Professional Documents
Culture Documents
Introduction
Basic Terms - Meaning
An asset is anything of durable value, that is, anything that acts as a means to store value over
time. Real assets are assets in physical form (e.g., land, equipment, houses, etc.), including
"human capital" assets embodied in people (natural abilities, learned skills, knowledge).
Financial assets are claims against real assets, either directly (e.g., stock share equity claims)
or indirectly (e.g., money holdings, or claims to future income streams that originate ultimately
from real assets). Securities are financial assets exchanged in auction and overthe- counter
markets (see below) whose distribution is subject to legal requirements and restrictions (e.g.,
information disclosure requirements).
Lenders are people who have available funds in excess of their desired expenditures that they are
attempting to loan out, and borrowers are people who have a shortage of funds relative to
their desired expenditures who are seeking to obtain loans. Borrowers attempt to obtain funds
from lenders by selling to lenders newly issued claims against the borrowers' real assets, i.e., by
selling the lenders newly issued financial assets.
A financial market is a market in which financial assets are traded. In addition to enabling
exchange of previously issued financial assets, financial markets facilitate borrowing and
lending, by facilitating the sale by newly issued financial assets. A financial institution is an
institution whose primary source of profits is through financial asset transactions. Examples
of such financial institutions include discount brokers, banks, insurance companies, and complex
multi-function financial institutions.
Brokers
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a seller
(or buyer) to complete the desired transaction. A broker does not take a position in the
assets they trade. The profits of brokers are determined by the commissions they charge to the
users of their services (the buyers, the sellers, or both).
Dealers
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take
positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to sell
out of inventory rather than always having to locate sellers to match every offer to buy.
Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits by
buying assets at relatively low prices and reselling them at relatively high prices (buy low
- sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the price
at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and
represents the dealer's profit margin on the asset exchange.
Investment Banks
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial
Public Offerings) by engaging in a number of different activities:
Advice: Advising corporate on whether they should issue bonds or stock, and, for bond
issues, on the particular types of payment schedules these securities should
offer;
Underwriting: Guaranteeing corporate a price on the securities they offer, either
individually or by having several different investment banks form a syndicate to
underwrite the issue jointly;
intermediaries make profits by charging relatively high interest rates to borrowers and paying
relatively low interest rates to savers.
Auction Markets
An auction market is some form of centralized facility (or clearing house) by which buyers and
sellers, through their commissioned agents (brokers), execute trades in an open and
competitive bidding process. The "centralized facility" is not necessarily a place where buyers
and sellers physically meet. Rather, it is any institution that provides buyers and sellers with a
centralized access to the bidding process. All of the needed information about offers to buy (bid
prices) and offers to sell (asked prices) is centralized in one location which
is readily accessible to all would-be buyers and sellers, e.g., through a computer network. No
private exchanges between individual buyers and sellers are made outside of the centralized
facility. An auction market is typically a public market in the sense that it open to all agents who
wish to participate. Auction markets can either be call markets - such as art auctions for which bid and asked prices are all posted at one time, or continuous markets - such as stock
exchanges and real estate markets.
Over-the-Counter Markets
An over-the-counter market has no centralized mechanism or facility for trading. Instead, the
market is a public market consisting of a number of dealers spread across a region, a country, or
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indeed the world, who make the market in some type of asset. That is, the dealers themselves
post bid and asked prices for this asset and then stand ready to buy or sell units of
this asset with anyone who chooses to trade at these posted prices. The dealers provide customers
more flexibility in trading than brokers, because dealers can offset imbalances in
the demand and supply of assets by trading out of their own accounts.
The money market is the market for shorter-term securities, generally those with one year or less
remaining to maturity.
The capital market is the market for longer-term securities, generally those with more than one
year to maturity.
Exchange Rates
We have been talking about the purchase and sale of foreign exchange. Of course, these
transactions must take place at some price. We call that price the exchange rate. Thatis, an
exchange rate is the rate at which two di_erent monies trade for each other. In this book, an
exchange rate is the number of units of the domestic money required to purchase one unit of a
foreign money. This type of exchange rate is called a direct quote. With this convention, an
exchange rate is like any other price: the domestic currency cost of a purchase.
Speculators
Central Banks of countries
Each of the above players has its own objective for participating in the FX market
Cross Rates
A cross exchange rate reflects the amount of one foreign currency per unit of another foreign
currency.
Example Direct quote: $1.50/, $.009/
Indirect quote: .67/$, 111.11/$
Value of in = value of in $
value of in $
= $1.50/
$.009/
= 166.67/
local governments, water districts, global, national, and local companies, and many other types
of institutions sell bonds. Stock is the type of equity security with which most people are
familiar. When investors (savers) buy stock, they become owners of a "share" of a company's
assets and earnings. If a company is successful, the price that investors are willing to pay for its
stock will often rise and shareholders who bought stock at a lower price then stand to make a
profit. If a company does not do well, however, its stock may decrease in value and shareholders
can lose money. Stock prices are also subject to both general economic and industry-specific
market factors. In our example, if Carlos and Anna put their money in stocks, they are buying
equity in the company that issued the stock. Conversely, the company can issue stock to obtain
extra funds. It must then share its cash flows with the stock purchasers, known as stockholders.
