“International Finance and Payments” Course II “International Financial Markets and Institutions” Lect. Cristian PĂUN URL: Academy of Economic Studies Faculty of International Business and Economics

Course 2: International Financial Markets and Institutions2 International Financial System - review IFS ensures the capital transfers between the investors and financing beneficiaries (or debtors) – main function; IFS is composed by financial markets, financial institutions and financial instruments; Bretton Woods Agreement is the base for actual IFS; the evolution of IFS was determined by several factors; EMS was an European alternative for IFS; BP registers all the commercial and financial transactions of a country with the rest of the World; we use this BP to determine the need for financial resources for a country this BP should be in equilibrium and the deficits can be reduced using different policies; the fixed exchange rate ensures an automatic equilibrium for a BP.

Course 2: International Financial Markets and Institutions3 Financial System - structure Government Population Private companies Financial Institutions Financial transactions Financial Markets

Course 2: International Financial Markets and Institutions4 Financial Markets - characteristics Money Markets (maturity < 1 year): -very liquid; - transactions with credit instruments; - small fluctuations for the securities prices => low risk FINANCIAL MARKETS Capital Markets (maturity > 1 year): - transactions with debt and equity securities (bonds, equities) - higher prices fluctuations International Credit Markets, Euromarkets and FX Markets -Primary market: is a financial market in which new issues of a security are sold to initial buyers; - Secondary market: is a financial market in which security (previously issued) can be resold by the investors for cash. Exchange offices (NYSE, CBOT) OTC Markets

Course 2: International Financial Markets and Institutions5 Financial Markets - characteristics CharacteristicsMoney MarketsCapital Markets MaturityUnder 1 yearBelow 1 year RisksLowerHigher InstrumentsCredit instrumentsDebt and Equity instruments LiquidityHigherLower Transaction volumeLowerHigher Credit instrumentsDebt and Equity Instruments - Treasury bills;- Common Stocks - Commercial Papers;- Preferred Stocks - Banker’s Acceptance;- Bonds - DC;- Investment Funds Participations - Credits;- Insurance Policies - Pension Funds Policies - Derivatives

Course 2: International Financial Markets and Institutions6 Financial Resources for a company Financing Decision Internal Resources External Resources - Reinvesting the profits; - Increasing capital; -Debt to equity conversion; - Amortization. - Credits; - Bond issuing; - Equity.

Course 2: International Financial Markets and Institutions7 Advantages: increase the company value; higher autonomy from financial institutions; lower costs (such as banking commissions and taxes); advantages from fiscal regimes applied to reinvested profits; small companies or new business; leveraged companies (high debt). Disadvantages: opportunity costs; taxation. Why we should use internal resources ? Real cost for internal financial resources Internal resources are the most expensive financial resources !!!

Course 2: International Financial Markets and Institutions8 Advantages: mature business – “cash-flow cows”; less costly then own financial resources; important financial resources that can be obtained; higher maturity; fiscal regimes in case of the interest paid to a bank; Disadvantages: additional costs (taxes, commissions applied); the dependence from the financial institutions; the reimbursement program; a good projection for your business development (future income and cash- flow prediction). Why we should use external resources ?

Course 2: International Financial Markets and Institutions9 Direct Financing vs. Indirect Financing Debtor (Beneficiary) Investor or Creditor Direct Financing Financial Intermediaries Indirect Financing

Course 2: International Financial Markets and Institutions10 Direct Financing vs. Indirect Financing Advantages for indirect financing: a good information about capital resources; lower risks (some institutions share or cover the financial risks); financing consultancy; financing facilities; different financing alternatives; financing condition imposed by the financial institutions; lower transaction costs. Disadvantages for indirect financing: higher operational costs; inexistence of a direct contact with financial markets; historical relations with a financial institution.

Course 2: International Financial Markets and Institutions11 Services provided by financial institutions selling and buying financial securities; international payments; international financing (incl. export financing); financial consultancy; international markets surviving (rating agencies); insurance against financial risks; guarantees for financial transactions; managerial expertise; companies surviving (competitors, clients); portfolio management; investment funds management.

Course 2: International Financial Markets and Institutions12 Financial Institutions Public Financial Institutions Private Financial Institutions I. International Financial Institutions: - International Monetary Fund; - World Bank (IBRD, IDA, IFC, IMGA); - EBRD; - European Investment Bank; - Bank for International Settlements; II. Government Institutions: - Export Credit Agencies; - Export Guarantee Credit Agencies; - Export Insurance Agencies; III. Depository Institutions: - Commercial Banks; - Savings and Loans Associations; - Mutual Savings Banks; - Credit Unions. IV. Non – depository Institutions: - Investment Banks; - Mutual Funds; - Pension Funds; - Insurance Companies; - Financing Companies; - Venture Capital; - Stock Markets Brokers and Dealers.

