively regular deviations in the former instance).


The traditional form of currency swap generally denotes a combination of a purchase (sale) in the spot market and an offsetting sale to the same party (purchase) in the forward market; but it may sometimes refer to offsetting transactions at different maturities, or combinations of both. Swap transactions combining a purchase (sale) in the forward market for one maturity and a sale (purchase) in the forward market for a different maturity are called “forward/forward” swaps.

Currency swaps are frequently combined with credit transactions to exploit interest differentials while simultaneously hedging against exchange risk. For example, if traders have easier access to cheaper foreign credit markets than other agents, they could borrow abroad to purchase a required amount of domestic currency in the spot market. At the same time, they will engage in a forward contract to purchase the amount of foreign exchange they are obliged to pay (principal plus interest) when the foreign loan falls due. Currency swaps are frequently used by banks and multinational corporations to match the structure of their currency holdings or obligations to the expected payment flows in the respective currencies in order to limit their exposure to exchange rate risk.

Recently, a new form of currency swap has emerged. Instead of operating in the forward market, a domestic company may sell a certain amount of foreign currency to a foreign company and simultaneously enter into an agreement to reverse the transaction in the future at the same spot rate underlying the initial transaction. Usually, this kind of swap occurs in the framework of a credit swap agreement. For instance, a foreign company operating in the domestic market may not be able to borrow in the domestic market as easily as it can abroad. It may, therefore, decide to borrow abroad and to sell the proceeds to a domestic company in need of foreign exchange. At the same time, the parties agree that the foreign company will repurchase the same amount of foreign exchange at the initial exchange rate when its credit contract matures. Interest differentials are usually covered by direct payments, and these may, depending on the maturity of the agreement, be made at several intervals over the contract period. In order to limit the exchange risk, the parties may agree on a topping-up clause, which provides for additional payments if the exchange rate moves beyond certain limits. Alternatively, instead of selling and repurchasing currencies at different points in time, the companies may agree to lend the relevant currencies to each other for a certain period (in arrangements known as parallel or back-to-back loans).


A currency futures contract is a standardized contract establishing a binding obligation to buy or sell a particular currency at a designated exchange rate on a specific future date (compared with after a specific interval in the case of forward contracts). Futures exchanges exist in Chicago (CME, IMM, Midam), London (LIFFE), New York (NYCE), Toronto, Auckland, Sydney, and Singapore (SIMEX). The futures market is organized in such a way that its members openly trade futures contracts of a standardized size for standard maturity dates.11 Payments associated with futures contracts are handled separately by a clearinghouse. Once a contract is struck, the clearinghouse interposes itself between buyer and seller and becomes the counterparty to both sides of a contract. Consequently, the clearinghouse absorbs the full credit risk from the market and only the exchange risk is left with seller or buyer. Exchange houses act solely as brokers and charge sellers and buyers a fixed commission for each deal, which covers the cost of entering into a contract and of terminating it.

Unlike forward contracts, which establish ownership with regard to the contracted amounts, futures contracts do not constitute ownership, but only an obligation to buy or sell a fixed amount at a fixed date at the specified rate. In recognition of default risk, the clearinghouse requires traders to put up a deposit called “initial margin,” in order to ensure that the terms of the contracts are respected by the traders. This initial margin is set by the clearinghouse and varies between 0.1 percent and 3 percent of the contract value. At the end of the business day, the clearinghouse calculates the gains or losses experienced by market participants as a result of changes in the value of their respective futures contracts; these gains or losses, called “variation margins,” are added to or subtracted from the futures margin accounts market participants are required to hold with the clearinghouse. If, as a result of a loss, the initial margin deposited is reduced and falls short of a minimum maintenance balance, traders are required to top up their accounts to the initial balance.

Futures markets allow traders to match foreign exchange payments or receipts at an uncertain date in the future with corresponding specific obligations in the futures market, because traders can close out their obligations in the futures market by an offsetting sale or purchase on any business day before maturity. In practice, more than 95 percent of futures contracts are closed out by offsetting contracts, and only a small fraction is settled through actual delivery at maturity.

In contrast to outright transactions in the forward market, the system of commissions and margins may involve a substantial liquidity cost over the duration of a futures contract, as futures prices tend to be highly volatile. It has been suggested that when brokerage commissions are added to bid-ask spreads the cost of foreign exchange futures may be higher than that of forward transactions. However, cost comparisons are difficult to make because of differences in the services provided.12 Because of their standardization and high liquidity, futures are often more attractive than forward markets to small participants, which do not have access to the open forward market, while large-scale operators may also find futures more attractive, because they are more flexible and anonymous.

Currency Options

Currency options give the holder the right to buy (call option) or sell (put option) a currency at a given price at a future date, but do not oblige the holder to exercise this right. Options that can be exercised at any time between the date of writing and the expiration date are “American options”; options that can only be exercised at maturity are “European options.” As in the futures market, option contracts are typically for standard amounts and expiration dates and are traded either on an organized exchange or in the over-the-counter market. Options exchanges exist in Chicago (CBOE, CME), London (LIFFE), Amsterdam, Bangkok, Montreal, Philadelphia, Singapore, Sydney, and Vancouver.13

The buyer of an option pays a premium to the option writer. This premium is defined in the contract and depends, inter alia, on the exchange rate at which the option may be exercised—the exercise or strike price. These strike prices are standardized as well, and at any point in time options are traded at a range of strike prices which are set at intervals above and below the current spot rate. The system of strike prices allows option buyers to choose the extent to which they want to limit their market risk.

As writers of a currency option are exposed to an unlimited market risk, they are required to put up a margin, which is set by the exchange according to whether the option would provide the buyer currently with a profit or a loss when exercised. Currency options enable the buyer to limit their market risk when it is uncertain whether (American or European option) or when (only American option) they will actually make a foreign transaction in the future, or, alternatively, when they have a strong opinion about future currency movements. The premium for a currency option represents the cost at which they can insure themselves against the risk resulting from exchange rate fluctuations.14

Range Forward Options

Range forward options typify a number of more sophisticated market instruments that have been developed recently (see Section IV for further discussion). They are offered by a large number of investment and commercial banks to enable the buyers to limit their potential exposure to exchange rate risk to a margin around a specified rate. A range forward contract defines a floor and a ceiling for the exchange rate, beyond which the buyer may exercise his option to buy or sell foreign exchange; within the range, which represents the risk that the transactor is prepared to absorb himself, the exchange rate is simply the spot rate at maturity. As range forward contracts are constructed by combining the sale of a call option and the purchase of a put option (or vice versa) in such a way that the net premium amounts to zero, bank customers are not required to pay a premium when entering into a contract, while the banks usually profit by offering a smaller range to the customer than the range they obtain in the exchange.