C. Internationalization of Capital Markets in the Late 1990s One of the most important
developments since the 1970s has been the internationalization, and now globalization, of
capital markets. Let's look at some of the basic elements of the international capital markets.
1. The International Capital Market of the Late 1990s was Composed of a Number of
Closely Integrated Markets with an International Dimension. Basically, the international
capital market includes any transaction with an international dimension. It is not really a
single market but a number of closely integrated markets that include some type of
international component. The foreign exchange market was a very important part of the
international capital market during the late 1990s. Internationally traded stocks and bonds
have also been part of the international capital market. Since the late 1990s, sophisticated
communications systems have allowed people all over the world to conduct business from
wherever they are. The major world financial centers include Hong Kong, Singapore, Tokyo,
London, New York, and Paris, among others. It's not hard to find examples of securities that
trade in the international capital markets. Foreign bonds are a typical example of an
international security. A bond sold by a Korean company in Mexico denominated in Mexican
pesos is a foreign bond. Eurobonds are another example. A Eurobond is a bond denominated
in a currency other than that of the country in which it is sold. A bond denominated in
Japanese yen that is sold in France is an example. In the late 1990s, the Eurobond became
the primary bond of choice in the international marketplace. In 1995, over 80% of new
issues in the international bond market were Eurobonds. The primary reason for their
popularity was that because they could be repaid in any of several predetermined currencies,
the issuing company could choose the currency it preferred. Maybe you have heard of
American Depository Receipts (ADRs) or Global Depository Receipts (GDRs). In the late
1990s, these were used extensively in the privatization of public enterprises in developing
and transitioning (i.e. socialism to capitalism) countries. ADRs and GDRs are certificates
issued by a depository bank, representing shares of stock of a foreign corporation held by the
bank. Of course, the foreign exchange market, where international currencies are traded, was
a tremendously large and important part of the international capital market in the late 1990s.
During this time, it was enormous, with market turn-over well above $1 trillion daily. The
average daily turnover in traditional foreign exchange markets rose to $1.9 trillion in April
2004. Commercial banks use the foreign exchange market to meet the needs of their
corporate customers, multinational corporations use the market to hedge against risks, and
central banks enter into the market to manage the value of currencies. In another part of this
E-Book, you will learn how the foreign exchange market affected developments in the Asian
financial crisis
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.
2. The Need to Reduce Risk Through Portfolio Diversification Explains in Part the Importance
of the International Capital Market During the Late 1990s. A major benefit of the
internationalization of capital markets is the diversification of risk. Individual investors, major
corporations, and individual countries all usually try to diversify the risks of their financial
portfolios. The reason is that people are generally riskaverse. They would rather get returns on
investments that are in a relatively narrow band than investments that have wild fluctuations
year-to-year. All portfolio investors look at the risk of their portfolios versus their returns. Higher
risk investments generally have the potential to yield higher returns, but there is much more
variability. For example, a short-term U.S. government bond is low risk and has a
correspondingly low return (currently under 5%). If you buy a short-term bond, you will make
fewer than 5%, but no more than that. Buying stock in a start-up company, however, is higher
risk. You could potentially get 100% or more returns, or you could lose all the money you
invested. Portfolio diversification looks at the risk versus the return available to get the highest
return possible at the lowest possible risk. When an investor or a company invests in many
different assets (stocks, bonds, mutual funds, etc.), risk is reduced because there is less reliance
on any single asset. By using world markets, risk can be reduced even more. Here is an example:
Suppose Corporation XYZ in 1996 had the following portfolio: 1000 shares of Japanese utility
company stock; 1000 shares of Mexican petroleum company stock; German government
bonds valued at 8000 deutsche marks (today called euros); 1000 shares of a Moroccan
mutual fund; Canadian municipal bonds valued at 8000 Canadian dollars. Suppose Corporation
ABC in 1996 had the following portfolio: 10,000 shares of Swedish steel company. If the steel
company in Sweden has a poor year for sales and profits, its stock value decreases. Corporation
ABC, which has not diversified, will have a terrible return on its portfolio. The next year, the
steel company may have a great year, so ABC will have a terrific portfolio return. Corporation
XYZ, with a diversified portfolio, can overcome a single poor return and still have a good overall
return on the portfolio. If utilities in Japan have a poor year, but Morocco is experiencing strong
economic growth, the Moroccan gain can offset the Japanese stock loss. Then, the next year,
perhaps the reverse would occur (Morocco experiences a slowdown while the Japanese utility
realizes higher profits than anticipated). The year-to-year return would fluctuate much less for
Corporation XYZ than for ABC. 3. The Principal Actors in the International Capital Markets of
the Late 1990s were Banks, Non-Bank Financial Institutions, Corporations, and Government
Agencies. Commercial banks powered their way to a place of considerable influence in
international markets during the late 1990s. The primary reason for this was that they often
pursued international activities that they would not have been able to undertake in their home
countries. The lack of international regulation fueled bank growth over the decades leading up to
the 1990s. Commercial banks undertook a broad array of financial activities during the late
1990s. They granted loans to corporations and governments, were active in the bond market, and
held deposits with maturities of varying lengths. Special asset transactions, like underwriting
were undertaken by commercial banks. By underwriting, the bank guaranteed a company issuing
stocks or bonds that it would find buyers for the securities at a minimum price. Non-bank
financial institutions became another fast-rising force in international markets during the late
1990s. Insurance companies, pension and trust funds, and mutual funds from many countries
began to diversify into international markets in the 1990s. Together, portfolio enhancement and a
widespread increase in fund contributors have accounted for the strength these funds had in the
international marketplace. Corporations often use foreign funds to finance investments.
