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Topic 1


Globalization of international financial markets

The structure of the international financial market


The eurocurrency market

The international equity market
The international debt market
The foreign exchange (currency) market

The international monetary system

1. Globalization of financial markets

The global economy has undergone through a number of

structural changes in the past few decades:
Real changes liberalization of product and factor markets,

allied with technological developments increased output in

many countries and particularly in the previously centrally
planned economies
Monetary changes a global commitment to maintain low
rates of inflation after the boost in inflation in the 70s
Financial changes growing completeness and integration of
world financial markets, fueled by deregulation and technology

Globalization of financial markets

Realities of global financial markets:

Short-term nature of capital flows
High turnover in financial markets
Multiplicity of agents
High number and complexity of instruments
High speed with which market participants react to new information
Global reach of financial institutions

Growing integration of financial markets, including emerging markets
Better financing of current account deficits
Financial contagion risks

How developed are the worlds financial markets?

The worlds financial assets totalled $294 trillion at end 2014

The value of the worlds financial assets exceeded the global
GDP by a factor of 3 this is an unprecedented degree of
financial depth
The financial crisis that worsened at end 2008 changed the evolutions

until 2007 still, the financial depth remained at values above 3

Most of the growth in financial depth before the crisis was due to
financial system leverage and equity valuations this trend seems
to return since 2013

The highest weight in the value of global financial assets is

held by debt we live in a leveraged world!

Global financial assets stock values

Stock of global financial assets as % of global GDP

Impact of market fluctuations on global equity

market capitalisation

The global financial marketplace

Assets securities issued by public and private bodies

(governments, financial institutions, companies)
these assets quality is critical for the stability of the global financial


Institutions central banks, commercial, and investment

their health keeps the global financial system stable

Linkages interbank networks using currency

without ready exchange of currencies the market cannot operate


The global financial marketplace


Types of assets traded in intl. financial markets

IMF expanded the coverage in transactions in order to better reflect the

innovative changes in international financial markets in recent years
Major types
Equity securities
Debt securities

Equity securities cover all instruments and records acknowledging,

after the claims of all creditors have been met, claims to the residual
values of incorporated enterprises major types:

Shares and stocks

Participation or similar documents (such as ADRs or GDRs)
Preferred stock or shares that provide for participation


Types of assets traded in intl. financial markets

Debt securities major types:

Bonds, debentures, notes give the holder the unconditional right to a

fixed money income or contractually determined variable money income
and, with some exceptions (perpetual securities), also provide the holder
with the unconditional right to a fixed sum as a repayment of principal on
a specified date or dates include:
nonparticipating preferred stock or shares
convertible bonds
bonds with optional maturity dates
negotiable certificates of deposit with maturities of more than one
dual currency bonds
zero coupon and other deep discounted bonds
floating rate bonds and indexed bonds
asset-backed securities

Types of assets traded in intl. financial markets

Money market securities give the holder the unconditional right to

receive a stated, fixed sum of money on a specified date
traded at a discount in organized markets
discount depends upon the interest rate and the time remaining to
include treasury bills (T-bills), commercial and financial paper,
bankers acceptances, negotiable certificates of deposit, and shortterm notes issued under the note issuance facilities

Derivatives they give the holder the right to receive an economic

benefit in the form of cash or a primary financial instrument at some

future date

options on currencies, interest rates, commodities, indices,

etc.; traded financial futures; warrants; arrangements such as
currency and interest rate swaps

2. The structure of international financial markets

Eurocurrency market
International equity market
International debt market
Foreign exchange (currency) market


2.1. The Eurocurrency market

Eurocurrencies deposits and loans in banks located in a country that

is not the issuing country of the currency

The term Eurocurrency or Eurobank is a misnomer since it refers to offshore

banking and is not limited to Europe

Banks that accept deposits and make loans in the Eurocurrency market
are called Eurobanks

Eurobanks can offer narrower spreads than domestic banks (the spread is the
difference between the deposit and loan interest rates)


The Eurocurrency market

US Domestic



Euro-Swiss Franc




The Eurocurrency market

Currency dimension

Onshore (USA)


Bank deposit in USD

USD denominated T-bills
and bonds
Corporate bonds in USD

Bank deposit in GBP

GBP denominated T-bills
and bonds
Corporate bonds in GBP

Deposit in euro-USD
Bonds in euro-USD

Deposit in euro-GBP
Bonds in euro-GBP

Offshore (Abroad)



London Interbank Offered Rate (LIBOR) the interest rate at which

large London banks make deposits or lend to each other

average interbank interest rate at which a selection of banks on the London money
market are prepared to lend to one another

LIBOR comes in 8 maturities (from overnight to 12 months) and in 5 different


the official LIBOR interest rates are announced once per working day at around
11:45 a.m. (London time) by the British Bankers' Association (BBA)

In the Eurodollar market, loan interest rates are quoted as percentage

points above LIBOR


Euro LIBOR vs. EURIBOR - 2014


Euro LIBOR vs. EURIBOR - 2015

Why did the Eurodollar market develop?

