International

Financial
System
 Meaning:-
• In finance, the financial system is the system that
allows the transfer of money between savers (and
investors) and borrowers. A financial system can
operate on a global, regional or firm specific level.

• Gurusamy, writing in Financial Services and

Systems has described it as comprising "a set
of complex and closely interconnected
financial institutions, markets, instruments,
services, practices, and transactions."
• A financial system can be defined at the global,
regional or firm specific level.
• The firm's financial system is the set of
implemented procedures that track the financial
activities of the company.
• On a regional scale, the financial system is
the system that enables lenders and
borrowers to exchange funds.
• The global financial system is basically a
broader regional system that encompasses all
financial institutions, borrowers and lenders
within the global economy.
• The global financial system (GFS)
is the financial system consisting
of institutions and regulators that act on the
international level, as opposed to those that act
on a national or regional level. The main
players are the global institutions, such as
International Monetary Fund and Bank for
International Settlements, national agencies
and government departments, e.g., central
banks and finance ministries, private
institutions acting on the global scale, e.g.,
banks and hedge funds, and regional
institutions, e.g., the Euro zone.
 Difference between IMS & IFS
International Monetary System
• It constitutes an integrated
set of money flows and
related governance
institutions that establish
the quantities of money,
the means for supporting
currency requirements and
the basis for exchange
among currencies in order
to meet payments
obligations within and
across countries.
International Financial System
• It constitutes the full range
of interest‐ and return‐
bearing assets, bank and
nonbank financial
institutions, financial
markets that trade and
determine the prices of
these assets, and the
nonmarket activities
through which the
exchange of financial
assets can take place.
• Central banks, international • Private equity transactions,
financial institutions, private equity/hedge fund joint
commercial banks and various ventures, leverage buyouts
types of money market funds whether bank financed or not,
— along with open markets for etc. are the best examples for
currency and, depending on international financial system.
institutional structure,
government bonds — are all
• In IMS money (in contrast to
part of the international
monetary system. financial assets) is not
interest bearing. But under
IFS it is a interest bearing.
• Money is used as a unit of
account and/or a medium of
• The IFS lies at the heart of the
exchange to support and foster
the exchange of goods and global credit creation and
services, and capital flows, allocation process.
within and across countries.
• Money is used as a unit of
account and/or a medium of
exchange to support and foster
the exchange of goods and
services, and capital flows,
within and across countries; to
calibrate values and advance the
exchange of financial assets;
and to foster the development
of financial markets.
• IMS events are often about the
availability of liquidity.
• IMS events can be resolved
primarily through central bank
action and common agreement.
• the IFS depends on the
effective functioning and
prudent management of the
IMS and the ready availability of
currencies to support the
payment system.
• The IFS encompasses the IMS
— but extends in function and
complexity well beyond the
IMS.
• IFS crises are more complex
and far reaching. They can
involve regulatory and reporting
changes; they have significant
and enduring economic effects.
Components of Financial System.

1. Money.

2. Banking and Financial

Institutions.

3. Financial Instruments.

4. Financial Markets.

5. Central Banks.
Money:-
• Money is defined as anything that is generally
accepted in payment for goods and services or
in the repayment of debt.

• Monetary theory ties changes in the money

supply to changes in aggregate economic
activity and the price level.
 Money and Recession
• The periodic but irregular upward and
downward movement of aggregate output
produced in the economy is referred to as the
business cycle.

• Sustained (persistent) downward movements in the

business cycle are referred to as recessions.

• Sustained (persistent) upward movements in the

business cycle are referred to as expansions.
• Recessions (unemployment) and booms
or expansion (inflation) affect all of us

• Evidence from business cycle fluctuations in

many countries indicates that recessions may be
caused by steep declines in the growth rate of
money.
 Money and Inflation
• The aggregate price level is the average price of
goods and services in an economy

• Inflation is a continual rise in the price level. It

affects all economic players.

• There is a strong positive association between

inflation and growth rate of money over long
periods of time. A sharp increase in the growth of
the money supply is likely followed by an
increase in the inflation rate.
• Countries that experience very high rates of
inflation have rapidly growing money
supplies.
 Banking and
Financial
• Financial Intermediaries are institutions that
Institutions:-
channel funds from individuals with surplus funds
to those desiring funds but have shortage of it.