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Corporations may sell stock, issue bonds, or obtain loans from commercial banks. The trend in
the late 1990s was for corporations to issue securities that attracted investors from all over the
world. The Eurobond, which we described above, was an example of this. A Eurobond is a
corporate bond not denominated in a single currency, but gives the lender the right to demand
repayment from a preset spectrum of currencies. For example, a bond may allow its holder the
right to be repaid in yen, euros or pounds. When the holding period is over, the holder chooses
the most preferable currency at that time. This partially protects buyers from exchange rate
fluctuations. Government agencies, including central banks, were also major players in the
international marketplace during the late 1990s. Central banks and other government agencies
borrowed funds from abroad. Governments of developing countries borrowed from commercial
banks, and state-run enterprises also obtained loans from foreign commercial banks. 4. Changes
in the International Marketplace Resulted in a New Era of Global Capital Markets During the
Late 1990s, which were Critical to Development. Many observers say we entered an era of
global capital markets in the 1990s. The process was attributable to the existence of offshore
markets, which came into existence decades prior because corporations and investors wanted to
escape domestic regulation. The existence of offshore markets in turn forced countries to
liberalize their domestic markets (for competitive reasons). This dynamic created greater
internationalization of the capital markets. Up until the 1990s, capital markets in the United
States were larger and more developed than markets in the rest of the world. During the 1980s
and 1990s, however, the relative strength of the U.S. market decreased considerably as the world
markets began to grow at phenomenal rates. Three primary reasons account for this phenomenon.
First, citizens around the world (and especially the Japanese) began to increase their personal
savings. Second, many governments further deregulated their capital markets since 1980. This
allowed domestic companies more opportunities abroad, and foreign companies had the
opportunity to invest in the deregulated countries. Finally, technological advances made it easier
to access global markets. Information could be retrieved quicker, easier, and cheaper than ever
before. This allowed investors in one country to obtain more detailed information about
investments in other countries, and obtain it quite efficiently. So, in the late 1990s we witnessed
the globalization of markets - i.e., the increased integration of domestic markets into a global
economy. This differed from the process of internationalization, which connected less integrated
domestic markets of the past with offshore markets. The global capital markets became critical to
development in an open economy. Developing countries, like all countries, must encourage
productive investments to promote economic growth. Domestic savings could be used to make
productive investments. Typically, developing countries have suffered from low domestic
savings rates (although this is not true of the Asian economies of the late 1990s). Thanks to
global capital, however, developing countries added to domestic savings by borrowing savings
from abroad. If the foreign savings are invested wisely, the borrowing country will grow
economically. Thus, foreign savings, which many people simply call foreign investment, can
benefit developing countries. But, as you will learn from the E-Book's discussion of the 19941995 Mexican and Asian financial crises, sudden surges in capital can destabilize countries,
especially those with relatively small economies. Before you click to the E-Book sections that
discuss those crises, you may want to take a moment to review the sources of capital that
developing countries have relied upon. D. Sources of Capital There are two sources of capital:
private sources and public sources. Both sources are very important to the economies of the
world. Capital flows result when funds are transferred across borders; the flows are recorded in
the balance of payments account. Read on for definitions, examples, and trends in capital flows.
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1. Private Sources of Capital. Foreign direct investment and portfolio investment (both debt and
equity flows) are important sources of private capital. Each is defined below. a. Foreign direct
investment. Foreign direct investment is capital invested by corporations in countries other than
their places of domicile (their home countries). Direct investment is not nearly as liquid as
portfolio investment and is therefore less volatile. The normal requirement to qualify as foreign
direct investment is for the foreign firm to own at least ten percent of voting stock. An example
of foreign direct investment is a Japanese company that starts a joint venture (50-50) in Mexico
with a Mexican company. The Japanese company has a long-term investment in the assets of the
joint venture and not merely a passive investment like portfolio investors, who can remove their
money from a country almost instantaneously. b. Portfolio investment: debt flows and equity
flows. Portfolio debt flows result from foreign investors buying domestic debt securities. A
German investor buying bonds in Canada is an example. Commercial bank lending (loans from
private financial institutions) is also portfolio debt. Portfolio equity flows occur, similarly, when
foreign investors purchase equity securities domestically. A Japanese investor who purchases
stock in the Brazilian stock market is creating an equity capital flow into Brazil. ADRs and
GDRs also fit into this category. 2. Public Sources of Capital. Public sources of capital include
official non-concessional loans of both multilateral and bilateral aid and official development
assistance (ODA). ODA is made up of grants and concessional multilateral and bilateral loans.
