International Financial Markets - Questions and Issues

(It is assumed that the first part of the stuff was covered by the midterm exam. Therefore, the following list of questions and issues refers to the remaining part only)

1.The evolution of the international monetary system since 1944.

2. International role of the US dollar, present challenges to its global position and possible alternatives (if any).

Noting that the dollar's share of foreign exchange reserves has already fallen from 80 percent in the mid-1970s to around 65 percent today, the Economist pointed out that questions about the dollar's role were raised in the early 1990s, but its pre-eminence survived. However at that time there was no alternative. Today one exists in the form of the euro. Over the longer term the dollar's biggest failure has been as a store of value. Since 1960 it has fallen by around two thirds against the euro (using the German currency as a proxy for the years prior to 1999 when the euro was established) and the Japanese yen. While the marked fall in the US dollar in the late 1980s had few ill effects on the economy, there is more cause for concern in the present situation. This is because the US current account deficit, running at close to 6 percent of GDP is almost twice as big as at its peak in the late 1980s and will keep widening. Furthermore, at that time the US was still a net creditor nation. Today it is the world's biggest debtor, with borrowing sucking in around 75 percent of the world's balance of payments surpluses and with foreign liabilities expected to reach $3.3 trillion, or 28 percent of GDP, by the end of this year.

“The requirements of a reserve currency are a large economy, open and deep financial markets, low inflation and confidence in the value of the currency. At current exchange rates the euro area's economy is not that much smaller than America's; the euro area is also the world's biggest exporter; and since the creation of the single currency, European financial markets have become deeper and more liquid. It is true that the euro area has had slower real GDP (gross domestic product) growth than America. But in dollar terms the euro area's economic weight has actually grown relative to America's over the past five years.”

US dollar as a safe haven for investors

Henry Kissinger once noted, "Who controls the food supply controls the people; who controls the energy can control whole continents; who controls money can control the world."

How the Dollar System works
After 1945, the US emerged from war with the world's gold reserves, the largest industrial base, and a surplus of dollars backed by gold. In the 1950's into the 1960's Cold War, the US could afford to be generous to key allies such as Germany and Japan, to allow the economies of Asia and Western Europe to flourish as a counter to communism. By opening the US to imports from Japan and West Germany, a stability was reached. More importantly, from pure US self-interest, a tight trade area was built which worked also to the advantage of the US.

That held until the late 1960's, when the costly Vietnam war led to a drain of US gold reserves. By 1968 the drain had reached crisis levels, as foreign central banks holding dollars feared the US deficits would make their dollars worthless, and preferred real gold instead.

In August 1971, Nixon finally broke the Bretton Woods agreement, and refused to redeem dollars for gold. He had not enough gold to give. That turn opened a most remarkable phase of world economic history. After 1971 the dollar was fixed not to an ounce of gold, something measurable. It was fixed only to the printing press of the Treasury and Federal Reserve.

The dollar became a political currency�do you have "confidence" in the US as the defender of the Free World? At first Washington did not appreciate what a weapon it had created after it broke from gold. It acted out of necessity, as its gold reserves had got dangerously low. It used its role as the pillar of NATO and free world security to demand allies continue to accept its dollars as before.

Currencies floated up and down against the dollar. Financial markets were slowly deregulated. Controls were lifted. Offshore banking was allowed, with unregulated hedge funds and financial derivatives. All these changes originated from Washington, in coordination with New York banks.

3. Emergence of the single European currency (the euro), its actual and potential role in the international monetary system.

The euro (currency sign: €; currency code: EUR) is the official currency of 16 out of 27 member states of the European Union (EU). The states are known collectively as the Eurozone.

The currency is also used in five further countries and territories with formal agreements and six other countries without such agreements. Hence it is the single currency for over 327 million Europeans.^[2] Including areas using currencies pegged to the euro, the euro directly affects close to 500 million people worldwide.^[3] As of November 2008^[update], with more than €751 billion in circulation^[4] (equivalent to about USD 953 billion^[5]), the euro is the currency with the highest combined value of cash in circulation in the world, having surpassed the U.S. dollar (USD).^[6] Based on IMF estimates of 2008 GDP and purchasing power parity among the various currencies, the Eurozone is the second largest economy in the world.^{[7][8][9] [10]}

The euro was introduced to world financial markets as an accounting currency on 1 January 1999, replacing the former European Currency Unit (ECU) at a ratio of 1:1. Physical coins and banknotes entered circulation on 1 January 2002.

In economics, an optimum currency area (or region) (OCA, or OCR) is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency. There are two models, both proposed by Robert A. Mundell: the stationary expectations model and the international risk sharing model. Mundell himself advocates the international risk sharing model and thus concludes in favour of the euro.

The most obvious benefit of adopting a single currency is to remove the cost of exchanging currency, theoretically allowing businesses and individuals to consummate previously unprofitable trades. The absence of distinct currencies also removes exchange rate risks. Financial markets on the continent are expected to be far more liquid and flexible than they were in the past. The reduction in cross-border transaction costs will allow larger banking firms to provide a wider array of banking services that can compete across and beyond the Eurozone. Another effect of the common European currency is that differences in prices—in particular in price levels—should decrease because of the 'law of one price'. Differences in prices can trigger arbitrage, i.e. speculative trade in a commodity across borders purely to exploit the price differential. Therefore, prices on commonly traded goods are likely to converge, causing inflation in some regions and deflation in others during the transition. Some evidence of this has been observed in specific markets.

