24 International Financial Markets-I

Vishal Kumar

1. Learning Outcome

After completing this module, you will be able to:

i. Understand the meaning of International Financial Markets

ii. Understand the types of International Financial Markets

iii. Know about the Participants in Financial Markets

2. Introduction

The international financial market is the worldwide marketplace in which buyers and sellers trade financial assets, such as stocks, bonds, currencies, commodities and derivatives across national borders. Over recent decades, there has been a steady increase in cross-border financial flows around the world. There are two main reasons for the integration of markets. First, various financial institutions including banks and institutional investors have expanded their activities geographically. In this process, they acted as an intermediary to channel funds from lenders to borrowers across national borders. Second, the more mature securities markets have gained a clear cross-border orientation. In many instances, newly issued securities are designed and offered to the public in such a way as to maximize their appeal to international investors. These developments reflected the progressive dismantling of controls on cross-border financial flows as well as the liberalization of national financial markets more generally.

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Technological advancement and financial innovation played a key role in developing globalization of financial markets for the last two decades. Information systems have become able to compute and store more data. Telecommunications networks have extended their ramifications and increased their capacity while more reliable data exchange protocols have made it possible to connect computing machines in more efficient ways. As a result, cross-border financial deals have become easier and more secure. Moreover, over the last two decades, more innovative financial products are evolved in the financial market, called as “derivative” instruments. These products make it possible for borrowers and lenders to customize their risk exposures as well as adjust them over time. With derivative products, borrowers and lenders can therefore, customise their contracts and hedge their risk by entering into a legally binding contract. Derivatives provide an effective solution to the problem of risk caused by uncertainty and volatility in underlying asset.

3. Types of International Financial Markets

International Financial Markets can be classified as:

Foreign Exchange Market

Foreign Exchange is a market where participant buy and sell foreign currencies i.e. in this market one currency is exchanged for other currency. The foreign exchange market (Forex or Currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The primary purpose of the foreign exchange market is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business’s income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries.

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In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of its following features:

huge trading volume, leading to high liquidity
geographical dispersion
continuous operation: 24 hours a day except weekends,
the variety of factors that affect exchange rates
the low margins of relative profit compared with other markets of fixed income
the use of leverage to enhance profit margins with respect to account size

Option Market

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Option market is a market where option contracts are traded. Option is a contract for the future delivery of a specific financial asset in exchange for another, in which the option holder has the right to buy/sell the financial asset at agreed price, exercise price or strike price but is not required to do so. The right to buy is a Call Option and right to sell is a Put Option. For such a right the option buyer pays the amount called as Option Premium. The option seller receives the premium and is obliged to make (or take) the delivery at an agreed upon price, if the buyer exercise his option. There are two types of option contracts:

American Option are the contracts in which the buyer of the option has the right to exercise his option at any time before the maturity date of the contract.
European Option are the contracts in the which the buyer of the option can only exercise his option on the maturity date of the contract.

There are two types of option markets-organized exchange and over the counter market. Exchange traded options are standardized contracts with predetermined prices, standard maturity period with fixed maturity months. The entire dealing is through clearing house. But over the counter market is related to the inter bank option contracts. These contracts are tailored as per the needs of the clients. No clearing houses are required for functioning of the market.

Future Market

Future market is a market where future contracts are traded. A future contract is an agreement to buy or sell a standard quantity of a specific financial asset on a future date at a specified price agreed upon between the parties through a transaction on the floor of organized future exchange. It is an organized market where contracts are undertaken by the parties for the future commitment of prices. It is an organized market where a recognized exchange is involved for the future delivery. Moreover, future contracts are standardized contracts, which must be settled though a clearing house of the stock exchange. These contracts are adjusted through daily mark to market basis.

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Euro Currency Market“Euro” refers to the funds outside the country of the currency in which these funds are denominated. Euro currency market is a market where Euro banks accept deposits and make loan which are essentially denominated in a currency other than the currency of the country where that Euro banks are located e.g. Eurodollars are dollar ‘denominated deposits in the banks outside the United States. Usually, Euro currency market includes all Euro currency liabilities, inter-bank deposits and transactions between Eurobond and non-bank users. But in its actual sense, it includes only those deposits and loans which take place between Euro banks and non-bankers. Initially, Euro currency market was originated as dollar denominated Euro deposits and Euro loans. But now it is not confined only to Euro dollar market. So many other currencies have taken the form of Euro currency.

