International Financial Markets and Institutions

International Financial Markets and Institutions

During the past decades, a trend of increased volume and mobility of capital flows has been observed in the global financial markets. According to a rough estimate, global GNPs annual value is now less than financial transactions' volume in all the financial markets of the world. Increase in financial mobility can be attributed as a result as well as cause of the increased financial integration of the economy of the world. Increased financial integration also plays a vital role in creating an impact on the domestic financial markets. Some powerful economies' governments held negotiations among themselves so as to focus on the policy stances of each other with regard to interest rate, monetary and the exchange rate.

In earlier years, the capital flows (as a result of differentials in interest rates) were not directed well towards industrial countries. But, in 1990s', these capital flows made emerging markets as their destinations. According to an estimate, the capital flows were only $15 billion in 1990s which increased to more than $100 billion in 1993. This rapid change in capital flows was the result of following three reasons. One of the most important reasons for this change in trend was that the developing countries having high account surpluses and growth rate became very attractive for investment as they possess a very high potential for appreciation in currency and capital gains. Secondly, the interest rates of industrial countries decreased due to recession. Last, but not the least, major U.S. industrial investors adopted diversification of investment to international due to increased potential for capital gains and growth. (Tornell and Martinez 2003 pp.110-112)

In early years, the regulation of domestic financial market was a very successful act as it was in line with effective and efficient economic performance. Financial conditions in other countries are dependent on the change in interest rate of a country. In order to increase the financial & capital flows between countries, control of interest rate must be considered in these circumstances. Thus, monetary policy instruments' efficacy is limited which is generally aimed at macroeconomic balances domestically.

Financial deregulation was started by countries because regulation of financial markets was not achieving the expected results due to increase in financial integration partly, and partly because these regulations started to create hindrances in efficient functioning of the financial markets; while the same regulations were serving their purpose efficiently earlier. It should be kept in mind that deregulation is not without challenges. It resulted in increased interdependence and decreased functioning of macro-economy in ways which are beyond human understanding. Behavior of interest rates, exchange rates and capital flows has been affected by financial deregulation in an unanticipated manner. (Tornell and Westermann 2005 pp.43)

The adoption of financial deregulation by emerging markets resulted in increased efficiency of these markets by reaping the benefits, on one hand, and paying the costs of being linked to the global capital market, on the other hand. Capital flows are directly proportional to the economic prospects of a country. With the betterment of economic prospects, the capital flows increases; thus making the growth & investment opportunities wider and resources scarce. On the expense of export industries competitiveness, increase in capital flows result in currency appreciation or it can also result in domestic credit expansion; thus making inflation rates higher. Financial integration of global capital market have made the policy options way diverse from before.

Definition of Terms

Financial globalization is the process of creating one market through integration of all the markets of the world.

International diversification is a risk reducing technique aimed at investing in more than one markets.

Cost of capital is defined as the rate which a company can get if it invests in some other project with the same exposure to risk.

Cost of equity is the rate of return which a company gives to its stockholders.

Cost of debt is the interest rate which a company pays on its debts.

The Impacts of Financial Deregulation and Capital Control on Financial Globalization and International Diversification

Increased penetration of financial deregulation and capital controls have resulted in diversification and globalization of financial markets. Financial deregulation and capital controls have also pawed way to financial market growth which in turn have resulted in more competitive, restructured and low cost financial services industry. Along with this, the fast-paced deregulation has made the volume of financial transactions more than the international trade in goods and services. The resulting economic instability and uncertainty posed threats to the international diversification of capital flows. Global financial markets are open 24/7 and are so quickly responding to the changes that the danger for chain reaction is growing which in turn can result in precipitation of the global financial market.

A prime example of an economic activity are financial markets in which capital controls and regulations can result in inefficiency, distortions, etc. rather than promoting effectiveness and efficiency. These markets have the potential to adopt and adjust to changes rapidly and efficiently. Fungible assets are generally traded in these markets. "Due to improvements in computer technology and communication, fungibility of assets is prevailing on global level; with minimized costs of transactions." (Schneider and Tornell 2004 pp.883-913) This assets fungibility does not depend on the currency denominations. This type of financial environment encourages swift price changes affects all assets, creating an impact on the global market. Market equilibrium can easily be restored with these swiftly changing prices due to changing financial conditions.

Still, financial services industry represents only a single segment of any economy. In this industry, there is too much emphasis on expectations, trust and confidence with a sudden impact on influencing reactions and actions, than any other segment of economy. One of the main reasons for regulating the financial markets is to maintain the level of trust in financial agents. This activity has resulted in objectives of economic policy which are broader as compared to the past; thus subordinating the financial markets. For example, credit controls and interest rates served monetary policy, exchange rate stabilization through capital controls. Thus, we can say that controls and regulation of financial markets have supported in reduction of financial volatility feedbacks on further factor markets. This remained calm till early 80s when encroachment of public sector on economic activities emerged as a concern for industrial countries. This was a major concern and was also discussed intellectually in the classical economist's theories of 19th century. Reformist stance of free-market was also promoted for policy makers and governments of the top industrial economies.

Due to this reason, the deregulation of economic activities took place. The focus of deregulation was the financial markets as it was more rapid and pronounced in these markets. Competition was stimulated with related substantia due to fast paced innovation and resulting financial activities liberalization. Capital market efficiency gains, due to liberalization, increased with more liquidity. Also there is a reduction in financial intermediation costs. Short-term liability and asset management have been improved due to introduction of risk-minimization techniques. Last, but not the least, this liberalization and deregulation have resulted in improved ability of withstanding risks and capitalization. (Ranciere and Westermann 2006 pp.65)

These recent transformations of global capital market have resulted in increased financial and economic costs as well. Risks associated with off-balance sheet emerged due to security lending by the commercial banks. Future solvency of banks could be mortgaged by these off-balance sheet risks. On the other hand, monetary policy implementation was made complicated by the increased volatility of global financial market, together with heightened substitutability of money for financial instruments.

Generally speaking, the worst impact of financial deregulation is the disconnection of other economy sectors and the financial markets. The growth of financial service industry is more fast-paced as compared to other segments of the economy in major industrial economies. This in turn results in increased transaction volume of financial capital flows. The increased financial market volatility poses risks of destabilization for other sectors of the economy.

Impact Of Financial Innovations And Technology On International Investments

Financial innovations and technology play a vital role in enhancement of international investments by businesses. Businesses have utilized innovations in financial markets to generate streams of revenues and future capital gains; thus maximizing the overall profits. Indexed mutual funds, money market funds, securitized investments and exchange traded funds are the examples of international investments purchased by companies to maximize their profits. New financial investments are also the result of financial innovations. Instruments like CDS and CDOs are the examples of investments in international financial market. Most of the businesses are interested to invest in these instruments if and only if they get the surety that the risks in these investments are less than the amount of capital/financial gains from these investments.

The widespread implementation of computer and communication technology can be attributed to be the product of recent structural changes and innovation in financial market. "Worldwide information accessibility and launch of new service firms are the gains from this innovation and technology implementation." (Ranciere and Westermann 2005 pp.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.