The euro is a major global reserve currency, sharing that status with the U.S. dollar (USD), which continues to be the primary reserve of most commercial and central banks.Since its introduction, the euro has been the second most widely-held international reserve currency after the U.S. dollar. Additionally, there has been suggestion that recent weakness of the US dollar might encourage parties to increase their reserves in euro at the expense of the dollar.

4. The role of the International Monetary Fund in the global financial system.

The International Monetary Fund (IMF) is an international organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rates and the balance of payments. It also offers financial and technical assistance to its members, making it an international lender of last resort. The International Monetary Fund was created in 1944 [1], with a goal to stabilize exchange rates and assist the reconstruction of the world's international payment system. Countries contributed to a pool which could be borrowed from, on a temporary basis, by countries with payment imbalances.

In the past a number of criticisms have been directed towards the role of the IMF. A major criticism against the IMF has been the fact that it should not only seek exchange rate stability around the world, but it should also identify what should be regulated and what is necessary to be regulated.

Secondly, the role of the IMF has been maligned by lawyers and economists alike. Lawyers have been the victims of legal technicality and economists have been the main designers when it came to the structure of the Fund.

Another major concern has been the fact that the IMF has not always been effective in the implementation of its policies, in addition to the fact that the IMF has not managed to persuade States to achieve consensus in a number of certain legal matters of international economic significance.

The IMF's failure to adapt its original governance arrangements to its changed operations has resulted in the following problems:

IMF-Supplier State Relations: The supplier states, because of their wealth and power are both independent from the IMF and have the votes and Board representation to control its decision making. This means that they can make decisions for the IMF that will never affect their citizens. This situation of decision-makers having power without accountability to those most affected by their decisions is ripe with potential for abuse.

IMF-Consumer State Relations: Although, there is great variation in conditions among the consumer states, the underlying causes of their macroeconomic challenges lie in the governance of their societies. The IMF has attempted to deal with this reality by increasing the range of non-macroeconomic issues its addresses in its operations in these countries, thereby becoming an important actor in their policy making processes. Although this narrows their policy space, consumer member states cannot effectively challenge the IMF because they are dependent on its financing or its approval for access to financing and cannot easily influence its decision making.

IMF-Non-State Actor Relations: The creators of the IMF believed that it was not necessary for the IMF to have any direct interaction with non-state actors, such as labor unions, human rights organizations or community associations. Given its important role in domestic policy making, this position is no longer valid. There is no obvious reason why the IMF, when it “descends” into the national policy-making process, should be less accessible or accountable to those people directly affected by its decisions than other actors in this process.

IMF-International Organizations Relations: The IMF, because of the broadening scope of its operations, encroaches on the “jurisdiction” of other UN specialized agencies. In general, because of disparities in their financial and political resources, these other agencies have been unable to either challenge the IMF or to effectively coordinate their activities with the IMF. The resulting de facto expansion of IMF “jurisdiction” both disempowers the other agencies and increases the cost of the IMF giving bad policy advice.

IMF's Lack of Internal Accountability: The IMF still operates on the erroneous assumption that its existing channels of accountability--the IMF's Board of Executive Directors, and the Board of Governors--are sufficient. Most consumer member states are only indirectly represented on the Board of Executive Directors, on which IMF supplier states hold the overwhelming majority of the votes, and the IMF's operations have become too complex for these directors to effectively exercise firm oversight over the management and staff. The Board of Governors, comprised of central bank chiefs and finance ministers, meets infrequently and is not designed to deal with particular operational cases.

Międzynarodowy Fundusz Walutowy, jako organizacja o charakterze światowym stale znajduje się pod ostrzałem krytyki. Żeby dobrze to zrozumieć trzeba się dokładnie przyjrzeć kilku faktom. Podstawą do przyznania kredytu jest spełnienie szeregu wymogów wystosowanych przez zarząd Funduszu. Reformy te dotyczą m.in. prywatyzacji, liberalizacji handlu i bezpośrednich inwestycji (FDI), zastosowania rynkowych zasad  w stosunku do kursów walut, zmiany wydatków publicznych w celu zwiększenia ich produktywności czy zmian w sposobie opodatkowania. Te cele są niewątpliwie bardzo trudne do osiągnięcia i przez to podatne na krytykę. Jednym z podstawowych zarzutów to  - czy jeden model reform pasuje do wszystkich państw?. Druga rzecz wzbudzająca kontrowersje to restrykcyjna polityka MFW mająca na celu likwidację inflacji i deficyty budżetowego. To ,,dokręcanie śruby'' spowalnia wzrost gospodarczy, jednak pozwala na wyjście z kryzysu i rozwój w dłuższej perspektywie czasu. W krajach, gdzie stawia się na krótkotrwałe skoki gospodarcze, ta polityka jest bardzo niepopularna ( było to widoczne m.in. podczas ostatniego kryzysu w Argentynie ). Bardzo krytykowana jest również zbyt duża rola państw założycielskich MFW w podejmowaniu strategicznych decyzji. Podważają to zwłaszcza kraje o bogatych złożach naturalnych (zrzeszone w tzw. grupie BRIC).       

 

 Postępujący kryzys finansowy i początkowe nikłe reakcje MFW spowodowały, że dyskusja na temat reformy tej instytucji weszła w fazę kluczową. Zgłaszana jest potrzeba dostosowania MFW do nowych realiów, w jakich znalazły się światowe gospodarki. MFW musi zostać przebudowany tak, by służył celom współczesnego świata - powiedział ostatnio brytyjski premier Gordon Brown.

