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International financial markets- structure and role

International monetary system. Dr Katarzyna Sum Chair of International Finance Warsaw School of Economics. International financial markets- structure and role. Getting started. Slides available for download: http://akson.sgh.waw.pl/~ksum/ Contact: ksum@sgh.waw.pl Office hours:

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International financial markets- structure and role

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  1. International monetary system Dr Katarzyna SumChair of International FinanceWarsaw School of Economics International financial markets- structure and role

  2. Getting started Slides available for download: http://akson.sgh.waw.pl/~ksum/ Contact: ksum@sgh.waw.pl Office hours: Wednesday 5.00-6.00 PM, room 20M

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

  4. Classification • Money market • Capital market • Foreign exchange market • Derivatives market

  5. Spot and forward market • Spot- transaction within 2 working days- primary intruments • Forward: transaction within 30,90 or 180 days- derivatives

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

  7. 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

  8. 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

  9. 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

  10. Foreign exchange market • Spot transactions • Currency futures • FX swaps • Currency options

  11. 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

  12. Derivatives market • Forward transactions • Swaps • Options

  13. Financial market intermediaries • Commercial banks • Investment banks • Investment funds and insurance companies • Hedge funds

  14. 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

  15. Current issues • Growing liquidity • Growing importance of the derivatives market • Growing importance of capital markets

  16. Growing liquidity • Capital flow liberalisation • IT progress • New instruments and products • New methods of risk management

  17. Growing importance of derivatives market • The need of new risk hedging techniques • Basic and structurized instruments • Growing role of speculation

  18. Growing importance of capital markets • Shrinking role of banks as financial intermediary • Growing role of bond issuance • Growing role of stock market transactions

  19. FX market- daily turnover Source: BIS

  20. 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

  21. FX market- numbers • Spotturnover • 37% of the whole turnover • 48% growth during 2007-2010 • Forward turnover • 63% of the whole turnover • 7% growthduring2007-2010

  22. Market participants • Hedgers • Arbitrageurs • Speculators

  23. Market participants • Hedging- taking a bet on price changes or buying „insurance” against price changes • Speculation and arbitrage- looking for extraordinary gains

  24. Turnover by instrument Source: BIS

  25. 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

  26. 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

  27. 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

  28. 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

  29. Derivatives- daily turnover Source: BIS

  30. Participants • Hedgers • Arbitrageurs • Speculators

  31. Instruments • Forward transactions • Swaps • Options

  32. Interest rate derivatives market • Forward rate agreement • Interest rate swap • Interest rate options

  33. Daily derivatives market turnover by instrument Source: BIS

  34. 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

  35. 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

  36. 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

  37. Arbitrage • F-S/S>i*t/360 or • F-S/S<i*t/360  Arbitrage • F-S/S=i*t/360  The price difference reflects the interest rate The prices on the spot and forward market change paralelly!

  38. Spot and forward on the FX market Premium FR> SR Discount FR<SR

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

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

  41. References • P. Krugman, M.Obstfeld, International economics: theory and policy.Part II, Pearson, Addison Wesley, Boston2009 • A. Sławiński, 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

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