Lecture on Global Financial Markets

Following is the lecture on Global Financial Markets. This is the over all introductory lecture which highlights the main areas of the Global Financial Market subject. Details of every topic will be posted one by one later.


The markets where economic units with surplus funds, such as corporations, governments and investors lend funds to other economic units that want to borrow.
  There are following financial markets:
  Foreign exchange market
  Eurocurrency market
  Eurocredit market
  Eurobond market
  International stock markets
  International development Institutions
Motives for Using GFM
  The markets for real or financial assets prevented from complete integration by barriers such as tax differentials, tariffs, quotas, labor immobility, communication costs, cultural differences, and financial reporting differences.
  These barriers can also create unique opportunities for specific geographic markets that will attract foreign investors.
  Reduction in capital access costs due to technological improvements and globalization.
  Globalization of financial markets has led to global center competition and regulatory arbitrage
  Investors invest in global markets:
  to take advantage of favorable economic conditions;
  When foreign currencies expect to appreciate against their own
  to reap the benefits of international diversification.
  Creditors provide credit in foreign markets:
  to capitalize on higher foreign interest rates;
  When foreign currencies expect to appreciate against their own
  to reap the benefits of international diversification.
  Borrowers borrow in foreign markets:
  to capitalize on lower foreign interest rates; and
  When foreign currencies expect to depreciate against their own.
Financial Market/Center
Prerequisites to be a financial center
                                a.            Political stability
                                b.            Minimal government interventions
                                c.             Legal infrastructure
                                d.            Financial infrastructure
Foreign Exchange Market
  The foreign exchange market allows currencies to be exchanged in order to facilitate international trade or financial transactions.
  There is no specific building or location where traders exchange currencies. Trading also occurs around the clock.
  The system for establishing exchange rates has evolved over time.
  From 1876 to 1913, each currency was convertible into gold at a specified rate, as dictated by the gold standard.
  This was followed by a period of instability, as World War I began and the Great Depression followed.
  The 1944 Bretton Woods Agreement called for fixed currency exchange rates.
  By 1971, the U.S. dollar appeared to be overvalued. The Smithsonian Agreement devalued the U.S. dollar and widened the boundaries for exchange rate fluctuations from ±1% to ±2%.
  Even then, governments still had difficulties maintaining exchange rates within the stated boundaries. In 1973, the official boundaries for the more widely traded currencies were eliminated and the floating exchange rate system came into effect.
Foreign Exchange Transactions
  Hundreds of banks facilitate foreign exchange transactions. At any point in time, arbitrage ensures that exchange rates are similar across banks.
  Trading between banks occurs in the interbank market. Within this market, foreign exchange brokerage firms sometimes act as middlemen.
Bank Attributes
  The following attributes of banks are important to foreign exchange customers:
  competitiveness of quote
  special relationship between the bank and its customer
  speed of execution
  advice about current market conditions
  forecasting advice
Eurocurrency Market
  U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars.
  In the 1960s and 70s, the Eurodollar market, or what is now referred to as the Eurocurrency market, grew to accommodate increasing international business and to bypass stricter U.S. regulations on banks in the U.S.
  Growth of Eurodollar Market caused by restrictive US government policies, especially
                  1.            Reserve requirements on deposits
                  2.            Special charges and taxes
                  3.            Required concessionary loan rates
                  4.            Interest rate ceilings
                  5.            Rules which restrict bank competition.
  The Eurocurrency market has few regulations typically, there are
  No reserve requirements
  No interest rate regulations or caps
  No withholding taxes
  No deposit insurance requirements
  No credit allocation regulations
  Less stringent disclosure requirements
  The Eurocurrency market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies.
  For example, the Eurocurrency market has historically recycled the oil revenues (petrodollars) from oil-exporting (OPEC) countries to other countries.
  Although the Eurocurrency market focuses on large-volume transactions, there are times when no single bank is willing to lend the needed amount.
  A syndicate of Eurobanks may then be composed to underwrite the loans. Front-end management and commitment fees are usually charged for such syndicated Eurocurrency loans.
  The recent standardization of regulations around the world has promoted the globalization of the banking industry.
