1. International Finance 130440-1165 Dr Katarzyna Sum Chair of International Finance Warsaw School of Economics INTERNATIONAL FINANCE

2. International Finance 130440-1165 Getting started Slides available for download: http://akson.sgh.waw.pl/~ksum/ Contact: ksum@sgh.waw.pl Office hours: Tuesday 01.30-02.30 PM, room 20M International Finance 130440-1165

3. Final note  A multiple choice test  The scope of test - according to the syllabus available on http://akson.sgh.waw.pl/~ksum/ International Finance 130440-1165

4. Broad lecture outline  The foreign exchange market  The balance of payments  International monetary system International Finance 130440-1165

5. 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 International Finance 130440-1165

6. Financial markets-classification and functions  The notion of financial markets  Classification, instruments, participants  Current developments  The FX market and the derivatives market International Finance 130440-1165

7. The notion of financial markets  Financial markets enable the flow of savings from households to companies  Allocation of savings  Offering instruments enabling financial management International Finance 130440-1165

8. Classification  Money market  Capital market  Foreign exchange market  Derivatives market International Finance 130440-1165

9. Spot and forward market  Spot- transaction within 2 working days- primary intruments  Forward: transaction within 30,90 or 180 days- derivatives International Finance 130440-1165

11. Money market  Enables liquidity management of several institutions  Short term borrowing and lending (up to 1 year)  Participants- banks International Finance 130440-1165

12. 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 International Finance 130440-1165

13. 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 International Finance 130440-1165

14. 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 International Finance 130440-1165

15. Foreign exchange market  Spot transactions  Currency futures  Currency/ FX swaps  Currency options International Finance 130440-1165

16. 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 International Finance 130440-1165

17. Derivatives market  Forward transactions  Swaps  Options International Finance 130440-1165

18. Financial market intermediaries  Commercial banks  Investment banks  Investment funds and insurance companies  Hedge funds International Finance 130440-1165

19. 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 International Finance 130440-1165

20. Current issues  Growing liquidity  Growing importance of the derivatives market  Growing importance of capital markets International Finance 130440-1165

21. Growing liquidity  Capital flow liberalisation  IT progress  New instruments and products  New methods of risk management International Finance 130440-1165

22. Growing importance of derivatives market  The need of new risk hedging techniques  Basic and structurized instruments  Growing role of speculation International Finance 130440-1165

23. Growing importance of capital markets  Shrinking role of banks as financial intermediary  Growing role of bond issuance  Growing role of stock market transactions International Finance 130440-1165

24. FX market- daily turnover Source: BIS International Finance 130440-1165

25. 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 International Finance 130440-1165

26. 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 International Finance 130440-1165

27. Market participants  Hedgers  Arbitrageurs  Speculators International Finance 130440-1165

28. Market participants  Hedging- taking a bet on price changes or buying „insurance” against price changes  Speculation and arbitrage- looking for extraordinary gains International Finance 130440-1165

29. Turnover by instrument Source: BIS International Finance 130440-1165

30. 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 International Finance 130440-1165

31. 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 International Finance 130440-1165

32. 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 International Finance 130440-1165

33. 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 International Finance 130440-1165

34. Derivatives- daily turnover Source: BIS International Finance 130440-1165

35. Participants  Hedgers  Arbitrageurs  Speculators International Finance 130440-1165

36. Instruments  Forward transactions  Swaps  Options International Finance 130440-1165

37. Interest rate derivatives market  Forward rate agreement  Interest rate swap  Interest rate options International Finance 130440-1165

38. Daily derivatives market turnover by instrument Source: BIS International Finance 130440-1165

39. 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 International Finance 130440-1165

40. 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 International Finance 130440-1165

41. 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 International Finance 130440-1165

42. 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! International Finance 130440-1165

43. Spot and forward on the FX market  Premium FR> SR  Discount FR<SR  Slower fluctuations of FR than SR International Finance 130440-1165

44. Speculation  The possibility to apply leverages  Low collateral needed  Daily settling of transactions  Larger risks and potential gains and losses International Finance 130440-1165

45. Derivatives-problems  Misusage of derivatives  Wrong risk ditribution on FM  Wrong assesment of risks  Eg. Currency options during the crisis International Finance 130440-1165

46. Summing up  Financial marktes enable the flow of savings from households to comapnies  Raising capital on financial markets may be avantagous vs banks International Finance 130440-1165

47. Summing up  Currently-growing liquidity of the financial markets  Currently- growing importance of the derivatives market  Currently-growing imoprtance of capital markets International Finance 130440-1165

48. 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 International Finance 130440-1165

49. 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