The Eurodollar market started in the late 1950s when

European banks began accepting deposits in U.S. dollars
The reserve-currency status of the dollar was an important factor
Some communist countries (USSR) were the earliest source of dollar

deposits held in Europe

Eurobanks developed as a result of profit considerations

The US financial market was highly and restrictively regulated: Regulation

Q 1958; Interest EqualizationTax 1963; Voluntary Foreign Capital Restraints

British banks began to offer higher interest rates for US dollars deposits


2.2. Equity markets

Types of markets
Primary markets: stocks are bought from the company that

issues them
Secondary markets: shares previously issued can be traded
among investors OTC versus stock exchanges

Functions of equity markets:

Help companies to raise capital
Enable companies to undertake more risk
By pricing shares they provide constant valuation of firms
Serve as markets for corporate control

Factors driving globalization of equity markets

shift from the prevalence of individual to the dominance of institutional
investors (pension, mutual and insurance funds, institutional traders hedge
funds and investment banks)
search for better investment opportunities and international diversification of
holdings interest in trading without the cost of becoming members in
different national stock exchanges and following domestic rules on trading


the speed of message transmission increased significantly demand from

trading firms to locate their order-generating computers as close as possible to
the matching engines of exchanges

Markets have been gradually opened to non-residents for trading
Success story: European Union


Major trends in intl. equity markets

Market consolidations and mergers between exchanges

Euronext (2000) merger of the Amsterdam Exchanges, Brussels Exchanges,

and Paris Bourse
a single trading platform serving all members at each of the three subsidiary
exchanges, with access to all shares and products
a single order book exists for each stock, allowing for transparency and liquidity,
as well as a single clearinghouse and payment and delivery system

NYSE Euronext (2007) merger of Euronext and NYSE

2008 NYSE Euronext acquired American Stock Exchange NYSE AMEX

Norex alliance among the Nordic and Baltic exchanges in Denmark, Estonia,
Finland, Latvia, Lithuania, Sweden (all owned and operated by OMX, the largest
integrated securities market in Northern Europe), Iceland, and Norway


2008 NASDAQ OMX acquired the Philadelphia Stock Exchange

Major trends in intl. equity markets

Electronic, algorithmic and high frequency trading

Starting in the mid-1980 open outcry pits were gradually replaced by
computers displaying and matching orders, with traders sending their
orders via computer networks from the dealing rooms of investments firms
Mid-1990 with Internet and remote access, the connections between
exchange order matching and display engines could extend across borders,
and investors themselves could send their orders to trading firms via
computer networks
2000s an increasing part of trading is generated by trading firms writing
and installing algorithms on computers, which generate orders
High frequency trading (HFT) rapid trading of securities, carried out by

computers to move in and out of positions in seconds or fractions of a second

investors focused on HFT rely on advanced computer systems, the processing
speed of their trades and their access to the market

Liquidity and concentration in intl. equity markets

The equity markets of the developed world tend to be much

more liquid than emerging markets
Liquidity refers to how quickly an asset can be sold without a

major price concession

Emerging markets tend to be much more concentrated than

developed markets
a few issues
account for a much larger percentage of the overall market
capitalization in emerging markets than in the equity markets of
the developed world

Concentrated in relatively few companies


Recent developments in international equity markets

The value of share trading rose in 2014 10% worldwide to 29.7 trillion USD
from the second half of 2013 (+6.8% yoy)
The number of trades rose in 2014 10% from the second-half of 2013 (+12%
yoy); the average value of trades decreased
A continuing strong performance of equity markets global market
capitalisation rose 6% to 68,7 trillion USD from the second-half of 2013 (+21%
Good performance of IPO markets and investment flows the number of
IPOs fell 11% compared to the second half of 2013 but increased 42% yoy
Total investment flows in USD increased 17% compared to the second-half of
2013(+11% yoy.)
Exchange Traded Derivatives (ETD) volumes were stable the total
number of contracts traded decreased 0.2% from the second-half of 2013 (-13%

Global equity market capitalization


Equity market capitalisation by exchanges (USD billion)