  In particular, the Single European Act has opened up the European banking industry.
  The 1988 Basel Accord signed by G-10 central banks outlined common capital standards, such as the structure of risk weights, for their banking industries.
  The Eurocurrency market in Asia is sometimes referred to separately as the Asian dollar market.
  The primary function of banks in the Asian dollar market is to channel funds from depositors to borrowers.
  Another function is interbank lending and borrowing.
Eurocredit Market
  Loans of one year or longer are extended by Eurobanks to MNCs or government agencies in the Eurocredit market. These loans are known as Eurocredit loans.
  Floating rates are commonly used, since the banks’ asset and liability maturities may not match - Eurobanks accept short-term deposits but sometimes provide longer term loans.
Eurobond Market
There are two types of international bonds.
Œ  Bonds denominated in the currency of the country where they are placed but issued by borrowers foreign to the country are called foreign bonds or parallel bonds (Toronto Dominion trade OTC in the U.S).
  Bonds that are sold in countries other than the country represented by the currency denominating them are called Eurobonds.
Types of Foreign Bonds
Three Major Types of Foreign Bonds
                                                1.)           Fixed rate
                                                2.)           Floating rate
                                                3.)           Equity related
  The emergence of the Eurobond market is partially due to the 1963 Interest Equalization Tax imposed in the U.S.
  The tax discouraged U.S. investors from investing in foreign securities, so non-U.S. borrowers looked elsewhere for funds.
  Then in 1984, U.S. corporations were allowed to issue bearer bonds directly to non-U.S. investors, and the withholding tax on bond purchases was abolished.
  Eurobonds are underwritten by a multi-national syndicate of investment banks and simultaneously placed in many countries through second-stage, and in many cases, third-stage, underwriters.
  Eurobonds are usually issued in bearer form, pay annual coupons, may be convertible, may have variable rates, and typically have few protective covenants.
  Interest rates for each currency and credit conditions in the Eurobond market change constantly, causing the popularity of the market to vary among currencies.
  About 70% of the Eurobonds are denominated in the U.S. dollar.
  In the secondary market, the market makers are often the same underwriters who sell the primary issues.
                a.            Use London Interbank Offer Rate:  LIBOR as basic rate
                b.            Six month rollovers
                c.             Risk indicator:  size of margin between cost and                rate charged.
Note Issuance Facility (NIF)
                1.  Low-cost substitute for loan
                2.  Allows borrowers to issue own notes
                3.  Placed/distributed by banks
NIFs vs.  Eurobonds                       
1.  Differences:
                a.  Notes draw down credit as needed
                b.  Notes let owners determine timing
                c.  Notes must be held to maturity                                          
Eurobond vs  Eurocurrency Loans
                a.  Eurocurrency loans use variable rates
                b.  Loans have shorter maturities
                c.  Bonds have greater volume
                d.  Loans have greater flexibility
                e.  Loans obtained faster
International Stock Markets
  In addition to issuing stock locally, MNCs can also obtain funds by issuing stock in international markets.
  This will enhance the firm’s image and name recognition, and diversify the shareholder base. The stocks may also be more easily digested.
  Cross listing internationally can
                                1.)  diversify risk
                                2.)  increase potential demand
                                3.)  build base of global owners.
  Note that market competition should increase the efficiency of new issues.
  The locations of the MNC’s operations can influence the decision about where to place stock, in view of the cash flows needed to cover dividend payments.
  Market characteristics are important too. Stock markets may differ in size, trading activity level, regulatory requirements, taxation rate, and proportion of individual versus institutional share ownership.
  Electronic communications networks (ECNs) have been created to match orders between buyers and sellers in recent years.
  As ECNs become more popular over time, they may ultimately be merged with one another or with other exchanges to create a single global stock exchange.
Benefits of International Listing
          Enhanced international visibility
          Market support
          Investors confidence
          Increased demand for products and services
          Increase in profitability
Once Traded
          Aura of reliability
          Accuracy in reporting  financial data
World’s  Equity Market Capitalization
The total market capitalization of all publicly traded companies in the world was
          At year-end 2006: $52 trillion
          US$51.2 trillion in January 2007
          Rose as high as US$57.5 trillion in May 2008
          Dropped below US$50 trillion in August 2008
          US$40 trillion in September 2008.