• Among other services, they allow individuals to

earn a decent return on their money while at the
same time avoiding risk; e.g., banks, insurance
companies, finance companies, investment
banks, mutual funds, brokerage houses,
• Banks are financial institutions that accept deposits
and make loans.

• Banks make the monetary system a lot more

efficient by reducing our need to carry a lot of
cash.

• Innovations in banking like debit cards, direct

deposit, and automatic bill-paying reduce that
inconvenience even further, and also reduce such
bank-related inconveniences of time spent standing
in line at the bank, writing checks, or visiting the
 Financial Instruments:-
• “Securities” is a name that commonly refers to
financial instruments that are traded on financial
markets.

• A security (financial instrument) is a formal

obligation that entitles one party to receive
payments and/or a share of assets from
another party; e.g., loans, stocks, bonds.

• Even an ordinary bank loan is a financial

instrument.
 Financial
• Markets:-
Financial markets are mechanisms that allows
people to easily buy and sell (trade) financial
securities (such as stocks and bonds), commodities
(such as precious metals or agricultural goods),
and other fungible items of value at low
transaction costs and at prices that reflect;
• e.g., Bahrain Stock Exchange, New York Stock
Exchange, U.S. Treasury's online auction site for its
bonds.
• Financial markets such as stock market and bond
market are essential to promote greater economic
efficiency by channeling funds from who do not
have productive use of fund (savers) to those
who do (investors).

• While well-functioning financial markets promote

growth, poorly performing financial markets can
be the cause of poverty.

• Thus, activities in financial markets may increase

activities in financial markets affect business
• A financial market is a market in which financial
assets (securities) can be purchased or sold

• Financial markets facilitate financing and investing by

households, firms, and government agencies

• Participants that provide funds are called surplus

units
– e.g., households

• Participants that enter markets to obtain funds are

deficit units
–
Types of Financial Markets:-

• Money and Capital Market.

• Primary and Secondary Market.

• Debt Market.
 The Bond Market and Interest Rates
• A bond is a debt security that promises to make
specified rate of interest payments periodically for a
specified period of time, with principal to be
repaid when the bond matures.

• An interest rate is the cost of borrowing or the price

paid for the rental of borrowed funds.

• Everything else held constant, a decline in interest

rates will cause consumption and investment to
increase;
• An increase in interest rates might encourage
consumers to save more because more can be
earned in interest income but discourage investors
from taking loans.
• Thus, consumption and investment would
decrease.

• The bond markets are important because they are

the markets where interest rates are determined
 The Stock Market
• A stock (a common stock) represents a share of
ownership of a corporation, or a claim on a
firm's earnings/assets.
• Stocks are part of wealth, and changes in their
value affect people's willingness to spend.

• Changes in stock prices affect a firm's ability to raise

funds, and thus their investment.

• The stock market is important because it is the

most widely followed financial market
• A rising stock market index due to higher share
prices increases people's wealth and as a result
may increase their willingness to spend.

• When stock prices fall an individual's wealth may

decrease and their willingness to spend may
decrease.

• Changes in stock prices affect firms' decisions to sell

stock to finance investment spending.

• Fear of a major recession causes stock prices to

 The Foreign Exchange Market
• The foreign exchange market is where funds are
converted from one currency into another.

• The foreign exchange rate is the price of one

currency in terms of another currency.