Each is discussed in turn below. a. Official non-concessional loans: multilateral & bilateral aid.
Official non-concessional multilateral aid consists of loans from the World Bank, regional
development banks, and other intergovernmental agencies such as multilateral organizations. The
term "non-concessional" refers to the fact that these loans are based on market rates, must be
repaid, and are not partly grants. By contrast, official nonconcessional bilateral aid is loans from
governments and their central banks or other agencies. Export credit agency loans are also
included here. "Bilateral" refers to the fact that the entities providing the funding provide aid
only in their home country. b. ODA: official grants and concessional loans. ODA refers in part to
official public grants that are legally binding commitments and provide a specific amount of
capital available to disburse (give out) for which no repayment is required. Concessional bilateral
aid refers to aid from governments, central banks, and export credit agencies that contains a
partial grant element (25% or more), or partially forgives the loan. Similarly, concessional
multilateral aid contains a partial grant, or forgiveness of the loan. Multilateral aid comes from
the World Bank, regional development banks and intergovernmental agencies. 3. Private Capital
Became Very Important to Development in the Late 1990s. During the 1990s, the sources of
capital for developing countries changed drastically. In 1990, a World Bank publication listed
aggregate net long-term resource flows to developing countries (private and public sources of
capital) as 101.9 billion U.S. dollars. Of that number, approximately 57% was from official loans
or grants, and the remaining 43% came from private sources. Just five years later, in 1995, only
28% of the resources were from official sources, with the remaining 72% from private sources.
During the course of those five years, official funding remained relatively constant. Private
funding, however, skyrocketed. From the 1990 figure of $44 billion, private sources increased
almost 400% to $167 billion. All types of private funding increased. Portfolio equity flows went
from $4 billion to $22 billion over the 5-year period. Foreign direct investment went from $25
billion to $90 billion. Private debt flows went from $15 billion to almost $55 billion. Clearly,
there was a fundamental change in the sources of funds for developing countries to draw from
during the late 1990s. Why did this major change occur? As stated previously, international
portfolio diversification became more prevalent every day. Insurance companies, mutual funds,
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pension funds, and securities houses were looking to diversify. They also had more funds than
ever to invest. Worldwide, portfolios were absorbing an increasing share of aggregate savings.
These portfolios were coming more and more under the control of professional fund managers.
The "pros" are generally more apt to diversify in the international marketplace. As overall
international portfolio diversification grew, so too did the share of international portfolio
diversification that went to developing countries. For example, according to the IMF, the five
largest industrial countries in the late 1990s (U.K., U.S., Japan, Germany and France) increased
their international investments from $100 billion in 1980 (about 5% of assets) to $900 billion in
1993 (more than 7% of assets). In 1987, $0.50 of every $100 of foreign portfolio investment
went to emerging marketsby 1993, that figure increased to $16 of every $100. Net capital
inflows to developing countries as a percentage of world savings more than doubled (from 0.8%
to 2%) between 1990 and 1993. Capital flows to developing countries acted as catalysts,
propelling the world closer to a seamless global marketplace during the late 1990s. The growth
of global institutional investors resulted in capital flows to emerging markets based more on
short-term liquidity and performance than long-term business ventures. To protect themselves
from the risks of these volatile cash flows, developing countries can take some precautionary
measures. The central bank can intervene in foreign exchange markets and capital controls can
be imposed. As the Asian financial crisis illustrates, however, the dangers are real and very
powerful. Net private capital flows to major emerging market economies fell to about $200
billion in 1997, from a peak of $295 billion in 1996. The Asian crisis was the primary reason for
the turnaround. The five economies most affected by the crisis (South Korea, Indonesia,
Thailand, Malaysia and the Philippines) had an inflow of $93 billion in 1996. In 1997, they had a
combined outflow of $12 billion. That is a net change of $105 billion in one year! That fact
succinctly illustrates the perils of globalization and the upheaval that it can cause to governments
and individuals. Portfolio equity investment outside Asia increased from 1996 to 1997, growing
50%. Commercial banks around the world cut back their financing the most during the late
1990s. After lending about $100 billion in 1996, commercial banks actually took in more than
they lent out in emerging markets in 1997. Net official cash flows rose in 1997, as the IMF and
other financial institutions came to the aid of the Asian economies. Even as net official flows
increased by $27 billion over the previous year, 1997 total capital flows were only $229 billion
after reaching almost $300 billion in 1996.
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Financial
Intermediaries
Financial
Markets
Interbank
Individual Banks
Stock Exchange
s
Insurance Companies Money Market
Companie Pension
Funds Bond
Market
s
Mutual Funds
Foreign
Exchange
Borrowers
Individuals
Companies
Central
Government
Municipalities
Public
Corporations
Lenders
Who have enough money to Lend or to give someone money from own pocket at the condition
of getting back the principal amount or with some interest or charge, is the Lender.
