International financial markets- structure and role

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International monetary system

• International financial markets- structure and
  role

• Dr Katarzyna SumChair of International
  FinanceWarsaw School of Economics

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Getting started

• Slides available for download
• http//akson.sgh.waw.pl/ksum/
• Contact
• ksum_at_sgh.waw.pl
• Office hours
• Wednesday 5.00-6.00 PM, room 20M

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The notion of financial markets

• Financial markets enable the flow of savings
  from households to companies
• Allocation of savings
• Offering instruments enabling financial
  management

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Classification

• Money market
• Capital market
• Foreign exchange market
• Derivatives market

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Spot and forward market

• Spot- transaction within 2 working days-
• primary intruments
• Forward transaction within 30,90 or 180 days-
  derivatives

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Money market

• Enables liquidity management of several
• institutions
• Short term borrowing and lending
• (up to 1 year)
• Participants- banks

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Money market

• Short term (few days-3 months)
• repo conducting two contrary transactions on
• the spot and the forward market
• Long term (3 months-1 year)
• treasury bills- issued by governements
• certificates of deposits- issued by banks
• commercial papers- issued by companies

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Capital market

• Enables participants to allocate or gain capital
• Long term fundraising
• Stock and bond market
• Participants
• stock market- issuers (companies) and
  shareholders (institutional and private
  investors)
• bond market- issuers (governements or
• companies), banks

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Foreign exchange market

• Enables currency exchange in order to conduct
  international trade, enables also currency
  investment trade
• Participants
• commercial banks, central banks, companies, hedge
  funds, investment funds
• acting as
• hedgers, arbitrageurs, speculators

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Foreign exchange market

• Spot transactions
• Currency futures
• FX swaps
• Currency options

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Derivatives market

• Enables institutions to hedge the risk of
  changes in security prices and exchange rates
• The price derives from the value of the
  underlying instrument
• Participants
• commercial banks, central banks, companies, hedge
  funds, investment funds
• acting as
• hedgers, arbitrageurs, speculators

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Derivatives market

• Forward transactions
• Swaps
• Options

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Financial market intermediaries

• Commercial banks
• Investment banks
• Investment funds and insurance companies
• Hedge funds

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Raising capital- banks vs FM

• Financial markets are able to take higher risks
  than banks
• Lower risk premium no colleteral needed ?
  lower cost of fundraising at the financial
  markets
• Financial markets are more future oriented than
  banks
• Monitoring the efficiency of the borrower

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Current issues

• Growing liquidity
• Growing importance of the derivatives market
• Growing importance of capital markets

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Growing liquidity

• Capital flow liberalisation
• IT progress
• New instruments and products
• New methods of risk management

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Growing importance of derivatives market

• The need of new risk hedging techniques
• Basic and structurized instruments
• Growing role of speculation

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Growing importance of capital markets

• Shrinking role of banks as financial intermediary
• Growing role of bond issuance
• Growing role of stock market transactions

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FX market- daily turnover

• Source BIS

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FX market- numbers

• 10 of the transactions related to trade, 90
  speculation
• Financial centres
• London 36 of global transactions
• New York 18 of global transactions
• Tokio 6 of global transactions

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FX market- numbers

• Spot turnover
• 37 of the whole turnover
• 48 growth during 2007-2010
• Forward turnover
• 63 of the whole turnover
• 7 growth during 2007-2010

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Market participants

• Hedgers
• Arbitrageurs
• Speculators

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Market participants

• Hedging- taking a bet on price changes or buying
  insurance against price changes
• Speculation and arbitrage- looking for
  extraordinary gains

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Turnover by instrument

• Source BIS

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FX swaps

• an instrument being a contract for exchanging
  one currency against another at the spot ER
  parallely aggreeing on a reversed transaction at
  the forward ER in the future
• betting on ER changes
• Example
• a company wants to invest an amount of USD in
  bonds denominated in EUR knowing to be needing
  USD back in 3 months

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Currency futures

• An instrument being a contract for exchanging
  one currency for another at a specified date in
  the future at a specified ER
• Betting on ER changes
• Example
• arbitrageurs expecting high volatility of the
  spot ER

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Currency options

• An instrument which gives the owner the right
  but no obligation to buy or sell an amount of
  foreign currency at a specified ER
• Insurance against potential losses
• Put and call options
• The option issuer is obliged to buy or sell the
  foreign currency if the owner wishes to execute
  his right

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Currency options

• Example
• Receiving payments in foreign currency at an
  unspecified date- put option
• Settling payments in a foreign currency at an
  unspecified date- call option
• Popular for commercial banks and institutions
  managing large investments abroad due to high
  market risk exposure

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Derivatives- daily turnover

• Source BIS

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Participants

• Hedgers
• Arbitrageurs
• Speculators

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Instruments

• Forward transactions
• Swaps
• Options

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Interest rate derivatives market

• Forward rate agreement
• Interest rate swap
• Interest rate options

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Daily derivatives market turnover by instrument

• Source BIS

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Forward rate agreement

• Forward rate agreement- an instrument being a
  contract for settling the difference between the
  forward rate at the day of signing the contract
  and the interest rate on the day of the
  settlement of the contract
• Example
• having 3 months bonds and hedging the risk of
  their value decrease by signing a FRA contract

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Interest rate swap

• Interest rate swap- an instrument being a
  contract for settling periodically interest rate
  differences between the long term interest rate
  at the day of signing the contract and the short
  term interest rate in the next periods
• Example
• the purchase of 5 year bonds financed through a
  3 months loan- hegding the risk of their price
  decrease

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Interest rate options

• Higher cost than other derivatives
• We actually have to buy the insurance against
  price changes
• In practice- investors buying and issuing
  options at the same time

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Arbitrage

• F-S/Sgtit/360 or
• F-S/Sltit/360
• ? Arbitrage
• F-S/Sit/360 ?
• The price difference reflects the interest rate
• The prices on the spot and forward market change
  paralelly!

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Spot and forward on the FX market

• Premium FRgt SR
• Discount FRltSR

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Speculation

• The possibility to apply leverages
• Low collateral needed
• Daily settling of transactions
• Larger risks and potential gains and losses

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Derivatives-problems

• Misusage of derivatives
• Wrong risk ditribution on financial markets
• Wrong assesment of risks
• Eg. Currency options during the crisis

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References

• P. Krugman, M.Obstfeld, International economics
  theory and policy.Part II, Pearson, Addison
  Wesley, Boston 2009
• A. Slawinski, Rynki finansowe, PWE, Warszawa
  2006.
• Triennial Central Bank Survey, Foreign exchange
  and derivatives market activity in April 2010,
  Monetary and Economic Department, Bank of
  International Settlements, 2010