  Jest kilka kwestii, z którymi zgadza się większość państw członkowskich. Po pierwsze zarządzanie funduszu musi być rozszerzone o większą ilość podmiotów. Specjaliści oceniają, że większą rolę decyzyjną powinny otrzymać wschodzące gospodarki, Chiny i Indie. Ograniczoną rolę miałyby dostać państwa, które ostatnio mniej znaczą na arenie międzynarodowej, na przykład Anglia i Francja. Ponadto jest planowana formuła mająca na nowo określić system kwot wpłacanych do Funduszu, co jednak nie spowoduje to wzrostu znaczenia państw rozwijających się. Oprócz PKB danego kraju, będzie się zwracać uwagę na PKB w stosunku do parytetu siły nabywczej.

 

Kolejnym planem jest stworzenie systemu wczesnego ostrzegania przed kryzysami. Pojawiają się opinię, że Fundusz wykonałby w tej kwestii lepszą pracę niż analitycy z sektora prywatnego (wliczając w to agencje ratingowe),  gdzie często występuje konflikt interesów. Dyskusja dotyczy też mobilności kapitału i co się z tym wiąże, przejrzystości sytemu kredytów. Zgłaszana jest potrzeba poskromienia mało przejrzystego i rozdmuchanego systemu derywatyw, czyli instrumentów pochodnych w bankach i innych instytucjach finansowych. Ważne jest niedopuszczenie w przyszłości do nagłych załamań cen towarów, kursów walut i innych podstawowych komponentów gospodarki.

 

Z inicjatywą wychodzi też sam Fundusz. Ostatnio dyrektor naczelny Dominique Strauss-Kahn przedstawił pięciostopniowy plan reformy MFW. Pierwszym problemem, który musi być rozwiązany jest coraz większy problem finansowy wewnątrz tej instytucji. Przez ostatnie kilka lat Fundusz nie był obecny na arenie międzynarodowej, mniej państw występowało o pożyczki więc drastycznie zmniejszył się dochód generowany z procentów od przyznawanych kredytów. Istnieje plan sprzedaży około 400 ton złota i ustanowienia możliwości wpłat darowizn na niektóre działania MFW. Drugi punkt dotyczy usprawnienia nadzoru państw członkowskich. Coroczne sprawozdania są bardzo uciążliwe dla personelu, który musi przygotowywać kompleksowy raport na temat stanu gospodarczego i politycznego krajów członkowskich. Dlatego tam gdzie będzie to możliwe dotychczasowe sprawozdania mają być organizowane co dwa lata.. Dzięki temu Fundusz będzie mógł skupić na sprawach najważniejszych. Trzecią reformą ma być ustanowienie nowej formy multilateralnego nadzoru w celu skonfrontowania potencjalnych zagrożeń dla stabilności systemu monetarnego. Na podstawie międzynarodowych spotkań pracownicy Funduszu mają tworzyć sprawozdania, które później będą przedyskutowywane przez zarząd. Pierwsza taka runda miała miejsce z udziałem Chin, państw strefy Euro, Japonii, Arabii Saudyjskiej i Stanów Zjednoczonych. Zakończyło się to jednak niepowodzeniem z powodu nieprzejednanych stanowisk Chin i USA. Wyciągnięto z tego taki wniosek, że dopóki MFW nie będzie mógł przedłożyć własnej opinii na forum międzynarodowym, wielostronny nadzór nie przyniesie spodziewanych efektów.  

 

Kolejny punkt pana Strauss-Kahn'a to ustanowienie nowego obiektu w strukturach Funduszu, który zapewniałby zabezpieczenie krajom, które prowadzą odpowiedzialną politykę makroekonomiczną i posiadają zrównoważony budżet, jednak pomimo tego są narażone na kryzys z powodu słabego bilansu oraz nieodporności systemu. Państwa zakwalifikowane do tych funduszy będą mogły brać bardzo duże pożyczki. Piąta reforma ma dotyczyć podziału kwot i systemu głosów w MFW.

Nie są to wszystkie planowane zmiany. Istnieje jeszcze wiele propozycji, między innymi wystosowana przez grono ekspertów pod przewodnictwem Pedro Malana z brazylijskiego Unibanco, chcących ucięcia długoterminowych pożyczek dla biednych krajów. Natomiast wniosek Tommaso Padoa-Schioppa, ministera finansów w rządzie włoskim, dotyczy skonsolidowania państw strefy Euro w Funduszu.

Przed nadchodzącym spotkaniem w Waszyngtonie odbyła się dwudniowa sesja ministrów finansów i dyrektorów banków centralnych państw członkowskich G-20. Na sesji osiągnięto porozumienie co do potrzeby reformy m.in. Międzynarodowego Funduszu Walutowego, jednak konkretne decyzje zostaną podjęte na zaczynającym się dzisiaj szczycie w stolicy Stanów Zjednoczonych.

5. The nature and functions of the Special Drawing Rights.

Special Drawing Rights (SDRs) are potential claims on the freely usable currencies of International Monetary Fund members. SDRs have the ISO 4217 currency code XDR. SDRs are defined in terms of a basket of major currencies used in international trade and finance. At present, the currencies in the basket are the euro, the pound sterling, the Japanese yen and the United States dollar. Before the introduction of the euro in 1999, the Deutsche mark and the French franc were included in the basket. The amounts of each currency making up one SDR are chosen in accordance with the relative importance of the currency in international trade and finance. The determination of the currencies in the SDR basket and their amounts is made by the IMF Executive Board every five years.

SDRs are used as a unit of account by the IMF and several other international organizations. A few countries peg their currencies against SDRs, and it is also used to denominate some private international financial instruments. For example, the Warsaw convention, which regulates liability for international carriage of persons, luggage or goods by air uses SDRs to value the maximum liability of the carrier.