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Euro market includes both capital market and money market. Euro banking involves attracting funds from non- residents and “making loans to other non-residents. Initially it was confined only to dollar deposits and loans but now it has taken so many shapes i.e. GDRs, ADRs, FRNs, EMTNs, FRCDs, ECPs, EBs and so many other instruments. Euro market continued to grow by attracting both borrowers and depositors by offering much better rates as compared to domestic market. So many countries have eased exchange controls and also encouraged offshore banking. Funds have found their way into Euro currency arena. As a result, the size of Euro market is growing day by day. In case of currencies, which are relatively free convertible into other currencies, deep Euro markets exist. Euro banks are generally located in those centers that refrain from regulating foreign currency banking activities. Though so many currencies have entered in Euro market yet Euro dollar market remains the major players in Euro currency market London is main centre of Euro Currency.

4. Participants in Financial Markets

Borrowers/Issuers, Lenders/Investors and Intermediaries are the major players of the international markets. The role of these players is discussed below:

Borrowers/issuers

These are primarily corporates, banks, financial institutions, government and quasi-government bodies and supranational organizations, which need forex funds for various reasons. The important reasons for corporate borrowings are, need for foreign currencies for operation in markets abroad, duly saturated domestic market and expansion of operations into other countries.

Governments borrow in the global financial market for adjusting the balance of payments mismatches, to gain net capital investments abroad and to keep a sufficient inventory of foreign currency reserves for contingencies like supporting the domestic currency against speculative pressures.

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Further, the supranational organizations like the International Monetary Fund (IMF), World Bank, International Finance Corporation, Asian Development Bank, etc., borrow usually, long-term funds to finance diversified financing, sometimes linked to swaps for hedging current/interest rate exposures. These supranational are also typical examples of large entities appearing in the global markets as both issuers and borrowers.

Lenders/Investors

In case of Euro-Loans, the lenders are mainly banks who possess inherent confidence on the credibility of the borrowing corporate or any other entity mentioned above. In case of a GDR, it is the institutional investors and high net worth individuals who subscribe to the equity of the corporates. For an ADR, it is the institutional investor or the individual investor through the Qualified Institutional Buyer who puts in the money in the instrument depending on the statutory status attributed to the ADR as per the statutory requirements of the land. Investors in the global markets come in a large range who invests to suit their own requirements, investment objectives, risk taking abilities and liabilities. The investor range includes private individuals investing through Swiss Banks, the IMF and the World Bank. The other major investors are insurance companies, professional pension fund managers and investment trusts. In the United Kingdom, with London still a major force in the international finance market, it is the pension fund and insurance companies which are the major investors in the equity markets and bond markets. In the USA and Japan, the private player has an important role in the equity markets. In Germany, on the other hand, commercial banks play a dominant role as investors.

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Speculators

Speculators are type of investors’ who take higher than average risks, seeking for abnormal profits, as they are mainly concerned about speculating which might be the futuristic prices of a certain asset e.g. currency or a commodity; mainly they are involved in buying and selling future and option contracts in the short term, as they represent almost 70% of investors’; which might be known by “Risk Seekers”.

Hedgers

Hedgers are types of investors’ who tries to avoid or cancel any risks that can be accompanied with certain investment, they try to take positions that might prevent them from any potential losses, these types of investors’ are widely found in markets that are full of uncertainties and high volatility. There are many types of hedging positions like natural hedges, hedging credit risk, hedging currency risk, hedging equity and equity futures. Which are also known by “Risk Neutrals”.

Arbitragers

Arbitragers are types of investors’ who buy securities in one market then immediately resell it in another market in order to profit from prices divergence, as this type of dealing is only suggested only for well experienced investors’ as any delay in transactions could result of huge losses; the effect of these transaction would result in adjusting price differences between markets.

Intermediaries

The There are a number of market intermediaries known as financial intermediaries or merchant bankers, operating in financial system. These are also known as investment managers or investment bankers. The objective of these intermediaries is to smoothen the process of investment and to establish a link between the investors and the users of funds. Corporations and Governments do not market their securities directly to the investors. Instead, they hire the services of the market intermediaries to represent them to the investors. Investors, particularly small investors, find it difficult to make direct investment. A small investor desiring to invest may not find a willing and desirable borrower. He may not be able to diversify across borrowers to reduce risk. He may not be equipped to assess and monitor the credit risk of borrowers.

