International Financial Markets

10 October 2016

This section begins the study of the international financial system by exploring the structure of the international financial markets. The two interrelated systems that comprise the international financial markets are the international capital market and the foreign exchange market. 2. INTERNATIONAL CAPITAL MARKET A capital market is a system that allocates financial resources in the form of debt and equity according to their most efficient uses. Its main purpose is to provide a mechanism to borrow or invest money efficiently.

Purposes of National Capital Markets National capital markets help individuals and institutions borrow the money from lenders; intermediaries exist to facilitate financial exchanges. Commercial banks lend their investors’ deposits at a specific rate of interest and provide loans and finance import/export activities. Investment banks act as agents, introducing clients to organizations that provide investment or borrowing opportunities. 1. Role of Debt a. Debt consists of loans in which the borrower promises to repay the borrowed amount (the principal) plus a predetermined rate of interest.

Company debt normally takes the form of bonds—debt instruments specifying the timing of principal and interest payments. b. The holder of a bond (the lender) can force the borrower into bankruptcy if payment is not made on a timely basis. Bonds to fund investments are issued by private-sector companies and by municipal, regional, and national governments. 2. Role of Equity a. Equity is part ownership of a company in which the equity holder participates with other part owners in the company’s financial gains and losses.

Equity normally takes the form of stock—shares of ownership in a company’s assets that give shareholders a claim on the company’s future cash flows. b. Shareholders may be rewarded with dividends—payments made out of surplus funds—or by increases in the value of their shares. They may also suffer losses due to poor company performance—and thus decreases in the value of their shares. Dividend payments are not guaranteed, but decided by the company’s board of directors and based on financial performance. c. Shareholders can sell one stock and buy another or liquidate exchange stock for cash.

Liquidity refers to the ease with which bondholders and shareholders convert investments into cash. B. Purposes of the International Capital Market The international capital market is a network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries. Large international banks gather excess cash of investors and savers around the world and then channel it to global borrowers. 1. Expanding the Money Supply for Borrowers a. Companies unable to obtain funds from investors in the domestic market seek financing in the international capital market. . Essential for firms in countries with small or developing capital markets or emerging stock markets. c. An expanded supply of money benefits small companies that might not get financing under intense competition for capital. 2. Reducing the Cost of Money for Borrowers a. An expanded money supply reduces the cost of borrowing. The “price” reflects supply and demand. Excess funds create a buyer’s market, forcing interest rates lower. b. Projects regarded as infeasible because of low expected returns might be viable at a lower financing cost. 3. Reducing Risk for Lenders a.

The international capital market expands the available set of lending opportunities. Investors reduce portfolio risk by spreading their money over many debt and equity instruments. b. Investing in international securities benefits investors because some economies are growing while others are in decline. C. Forces Expanding the International Capital Market 1. Information Technology Information technology reduces the cost (in both time and money) of communicating around the globe. Electronic trading after the daily close of formal exchanges facilitates faster response times. 2. Deregulation

Deregulation increases competition, lowers cost of financial transactions, and opens many national markets to global investing and borrowing. Continued growth depends on further deregulation. 3. Financial Instruments Increased competition is creating the need to develop innovative financial instruments. Securitization is the unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments, or securities. D. World Financial Centers Three most important financial centers are London, New York, and Tokyo. 1. Offshore Financial Centers

A country or territory, whose financial sector features few regulations and few, if any, taxes. They: (1) are economically and politically stable; (2) are advanced in telecommunications; (3) offer large amounts of funding in many currencies; and (4) provide a less costly source of financing. a. Operational Centers see a great deal of financial activity (e. g. , London for currencies; Switzerland for investment capital). b. Booking Centers are usually located on a small, island nation or territory with favorable tax and/or secrecy laws. Funds pass through on their way to large operational centers.

Typically are offshore branches of domestic banks used to record tax and currency exchange information. c. Both types attract attention in the expanding world of electronic commerce.  International Bond Market The international bond market consists of all bonds sold by issuing companies, governments, or other organizations outside their own countries. Buyers include medium- to large-size banks, pension funds, mutual funds, and governments. 1. Types of International Bonds a. Eurobond i. Bond issued outside the country in whose currency t is denominated (e. g. , A bond issued in Venezuela in U. S. dollars, and sold in Britain, France, and Germany). ii. Account for 75 to 80% of all international bonds because governments of countries in which they are sold. Do not regulate them. Absence of regulation reduces the cost of issuing a bond but increases its risk. b. Foreign Bond i. Sold outside the borrower’s country and denominated in the currency of the country in which it is sold (e. g. , Yen-denominated bond issued by the German carmaker BMW in Japan’s domestic bond market). ii. Account for 20 to 25% of all international bonds. iii.

Countries require issuers to meet certain regulatory requirements and disclose details about company activities, owners, and upper management. 2. Interest Rates: A Driving Force a. Borrowers from newly industrialized and developing countries borrow money from nations where interest rates are lower. b. Meanwhile, investors in developed countries buy bonds in newly industrialized and developing nations to obtain a higher return. c. Many emerging countries see the need to develop their own national markets. Volatility in the global currency market hurts projects that earn funds in those currencies and pay debts in dollars.

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