Chapter21 The Global Capital Market

Chapter21The Global Capital Market

Performance and Policy ProblemsPerformance and Policy Problems

The international Capital Market And The Gains From Trade

Three Types Of Gain From TradeThree Types Of Gain From Trade Trades of goods or services for goods or Trades of goods or services for goods or

services services Trades of goods or services for assetsTrades of goods or services for assets Trades of assets for assetsTrades of assets for assets

Goods and services

assetsassets

Goods and services


The International Capital Market And The Gains From Trade

Risk-averseRisk-averse investors in foreign currency investors in foreign currency assets base their demand for a particular assets base their demand for a particular asset on its riskiness in addition to its asset on its riskiness in addition to its expected return.This observation is basic to expected return.This observation is basic to understanding why countries exchange understanding why countries exchange assets.assets.

The International Capital Market And The Gains From Trade

Portfolio diversificationPortfolio diversification as a motive for as a motive for international asset trade.When an economy international asset trade.When an economy is opened to the international capital is opened to the international capital market,it can reduce the riskiness of its market,it can reduce the riskiness of its wealth by placing some of its”eggs” in wealth by placing some of its”eggs” in additional foreign “baskets”.additional foreign “baskets”.


The menu of international The menu of international assets:debt versus equityassets:debt versus equity

Debt instruments must repay a fixed value Debt instruments must repay a fixed value regardless of the economic circumstances.regardless of the economic circumstances.

Equity instruments is a claim to a firm`s Equity instruments is a claim to a firm`s profits,rather than to a fixed payment,and profits,rather than to a fixed payment,and its payoff will vary according to its payoff will vary according to circumstances.circumstances.

By choosing how to divide their By choosing how to divide their portfolios between debt and equity portfolios between debt and equity instruments,individuals and nations can instruments,individuals and nations can arrange to stay close to desired arrange to stay close to desired consumption and investment levels. consumption and investment levels.


International Banking And The International Capital Market The structure of the international capital The structure of the international capital

marketmarket Commercial banks:the center of the Commercial banks:the center of the

international capital market.international capital market. Corporations:finance their investments by Corporations:finance their investments by

drawing on foreign sources of funds.drawing on foreign sources of funds. Nonbank financial institutions:move into Nonbank financial institutions:move into

foreign assets to diversify their portfolios.foreign assets to diversify their portfolios.

International Banking And The International Capital Market

Growth of the international capital Growth of the international capital marketmarket

An important reason for that development An important reason for that development is related to exchange rate systems.is related to exchange rate systems.

A country can`t have more than two items A country can`t have more than two items from the following list:from the following list:

1.1. Fixed exchange rateFixed exchange rate

2.2. Monetary policy oriented toward Monetary policy oriented toward domestic goalsdomestic goals

3.3. Freedom of international capital Freedom of international capital movementsmovements


International Banking And The International Capital Market Offshore banking and offshore Offshore banking and offshore

currency tradingcurrency trading Offshore banking isOffshore banking is to describe the to describe the

business that banks ` foreign offices business that banks ` foreign offices conduct outside of their home conduct outside of their home countries.Bank may conduct foreign countries.Bank may conduct foreign business through three types of institution:business through three types of institution:

1.1. An agency office located abroadAn agency office located abroad

2.2. A subsidiary bank located abroadA subsidiary bank located abroad

3.3. A foreign branchA foreign branch


Eurodollar And Other Eurocurrencies

How big is the eurocurrency market?How big is the eurocurrency market? In the mid-1990s,the size of the currency In the mid-1990s,the size of the currency

market stood at around $8 trillion.market stood at around $8 trillion.

How eurocurrencies are created?How eurocurrencies are created? The typical eurocurrency deposit is a The typical eurocurrency deposit is a

nonnegotiable time deposit with a fixed nonnegotiable time deposit with a fixed term to maturity ranging from overnight to term to maturity ranging from overnight to five years.five years.

Take a example to explain the creating Take a example to explain the creating process of eurocurrencies.process of eurocurrencies.



The growth of eurocurrency tradingThe growth of eurocurrency trading The main reasons for the growth of The main reasons for the growth of

offshore banking activities:offshore banking activities:

1.1. The growth of world tradeThe growth of world trade

2.2. Government financial Government financial regulations(including taxes) regulations(including taxes)

3.3. Political considerations Political considerations


The importance of regulatory asymmetriesThe importance of regulatory asymmetries The major factor behind the continuing The major factor behind the continuing

profitability of Eurocurrency trading is profitability of Eurocurrency trading is regulatory.regulatory.