In Europe, the euro is displacing the SDR as a basis to set values of various currencies, including Latvian lats. This is a result of the ERM II convergence criteria which now apply to states entering the European Union.

SDRs basically were created to replace gold in large international transactions. Being that under a strict (international) gold standard, the quantity of gold worldwide is relatively fixed, and the economies of all participating IMF members as an aggregate are growing, a perceived need arose to increase the supply of the basic unit or standard proportionately. Thus SDRs, or "paper gold", are credits that nations with balance of trade surpluses can 'draw' upon nations with balance of trade deficits.

So-called "paper gold" is little more than an accounting transaction within a ledger of accounts, which eliminates the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

Joseph Stiglitz has argued that usage by central banks of SDRs as foreign exchange reserve could be viewed as the prelude to the creation of a single world currency.^[2] It has also been suggested that having holders of US dollars convert those dollars into SDRs would allow diversification away from the dollar without accelerating the decline of the value of the dollar.^[3][4]

Other uses

SDRs are the basis for the international fees of the Universal Postal Union, responsible for the world-wide postal system. As a spinoff from the postal services, SDRs are also used to transfer roaming charge files between international mobile telecoms operators and charges for some radio communications.^{[citation needed]}

SDRs limit carrier liability on international flights (see Montreal Convention, Warsaw Convention), as well as ship owner liability for cargo damages and oil pollution.

6. What are the so-called eurocurrencies, why did the eurocurrency market emerge and what factors propelled its subsequent expansion?

Eurocurrency is the term used to describe deposits residing in banks that are located outside the borders of the country that issues the currency the deposit is denominated in. For example a deposit denominated in US dollars residing in a Japanese bank is a Eurocurrency deposit, or more specifically a Eurodollar deposit.

Key points are the location of the bank and the denomination of the currency, not the nationality of the bank or the owner of the deposit/loan.

What Does Eurocurrency Market Mean?

The money market in which Eurocurrency, currency held in banks outside of the country where it is legal tender, is borrowed and lent by banks in Europe. 

The Eurocurrency market allows for more convenient borrowing, which improves the international flow of capital for trade between countries and companies.

7. Explain the mechanism of Eurodollar-deposit creation.

Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Neither is there any connection with the euro currency.

Gradually, after the Second World War, the quantity of U.S. dollars outside the United States increased enormously, as a result of both the Marshall Plan and imports into the U.S., which had become the largest consumer market after World War II.

As a result, enormous sums of U.S. dollars were in the custody of foreign banks outside the United States. Some foreign countries, including the Soviet Union, also had deposits in U.S. dollars in American banks, granted by certificates.

During the Cold War period, especially after the invasion of Hungary in 1956, the Soviet Union feared that its deposits in North American banks would be frozen as a retaliation. It decided to move some of its holdings to the Moscow Narodny Bank, a Soviet-owned bank with a British charter. The British bank would then deposit that money in the US banks. There would be no chance of confiscating that money, because it belonged to the British bank and not directly to the Soviets. On February 28, 1957, the sum of $800,000 was transferred, creating the first eurodollars. Initially dubbed "Eurbank dollars" after the bank's telex address, they eventually became known as "eurodollars"^[2] as such deposits were at first held mostly by European banks and financial institutions.^[2]

Gradually, as a result of the successive commercial deficits of the United States, the eurodollar market expanded worldwide.

Historically, it was the convention that a bank branch would only accept deposits in the domestic currency where it was located. For example, a British bank would only accept British pound deposits at its branches in the UK. If it wanted to accept Japanese yen deposits, it would open a branch in Japan to accept those deposits. Prior to the 1950s, exceptions to this convention were rare. Then things started to change.

During the Cold War, Soviet-block nations often had to pay for imports with US dollars—or receive US dollars for their exports. They were loath to leave their dollar deposits with banks in the United States due to the risk of those deposits being frozen or seized. Instead, they started placing the deposits with European banks. Because they were US dollars held in Europe, the funds came to be known as Eurodollars, and the deposits were Eurodollar deposits. The banks started to lend those deposited dollars out. This was the beginning of the Eurodollar market.

As the US dollar increasingly became the currency for international trade, European banks expanded their Eurodollar operations, taking deposits and making loans in dollars to ensure themselves a continuing role in international finance. The market was further fueled by financial regulations in the United States, which drove dollar deposits offshore. Regulation Q capped the interest rates US banks could offer on domestic deposits, but Eurodollar deposits were not subject to those caps. When interest rates shot up in the early 1980s, dollar deposits migrated from the United States to Europe. Regulation Q was rescinded as of 1986. However, the United States was then requiring banks to hold capital against deposits. This was an expense European banks didn't face. They were still able to offer higher rates on deposits, and the Eurodollar market continued to grow. Today, America's persistent balance of payments deficit continues to ensure a ready supply of dollars available for Eurodollar deposits.

The Eurodollar market has become global, so its name is a bit of a misnomer. A bank in Japan or Singapore may accept dollar deposits, but these are still called Eurodollar deposits. The market also includes other currencies, so there are Eurosterling, Euroyen, Euroswiss, etc. To confuse matters, in 1999, the European Union embraced the euro as its new currency, so you can now hear of Euroeuro. Eurocurrency is the general term for any currency deposited in bank branches outside countries where it is the national currency.

