International Financial System

By:- Vikram.G.B Lecturer, P.G. Dept. of Commerce V.D.C Bangalore-55

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 International Financial 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.

It constitutes the full range of interest and returnbearing 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 financial institutions, commercial banks and various types of money market funds along with open markets for currency and, depending on institutional structure, government bonds are all part of the international monetary system. 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.

Private equity transactions, private equity/hedge fund joint ventures, leverage buyouts whether bank financed or not, etc. are the best examples for international financial system. In IMS money (in contrast to financial assets) is not interest bearing. But under IFS it is a interest bearing.

The IFS lies at the heart of the global credit creation and allocation process.

 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 Institutions: Financial Intermediaries are institutions that 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 ATM.

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 cycle.

 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

e.g., the government

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 nowadays.

 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 fall, everything else held constant, which in turn causes consumer spending to decrease

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 dollardenominated Eurobond that might be purchased in the United Kingdom, Germany, Canada, and the

 Like many bonds, Eurobonds are usually fixedrate, 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 brokerdealer 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 nonstandardized 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-thecounter 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.