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Market intermediaries help investors to select investments by providing investment consultancy, market analysis and credit rating of investment instruments. In order to operate in secondary market, the investors have to transact through share brokers. Mutual funds and investment companies pool the funds (savings) of investors and invest the corpus in different investment alternatives. These market intermediaries provide different types of financial services to the investors. They provide expertise to the securities issuers. They are constantly operating in the financial market. Small investors in particular and other investors too, rely on them. It is in their (market intermediaries) own interest to behave rationally, maintain integrity and to protect and maintain reputation, otherwise the investors would not be trusting them next time. In principle, these intermediaries bring efficiency to corporate fund raising by developing expertise in pricing new issues and marketing them to the investors. Some of these are discussed as follows:

Lead Managers: The responsibilities of a Lead Manager include undertaking due diligence and preparing the offer circular, marketing the issues including arranging the roadshows. Lead manager, sometimes in consultation with the issuer, can choose to invite a syndicate of investment banks to buy some of the Bonds,/DRs (Depository Receipts) and help sell the remainder to other investors. ‘Co- managers’ are thus invited to join the deal, each of whom agrees to take a substantial portion of the issue to sell to their investor clients. Quite often there will be more than one lead manager as mandates are sometimes jointly won, or the investment bank which actually won the mandate from the issuer may decide that it needs another institution to ensure a successful launch. Two or more managers may also reflect the fact that a geographical spread of placing power is required or deemed appropriate. One of the lead manager will ‘run the books’ for the issue. This essentially involves arranging the whole issue, sending out invitation telexes, allotting Bonds /DRs, etc.
Underwriters: The lead managers and co-managers act as underwriters for the issue, taking on the risk of interest rates or markets moving against them before they have placed Bonds/DRs. Lead managers may also invite additional investment banks to act as sub-underwriters, thus forming a larger underwriting group. A third group of investment banks may also be invited to join the issue as members of selling group, but these institutions only receive a commission in respect of any Bonds/DRs sold and do not act as underwriters. The co-managers and the underwriters are also members of the selling group.

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Agents and Trustees: These intermediaries are involved in the issue of bonds/ convertibles. The issuer of bonds/convertibles, in association with the lead manager must appoint ‘paying agents’ in different financial centers, who will arrange for the payment of interest and principal due to investors under the terms of the issue. These paying agents will be banks
Lawyers and Auditors: The lead manager will appoint a prominent firm of solicitors to draw up documentations evidencing Bond/DRs issue. The various draft documents will be scrutinized by lawyers acting for the issuer and in due course by the co-managers and any other party signing a document related to the issue. Many of these documents are prepared in standard forms, but each needs to be reviewed carefully to ensure that all parties to the transactions are fully satisfied with the wording. The issuer will also appoint legal advisors to seek advice on matters pertaining to Indian/English/ American law and to comment on necessary legal documentation. Auditors or reporting accountants will become involved as well, supplying financial information, summaries and an audit report which. will be incorporated into the ‘offering circular’. The auditors provide comfort letters to the lead manager on the financial health of the issuer. Further, they also provide a statement of difference between the UK and the Indian GAAP in case of GDR issue.

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Listing Agents and Stock Exchanges: The listing agent facilitates the documentation and listing process for listing on stock exchanges and keeps on file information regarding the issuer such as Annual Reports, Articles of Association, the Depository Agreement, etc.
Depository Bank: Depository Bank is involved only in the issue of DRs. It is responsible for issuing the actual DRs, disseminating information from the issuer to the DR holders, paying any dividends or other distributions and facilitating the exchange of DRs into underlying shares when presented for redemption.
Custodian: The custodian holds the shares underlying DRs on behalf of the Depository and is responsible for collecting rupee dividends on the underlying shares and repatriation of the same to the Depository in US dollars/foreign currency.
Printers: The printers are responsible for printing and delivery of the preliminary and final offering circulars as well as the DRs/Bond certificates.

6. Summary: In this module we have learnt about the concept of international financial markets, the reasons for its growth, various types of International financial market and the participants of financial markets. As we have discussed in the beginning of the module that there has been a steady increase in cross-border financial flows around the world over the last few years. There are two main reasons for this financial flow. First, various financial institutions including banks and institutional investors have expanded their activities geographically. In this process, they acted as an intermediary to channel funds from lenders to borrowers across national borders.

Second, the more mature securities markets have gained a clear cross-border orientation. Technological advancement and financial innovation played a key role in developing globalization of financial markets for the last two decades. The advancement in ICT leads to the development of more innovative financial products in the financial market, called as “derivative” instruments. These products make it possible for borrowers and lenders to customize their risk exposures as well as adjust them over time.

Suggested Readings:

Sundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
Cullen. (2010). International Business. Routledge.
Bennett Roger (2011). International Business. Pearson Education, New Delhi
Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.
Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House, New Delhi.
Levi MauriceD. (2009). International Finance. Routledge.
Conklin David w. (2011). The Global Environment of Business. Sage Publications.
Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
Saleem Shaikh (2010). Business Environment. Pearson Education, New Delhi.