Theme 5. International Financial Markets

1. Main features of Capital Market. Purposes of International Capital Market

2. Forces Expanded International Capital Market

3. International Bond Market

4. International Equity Market

5. Eurocurrency Market

6. Foreign Exchange Market

1. Main features of Capital Market. Purposes of International Capital Market

The two interrelated systems that comprise the international financial markets are the (1) international capital market and (2) foreign exchange market.

International Capital Market

A capital market is a system that allocates financial resources in the form of debt and equity according to their most efficient uses. Its main purpose is to provide a mechanism through which those who wish to borrow or invest money can do so efficiently. Individuals, companies, governments, mutual funds, pension funds, and all types of nonprofit organizations participate in capital markets. For example, an individual might want to buy her first home; a midsize company might want to add production capacity; and a government might want to develop a new fiber optic telecommunications system. Sometimes these individuals and organizations have excess cash to lend; at other times, they need funds.

Purposes of National Capital Markets

There are two primary means by which companies obtain external financing: debt and equity. Capital markets function to help them obtain both types of financing. However, to understand the international capital market fully we need to review the purposes of capital markets in domestic economies. Quite simply, national capital markets help individuals and institutions borrow the money that other individuals and institutions want to lend. Although in theory borrowers could search individually for various parties who are willing to lend or invest, this would be a time-consuming process. Consequently, intermediaries of all kinds exist to facilitate financial exchanges. Most of us are familiar with the most common capital-market intermediaries:

• Commercial banks lend borrowers their investors' deposits at a specific rate of interest. They provide loans for new investment projects and may help to finance a firm's import or export activities.

• Investment banks help clients to invest excess capital and to borrow needed capital. They act as agents, introducing clients to organizations that provide either investment or borrowing opportunities.

Example: Merrill Lynch in Tokyo, Japan

Large financial institutions benefit borrowers and lenders worldwide in many ways. As investment banks, they underwrite debt and equity securities and advise corporations, governments, and institutions. As asset managers, they are caretakers of the personal financial savings of individuals. In fact, Merrill Lynch (www.ml.com) has a truly global reach, with offices in 35 countries and total client assets of around $1.5 trillion..

Role Of Debt Debt consists of loans, for which the borrower promises to repay the borrowed amount (the principal) plus a predetermined rate of interest. Company debt normally takes the form of bonds - instruments that specify the timing of principal and interest payments. The holder of a bond (the lender) can force the borrower into bankruptcy if the borrower fails to pay on a timely basis. Bonds issued for the purpose of funding investments are commonly issued by private-sector companies and by municipal, regional, and national governments.

Role of Equity Equity is part ownership of a company, in which the equity holder participates with other part owners in the company's financial gains and losses. Equity normally takes the form of stock - shares of ownership in a company's assets that give shareholders (stockholders) a claim on the company's future cash flows. Shareholders may be rewarded with dividends - payments made out of surplus funds - or by increases in the value of their shares. Of course, they may also suffer losses due to poor company performance-and thus decreases in the value of their shares. Dividend payments are not guaranteed, but are determined by the company's board of directors and based on financial performance. In capital markets, shareholders can either sell one company's stock for that of another or liquidate them - exchange them for cash. Liquidity, which is a feature of both debt and equity markets, refers to the ease with which bondholders and shareholders may convert their investments into cash

Purposes of the International Capital Market

The international capital market is a network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries. It consists of both formal exchanges (in which buyers and sellers meet to trade financial instruments) and electronic networks (in which trading occurs anonymously). This market makes use of unique and innovative financial instruments specially designed to fit the needs of investors and borrowers located in different countries that are doing business with one another. Large international banks play a central role in the international capital market. They gather the excess cash of investors and savers around the world and then channel this cash to borrowers across the globe.

Expanding the Money Supply for Borrowers. The international capital market is a conduit for joining borrowers and lenders in different national capital markets. Thus, a company that is unable to obtain funds from investors in its own nation can seek financing from investors elsewhere, making it possible for the company to undertake an otherwise impossible project. The option of going outside the home nation is particularly important to firms in countries with small or developing capital markets of their own - particularly those with emerging stock markets. An expanded supply of money also benefits small but promising companies that might not otherwise get financing if there is intense competition for capital.

Reducing the Cost of Money for Borrowers. An expanded money supply reduces the cost of borrowing. Like the prices of potatoes, wheat, and other commodities, the "price" of money is determined by supply and demand. If its supply increases, its price - in the form of interest rates - falls. That is why excess supply creates a buyer's (borrower's) market, forcing down interest rates and the cost of borrowing. Projects regarded as infeasible because of low expected returns might be viable at a lower financing cost.

Reducing Risk for Lenders. The international capital market expands the available set of lending opportunities. In turn, an expanded set of opportunities helps reduce risk for lenders (investors) in two ways:

• Investors enjoy a greater set of opportunities from which to choose. They can thus reduce overall portfolio risk by spreading their money over a greater number of debt and equity instruments. In other words, if one investment loses money, the loss can be offset by gains elsewhere.

• Investing in international securities benefits investors because some economies are growing while others are in decline. For example, the prices of bonds in Thailand do not follow bond - price fluctuations in the United States, which are independent of prices in Hungary. In short, investors reduce risk by holding international securities whose prices move independently.

Unfortunately, small would-be borrowers still face some serious problems in trying to secure loans. In particular, interest rates are often high, and many entrepreneurs have nothing to put up as collateral. But as you can see from the Entrepreneur's Survival Kit tided, "Where Microcredit Is Due," some unique methods are available for getting capital into the hands of small businesspeople - particularly in developing nations.

Where Microcredit is Due

Obtaining capital challenges the entrepreneurial spirit in many developing countries. If a person is lucky enough to obtain a loan, it is typically from a loan shark, whose inordinate interest rates devour most of the entrepreneur's profits. However, an alternative money-lending practice is growing in popularity. In obtaining microcredit, small groups of low-income entrepreneurs borrow money at competitive rates without having to put up collateral. Besides being collateral-free, microcredit offers the following advantages:

• Borrowers Sink or Swim Together. For better or worse, group members are joined at the economic hip: If a member fails to pay off a loan, everyone may lose future credit. Often, however, peer pressure and support help to defend against this contingency. In addition, strong family ties in developing countries tend to furnish important support networks.

• Most Loans Go to Women. Although the outreach to male borrowers is increasing, most microcredit borrowers are women. Women tend to be better at funneling profits into family nutrition, clothing, and education, as well as into business expansion. The successful use of microcredit in Bangladesh has increased wages, community income, and the status of women. One local bank that has already loaned $450 million to 2.1 million borrowers enjoys a 98 percent on-time payback record.

• It Might Work Even in Developed Countries. The microcredit concept was pioneered in developed countries as a way for developing countries to create the foundation for a market economy. Nowadays, the use of microcredit within developed nations might be a way to spur economic growth in depressed geographic areas, such as inner cities. But whereas microcredit loans in developing countries typically average less than $100, those in developed nations average a minimum of $500.