International Finance 130440-1165 Dr Katarzyna Sum Chair of International Finance Warsaw School of...

International Finance 130440-1165

Dr Katarzyna SumChair of International FinanceWarsaw School of Economics

INTERNATIONAL FINANCE


Getting started

Slides available for download:

http://akson.sgh.waw.pl/~ksum/

Contact:[email protected]

Office hours:Tuesday 01.30-02.30 PM, room 20M


mailto:[email protected]


Final note

A multiple choice test

The scope of test - according to the

syllabus available on

http://akson.sgh.waw.pl/~ksum/



Broad lecture outline

The foreign exchange market The balance of payments International monetary system



Basic literature

P. Krugman, M.Obstfeld, International economics: theory and policy.Part II, Pearson, Addison Wesley, Boston 2009.

F. Mishkin, The economics of money banking and

financial markets, 8e., Prentice Hall, 2007



Financial markets-classification and functions

The notion of financial markets Classification, instruments, participants Current developments The FX market and the derivatives

market



The notion of financial markets

Financial markets enable the flow of savings from households to companies

Allocation of savings Offering instruments enabling financial

management



Classification

Money market Capital market Foreign exchange market Derivatives market



Spot and forward market

Spot- transaction within 2 working days-

primary intruments

Forward: transaction within 30,90 or 180 days- derivatives



Money market

Enables liquidity management of several institutions

Short term borrowing and lending (up to 1 year)

Participants- banks



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



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



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



Foreign exchange market

Spot transactionsCurrency futuresCurrency/ FX swaps Currency options



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



Derivatives market

Forward transactions

Swaps

Options



Financial market intermediaries

Commercial banks

Investment banks

Investment funds and insurance companies

Hedge fundsInternational Finance

130440-1165


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



Current issues

Growing liquidity Growing importance of the derivatives

market Growing importance of capital markets



Growing liquidity

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



Growing importance of derivatives market

The need of new risk hedging techniques

Basic and structurized instruments

Growing role of speculation



Growing importance of capital markets

Shrinking role of banks as financial intermediary

Growing role of bond issuance

Growing role of stock market transactions



FX market- daily turnover

Source: BIS

0

500

1000

1500

2000

2500

3000

3500

4000

4500

1992 1995 1998 2001 2004 2007 2010

billions USD



FX market- numbers

10% of the transactions related to trade, 90% speculation

Financial centres:

London 36% of global transactions Nowy Jork 18% of global transactions Tokio 6% of global transactions



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



Market participants

Hedgers

Arbitrageurs

Speculators



Market participants

Hedging- taking a bet on price changes or buying „insurance” against price changes

Speculation and arbitrage- looking for extraordinary gains



Turnover by instrument

Source: BIS



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



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



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



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



Derivatives- daily turnover

Source: BIS

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

1998 2001 2004 2007 2010

billions USD



Participants

Hedgers

Arbitrageurs

Speculators



Instruments

Forward transactions

Swaps

Options



Interest rate derivatives market

Forward rate agreement

Interest rate swap

Interest rate options



Daily derivatives market turnover by instrument

Source: BIS



FRA

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



IRS

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



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



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!



Spot and forward on the FX market

Premium FR> SR

Discount FR<SR

Slower fluctuations of FR than SR



Speculation

The possibility to apply leverages

Low collateral needed

Daily settling of transactions

Larger risks and potential gains and losses



Derivatives-problems

Misusage of derivatives

Wrong risk ditribution on FM

Wrong assesment of risks

Eg. Currency options during the crisis



Summing up

Financial marktes enable the flow of

savings from households to comapnies

Raising capital on financial markets may

be avantagous vs banks



Summing up

Currently-growing liquidity of the financial markets

Currently- growing importance of the derivatives market

Currently-growing imoprtance of capital markets



Summing up

The largest turnover on derivatives market

A large amount currency market derivatives

Only 10% related to trade

Derivatives can be usufull intruments provided

there is proper risk assesment



References

P. Krugman, M.Obstfeld, International economics: theory and

policy.Part II, Pearson, Addison Wesley, Boston 2009

F. Mishkin, The economics of money banking and financial

markets, 8e., Prentice Hall, 2007

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


International Finance 130440-1165 Dr Katarzyna Sum Chair of International Finance Warsaw School of...

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