Companies
Companies tend to be borrowers of capital. When companies have surplus cash that is not needed
for a short period of time, they may seek to make money from their cash surplus by lending it via
short term markets called money markets.
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There are a few companies that have very strong cash flows. These companies tend to be lenders
rather than borrowers. Such companies may decide to return cash to lenders (e.g. via a share
buyback.) Alternatively, they may seek to make more money on their cash by lending it (e.g.
investing in bonds and stocks)
Borrowers
Individuals borrow money via bankers' loans for short term needs or longer term mortgages to
help finance a house purchase.
Companies borrow money to aid short term or long term cash flows. They also borrow to fund
modernisation or future business expansion.
Governments often find their spending requirements exceed their tax revenues. To make up this
difference, they need to borrow. Governments also borrow on behalf of nationalised industries,
municipalities, local authorities and other public sector bodies. . In the UK, the total borrowing
requirement is often referred to as the Public sector net cash requirement (PSNCR).Governments
borrow by issuing bonds. In the UK, the government also borrows from individuals by offering
bank accounts and Premium Bonds. Government debt seems to be permanent. Indeed the debt
seemingly expands rather than being paid off. One strategy used by governments to reduce the
value of the debt is to influence inflation.
Municipalitiesand local authorities may borrow in their own name as well as receiving funding
from national governments. In the UK, this would cover an authority like Hampshire County
Council.Public Corporationstypically include nationalised industries. These may include the
postal services, railway companies and utility companies.
Many borrowers have difficulty raising money locally. They need to borrow internationally with
the aid ofForeign exchange markets.
Borrower's having same need can form them into a group of borrowers. It can also take an
organizational form. just like Mutual Fund. They can provide mortgage on weight basis. The
main advantage is that it lowers their cost of borrowings.
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Cost of borrowing
Bonds are issued in both fixed rate and floating rate forms. Fixed rate bonds are an attractive
exposure management tool since the known long-term currency inflows can be offset by the
known long-term outflows in the same currency. In contrast, currency loans carry variable rates
2.
Maturity
Bonds have longer maturities while the period of borrowing in the currency market has tended
to lengthen over time.
3.
Earlier, the funds available for lending at any time have been much more in the inter-bank
market than in the bond market. But of late, this situation does not hold true. Moreover, although
in the past the flotation costs of a Euro currency loan have been much lower than a Euro bond
(about 0.5 % of the total loan amount versus about 2.25 % of the face value of a Euro bond
issue), compensation has worked to lower Euro bond flotation costs.
4.
Flexibility
In a Euro bond issue, the funds must be drawn in one sum on a fixed date and repaid according
to a fixed schedule, unless the borrower pays a substantial prepayment penalty. By contrast, the
drawdown in a floating rate loan can be staggered tosuit the borrowers needs and can be repaid
in whole or in part at any time, often without penalty. Moreover, a Euro currency loan with a
multi-currency clause enables the borrower to switch currencies on any roll-over date whereas
switching the denomination of a Euro bond from currency A to currency B would require a
costly, combined, refunding and reissuing operation.
5. Speed
Funds can be raised by a known borrower very quickly in the Euro currency market. Often, a
period of two to three weeks should suffice. A Euro bond financing generally takes more time,
though the difference is becoming less significant.
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Credit Market
Credit or Loans are the loans extended for one year or longer. The market that deals in such loans
is called Credit Market.
The common maturity for credit loans is 5 years. Since banks accept short-term deposits and
provide long-term loans, it is likely that asset liability mismatch may arise. To avoid this banks
often extend floating rate credit loans fixed to some market interest rate. The London Inter Bank
Offer Rate (LIBOR) is the most commonly used interest rate. It is the rate charged for loans
between Banks. Participants in credit Market.
The major lending banks in the credit market are banks, American, Japanese, British, Swiss,
French, German and Asian (specially that of Singapore) banks, Chemical Bank, JP Morgan,
Citicorp, Bankers Trust, Chase Manhattan Bank, First National Bank of Chicago, Barclay's
Bank, National Westminster, BNP, etc. Among the borrowers, there are banks, multinational
groups, public utilities, government agencies, local authorities, etc.
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Characteristics of credit
A major part (more than 80 %) of the debts is made in US dollars. The second (but far behind) is
Pound Sterling followed by Deutsch mark, Japanese yen, Swissfranc and others.
Most of the syndicated debts are of the order of $50 million. As far as the upper limits are
concerned, amounts involved are of as high magnitude as $5 billion and more. In 1990, Euro
tunnel borrowed $6.8 billion.
On an average, maturity periods are of about five years (in some cases it is about 20 years). The
reimbursement of the loan may take place in one go (bullet) or in several installments.
The interest rate on Euro debt is calculated with respect to a rate of reference, increased by a
margin (or spread). The rates are available and generally renewable (roll over credit)every six
months, fixed with reference to LIBOR. The LIBOR is the rate of money market applicable to
short-term credits among the banks of London. The reference rate can equally be PIBOR at Paris
and FIBOR at Frankfurt, etc. It is revised regularly.
