International financial systemV. Babu

Introduction A financial market is a mechanism that allows people to 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 the efficient-market hypothesis.

Introduction International financial markets involves the freedom and opportunity to raise funds from and to invest anywhere in the world, through any type of instrument. As a result of integration, anything affecting the financial markets in one part of the world automatically and quickly affects those in the rest of the world also.

Reasons for international financial marketsThe development of new financial instruments: Instruments of the euro-dollar market, interest rate swap, currency swap, futures contracts, forward contracts, options, etc.

Liberalization of regulations governing the financial markets: Though the extent and direction of liberalization has been different in different countries, based on the domestic compulsions and the local perspective, it has been substantial enough to make operations in foreign markets a lucrative affair.

Increased cross penetration of foreign ownership: This helped the countries that developed an international perspective while deciding on various factors influencing the process of globalization.

Role of financial marketsefficiently transfer resources from the surplus unitperforming this function in a better manners to the deficit units.Capital-rich countries generally enjoy a lower return on capital than the capital-poor countries.

Role of financial marketscapital-rich country will benefit by earning a higher return on their investments, and the cash-poor country will benefit by earning profits on the project.more efficient allocation of capital possible to enjoy the benefits of diversification.

International Money MarketEurocurrency is a time deposit in an international bank located in a country different than the country that issued the currency.For example, Eurodollars are U.S. dollar-denominated time deposits in banks located abroad.Euroyen are yen-denominated time deposits in banks located outside of Japan.The foreign bank doesnt have to be located in Europe.

Eurocurrency MarketMost Eurocurrency transactions are interbank transactions in the amount of $1,000,000 and up.Common reference rates includeLIBOR the London Interbank Offered RatePIBOR the Paris Interbank Offered RateSIBOR the Singapore Interbank Offered RateA new reference rate for the new euro currencyEURIBOR the rate at which interbank time deposits of are offered by one prime bank to another.

EurocreditsEurocredits are short- to medium-term loans of Eurocurrency.The loans are denominated in currencies other than the home currency of the Eurobank.Often the loans are too large for one bank to underwrite; a number of banks form a syndicate to share the risk of the loan.Eurocredits feature an adjustable rate. On Eurocredits originating in London the base rate is LIBOR.

Forward Rate AgreementsAn interbank contract that involves two parties, a buyer and a seller.The buyer agrees to pay the seller the increased interest cost on a notational amount if interest rates fall below an agreed rate.The seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreed rate.

Forward Rate Agreements: UsesForward Rate Agreements can be used to: Hedge assets that a bank currently owns against interest rate risk.Speculate on the future course of interest rates.

EuronotesEuronotes are short-term notes underwritten by a group of international investment banks or international commercial banks.They are sold at a discount from face value and pay back the full face value at maturity.Maturity is typically three to six months.

Euro-Medium-Term NotesTypically fixed rate notes issued by a corporation.Maturities range from less than a year to about ten years.Euro-MTNs is partially sold on a continuous basis this allows the borrower to raise funds as they are needed.

Eurocommercial PaperUnsecured short-term promissory notes issued by corporations and banks.Placed directly with the public through a dealer.Maturities typically range from one month to six months.Eurocommercial paper, while typically U.S. dollar denominated, is often of lower quality than U.S. commercial paperas a result yields are higher.

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. Example: A French company issuing a dollar-denominated Eurobond that might be purchased in the United Kingdom, Germany, Canada, and the United States.

Eurobond Market StructurePrimary MarketVery similar to U.S. underwriting.Secondary MarketOTC market centered in London.Comprised of market makers as well as brokers.Market makers and brokers are members of the International Securities Market Association (ISMA).Clearing ProceduresEuroclear and Cedel handle most Eurobond trades.

The Worlds Bond MarketsA statistical Perspective:The total market value of the worlds bond markets are about 50% larger than the worlds equity markets.Most issues are denominated in U.S. dollars, Japanese Yen are second, followed by Deutchmarks in a distant third.

A Statistical Perspective:

Domestic

International

Total

$

47.8%

45.1%

47.5%

18.0%

11.7%

17.2%

DM

7.0%

10.3%

7.4%

Foreign Bonds and EurobondsBearer Bonds and Registered BondsNational Security RegistrationsWithholding TaxesRecent Regulatory ChangesGlobal Bonds

Bearer Bonds and Registered BondsBearer Bonds are bonds with no registered owner. As such they offer anonymity but they also offer the same risk of loss as currency.Registered Bonds: the owners name is registered with the issuer.U.S. security laws require Yankee bonds sold to U.S. citizens to be registered.

National Security RegistrationsYankee bonds must meet the requirements of the SEC, just like U.S. domestic bonds.Many borrowers find this level of regulation burdensome and prefer to raise U.S. dollars in the Eurobond market.Eurobonds sold in the primary market in the United States may not be sold to U.S. citizens.Of course, a U.S. citizen could buy a Eurobond on the secondary market.

Withholding TaxesPrior to 1984, the United States required a 30 percent withholding tax on interest paid to nonresidents who held U.S. government or U.S. corporate bonds.The repeal of this tax led to a substantial shift in the relative yields on U.S. government and Eurodollar bonds.This lends credence to the notion that market participants react to tax code changes.

Types of InstrumentsStraight Fixed Rate DebtFloating-Rate NotesEquity-Related BondsZero Coupon BondsDual-Currency Bonds Composite Currency Bonds

Frequency of PaymentAnnualSize of CouponPayoff at MaturityCharacteristics of International Bond Market InstrumentsCurrency of issueFixedEvery 3 or 6 monthsVariableCurrency of issue

Currency Distribution of International Bond Offerings

Futures Contracts: PreliminariesA futures contract is like a forward contract:It specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today.A futures contract is different from a forward contract:Futures are standardized contracts trading on organized exchanges with daily resettlement through a clearinghouse.

Futures Contracts: PreliminariesStandardizing Features:Contract SizeDelivery MonthDaily resettlementInitial Margin (about 4% of contract value, cash or T-bills held in a street name at your brokers).

Daily Resettlement: An ExampleSuppose you want to speculate on a rise in the $/ exchange rate (specifically you think that the dollar will appreciate).

Currently $1 = 140. The 3-month forward price is $1=150.

Sheet1

Currency per

U.S. $ equivalentU.S. $

WedTueWedTue

Japan (yen)0.00714285710.0071942446140139

1-month forward0.0069930070.0070422535143142

3-months forward0.00666666670.0067114094150149

6-months forward0.006250.0062893082160159

Sheet2

Sheet3

Daily Resettlement: An ExampleCurrently $1 = 140 and it appears that the dollar is strengthening. If you enter into a 3-month futures contract to sell at the rate of $1 = 150 you will make money if the yen depreciates. The contract size is 12,500,000Your initial margin is 4% of the contract value:

Daily Resettlement: An ExampleIf tomorrow, the futures rate closes at $1 = 149, then your positions value drops.Your original agreement was to sell 12,500,000 and receive $83,333.33But now 12,500,000 is worth $83,892.62You have lost $559.28 overnight.

Daily Resettlement: An ExampleThe $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05This is short of the $3,355.70 required for a new position.

Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds or your position will be closed out. This is usually done with a reversing trade.

Currency Futures MarketsThe Chicago Mercantile Exchange (CME) is by far the largest. Others include:The Philadelphia Board of Trade (PBOT)The MidAmerica commodities ExchangeThe Tokyo International Financial Futures ExchangeThe London International Financial Futures Exchange