1. Instruments of Financial Markets at Studienzentrum Genrzensee Switzerland. August 30-September 17, 2004 Course attended by: Muhammad Arif Senior Joint Director (FSCD)

2. Outline Introduction to Finance Introduction to Finance Monetary Policy and Financial Markets. Monetary Policy and Financial Markets. The Swiss Approach to Managing Monetary Reserves. The Swiss Approach to Managing Monetary Reserves. Financial Crisis in Emerging markets. Financial Crisis in Emerging markets. Derivatives. Derivatives. Cross-border Collateral Transactions. Cross-border Collateral Transactions. The Swiss National Bank Policy / Challenges The Swiss National Bank Policy / Challenges Implementation of Monetary Policy by Swiss National Bank Implementation of Monetary Policy by Swiss National Bank

3. Introduction to Finance. 1. Introduction to Financial Markets. 2. Market Efficiency. 3. Portfolio Theory.

4. Introduction to Financial Markets Real Assets Real Assets All Assets which are used to produce goods and services e.g. Machines, Buildings. All Assets which are used to produce goods and services e.g. Machines, Buildings. Financial Assets. Financial Assets. Financial Assets are claims to the income generated by real assets, or by the government. E.g. Equity, bonds. Financial Assets are claims to the income generated by real assets, or by the government. E.g. Equity, bonds. Derivative Financial Assets. Derivative Financial Assets. A derivative is a financial assets which is a claim on another asset. e.g. Options, futures. A derivative is a financial assets which is a claim on another asset. e.g. Options, futures.

5. What are an assets Returns? What are an assets Returns? An asset return are the ratio between An asset return are the ratio between What asset pays you. What asset pays you. What you are paid for the asset. What you are paid for the asset. Returns have a time dimensions Returns have a time dimensions How much time elapsed between you buying the assets and the assets giving you payoffs? How much time elapsed between you buying the assets and the assets giving you payoffs? Introduction to Financial Markets

6. A market is called efficient if any new information is immediately and fully reflected in prices A market is called efficient if any new information is immediately and fully reflected in prices In efficient markets, only news (unanticipated information) could cause a change in the future. In efficient markets, only news (unanticipated information) could cause a change in the future. Prices are not predictable in efficient markets. Prices are not predictable in efficient markets. Market Efficiency

7. Types of Market Efficiency. Types of Market Efficiency. Strong Form Strong Form All public and private information. All public and private information. Semi-strong form. Semi-strong form. All public information. All public information. Weak form. Weak form. Past stock prices. Past stock prices. Market Efficiency

8. Portfolio Theory Risk Measurement Risk Measurement Variance Variance Standard Deviation Standard Deviation Mean-Variance Criterion Mean-Variance Criterion Risk averse investor prefers: Risk averse investor prefers: Higher Expected return Higher Expected return Lower Risk. Lower Risk. Portfolio variance Portfolio variance Need to take squared weights (because variance depends on squared deviations) Need to take squared weights (because variance depends on squared deviations) How strongly correlated returns. How strongly correlated returns.

9. Monetary Policy and Financial Markets. Outline Outline 1. Money Supply 2. Monetary Policy and Prices of Financial Assets. 3. Monetary Policy, Inflation and Assets Returns. 4. Assets Prices and Monetary Policy.

10. Money Supply Goal of Monetary Policy is Price Stability. Goal of Monetary Policy is Price Stability. Intermediate Target; Intermediate Target; A Variable influencing the ultimate inflation goal and yet influenced by central bank. A Variable influencing the ultimate inflation goal and yet influenced by central bank. Operating Target; Operating Target; Further from goal (than intermediate target) yet central bank has stronger influence on it. Further from goal (than intermediate target) yet central bank has stronger influence on it. Instruments: Instruments: Direct Control Direct Control Reserve requirements. Reserve requirements. Standing Facilities. Standing Facilities. Open Market Operations. Open Market Operations.

11. Monetary Policy and Prices of Financial Assets. Interest Rates and Bond Prices. Interest Rates and Bond Prices. The liquidity effect. The liquidity effect. Tracing a monetary shock (observing the liquidity effect) Tracing a monetary shock (observing the liquidity effect) The term structure of interest rates. The term structure of interest rates. The effect of Monetary Policy on: The effect of Monetary Policy on: Risky assets. Risky assets. Exchange rates. Exchange rates. Share prices Share prices

12. Monetary Policy, Inflation and Assets Returns Evidence of Inflation. Evidence of Inflation. Inflation and interest rate. Inflation and interest rate. Hedging the Risk of Inflation. Hedging the Risk of Inflation. Bonds Bonds Shares Shares Inflation and Exchange rates. Inflation and Exchange rates. Disinflation and Share Prices. Disinflation and Share Prices.