          Almost 83% of the market capitalization is accounted for by the market capitalization of the developed world.
          The other 17% is accounted for by the market capitalization of developing countries in “emerging markets”.
          Latin America
          Eastern Europe
International Equity Market Benchmarks
  Equity Market Benchmarks
  An index of stocks from a particular country (or region) is used to measure or gauge the activity and performance of that country’s (or region’s) equity market(s).
  Morgan Stanley Capital International (MSCI) World Index
  Market –value weighted index of 2,600 share issues of major corporations worldwide.
  Also many regional indices, emerging market indices.
  Dow Jones also provides indices for world regions.
  World Equity Benchmark Shares (WEBS)
  Country-specific baskets of stocks designed to replicate the country indexes of 20 countries and 3 regions.
  WEBS are subject to U.S. SEC and IRS diversification requirements.
  Low cost, convenient way for investors to hold diversified investments in several different countries.

Trading in International Equities
  During the 1980s world capital markets began a trend toward greater global integration.
  Diversification, reduced regulation, improvements in computer and communications technology, increased demand from MNCs for global issuance.
Cross-Listing of Shares
  Cross-Listing refers to a firm having its equity shares listed on one or more foreign exchanges.
  The number of firms doing this has exploded in recent years.
  It expands the investor base for a firm.
  Establishes name recognition for the firm in new capital markets, paving the way for new issues.
  May offer marketing advantages.
  May mitigate possibility of hostile takeovers.
Global Depository Receipts
A receipt issued by a bank as evidence of ownership of one or more shares of the underlying stock of a foreign corporation that the bank holds in trust. The advantage of the GDR structure is that the corporation does not have to comply with all the issuing requirements of the foreign country where the stock is to be traded.
American Depository Receipts
  American depository receipts (ADRs) are certificates that represents the number of foreign shares that are deposited at a U.S. bank.
  Bank of New York is the main depository bank
  The bank serves as a transfer agent for the ADRs
  There are many advantages to trading ADRs as opposed to direct investment in the company’s shares:
  ADRs are denominated in U.S. dollars, trade on U.S. exchanges and can be bought through any broker.
  Dividends are paid in U.S. dollars.
  Most underlying stocks are bearer securities, the ADRs are registered.
American Depository Receipts
  Level 1 ADRs
-          OTC
-          Easiest, least expensive and least regulated way for foreign companies to market ADRs in USA
-          Requires minimal SEC registration
-          Cannot be used to raise new capital
  Level 2 ADRs
-          Sold on Nasdaq, NYSE and AMEX
-          Stricter SEC requirements
-          More liquid than Level 1 ADRs
  Level 3 ADRs
-          Are used to raise new equity capital in US markets.
-          Stricter requirements than Level 1 and Level 2 ADRs.
Global Registered Shares
  DaimlerChrysler AG is a German firm, whose stock trades as a GRS.
  GRS are one share traded globally, unlike ADRs, which are receipts for banks deposits of home-market shares and traded on foreign markets.
  They trade in both dollars and euros.
  All shareholders have equal status and voting rights.
Factors Affecting International Equity Returns
  Macroeconomic Factors
  International monetary variables (such as Interest rate differentials, change in domestic inflation expectations)  have only weak influence on equity returns in comparison to domestic variables. (Solnik 1984)
  Exchange Rates
  Changes in exchange rates generally explain a larger portion of the variability of foreign bond indexes than foreign equity indexes, but that some foreign equity markets are more exposed to exchange rate changes than are the respective foreign bond markets. (Adler and Simon, 1986)
  Cross-correlations studies among major stock markets and exchange markets are relatively low but positive. The exchange rate changes in a given country reinforce the stock market movements in that country as well as in the other countries examined. (Eun and Resnick, 1988)
  Industrial Structure
  Studies examining the influence of industrial structure on foreign equity returns are inconclusive.
