Transcript THE EURO AREA ENLARGMENT

Dr Katarzyna Sum
Chair of International Finance
Warsaw School of Economics
INTERNATIONAL FINANCE
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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
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Final note
 A multiple choice test
 The scope of test - according to the
syllabus available on
http://akson.sgh.waw.pl/~ksum/
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Broad lecture outline
 The foreign exchange market
 The balance of payments
 International monetary system
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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
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Financial markets-classification and
functions




The notion of financial markets
Classification, instruments, participants
Current developments
The FX market and the derivatives
market
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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 daysprimary 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
Currency/ 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
4500
4000
3500
3000
2500
billions USD
2000
1500
1000
500
0
1992
1995
1998
2001
2004
Source: BIS
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2007
2010
FX market- numbers
10% of the transactions related to trade, 90%
speculation
Financial centres:
 London
 Nowy Jork
 Tokio
36% of global transactions
18% of global transactions
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
5000
4500
4000
3500
3000
2500
billions USD
2000
1500
1000
500
0
1998
2001
2004
Source: BIS
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2007
2010
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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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
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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
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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/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!
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Spot and forward on the FX market
Premium FR> SR
Discount FR<SR
Slower fluctuations of FR than SR
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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 FM
 Wrong assesment of risks
 Eg. Currency options during the crisis
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Summing up
 Financial marktes enable the flow of
savings from households to comapnies
 Raising capital on financial markets may
be avantagous vs banks
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Summing up
Currently-growing liquidity of the financial
markets
Currently- growing importance of the
derivatives market
Currently-growing imoprtance of capital
markets
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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
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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
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