Functions of foreign exchange

Foreign exchange divisions usually operate within the treasury sections of the main banks. They have three main functions:

1: To manage the foreign exchange risk of the bank itself, which would involve the bank borrowing and lending in foreign currencies and its foreign currency income and outgoings;

2: To handle the foreign exchange requirements of customers, mainly buying and selling foreign currency on the spot (daily), and deal with futures markets for large corporates, including exporters and importers, and investors;

3: To undertake proprietary currency trading for the bank. This involves taking positions on currencies for the bank itself - effectively speculating that certain currencies will rise and fall.

The problems at Allfirst appear to have arisen in the bank's proprietary trading operation.

Dealers in this area try to make profits for their bank through speculating on currency prices on the market and, broadly, buying when they expect a currency to rise and selling when they expect it to fall.

Currency trading has become a highly complex area, in which a range of financial instruments called derivatives have been developed to help traders hedge their risks.

These derivatives include the options contracts used in the Allfirst case.