Source: World Federation of Exchanges


Equity alternatives in the global market


2.3. The international debt market

Wide variety of different maturities, repayment structures,

and currencies of denomination

The markets and their many different instruments vary by

source of funding, pricing structure, maturity, and subordination
or linkage to other debt and equity instruments


International debt markets and instruments


2.4. The foreign exchange market (FOREX)

FOREX provides:
the physical and institutional structure through which the money of

one country is exchanged for that of another country;

the determination rate of exchange between currencies
the infrastructure where foreign exchange transactions are physically

Foreign exchange means the money of a foreign country; that is, foreign
currency bank balances, banknotes, checks and drafts.
A foreign exchange transaction is an agreement between a buyer and a
seller that a fixed amount of one currency will be delivered for some other
currency at a specified date.

Organization of FOREX

The first global 24-hour market in the world and by far the largest
OTC market 2 tiers:
Wholesale tier liquid inter-bank market
historically, it accounted for 60 to 70% of transactions
2013: trading between dealers in the interbank market dropped
to 39%
there are FX brokers who match buy and sell orders but do not
carry inventory and FX specialists (dealers)
there are corresponding banking relationships that facilitate the
functioning of the market

Retail tier client market

2013: increased importance, mainly due to e-trading


Market structure


The trading day in FOREX


FOREX rythms


FOREX Participants

Bank and non-bank FX dealers market makers

Individuals and firms conducting commercial and investment


Speculators and arbitragers

Central banks and treasuries

FX brokers


Market Participants: Bank and Nonbank Foreign

Exchange Dealers

Banks and a few nonbank foreign exchange dealers operate in both the interbank and
client markets.

The profit from buying foreign exchange at a bid price and reselling it at a slightly
higher offer or ask price.

Dealers in the foreign exchange department of large international banks often function
as market makers.

These dealers stand willing at all times to buy and sell those currencies in which they
specialize and thus maintain an inventory position in those currencies.


Top dealers FOREX

Source: Euromoney FX Survey 2015


Market Participants: Individuals and Firms

Individuals (such as tourists) and firms (such as importers, exporters and

MNEs) conduct commercial and investment transactions in the foreign
exchange market.

Their use of the foreign exchange market is necessary but nevertheless

incidental to their underlying commercial or investment purpose.

Some of the participants use the market to hedge foreign exchange risk.


Market Participants: Speculators and Arbitragers

Speculators and arbitragers seek to profit from trading in the market itself.

They operate in their own interest, without a need or obligation to serve

clients or ensure a continuous market.

While dealers seek the bid/ask spread, speculators seek all the profit
from exchange rate changes and arbitragers try to profit from
simultaneous exchange rate differences in different markets.


Market Participants: Central Banks and Treasuries

Central banks and treasuries use the market to acquire or spend

their countrys foreign exchange reserves as well as to influence the
price at which their own currency is traded.
They may act to support the value of their own currency because of
policies adopted at the national level or because of commitments
entered into through membership in joint agreements such as the
European Monetary System.
The motive is not to earn a profit as such, but rather to
influence the foreign exchange value of their currency in a
manner that will benefit the interests of their citizens.
As willing loss takers, central banks and treasuries differ in motive
from all other market participants.


Largest central banks foreign exchange reserves

Market Participants: Foreign Exchange Brokers

Foreign exchange brokers are agents who facilitate trading

between dealers without themselves becoming principals in the
Dealers use brokers to expedite the transaction and to remain
anonymous, since the identity of participants may influence
short-term quotes.
They do not bear currency risk and are paid on a commission


Motives for FX transactions

Arbitrage is the simultaneous, or nearly simultaneous, purchase of

securities in one market for sale in another market with the expectation
of a risk-free profit

Still, there is delivery risk

Speculation entails more than the assumption of a risky position it

implies financial transactions undertaken when an individuals
expectations differ from the markets expectation
Hedging is the avoidance of foreign exchange risk by entering into a
transaction that lays off the risk to a willing counter party


Markets by delivery date

Spot (rate: St)

immediate (t) payment and delivery of currencies
settlement day : 1 or 2 working days

Forward (rate: Ft,T)

payment and delivery at some future date (T)

maturities: 30, 90, 180, 270, and 360 days, and up to ten


FX swap transactions

both a spot and a forward transaction, or two forwards

transactions of different maturities, with the same counterparty

Foreign exchange market turnover

Global net turnover (2013) = US$ 5.3 trillion per business day
Turnover = total US dollar value of all spot, outright forward, and foreign exchange swap transactions concluded (not settled) during the month of April (average)