International Development Institutions
  Agencies that Facilitate International Flows
  International Monetary Fund (IMF)
  World Bank Group
  World Trade Organization (WTO)
  Bank for International Settlements (BIS)
  Regional Development Agencies
International Monetary Fund (IMF)
  The IM F is an organization of 183 member countries. Established in 1946, it aims
  to promote international monetary cooperation and exchange stability;
  to foster economic growth and high levels of employment; and
  to provide temporary financial assistance to help ease imbalances of payments.
          Its operations involve surveillance, and financial and technical assistance.
          In particular, its compensatory financing facility attempts to reduce the impact of export instability on country economies.
          The IM F uses a quota system, and its unit of account is the SDR (special drawing right).
          The weights assigned to the currencies in the SDR basket are as follows:
Currency      2001 Revision                     1996 Revision
U.S. dollar                   45                           39
Euro                                      29
   Deutsche mark                                         21
   French franc                                            11
Japanese yen               15                           18
Pound sterling              11                           11
World Bank Group
  Established in 1944, the Group assists development with the primary focus of helping the poorest people and the poorest countries.
  It has 183 member countries, and is composed of five organizations - IBRD, IDA, IFC, MIGA and ICSID.
International Bank for Reconstruction and Development
  Better known as the World Bank, the IBRD provides loans and development assistance to middle-income countries and creditworthy poorer countries.
  In particular, its structural adjustment loans are intended to enhance a country’s long-term economic growth.
  The IBRD is not a profit-maximizing organization. Nevertheless, it has earned a net income every year since 1948
  It may spread its funds by entering into cofinancing agreements with official aid agencies, export credit agencies, as well as commercial banks.
International Development Association
  IDA was set up in 1960 as an agency that lends to the very poor developing nations on highly concessional terms.
  IDA lends only to those countries that lack the financial ability to borrow from IBRD.
  IBRD and IDA are run on the same lines, sharing the same staff, headquarters and project evaluation standards.
International Finance Corporation
  The IFC was set up in 1956 to promote sustainable private sector investment in developing countries, by
  financing private sector projects;
  helping to mobilize financing in the international financial markets; and
                                providing advice and technical assistance to businesses and governments.
Multilateral Investment Guarantee Agency
  The MIGA was created in 1988 to promote FDI in emerging economies, by
  offering political risk insurance to investors and lenders; and
  helping developing countries attract and retain private investment.
International Centre for Settlement of Investment Disputes
  The ICSID was created in 1966 to facilitate the settlement of investment disputes between governments and foreign investors, thereby helping to promote increased flows of international investment.
World Trade Organization (WTO)
  Created in 1995, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT).
  It deals with the global rules of trade between nations to ensure that trade flows smoothly, predictably and freely.
  At the heart of the WTO's multilateral trading system are its trade agreements.
  Its functions include:
  administering WTO trade agreements;
  serving as a forum for trade negotiations;
  handling trade disputes;
  monitoring national trading policies;
  providing technical assistance and training for developing countries; and
  cooperating with other international groups.
Bank for International Settlements (BIS)
  Set up in 1930, the BIS is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability.
  It is the “central banks’ central bank” and “lender of last resort.”
  The BIS functions as:
  a forum for international monetary and financial cooperation;
  a bank for central banks;
  a center for monetary and economic research; and an agent or trustee in connection with international financial operations.
Regional Development Agencies
  Agencies with more regional objectives relating to economic development include
  the Inter-American Development Bank;
  the Asian Development Bank;
  the African Development Bank; and
  the European Bank for Reconstruction and Development.
  Islamic  Development Bank
Comparison of Global Financial Markets

Comparison of Global Financial Markets
  The foreign cash flow movements of a typical MNC can be classified into four corporate functions, all of which generally require the use of the foreign exchange markets.
1.   Foreign trade. Exports generate foreign cash inflows while imports require cash outflows.
2.   Direct foreign investment (DFI). Cash outflows to acquire foreign assets generate future inflows.
3.   Short-term investment or financing in foreign securities, usually in the Eurocurrency market.
4.   Longer-term financing in the Eurocredit, Eurobond, or international stock markets.

Acknowledge to  Dr. Babar Zaheer Butt on sharing his prestigious presentation to this blog.