27-29) This provoked financial demands and awareness of the people in different parts of the world. People and businesses are dissatisfied with the traditional financial systems due to lack of opportunities for investors. Businesses today require more diversified portfolios for investments because this will reduce their investment risks and increase the probability of future capital flows.
Increased capital mobility has increased the importance of exchange rates which is serving as a monetary policy channel in some industrialized economies. In mid 2000s, there was a sharp shift in the flow of international investments and savings (geographic pattern) resulting in the segmentation of current account imbalances. This was also a major contributing factor. Additionally, the domestic financial markets were also affected by the change in regulatory environment. The two important factors for this are as follows:
1. Rapid growth of OTC (over-the-counter) markets of derivatives in terms of complexity as well as volume of transactions. During the period of April 1995-2007, the daily increment in interest rate and foreign exchange contracts turnover in OTC was $3.1 trillion. Between 1995 and 2007, the outstanding OTC amounts increased 10 times with 20% per year as an average rate. This is attributed to increased volumes of plain villa contracts with new complex products proliferation.
2. BAB (Banking Across Borders). There was a drastic increase in the foreign activities of most of the banks with an intervention of banking markets and international capitals. This resulted in a very positive change in the international banking scenario. Due to the launch of flexible financial instruments, customers and banks both got some relief from stresses and this helped customers to manage the volatility of interest rates and exchange rates during the recent past. (Ranciere and Westermann 2003 pp.33-35)
The international financial system has been transformed by the increase in the pace of deregulation, innovation and the structural change. Most of the newly introduced financial instruments are playing a vital role in the global financial system; there is a shift of loans offered by banks to international flow of credits into the direct credit market; multiplication in the daily volume of transactions; close integration in the financial system has been increased globally; flow of capital do not consider the boundaries and is much more mobile. The fast-paced growth in the transaction volume being settled down through payment system can pose a threat of potential systematic risk. Due to innovation and technology, transaction costs have been reduced dramatically. According to a rough estimate, there is a 90% decline in the costs of transactions just because of innovation and technological advances in the global financial system. (Klein 2005 pp.19-21)
Portfolio transformation services as well as global liquidity re-distribution has been produced by the Euro-banks for their sovereign and corporate customers. A secular discontinuity has been marked by the financial innovations and technology in the Euro-banking has resulted in banking revolutions, related to deregulation, competition and the funding of wholesale financial market. Thus we can say that innovations and technological advances have played a vital role in spread of international investments; thus making international investment opportunities easier and less risky.
Benefits and Risks of a Carry Trade Strategy
Carry-trade is one of the most profitable investment strategies for a Forex investor to maximize profits. In a carry-trade, purchase of high interest rate currency is done by selling the currency having low interest rate. In this transaction, the interest rate differential is the net difference in the two currencies interest rates. Although, high return on investment is one of the biggest advantages of a carry-trade strategy but there are also certain risks associated with this type of trading strategy.
Exchange rates are uncertain and this is the most obvious disadvantage or risks of carry-trade strategy. Due to this reason, it is necessary for the investor to consider other factors except interest rates on currencies. Pairs' directional movement is one of the factors to be considered for finding out whether investments in these pairs are profitable or not. It is a fact that if there is a decline in the percentage more than the interest rate gain, an investor can make a gain on interest rate while losing on capital. As a result, an overall loss is expected although there is a gain on differential on interest rates.
There are a couple of objectives of carry-trade. Firstly, an investor expects to gain money on differential of interest rate. Secondly, an investor has the chance to make profits from the appreciation of capital. If there is an appreciation in carry-trade pair, the return on investment would be better. In case, any objective is left behind or investor does not meet anyone objectives, there is a risk. There is a definite risk for loss of money in carry-trade but the use of Forex by smart investors is a good strategy to minimize expected losses. (Kaminsky and Reinhart 1999 pp.473-500)
Variation in the interest rate of pairs of currencies is another risk associated with the carry-trade strategy. This interest rate variation can make a carry-trade a magnificent opportunity for converting into sour and result in a bad investment having money losses rather than gain. "Carry-trade is a long-term investment; there is a chance of currency appreciation as well as depreciation." This is a potential risk for investors who invest in Forex for gaining profits. Fluctuations in foreign currency are a must as there is no currency in the world which is purely stable. This creates risks of exchange rate for investors who invest in carry-trade. Therefore, it is recommended that Forex investors should analyze the trends of foreign exchange rates well before investing in currency pairs through carry-trade. (Edison and Slok 2004 pp.111-115)
Carry-interest trading is very advantageous because it provides the investor with interest as well as trading gains. Leverage can also be used in carry-trade as per the advantage of the investor. The interest paid by the broker is on amount of leverage that the investor is utilizing. Thus, we can say that carry-trade strategy has its advantages as well as disadvantages. It is very necessary for the investor to analyze the trends of exchange rate so that the investment decision is more profitable.
Borrowing in the International Capital Markets
It is a fact that capital flows in international markets have increased due to the decreased barriers in international trade as well as the integration and innovation of the global financial market. In this scenario, companies can take advantage by increasing the share price on one hand, while decreasing the cost of capital on the other. Most of the companies are involved in creation of new securities for investors in the international financial market just to attract the investors and practitioners from all around the world. We can take the example of American Depositary Receipt (ADR). ADR is an instrument which provides way for the companies to list their equity shares on international exchanges or foreign exchanges. Additionally, there are cross border corporate debt securities like 144a and Yankee which are important instruments in the international financial markets. The evidence of importance of these instruments is that large amount of literature has been written on these instruments which are related to information disclosure, equity and debt to market, investor protection, corporate governance and market microstructure. Companies generally benefit from these securities by trading them in international market while existing securities in the domestic market. "Companies increase their share price in the home market to maximize profits, while trading in international market gives them advantage of the cost of capital." These are the global securities which are traded in various markets at the same time reducing the cost of capital for the firm and without any trading barriers. These new instruments have the capability to reduce the cost of capital for example; Global bonds are the instruments which can be sold at the same time in different markets. (Bekaert and Lundblad 2005 pp.3-55)
An enterprise's investment project is generally dealt by the investor who requires minimum profitability on his investment. These types of investment decisions are generally taken by companies to reduce the cost of capital, while at the same time increase the share price. Market efficiency can be improved by increased competition which results in reduced costs of capital for borrowers/company investing in diversified portfolios. Additionally, long-term growth potential is increased by increasing the market efficiency. (Ranciere and Westermann 2005 pp.27-29)
Securities market globalization is the result of the financial integration and innovation. This in turn results in lowering the cost of capital while at the same time increasing the share price in market. Equity value is increased by the private sector investment resulting in handsome amount of profits for every investor. The advantage of this scenario is the sharing of equity risk takes place among different investors having different portfolios. Due to this reason, there is decreased level of market risk premium and decreased cost of capital triggering the share price for a given level of capital flows or profits. Another advantage is…