Source: BIS - 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity


Currency distribution

Source: BIS - 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity


Counterparty distribution

Source: BIS - 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity


The geography of FX trading (2013)

Source: BIS - 2013 Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity


3. The international monetary system

Types of exchange rate regimes
The evolution of exchange rate regimes a brief history
The European Monetary System
Currency regime in Romania

Currency terminology

Exchange rate / foreign currency exchange rate

Exchange rate regime/system
Devaluation versus depreciation
Revaluation versus appreciation
Hard versus soft currencies

The International Monetary System

The international monetary system (IMS) can be defined as the

structure within which
foreign exchange rates are determined
international trade and capital flows take place
balance of payments adjustments are made

Main components:
a number of public institutions multilateral institutions (IMF, World Bank,
etc...) and central banks
specific financial markets foreign exchange markets and eurocurrency
certain international agreements or rules of the game

range from the Bretton-Woods Agreement of 1944 to less encompassing

accords (Plaza 1985, Louvre 1987)

Main components of IMS

Since the end of the second world war, and the signing of the
Bretton-Woods Agreement, all three components of the IMS
have experienced major changes:
The institutions such as the IMF and the World Bank have seen their

activities change dramatically

The international financial markets have grown tremendously in terms
of volume and assets traded
The rules of the game have been altered substantially

Exchange rate regimes

Two main types:

Free float
Fixed/pegged exchange rates

Alternative systems:
Managed/dirty float
Target zones
No national currency (dollarization)

Free Float

The value of a free floating exchange rate is exclusively established by

demand and supply in the foreign exchange market, with no outside
Over time, the exchange rate will fluctuate randomly as market
participants assess and react to new information
Central bank (monetary authority) does not intervene in the process of
currency value determination

Fixed-Rate System

Currencies maintained at a parity against another currency or basket of

Central banks actively buy or sell their currencies in the foreign
exchange market whenever the exchange rate deviates from par value
In order to intervene on the FOREX, central bank maintains reserves,
which absorb the burden of exchange rate adjustment high volatility
of reserves
Currency devaluation and revaluation is common
Typically accompanied by exchange control measures

Managed Float

Assumes central bank intervention, which manipulates the exchange rate

given its objectives:

smoothing out exchange rate fluctuations

leaning against the wind
unofficial pegging of exchange rate

Central bank support of the rate is not automatic

Central bank reserves fluctuate quite heavily, but typically around a certain

World - Allocated Reserves by Currency (in Percent) 2014Q3

Source: IMF

Target zones

The exchange rate is maintained within a specific band around a central

value (parity)

The Bretton-Woods System: bands of 1% against the USD

The European Monetary System (EMS): bands of 2.25% against ECU (with
subsequent changes for some currencies)
The Exchange Rate Mechanism II: bands of 15% against Euro (with some de jure
or de facto exceptions)

Example of a target zone: DEM in the Bretton-Woods

Upper intervention point
Central bank buys DEMs and sells $
4.0404 DEM/$
4.0000 DEM/$
3.9603 DEM/$
Lower intervention point
Central bank buys $ and sell DEMs

Example of a target zone: FRF/DEM in EMS

Example of a target zone: DKK/EUR in ERM II


The exchange rate fluctuates within a band around a parity, but is periodically
adjusted, typically depending on the inflation differential between the two
Currency mini-devaluations happen rather frequently, sometimes even daily,
and are announced by the monetary authority
Devaluations purpose is to maintain the economys competitiveness
Usually implemented by emerging markets with hyperinflationary
Example: Mexican peso, 1990-1994

Crawling-peg: example

Brief history of IMS

The present monetary system has its roots in the gold exchange
standard or Bretton-Woods system which existed from 1944-1971

Bretton-Woods objectives:
stable exchange rates a fixed exchange rate regime 1%
band of fluctuation
elimination of exchange controls
return to free convertibility of currencies

Gold and US dollar served as international reserve assets

Brief history of IMS

Due to the persistence of currency misalignments and massive

balance-of-payments deficits or surpluses, the IMS entered a
period of crises in the years 1971-1973

Since early 1973, major currencies had been practicing some

form of "managed floating", which was finally recognized in
1976 with important amendments to the articles of the
International Monetary Fund

Exchange rate fluctuations under floating



Currency arrangements

Source: Bekaert & Hoddrick, 2011

European Monetary System

The roots of EMS: the snake/1972 fixed exchange rate

system with a band of 1.125% against USD
European Monetary System (EMS) / 1979

major objectives:
zone of monetary stability in Europe
coordinating exchange rate policies towards non-EMS countries
paving the way for the eventual European monetary union
two main instruments:
1. European Currency Unit (ECU)
2. Exchange Rate Mechanism (ERM)