8. Discuss both positive and negative consequences of existence of the Eurodollar market.

Pros

- narrower interest rate spread; depositors can earn more in Eurodollar market than in the US

- cheaper financing for borrowers because Eurodollar markets operate using interbank rates

- profitable margins and rates for Eurodollar investors due to lack of US reserve requirements

- convenient instrument to hold excess corporate liquidity

- effective source of short term bank loans (till recent financial crisis)

- flexible deposit maturities - can be adjusted to the investors' needs

- can be used for covered and uncovered interest rate arbitrage

Cons

• no supervisory body (such as SEC in the US) - a con when considering macroeconomic effects of an uncontrolled capital flows, but it's a plus when considered from the investor's point of view

• no lender of last resort (such as FED)

• no insurance (like the one provided by FDIC)

• macroeconomic: its appeared to be much harder for particular countries to manage their domestic monetary conditions

• extensive speculation has sometimes destabilizing and volatile effect (like today)

• times of glut of petrodollars: banks recycled the funds collected in eurodollars into loans to unstable countries and so provoked the debt crisis

9. International banking - basic problems in supervision and regulation.

Conceptually, global banking, by which I mean both direct entry and cross-border inter-bank lending, may influence macro-stability in both positive and harmful ways. Those who see potential harm argue that trans-national banks stimulate capital flight, particularly in developing markets, and in stressful times may be a source of capital outflows and currency crises. Second, some analysts argue that foreign banks may lack commitment to their host country and will flee, or withdraw credit, when faced with problems in local markets or in their home market. A third concern is that the participation of foreign banks may be associated with broader efforts at deregulation and may overwhelm domestic banking supervisors, creating a riskier environment.

First, enhancing risk management practices is of great importance. In this context, strengthening the capital treatment of structured credit and securitisation activities, mitigating the build-up of excessive exposures and risk concentrations and revising banks' stress testing practices both in the context of liquidity and credit risk management are some of the areas where work is currently underway., I would like to welcome the development of guidelines by the industry (such as the reports of the Institute of International Finance and the Counterparty Risk Management Policy Group III - “Corrigan report”) and stress the congruency of their recommendations with those put forward by public authorities.

Second, enhancing transparency and valuation practices is crucial for restoring confidence in financial markets. Progress has already been marked in this respect, as many financial institutions have improved disclosure in their interim financial reporting for the second quarter of 2008, especially in relation to their risk exposures, valuation methods and off-balance sheet entities. Relevant guidance has been provided and is also being further developed by the Basel Committee on Banking Supervision and public sector initiatives, such as the European and the American Securitisation Fora. In addition, the International Accounting Standards Board is accelerating its work to enhance accounting and disclosure standards of off-balance sheet entities and to develop guidance for valuation in markets that are no longer active. I take this opportunity to welcome the amendments adopted by the International Accounting Standards Board and implemented in the EU by the European Commission earlier this month. These amendments introduce the possibility to reclassify assets in line with what is already permitted by the US GAAP and require additional disclosure requirements linked to these reclassifications in order to ensure full transparency. The ECB has been championing enhanced transparency and valuation practices as well as consistency at the international level and will continue following all relevant developments given the importance of accounting standards to financial stability.

Third, reviewing regulation on capital adequacy to assess the extent to which the current regulatory framework encourages procyclical behaviour by financial institutions is pivotal in promoting financial stability. In the short term, regulators have agreed to avoid measures that will in effect tighten capital requirements, impinging on the financial standing of banks and negatively impacting the supply of credit and the economy as a whole. At the same time, work has been initiated to investigate the impact of factors potentially contributing to procyclicality from a longer-term perspective.

Finally, I would like to discuss the measures aiming at enhancing the cooperation among central banks, supervisors and regulators in the current context. On the crisis prevention side, it has been agreed that there is a need to reinforce multilateral surveillance. To this end, the FSF and the IMF will intensify their cooperation with a view to enhancing the assessment of financial stability risks on a global scale. In the EU context, the same is envisaged for the Committee of European Banking Supervisors and the Banking Supervision Committee of the European System of Central Banks. These initiatives should also be reflected at national level. To this end, strengthening cooperation and exchange of information between central banks and supervisory authorities can effectively exploit the synergies between the macro- and micro-prudential approaches and contribute to establishing a more efficient framework for the identification and monitoring of risks to financial stability.

On the crisis management side, it is important to ensure that the central banks' operational framework is sufficiently flexible to deal with extraordinary situations and that supervisors' cross-border arrangements for dealing with weak banks are sufficiently robust. This is particularly pressing given the global nature of financial markets and the emergence of large cross-border groups spanning across a large number of jurisdictions and thus being supervised by a multitude of national authorities. In this respect, let me mention that in the EU context the review of the Capital Requirements Directive is expected to lead to enhancing the role of the consolidating supervisor and to provide the institutional underpinning for the operation of supervisory colleges under the auspices of the Committee of European Banking Supervisors (CEBS). Furthermore, supervisory cooperation should also be intensified on a cross-sector basis as the boundaries between financial activities are becoming increasingly blurred and all financial sectors can be affected by market developments. More broadly, all competent financial authorities, including central banks, supervisors and ministries of finance should strengthen their coordination mechanisms for managing crises impacting cross-border financial institutions. In the EU, the Memorandum of understanding on financial stability arrangements that was signed in June 2008 represents an important step in this direction.

10. Types of instruments used in the international credit market.

Hedge instruments:

- swaps

- futures

- options

- forwards

… together called credit derivatives

In finance, a credit derivative is a derivative whose value derives from the credit risk on an underlying bond, loan or other financial asset. In this way, the credit risk is on an entity other than the counterparties to the transaction itself.^[1] This entity is known as the reference entity and may be a corporate, a sovereign or any other form of legal entity which has incurred debt.^[2] Credit derivatives are bilateral contracts between a buyer and seller under which the seller sells protection against the credit risk of the reference entity.^[3]

Where credit protection is bought and sold between bilateral counterparties this is known as an unfunded credit derivative. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.

Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives. An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e. payments of premiums and any cash or physical settlement amount) itself without recourse to other assets. A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. The advantage of this to the protection buyer is that it is not exposed to the credit risk of the protection seller^[7].

Unfunded credit derivative products include the following products:

• Credit default swap (CDS)

• Total return swap

• Constant maturity credit default swap (CMCDS)

• First to Default Credit Default Swap

• Portfolio Credit Default Swap

• Secured Loan Credit Default Swap

• Credit Default Swap on Asset Backed Securities

• Credit default swaption

• Recovery lock transaction

• Credit Spread Option

• CDS index products

Funded credit derivative products include the following products:

• Credit linked note (CLN)

• Synthetic Collateralised Debt Obligation (CDO)

• Constant Proportion Debt Obligation (CPDO)

• Synthetic Constant Proportion Portfolio Insurance (Synthetic CPPI)

A credit default swap, in its simplest form (the unfunded single name credit default swap) is a bilateral contract between a protection buyer and a protection seller. The credit default swap will reference the creditworthiness of a third party called a reference entity: this will usually be a corporate or sovereign. The credit default swap will relate to the specified debt obligations of the reference entity: perhaps its bonds and loans, which fulfil certain pre-agreed characteristics. The protection buyer will pay a periodic fee to the protection seller in return for a contingent payment by the seller upon a credit event affecting the obligations of the reference entity specified in the transaction.

A total return swap (also known as Total Rate of Return Swap) is a contract between two counterparties whereby they swap periodic payments for the period of the contract. Typically, one party receives the total return (interest payments plus any capital gains or losses for the payment period) from a specified reference asset, while the other receives a specified fixed or floating cash flow that is not related to the creditworthiness of the reference asset, as with a vanilla Interest rate swap. The payments are based upon the same notional amount. The reference asset may be any asset, index or basket of assets.

The TRS is simply a mechanism that allows one party to derive the economic benefit of owning an asset without use of the balance sheet, and which allows the other to effectively "buy protection" against loss in value due to ownership of a credit asset.

The essential difference between a total return swap and a credit default swap is that the credit default swap provides protection against specific credit events. The total return swap protects against the loss of value irrespective of cause, whether default, widening of credit spreads or anything else i.e. it isolates both credit risk and market risk.

11. What do you know about the international market for bonds.

The bond market (also known as the debt, credit, or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds. Nearly all of the $923 billion average daily trading volume (as of early 2007) in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized, over-the-counter (OTC) market. However, a small number of bonds, primarily corporate, are listed on exchanges.

References to the "bond market" usually refer to the government bond market, because of its size, liquidity, lack of credit risk and, therefore, sensitivity to interest rates. Because of the inverse relationship between bond valuation and interest rates, the bond market is often used to indicate changes in interest rates or the shape of the yield curve.

Bond markets in most countries remain decentralized and lack common exchanges like stock, future and commodity markets. This has occurred, in part, because no two bond issues are exactly alike, and the number of different securities outstanding is far larger.

However, the New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds.

The Securities Industry and Financial Markets Association classifies the broader bond market into five specific bond markets.

• Corporate

• Government & agency

• Municipal

• Mortgage backed, asset backed, and collateralized debt obligation

• Funding

A Eurobond is an international bond that is denominated in a currency not native to the country where it is issued. It can be categorised according to the currency in which it is issued. London is one of the centers of the Eurobond market, but Eurobonds may be traded throughout the world - for example in Singapore or Tokyo.

Eurobonds are named after the currency they are denominated in. For example, Euroyen and Eurodollar bonds are denominated in Japanese yen and American dollars respectively. A Eurobond is normally a bearer bond, payable to the bearer. It is also free of withholding tax. The bank will pay the holder of the coupon the interest payment due. Usually, no official records are kept.

The majority of Eurobonds are now owned in 'electronic' rather than physical form. The bonds are held and traded within one of the clearing systems (Euroclear and Clearstream being the most common). Coupons are paid electronically via the clearing systems to the holder of the Eurobond (or their nominee account).

12. The nature and driving forces of the financial market globalization process.

- read add. Materials (Rybinski, ECB, NbP)

Globalization of financial markets is part of a wider phenomenon of globalization of

national economies. The rapid growth of the international trade in goods and services, which

has been in progress since the beginning of the 1960s, has entailed an increase in capital

flows. Between 1970 and 2000 the value of world exports of goods and services increased

twenty-five fold, accompanied by a fifty-fold increase in Foreign Direct Investment (FDI)

13. The process of securitization - its benefits and dangers.

Securitization (or Securitisation) is a structured finance process, which involves pooling and repackaging of cash flow producing financial assets into securities that are then sold to investors. The name "securitization" is derived from the fact that the form of financial instruments used to obtain funds from the investors are securities.

As a portfolio risk backed by amortizing cash flows - and unlike general corporate debt - the credit quality of securitized debt is non-stationary due to changes in volatility that are time- and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves; if improperly structured, the affected tranches will experience dramatic credit deterioration and loss.^[1]

All assets can be securitized so long as they are associated with cash flow. Hence, the securities which are the outcome of securitization processes are termed asset-backed securities (ABS). From this perspective, securitization could also be defined as a financial process leading to an issue of an ABS.

Securitization often utilizes a special purpose vehicle (SPV), alternatively known as a special purpose entity (SPE) or special purpose company (SPC), in order to reduce the risk of bankruptcy and thereby obtain lower interest rates from potential lenders. A credit derivative is also generally used to change the credit quality of the underlying portfolio so that it will be acceptable to the final investors.