Course 2: International Financial Markets and Institutions13 Primary Assets and Liabilities of Financial Intermediaries Type of intermediaryPrimary liabilities (sources of funds)Primary Assets (uses of funds) 1. Depository institutions: - Commercial BanksDepositsBusiness and consumer loans, Municipal Bonds, T-Bonds - Savings and loan associations DepositsMortgages loans - Mutual Savings BanksDepositsMortgages loans - Credit UnionsDepositsConsumer loans 2. Contractual Savings Institutions - Life Insurance CompaniesPremiums from policiesCorporate Bonds and Mortgages - Fire and casualty Insurance Companies Premiums from policiesMunicipal Bonds, corporate Bonds, Treasury securities - Pension FundsEmployer and employee contributionsCorporate bonds and stock 3. Investment Institutions - Financing CompaniesCommercial papers, stocks, bondsConsumer and business loans - Mutual FundsSharesStocks, Bonds - Money market mutual funds SharesMoney market instruments

Course 2: International Financial Markets and Institutions14 Type of intermediaries

Course 2: International Financial Markets and Institutions15 Financial Instruments A financial instrument is a contract between lender and borrower; This particular contract establish: the financing mechanism; the role of each institution / participant in the mechanism; the amount; the maturity; the currency; the financing cost (interest rate) and the payment method; the risk allocation between the participants; the payback of the loan; other aspects (special clause).

Course 2: International Financial Markets and Institutions16 Financial Instruments Direct InvestmentIndirect Investment - Investment Funds Participations; - Insurance Policies; - Pension Funds Participations. Money Market: Treasury Bills; Negotiable bank certificates of deposit; Commercial papers; Banker’s acceptances; Repurchase Agreements; Government Funds. Capital Market Derivatives:  Futures;  Options;  Swaps;  Caps;  Floors;  Collars. Fixed Income Instr.:  T-bonds;  Municipal Bonds.  Corporate Bonds. Equities:  Common stocks;  Preferred Stocks;  GDR.

Course 2: International Financial Markets and Institutions17 Money market instruments Treasury Bills; Negotiable bank certificates of deposit; Commercial papers; Banker’s acceptances; Repurchase Agreements; Federal Funds.

Course 2: International Financial Markets and Institutions18 A. Treasury Bills short term debt instruments maturity of 3, 6 or 12 month; have no interest payments (initially sold at a discount); the most liquid financial instruments; the safest financial instrument (no default risk) can be issued in different currencies (usually are issued in local currency) “risk free rate” instruments; B. Negotiable Bank Certificate of Deposits debt instrument sold by a bank to depositors (one of the most important capital source for banks); pays annual interest; at maturity pays back the original purchase price; can be negotiable now

Course 2: International Financial Markets and Institutions19 C. Commercial Papers short term instruments issued by banks or well known companies a high growth rate for this instruments (2000% between 1970 – 1996 in US); no interest payments (usually issued at a discount); interest rates are related to the issuer’s risk D. Banker’s Acceptances were developed in accordance with international trade development represent banks drafts (a promise of payment similar to a check) issued by a company for a future date and guarantee for a fee by the bank the bank acceptance = the guarantee these instruments are often resold on secondary market at a discount high growth rate (250% in US between 1970 and 1996)

Course 2: International Financial Markets and Institutions20 E. Repurchase Agreements - repos short term loans based on a collateral this instruments were introduced in 1961 increase the liquidity for financial instruments reverse repo’s F. Federal Funds overnight loans between banks and Central Bank the banks pay an interest rate federal funds rate (refinancing rate)

Course 2: International Financial Markets and Institutions21 Capital market instruments Stocks (common stocks, preferred stock); Mortgages; Treasury Bonds; Municipal Bonds; Corporate bonds

Course 2: International Financial Markets and Institutions22 Financial Instruments – risk classification Level 4: High Risk Instruments Derivatives, junk bonds Level 3: Potential Growth Rate Instruments: Blue chips, Mutual Funds Participations, Convertible Bonds. Level 2: Sure Income Instruments: T-Bills, Municipal Bonds / T-Bonds. Level 1: Risk free rate instruments: Cash, Deposit Certificates, Insurance Policies.