The margin depends on the supply and demand of the capital as also on the degreeof the risk of
these credits and the rating of borrowers. Financial institutions are in vigorous competition.
There is an active secondary market of Euro debts. Numerous techniques allowbanks to sell their
titles in this market.
3. Bond Market
Euro Bond issue is one denominated in a particular currency but sold to investors in national
capital markets other than the country that issued the denominating currency. An example is a
Dutch borrower issuing DM-denominated bonds to investors in the UK, Switzerland and the
Netherlands.
The Eurobond market is the largest international bond market, which is said to have originated in
1963 with an issue of Eurodollar bonds by Autos trade, an Italian borrower. The market has since
grown enormously in size and was worth about $ 428 billion in 1994.
bond markets in all currencies except the Japanese Yen are quite free from any regulation by the
respective governments. Straight bonds are priced with reference to a benchmark, typically
treasury issues. Thus a dollar bond will be priced to a yield a YTM (Yield-to-Maturity)
somewhat above the US treasury bonds of similar maturity, the spread depending upon the
borrowers ratings and market conditions.
Floatation costs of the bond are comparatively higher than costs indicated with syndicated
credits.
4. Commercial paper(CPs)
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International Capital Markets have come into existence to cater to the need of international
financing by economies in the form of short, medium or long-term securities or credits. These
markets also called markets, are the markets on which currencies, bonds, shares and bills are
traded/exchanged. Over the years, there has been a phenomenal growth both in volume and types
of financial instruments transacted in these markets. currency deposits are the deposits made in a
bank, situated outside the territory of the origin of currency. For example, dollar is a deposit
made in US dollars in a bank located outside the USA; banks are the banks in which currencies
are deposited. They have term deposits in currencies and offer credits in a currency other than
that of the country in which they are located.
A distinctive feature of the financial strategy of multinational companies is the wide range of
external services of funds that they use on an ongoing basis. British Telecommunication offers
stock in London, New York and Tokyo, while Swiss Bank Corporation-, aided by Italian,
Belgian, Canadian and German banks- helps corporations sell Swiss franc bonds in Europe and
then swap the proceeds back into US dollars.
Firms have three general sources of funds available: (i) internally generatedcash, (ii) short-term
external funds, and (iii) long-term external funds. External investment comes in the form of debt
or equity, which are generally negotiable (tradable) instruments. The pattern of financing varies
from country to country. Companies in the UK get an average of 60-70% of their funds from
internal sources. German companies get about 40-50% of their funds from external suppliers. In
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1975, Japanese companies got more than 70% of their money from outside sources, but this
pattern has since reversed; major chunks of finances come from internal sources.
Another significant aspect of financing behaviour is that debt accounts for the overwhelming
share of external finance. Industry sources of external finance also differ widely from country to
country. German and Japanese companies have relied heavily on bank borrowing, while the US
and British industry raised much more money directly from financial markets by the sale of
securities. However, in all countries, bank borrowing is on a decline. There is a growing
tendency for corporate borrowing to take the form of negotiable securities issued in the public
capital markets rather than in the form of commercial bank loans. This process known as
securitisation is most pronounced among the Japanese companies.
7. Petro Dollar
During the oil crises of 1973, the Capital markets have played a very important role. They
accepted the dollar deposits from oil exporters and channeled the funds to the borrowers in other
countries. This is called recycling the petrodollars.
8. Junk Bonds
A junk bond is issued by a corporation or municipality with a bad credit rating. In exchange for
the risk of lending money to a bond issuer with bad credit, the issuer pays the investor a higher
interest rate. "High-yield bond" is a nicer name for junk bond The credit rating of a high yield
bond is considered "speculative" grade or below "investment grade". Thismeans that the chance
of default with high yield bonds is higher than for other bonds. Their higher credit risk means
that "junk" bond yields are higher than bonds of better credit quality. Studies have demonstrated
that portfolios of high yield bonds have higher returns than other bond portfolios, suggesting that
the higher yields more than compensate for their additional default risk.
Junk bonds became a common means for raising business capital in the 1980s, when they were
used to help finance the purchase of companies, especially by leveraged buyouts, the sale of junk
bonds continued to be used in the 1990s to generate capital
9. Samurai Bonds
They are publicly issued yen denominated bonds. They are issued by non-Japanese entities.
The Japanese Ministry of Finance lays down the eligibility guidelines for potential foreign
borrowers. These specify the minimum rating, size of issue, maturity and so forth. Floatation
costs tend to be high. Pricing is done with respect to Long-term Prime Rate.
Shibosai Bonds
They are private placement bonds with distribution limited to banks and institutions. The
eligibility criteria are less stringent but the MOF still maintains control.
Shogun / Geisha Bonds
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They are publicly floated bonds in a foreign currency while Geisha are their private counterparts.
10. Yankee Bonds
These are dollar denominated bonds issued by foreign borrowers. It is the largest and most active
market in the world but potential borrowers must meet very stringent disclosure, dual rating and
other listing requirements, options like call and put can be incorporated and there are no
restrictions on size of the issue, maturity and so forth.