European Monetary System

80s & 90s demise of the ERM

Maastricht Treaty / December 1991 creation of European Monetary Union
EMU principles:

system of fixed exchange rates among the member currencies

common European currency - Euro
common central bank - European Central Bank
strong coordination of fiscal, monetary, and exchange rate policies of member countries

Euro was introduced in 1999

Currently, 19 EU countries adopted euro as their official currency (Lithuania is
the latest, since January 1, 2015)

Four small states have been given a formal right to use the euro: Andorra, Monaco, San
Marino, Vatican City
Two non-EU countries use euro unilaterally: Montenegro and Kosovo

Exchange Rate Mechanism II

ERM II was introduced on 1 January 1999

This mechanism links the currencies of non-euro area Member States to the
euro convergence and easier euro adoption
Participation in the exchange rate mechanism is voluntary for all non-euro
area Member States
However, as ERM II membership is one of the convergence criteria for the
eventual adoption of the euro, new Member States are expected to join the
mechanism at some stage
For the currency of each Member State participating in the mechanism, a
central rate against the euro and a standard fluctuation band of 15% are

EU currencies included in the ERM II


Joined ERM II

Rate and
fluctuation band


Adopted Euro

Danish kroner

1 Jan 1999

7.46038; 2.25%



1 Jan 1999

353.109; 15%

17 Jan 2000: revalued

to 340.750

YES; 1 Jan 2001


28 June 2004

15.6466; 15%

YES; 1 Jan 2011


28 June 2004

3.45280; 15%

YES; 1 Jan 2015


28 June 2004

239.640; 15%

YES; 1 Jan 2007


2 May 2005

0.585274; 15%

YES; 1 Jan 2008


2 May 2005

0.702804; 15% (in

reality, 1%)

YES, 1 Jan 2014


2 May 2005

0.429300; 15%

YES; 1 Jan 2008


28 November

38.4550; 15%

19 March 2007:
revalued to 35.4424
29 May 2008:
revalued to 30.1260

YES; 1 Jan 2009

Currency regime in Romania

Regulatory body - National Bank of Romania

Present regime (1997) main issues:
the interbank exchange rate is freely determined by demand

and supply on the FOREX market, but under a MANAGED

current account convertibility of ROL since 1998

Capital account liberalization

started in 1999 schedule envisaged, as general principles,

liberalizing inflows before outflows and medium and long-term

flows before short-term ones
schedule completed in 2005

RON/EUR exchange rate, 2005-2015

Inflation targeting and RON/EUR exchange rate

Inflation targeting framework since 2005 lite inflation targeting in

Romania: an eye towards the exchange rate
Results of the inflation targeting monetary rule
Annual CPI inflation returned inside the variation band in
September 2014 (1.54%)
Low inflation levels throughout 2014 were driven by:

Persistence of the negative output gap and improved inflation expectations

Favourable supply-side developments

good harvest & oversupply for some fruit and vegetables due to the import ban
imposed by Russia
decline in global commodity prices

Corrections and downward statistical base effects linked to past increases in

administered prices

Inflation targeting in Romania

Source: NBR Inflation Report, February 2015

Romania Foreign exchange reserves

(mill. Euro)

Source: NBR Statistics

What lies ahead for RON?

RON will enter the ERM II mechanism, most probably around

2019-2021 (estimated)
The timing will be configured to ensure ex ante likelihood of
minimum necessary stay in ERM II, considering:
Possible volatile capital movements and restricted exchange

Inflation-targeting framework for monetary policy, to which
exchange rate developments must be clearly subordinated


Convergence criteria
What is

Price stability

Sound public

public finances

Durability of

How it is

Consumer price
inflation rate

deficit as % of

Government debt
as % of GDP

interest rate


Not more than

1.5 percentage
points above the
rate of the three
best performing
Member States

Not more than 2

percentage points
above the rate of
Reference value:
Reference value:
the three best
not more than
not more than 3%
Member States in
terms of price

Convergence criteria

In addition to meeting the economic convergence criteria, a euro-area

candidate country must make changes to national laws and rules, notably
governing its national central bank and other monetary issues, in order to
make them compatible with the Treaty.

In particular, national central banks must be independent, such that the

monetary policy decided by the European Central Bank is also

According to the Treaty, at least once every two years, or at the request
of a Member State with a derogation, the Commission and the European
Central Bank assess the progress made by the euro-area candidate
countries and publish their conclusions in respective convergence reports

Convergence criteria for Romania