International monetary system
International financial marketsstructure and role
Dr Katarzyna Sum
Chair of International Finance
Warsaw School of Economics

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

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

 Money market
 Capital market
 Foreign exchange market
 Derivatives market

 Spot- transaction within 2 working daysprimary intruments
 Forward: transaction within 30,90 or 180 days- derivatives

 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

 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 transactions
 Currency futures
 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

 Forward transactions
 Swaps
 Options

Financial market intermediaries
 Commercial banks
 Investment banks
 Investment funds and insurance companies
 Hedge funds

 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

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

 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

Source: BIS
4500
4000
3500
3000
2500
2000
1500
1000
500
0
1992 1995 1998 2001 2004 2007 2010 billions USD

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

 Spot turnover
 37% of the whole turnover
 48% growth during 2007-2010
 Forward turnover
 63% of the whole turnover
 7% growth during 2007-2010

 Hedgers
 Arbitrageurs
 Speculators

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

Source: BIS

 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

 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


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

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

Source: BIS
5000
4500
4000
3500
3000
2500
2000
1500
1000
500
0
1998 2001 2004 2007 2010 billions USD

 Hedgers
 Arbitrageurs
 Speculators

Instruments
 Forward transactions
 Swaps
 Options

 Forward rate agreement
 Interest rate swap
 Interest rate options

Daily derivatives market turnover by instrument
Source: BIS

 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

 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

 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

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

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

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