Advantages to issuer

Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to be rated AAA because of the strength of the underlying collateral and other credit enhancements.^[4]

Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect matched funding by eliminating funding exposure in terms of both duration and pricing basis."^[7] Essentially, in most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a high cost. Securitization allows such banks and finance companies to create a self-funded asset book.

Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting purposes, these firms will be able to lessen the equity on their balance sheets while maintaining the "earning power" of the asset.

Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain uncertain. Once the block has been securitized, the level of profits has now been locked in for that company, thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.

Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Two good example of this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business (thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write more profitable business.

Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet." This term implies that the use of derivatives has no balance sheet impact. While there are differences among the various accounting standards internationally, there is a general trend towards the requirement to record derivatives at fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or less universally accepted market standard documentation. In the case of Credit Default Swaps, this documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have for a long time provided documentation on how to treat such derivatives on balance sheets.

Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm. When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the parent company.

Admissibility: Future cashflows may not get full credit in a company's accounts (life insurance companies, for example, may not always get full credit for future surpluses in their regulatory balance sheet), and a securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.

Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending, whereas once the book has been securitized, the cash would be available for immediate spending or investment. This also creates a reinvestment book which may well be at better rates.

[edit] Disadvantages to issuer

May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a materially worse quality of residual risk.

Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations, especially if it is an atypical securitization.

Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

Risks: Since securitization is a structured transaction, it may include par structures as well as credit enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for structures where there are some retained strips.

[edit] Advantages to investors

Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)

Opportunity to invest in a specific pool of high quality credit-enhanced assets: Due to the stringent requirements for corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger pool of investment options.

Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors tend to like investing in bonds created through Securitizations because they may be uncorrelated to their other bonds and securities.

Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in theory) from the assets of the originating entity, under securitization it may be possible for the securitization to receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank would be paying higher interest to its creditors, and hence less profitable).

[edit] Risks to investors

Liquidity risk

Credit/default: Default risk is generally accepted as a borrower's inability to meet interest payment obligations on time. For ABS, default may occur when maintenance obligations on the underlying collateral are not sufficiently met as detailed in its prospectus. A key indicator of a particular security's default risk is its credit rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings.^[5]

However, the credit crisis of 2007-2008 has exposed the structural flaw in the securitization process, which causes the resultant ABS to be extremely high risk for investors - loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and securitization, which causes unchecked degradation of underwriting standards. This has proven to be an extremely high risk factor for investors, but was, until recently, dismissed by most professional practitioners of finance, due to the financial conflict of interest they had as beneficiaries of substantial fees from the issuance and securitization of debt.

Event risk

Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess Fixed Income Sectors: Asset-Backed Securities spread, a rise in the default rate on the underlying loans above a specified level, a decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.^[5]

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.^[5]

Contractual agreements

Moral hazard: Investors usually rely on the deal manager to price the securitizations' underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's excess spread.^[8]

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.^[5]

14. The foreign exchange market - its main segments and functions.

The foreign exchange (currency or FX) market is where currency trading takes place. FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another. The Foreign Exchange Market that we see today started evolving during the 1970s when worldover countries gradually switched to floating exchange rate from their erstwhile exchange rate regime, which remained fixed as per the Bretton Woods system till 1971.

Today FX market is one of the largest and most liquid financial markets in the world, and includes trading between large banks, central banks, currency speculators, corporations, governments, and other institutions. The average daily volume in the global forex and related markets is continuously growing. Traditional daily turnover was reported to be over US$ 3.2 trillion in April 2007 by the Bank for International Settlements. ^[1] Since then, the market has continued to grow. According to Euromoney's annual FX Poll, volumes grew a further 41% between 2007 and 2008. ^[2]

The purpose of FX market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of multifarious international currencies such as US Dollar, Pound Sterling, etc, and the need for trading in such currencies.

The foreign exchange market is unique because of

• its trading volumes,

• the extreme liquidity of the market,

• the large number of, and variety of, traders in the market,

• its geographical dispersion,

• its long trading hours: 24 hours a day except on weekends (from 22:00 UTC on Sunday until 22:00 UTC Friday),

• the variety of factors that affect exchange rates.

• the low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)

• the use of leverage

Unlike a stock market, where all participants have access to the same prices, the forex market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest investment banking firms. Within the inter-bank market, spreads, which are the difference between the bid and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the forex market are determined by the size of the “line” (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller investment banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail forex-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001-2004 period in terms of both number and overall size” Central banks also participate in the forex market to align currencies to their economic needs.

15. Nature and types of arbitrage operations in the forex market.

What Does Forex Arbitrage Mean?

A trading strategy that is used by forex traders who attempt to make a profit on the inefficiency in the pricing of currency pairs. The strategy involves reacting quickly to opportunities, and is usually accomplished through the use of computers.

Investopedia explains Forex Arbitrage...

As with other arbitrage strategies, the act of exploiting pricing inefficiencies will actually correct the problem in the market. For this reason, these opportunities are often only around for a very short time. Arbitrage currency trading requires the availability of real-time pricing quotes and the ability react quickly as opportunities present themselves.

Forex arbitrage calculators are available to help find these opportunities more quickly, but as with all software, programs and platforms used in retail forex trading, it is important to try them out in a demo account if possible. Trying out multiple products before deciding on one is the only way to determine what is best for the forex trader.

TWO-CURRENCY ARBITRAGE

Also known as spatial, locational or two-point arbitrage, two-currency arbitrage

opportunities arise when the exchange rate between two currencies is not the same in two financial centres.