• The foreign exchange market determines the

foreign exchange rate.
Euro Bond Market:-
• The Eurobond market is made up of
investors, banks, borrowers, and trading agents
that buy, sell, and transfer Eurobonds. Eurobonds
are a special kind of bond issued by European
governments and companies, but often
denominated in non-European currencies such as
dollars and yen.
• They are also issued by international bodies such as
the World Bank. The creation of the unified
European currency, the euro, has stimulated strong
interest in euro-denominated bonds as well;
• Eurobonds are unique and complex instruments
of relatively recent origin. They debuted in
1963, but didn't gain international significance
until the early 1980s. Since then, they have
become a large and active component of
international finance. Similar to foreign bonds,
but with important differences, Eurobonds
became popular with issuers and investors
because they could offer certain tax shelters and
anonymity to their buyers. They could also offer
borrowers favorable interest rates and
international exchange rates.
• Conventional foreign bonds are much simpler than
Eurobonds; generally, foreign bonds are simply issued
by a company in one country for purchase in
another. Usually a foreign bond is denominated in
the currency of the intended market. For example, if
a Dutch company wished to raise funds through debt
to investors in the United States, it would issue
foreign bonds (dollar-denominated) in the United
States. By contrast, Eurobonds usually are
denominated in a currency other than the issuer's,
but they are intended for the broader international
markets. An example would be a French company
issuing a dollar- denominated Eurobond that might
be purchased in the United Kingdom, Germany,
• Like many bonds, Eurobonds are usually fixed-
rate, interest-bearing notes, although many are
also offered with floating rates and other
variations. Most pay an annual coupon and
have maturities of three to seven years. They
are also usually unsecured, meaning that if the
issuer were to go bankrupt, Eurobond holders
would normally not have the first claim to the
defunct issuer's assets.
 Forward
•Markets:-
An informal agreement traded through a broker-
dealer network to buy and sell specified assets,
typically currency, at a specified price.

• A cash market transaction in which delivery of the

commodity is deferred until after the contract has
been made. Although the delivery is made in the
future, the price is determined on the initial trade
date.
• In finance, a forward contract is a non-
standardized contract between two parties to
buy or sell an asset at a specified future time at a
price agreed upon today

• an agreement between two parties in which one

party agrees to buy currency from the other
party at a later date at an exchange rate agreed
upon today.
• A special type of foreign currency transaction.
Forward contracts are agreements between two
parties to exchange two designated currencies at
a specific time in the future. These
contracts always take place on a date after
the date that the spot contract settles, and
are
used to protect the buyer from fluctuations in
currency prices.
• The forward market is the informal over-the-
counter financial market by which contracts for
future delivery are entered into. Standardized
forward contracts are called futures
contracts and traded on a futures exchange
Forward Foreign Exchange Contract
Definition:
An agreement to exchange one currency for
another, where
• The exchange rate is fixed on the day of the contract,
• but
The actual exchange takes place on a pre-determined date
in the future
• In a forward market for foreign exchange,
transactions which take place at a future dates are
covered.

• In a forward market there are parties which

demand or supply a given currency at some future
point of time. Forward transactions also known
as future contacts take place due to two reasons.
Firstly, to minimize risk of loss due to adverse
change in exchange rate and secondly to make
profit. First is called hedging and second is called
speculation.
 Futures Market:-
• In finance, a futures contract is a
standardized contract between two parties to buy
or sell a specified asset of standardized quantity and
quality for a price agreed upon today with delivery
and payment occurring at a specified future date,
the delivery date.
• A currency future, also FX future or foreign
exchange future, is a futures contract to
exchange one currency for another at a specified
date in the future at a price (exchange rate) that is
fixed on the purchase date
• A contractual agreement, generally made on the
trading floor of a futures exchange, to buy or
sell a particular commodity or financial
instrument at a pre-determined price in the
future. Futures contracts detail the quality and
quantity of the underlying asset; they are
standardized to facilitate trading on a futures
exchange. Some futures contracts may call for
physical delivery of the asset, while others are
settled in cash.
• A futures contract is between two parties with
an intermediary involved, the futures
exchange. The contract requires one
• of the parties to agree to make delivery of a
commodity or financial asset and the other party
to take or accept delivery of
• the same commodity or financial asset.
• Foreign exchange future market refers to a
type of financial derivative in which two parties
enter into a contract to buy/sell a particular
currency at a pre-determined price on a
specific future date
• A foreign exchange future market is 'marked
to market' thus making it a portfolio of
forward contracts that are adjusted daily for
cash settlements. This in fact mitigates the
credit risk to a very large extent.
•
• These are carried out through the clearing house
of the exchange. The margin payments accrue
to the exchange and the exchange ensures the
proper functioning of the contract.
• A foreign exchange future market contract rarely
results in a delivery. It is used by parties as it is a
highly liquid way of hedging and speculating
and efficient transactions can be fixed up
without delay.