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London Business School’s Hélène Rey and Vania Stavrakeva, Vice President and Economist at the Boston Fed, Jenny Tang, LBS Economics PhD programme participant, Adrien Rousset Planat, together with Sinem Hacioglu Hoke of the Federal Reserve Board of Governors, and Daniel A. Ostry of the Bank of England, present the clearest picture yet of how the global foreign exchange (FX) derivatives market actually works, and how it shapes exchange rates, in a new National Bureau of Economic Research working paper, Topography of the FX Derivatives Market: A View from London.

Using an unprecedented dataset covering 100m FX derivatives transactions in London, the world’s largest FX trading centre, the researchers map how different players interact day by day. Their findings show that exchange rates are influenced not just by macroeconomic news, but by who is trading and why.

The research finds that pension funds, investment funds, insurers and non-financial companies mainly use FX derivatives to hedge currency risk, especially exposure to the US dollar. Dealer banks sit at the centre of this activity, absorbing these hedging positions and providing liquidity to the market.

By contrast, hedge funds use FX derivatives primarily to speculate, frequently changing positions in response to interest rates, economic news and momentum strategies. These speculative trades play a key role in transmitting monetary policy shocks into exchange rate movements.

The study also uncovers an important but less visible group: non-bank market makers, who often end up holding the residual currency risk created by speculative trading, even though they keep little long-term exposure overall.

Crucially, the researchers show that FX derivatives trading is not just a sideshow to spot markets. Speculative flows by hedge funds help drive currency appreciation after interest-rate surprises, while the unwinding of hedges by investment funds can fuel dollar strength during periods of rising financial stress.

The findings challenge standard models of exchange rates and highlight why understanding the structure and composition of FX derivatives markets is essential for policymakers, central banks and investors alike.