Yankee bonds can be offered under rule 144a of Sec. These issues are exempt from elaborate
registration and disclosure requirements but rating, while not mandatory is helpful. Finally low
rated or unrated borrowers can make private placements. Higher yields have to be offered and
the secondary market is very limited.
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tremendous advances in risk management. The decade saw increasing activity in and
sophistication of the derivatives market, whichhad begun emerging in the seventies.
Taken together, these developments have given rise to a globally integrated financial marketplace
in which entities in need of short- or long-term funding have a much wider choice than before in
terms of market segment, maturity, currency of denomination, interest rate basis, incorporating
special features and so forth. The same flexibility is available to investors to structure their
portfolios in line with their risk-return tradeoffs and expectations regarding interest rates,
exchange rates, stock markets andcommodity prices.
4.
While opening up of the domestic markets began only around the end of seventies, a truly
international financial market had already been born in the mid-fifties and gradually grown in
size and scope during sixties and seventies. This refers to the well-known Eurocurrencies
Market. It is the largest offshore market.
Prior to 1980, Eurocurrencies market was the only truly international financial market of any
significance. Itis mainly an inter-bank market trading in time deposits and various debt
instruments. What matters is the location of the bank neither the ownership of the bank nor
ownership of the deposit. The prefix "Euro" is now outdated since such deposits and loans are
regularly traded outside Europe.
Over the years, these markets have evolved a variety of instruments other than time deposits and
short-term loans, e.g. certificates of deposit (CDs), euro commercial paper (ECP), medium- to
long- term floating rate loans, eurobonds, floating rate notes and euro medium-term notes
(EMTNs).
The difference between markets and their domestic counterparts is one of regulation. Eurobonds
are free from rating and a disclosure requirement applicable to many domestic issues as well as
registration with securities exchange authorities.
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Financial risk
In general, international projects are prone to greater financial risk as a bulk of finance is in the
form of debt. The major factors affecting financial risk are
degree of indebtedness, the terms and conditions of repayment of debt and currency used.
Some projects will have expenses and revenues that involve several currencies. As a result the
exchange rate risk is very high.
Projects maybe financed with floating rates. In view of the volatility observed on the rates like
LIBOR, the interest rate risk is also significant. Therefore it is necessary to plan the coverage of
all these risks.
2. Foreign Exchange Risk
As corporations expand their international activities, they begin to acquire foreign assets and
foreign liabilities. As exchange rates change, the values of these foreign assets and liabilities
change accordingly. For a corporation, exchange rate risk is the sensitivity of the value of the
corporation when the exchange rates change. Obviously, the change in the corporation value is
related to the net change in the values of the foreign assets and foreign liabilities. (E.g. foreign
direct investment, foreign exchange loss, sales and income from foreign sources.)
3. Economic Risk
Economic risk is risk created by changes in the economy. Typically, it is related to technological
changes, the actions of competitors, shifts in consumer preferences, etc. Ideally, a pure domestic
firm is affected only by domestic economic conditions - the domestic economic risk. However, in
today's integrated world economy, the concept of a pure domestic firm has less practical
relevance. Many firms that appear strictly pure domestic confront foreign economic risk
indirectly. (E.g.: local restaurant/dept store, real estate agent)
4. Political Risk
Political risk is risk created by political changes or instability in a country. These factors include,
but are not limited to, nationalization, confiscation, price controls, foreign exchange and capital
controls, administrative hurdles, uncertain property rights, discriminative or arbitrary regulations
on business practices (hiring, contract negotiation), civil wars, riots, terrorism, etc. Each country
in the world presents a different political profile and represents a unique source of political risk
that firms must assess and manage when they make foreign investments.
In order to minimize this risk, local investors or the local government may be associated with the
project. Insurance against political risk is another useful technique recommended for the purpose.
What constitutes political risk and how to measure it?
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Counter party Risk - The risk that a counter party will default on a financial obligation.
6.
Liquidity Risk -The risk that a financial position cannot be sold quickly at prevailing prices.
7. Delivery Risk - The risk that a buyer will not deliver payment of funds after a seller has
delivered securities or foreign exchange that were purchased.
8. Rollover Risk - The risk of being closed out from a financial market and unable to renew (or
roll over) a short-term contract.
9.
Other risks - Other risks relate to the risk of cost overruns and bad management.
3.
Project financing may be defined as financing of an economic unit, legally independent, created
with a view to setting up of a big project, which is commercially profitable and financially
viable.
Project is considered as a distinct legal entity and is financed, to a marked extent, by debt (65 to
75 percent). Therefore the risk to be borne is substantial.
There are two major methods of financing international projects:
1. Financing with total risk borne by lenders where only the future cashflows ensure the
reimbursement of the loan. This method of financing was used in petroleum and gas industry in
the USA and Canada. Due to increased level of risks, this method of project financing is
generally not preferred.
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2. In another type of financing, both the lender and the promoter share the risk. The problem
sometimes encountered in this method is to decide the proportion in which the risk is to be
shared between two parties.