13. Assets Prices and Monetary Policy. Assets Prices Assets Prices Forecast power on inflation Forecast power on inflation “cause” economic activity. “cause” economic activity. Assets prices and monetary transmission mechanism Assets prices and monetary transmission mechanism

14. The Swiss Approach to Managing Monetary Reserve Objectives of Monetary Reserves; Objectives of Monetary Reserves; Protection of Currency value. Protection of Currency value. Reserves for periods of crisis / war. Reserves for periods of crisis / war. Lender of last resort function. Lender of last resort function. Monetary policy instruments. Monetary policy instruments. Profit. Profit.

15. Financial Crises in Emerging Markets Dramatically affect portfolio returns. Dramatically affect portfolio returns. Widespread Phenomena. Widespread Phenomena. Have increased in emerging markets. Have increased in emerging markets. Associated to an increase in private portfolio flows. Associated to an increase in private portfolio flows. Increased interaction between financial sector and macro economy. Increased interaction between financial sector and macro economy. Challenge for economic analysis and for policy. Challenge for economic analysis and for policy.

16. Derivatives Derivative contracts Derivative contracts Are financial contracts Are financial contracts Specify cash flows based on the level of an underlying price or prices Specify cash flows based on the level of an underlying price or prices Value of derivative is derived from value of an underlying asset. Value of derivative is derived from value of an underlying asset. Are not fundamentally different from any other financial contract. Are not fundamentally different from any other financial contract.

17. Derivatives Forward Contracts Forward Contracts A forward contract specifies A forward contract specifies Maturity of contract. Maturity of contract. Quantity of commodity to be bought/sold Quantity of commodity to be bought/sold Price to be paid/received at maturity of contract. Price to be paid/received at maturity of contract. Clearing information Clearing information Barring default, there is no uncertainty about future cash flows. Barring default, there is no uncertainty about future cash flows. Almost all forward contracts are traded over the counter. Almost all forward contracts are traded over the counter.

18. Derivatives Future Contracts Future Contracts Future contracts are agreements to Future contracts are agreements to Resettle the change in the future prices on daily basis. Resettle the change in the future prices on daily basis. Purchase (deliver ) a specified quantity of the underlying asset at specified date for then current future price. Purchase (deliver ) a specified quantity of the underlying asset at specified date for then current future price. The buyer of a future is called long, the seller is called the short. The buyer of a future is called long, the seller is called the short.

19. Derivatives Swaps Swaps Interest rate Swaps Interest rate Swaps Exchange floating-rate payments for fixed rate payments. Exchange floating-rate payments for fixed rate payments. Currency swaps. Currency swaps. Exchange interest payments in one currency for interest payments in another currency. Exchange interest payments in one currency for interest payments in another currency. Commodity swaps Commodity swaps Exchange payments based on commodity price index for fixed payments. Exchange payments based on commodity price index for fixed payments.

20. Derivatives Options. Options. Call Option Call Option A financial call option gives its owner the right – but not an obligation-to buy the underlying asset at a fixed price during the life of option. A financial call option gives its owner the right – but not an obligation-to buy the underlying asset at a fixed price during the life of option. Put Option Put Option Right to sell at a fixed price. Right to sell at a fixed price.

21. Cross-border Collateral Transactions Use of securities as collateral is important. Use of securities as collateral is important. Risk mitigation technique in global financial markets. Risk mitigation technique in global financial markets. Large exposure, growing rapidly Cross border transactions. Large exposure, growing rapidly Cross border transactions. Improving legal framework for collateral transactions. Improving legal framework for collateral transactions.

22. The Swiss National Bank Policy / Challenges Founded in 1905. Founded in 1905. Exchange rate flexibility since 1973. Exchange rate flexibility since 1973. Monetary based targeting since 1975. Monetary based targeting since 1975. Interest rate targeting since 2000. Interest rate targeting since 2000. Joint Stock Corporation. Joint Stock Corporation. Monetary policy ensures price stability. Monetary policy ensures price stability. The main challenge being a non-member of EU and EMU, but strong economic links with Europe. The main challenge being a non-member of EU and EMU, but strong economic links with Europe.

23. Implementation of Monetary Policy by Swiss National Bank Concept: Concept: Definition of price stability, i.e. yearly growth rate of CPI of less then 2%. Definition of price stability, i.e. yearly growth rate of CPI of less then 2%. Inflation forecast, i.e. estimated at average lag of monetary policy on inflation to be about 3 years. Inflation forecast, i.e. estimated at average lag of monetary policy on inflation to be about 3 years. Operational Target is band of three month LIBOR. Operational Target is band of three month LIBOR.

24. Thank You. Thank You.