Triangular arbitrage (sometimes called triangle arbitrage) refers to taking advantage of a state of imbalance between three foreign exchange markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices.Triangular arbitrage offers a risk-free profit (in theory), so opportunities for triangular arbitrage usually disappear quickly, as many people are looking for them, or simply never occur as everybody knows the pricing relation.

MULTI-CURRENCY ARBITRAGE

16. Covered and uncovered interest arbitrage. (look Q19)

17. Covered interest parity condition - its practical significance.

Interest rate parity is an economic concept, expressed as a basic algebraic identity that relates interest rates and exchange rates. The identity is theoretical, and usually follows from assumptions imposed in economics models. There is evidence to support as well as to refute the concept.

Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one currency, exchanging that currency for another currency and investing in interest-bearing instruments of the second currency, while simultaneously purchasing futures contracts to convert the currency back at the end of the holding period, should be equal to the returns from purchasing and holding similar interest-bearing instruments of the first currency. If the returns are different, an arbitrage transaction could, in theory, produce a risk-free return. irp

Looked at differently, interest rate parity says that the spot price and the forward or futures price of a currency incorporate any interest rate differentials between the two currencies.

Two versions of the identity are commonly presented in academic literature: covered interest rate parity and uncovered interest rate parity.

Covered interest parity (also called interest parity condition) means that the following equation holds:

where:

• 
  is the domestic interest rate implied by debt of a given maturity;

• i_c is the interest rate in the foreign country for debt of the same maturity;

• S is the spot exchange rate, expressed as the price in domestic currency ($) of one unit of the foreign currency c, i.e. $/c;

• F is the forward exchange rate implied by a forward contract maturing at the same time as the domestic and foreign debt underlying
  and i_c. F is expressed in the same units as S, namely $/c.

Taking natural logs of both sides of the interest parity condition yields:

where all interest rates are now the continuously compounded equivalents. ln(F/S) is the forward premium, the percentage difference between the forward rate and the spot rate. Covered interest parity states that the difference between domestic and foreign interest rates equals the forward premium. When
, the forward price of the foreign currency will be below the spot price. Conversely, if
, the forward price of the foreign currency will exceed the spot price.

Covered interest parity assumes that debt instruments denominated in domestic and foreign currency are freely traded internationally (absence of capital controls), and have similar risk. If the parity condition does not hold, there exists an arbitrage opportunity. (see covered interest arbitrage and an example below).

The interest parity condition may also be expressed as:

The following common approximation is valid when S is not too volatile:

18. Nature and types of currency speculation.

The term carry trade without further modification refers to currency carry trade: investors borrow low-yielding and lend high-yielding currencies. It tends to correlate with global financial and exchange rate stability, and retracts in use during global liquidity shortages.^[2]

The risk in carry trading is that foreign exchange rates may change to the effect that the investor would have to pay back more expensive currency with less valuable currency.^[3] In theory, according to uncovered interest rate parity, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate one. However, carry trades weaken the currency that is borrowed, because investors sell the borrowed sum and convert it to other currencies.

19. Discuss the relationship between interest arbitrage and currency speculation.

In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. A person who engages in arbitrage is called an arbitrageur such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

Speculation (in a financial context) is the assumption of the risk of loss, in return for the uncertain possibility of a reward. Only if one may safely say that a particular position involves no risk may one say, strictly speaking, that such a position represents an "investment." Financial speculation involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. Speculation represents one of four market roles in Western financial markets, distinct from hedging, long- or short-term investing, and arbitrage.

Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency. The proceeds of the investment are only known exactly if the financial instrument is risk-free and only pays interest once, on the date of the forward sale of foreign currency. Otherwise, some foreign exchange risk remains.

Similar trades using risky foreign currency bonds or even foreign stock may be made, but the hedging trades may actually add risk to the transaction, e.g. if the bond defaults the investor may lose on both the bond and the forward contract.

Uncovered interest arbitrage is a form of arbitrage where funds are transferred abroad to take advantage of higher interest in foreign monetary centers. It involves the conversion of the domestic currency to the foreign currency to make investment; and subsequent re-conversion of the fund from the foreign currency to the domestic currency at the time of maturity. A foreign exchange risk is involved due to the possible depreciation of the foreign currency during the period of the investment.

20. Characteristic features and uses of a futures contract.

A financial contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. 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. The futures markets are characterized by the ability to use very high leverage relative to stock markets.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of corn could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of corn by going long or short using futures.

The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract.

In real life, the actual delivery rate of the underlying goods specified in futures contracts is very low. This is a result of the fact that the hedging or speculating benefits of the contracts can be had largely without actually holding the contract until expiry and delivering the good(s). For example, if you were long in a futures contract, you could go short the same type of contract to offset your position. This serves to exit your position, much like selling a stock in the equity markets would close a trade.

21. Discuss specific features of currency options and their practical uses.

In finance, a foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

(From investopedia.com)

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.

Practical uses -

- for exporters and importers - to hedge

- to speculate

22. What are currency swaps and interest swaps - what purposes do they serve?

A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange a given amount of one currency for another and, after a specified period of time, to give back the original amounts swapped. Currency swaps are often combined with interest rate swaps. For example, one company would seek to swap a cash flow for their fixed rate debt denominated in US dollars for a floating-rate debt denominated in Euro. This is especially common in Europe where companies shop for the cheapest debt regardless of its denomination and then seek to exchange it for the debt in desired currency.

For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least ten years, making them a very flexible method of foreign exchange.Currency swaps were originally done to get around exchange controls.During the global financial crisis of 2008 currency swaps were offered to other central banks by the Federal Reserve System including stable emerging economies such as South Korea, Singapore, Brazil, and Mexico.^[1]

An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments.

Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.

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