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Currency Markets
While opening up of the domestic markets began only around the end of seventies, a truly
international financial market had already been born in the mid-fifties and gradually grown in
size and scope during sixties and seventies. This refers to the well-known Eurocurrencies
Market. It is the largest offshore market.
Prior to 1980, Eurocurrencies market was the only truly international financial market of any
significance. Itis mainly an inter-bank market trading in time deposits and various debt
instruments. What matters is the location of the bank neither the ownership of the bank nor
ownership of the deposit. The prefix "Euro" is now outdated since such deposits and loans are
regularly traded outside Europe.
Over the years, these markets have evolved a variety of instruments other than time deposits and
short-term loans, e.g. certificates of deposit (CDs), euro commercial paper (ECP), medium- to
long- term floating rate loans, eurobonds, floating rate notes and euro medium-term notes
(EMTNs).
The mainfactors behind the emergence and strong growth of the Eurodollar markets were the
regulations on borrowers and lenders imposed by the US authorities which motivated both banks
and borrowers to evolve Eurodollar deposits and loans. Added to this are the considerations
mentioned above, viz. the ability of euro banks to offer better rates both to the depositors and the
borrowers and convenience of dealing with a bank that is closer to home, who is familiar with
business culture and practices in Europe.
Bond Market
Foreign Bond: issue is one offered by a foreign borrower to the investors in a national capital
market and denominated in that nations currency. An example is German MNC issuing dollar
denominated bonds to the U.S. investors.
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Bond: issue is one denominated in a particular currency but sold to investors in national capital
markets other than the country that issued the denominating currency. An example is a Dutch
borrower issuing DM-denominated bonds to investors in the UK, Switzerland and the
Netherlands.
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An example is a Dutch borrower issuing DM-denominated bonds to investors in the UK, Switzerland and
the Nether lands. The Eurobond market is the largest international bond market, which is said to have originated in
1963 with an issue of Eurodollar bonds by Autos trade, an Italian borrower. The market has since grown
enormously in size and was worth about $ 428 billion in 1994.Eurobond markets in all currencies except the
Japanese Yen are quite free from any regulation by the respective governments
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CONCLUSION
The global financial system is vast and global flows within this system have an enormous effect
on the real economies of different countries; that is, on GDP, economic growth, and the wellbeing of individuals. The global financial system is vast and consists of financial institutions
(banks and shadow banks) as well as financial markets in stocks, bonds, commodities, and
derivatives. The global financial system promotes economic growth by performing key
functions that facilitate and enhance the flow of capital from savers to investors, and increase the
set of opportunities to individuals and businesses. The global financial system is highly
interconnected. This interconnectedness increases the complexity of international regulation
harmonization, while simultaneously increasing the need for it. If regulation is not harmonized
across national boundaries, regulatory arbitrage may occur as banks from more tightly regulated
domains seek to escape to those with more lax regulation. This may then lead to an increase in
financial risk in the domain with lax regulation, but global interconnectedness may cause this
risk to spill over elsewhere, increasing global systemic risk. Thus, regulators must be cognizant
of the fact that any change in regulation in one part of the global financial system is likely to
have global ripple effects. Firms tap the global financial markets to raise capital and the depth
and liquidity of the global financial market help companies reduce their cost of capital and
improve access to funds, thereby facilitating investments and International Financial Markets: A
Diverse System Is the Key to Commerce 63 growth. Thus, better-developed global financial
markets spur entrepreneurship, investment, employment growth, and continued rise in GDP.
The global financial system promotes global trade through financing mechanisms outside the
banking system, through trade credit, which is credit extended by firms to their customers. Trade
credit is large in magnitude and increases with the size of global trade flows. Moreover, the
magnitude of trade credit is positively affected by the development of the global financial
system. Project financing has been creatively used to finance large-scale projects. It has often
involved private-public partnerships in which governments are able to get private companies to
build public infrastructure. Financial architecture refers to the composition of a financial
system, namely the relative importance of banks and markets in allocating capital. Roughly
speaking, financial systems fall into two broad categoriesbank-dominated and marketdominated. Market-dominated financial systems seem to be associated with a higher rate of
technological change, but regardless of whether a financial system is bank-dominated or marketdominated, development of the financial system promotes economic growth. Banks as well as
financial markets are subject to regulation, and in both cases regulators face tensions in enforcing
regulations that pull in opposite directions. Regulatory actions to achieve financial stability
create greater interconnectedness in the financial system. Bank regulation has multiple goals,
and it is being increasingly harmonized, but the danger is that regulation may go too far. While
regulation boosts economic International Financial Markets: A Diverse System Is the Key to
Commerce 64 growth to a point, beyond that point it reduces growth as the costs for banks to
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comply with regulation exceed its benefits to society. Shadow banking refers to maturity
transformation being conducted by financial intermediaries other than traditional commercial
banks, such as MMFs, investment banks, and hedge funds. This sector of the financial system
has grown faster than depository banking in recent years and is now bigger than traditional
banking in the United States. However, it provides valuable services to Main Street, including
households, and traditional commercial banks also play a role in shadow banking
Bibliography
www.Scribd.com
www.Investopedia.com
www.centerforcapitalmarkets.com
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