Freedom from reserve requirements is Freedom from reserve requirements is probably the most important regulatory probably the most important regulatory factor that makes eurocurrency trading factor that makes eurocurrency trading attractive to banks and their customers.attractive to banks and their customers.

Eurodollar And Other Eurocurrencies Eurocurrencies and macroeconomic Eurocurrencies and macroeconomic

stabilitystability Eurocurrencies and World inflation:the Eurocurrencies and World inflation:the

possibility that creation of eurocurrencies possibility that creation of eurocurrencies has had some inflationary effect,but it has has had some inflationary effect,but it has never set off the protracted inflation that never set off the protracted inflation that some worried observers of the eurocurrency some worried observers of the eurocurrency system seem to fear.system seem to fear.

Eurocurrencies and monetary control:The Eurocurrencies and monetary control:The fear that eurodollars can come “flooding fear that eurodollars can come “flooding back” into the United States is highly back” into the United States is highly exaggerated.exaggerated.


Regulating International Banking

1.The Problem of Bank Failure1.The Problem of Bank FailureThe reason for bank failuresThe reason for bank failures Consequences of banking collapseConsequences of banking collapse Precautionary bank regulation measures Precautionary bank regulation measures Deposit insuranceDeposit insurance Reserve requirement Reserve requirement Capital requirement Capital requirement Bank examination Bank examination Lender of the last resort facilitiesLender of the last resort facilitiesThe banking safeguards listed above The banking safeguards listed above are interdependentare interdependent


2.Difficuties in Regulating International 2.Difficuties in Regulating International BankingBanking

Why is an international banking system harder to Why is an international banking system harder to regulate?regulate?

The absence of deposit insuranceThe absence of deposit insurance The absence of reserve requirementThe absence of reserve requirement The difficulties of bank examination and The difficulties of bank examination and

enforcing capital requirement and asset enforcing capital requirement and asset restrictionsrestrictions

Uncertainty over the central bank’s responsibility for providing LLR assistance

3.International Regulatory Cooperation In 1974 , Basle Committee was set up. Its

job was to achieve “ a better coordination of the surveillance exercised by national authorities over the international banking system ……”


Regulating International Banking The failure of nonbank financial institutions The failure of nonbank financial institutions

also has serious consequences. It’s time to also has serious consequences. It’s time to take actions to regulate the international take actions to regulate the international activities of them.activities of them.

Case study :Case study :

It gives us an example of the nightmare It gives us an example of the nightmare that the global investment fund , Long that the global investment fund , Long Term Capital Management , nearly Term Capital Management , nearly collapsed in September 1998. The near collapsed in September 1998. The near failure of this institution always haunts failure of this institution always haunts global regulator’s sleep.global regulator’s sleep.


How Well Has the International Capital Market Performed ?

1.The Extent of International Portfolio Diversification1.The Extent of International Portfolio Diversification Though the extent of international portfolio Though the extent of international portfolio

diversification is low at present time , the world diversification is low at present time , the world capital market has certainly contributed to a rise in capital market has certainly contributed to a rise in the diversification since the early 1970s.the diversification since the early 1970s.


2.The Extent of Intertemporal Trade2.The Extent of Intertemporal Trade Martin Feldtein and Charles Horioka Martin Feldtein and Charles Horioka

suggested an alternative way of evaluating suggested an alternative way of evaluating the performance of the world capital market the performance of the world capital market : in a smoothly working international : in a smoothly working international capital market , countries’ domestic capital market , countries’ domestic investment rates can widely diverge from investment rates can widely diverge from their saving rates .their saving rates .

For many countries , differences between For many countries , differences between national saving and domestic investment national saving and domestic investment rates (that is , current account balances ) rates (that is , current account balances ) have not been large since world war have not been large since world war Ⅱ .Ⅱ .

However , in industrialized countries such However , in industrialized countries such as United States , Germany and Japan , the as United States , Germany and Japan , the external imbalances have been historically external imbalances have been historically high recently . high recently .


How Well Has the International Capital Market Performed ?3.Onshore-Offshore Interest Differentials3.Onshore-Offshore Interest Differentials A quite different barometer of the A quite different barometer of the

international capital market’s performance is international capital market’s performance is the relationship between onshore and the relationship between onshore and offshore interest rates on similar assets offshore interest rates on similar assets denominated in the same currency .denominated in the same currency .

If the world capital market is doing its job If the world capital market is doing its job of communicating information about global of communicating information about global investment opportunities , these interest investment opportunities , these interest rates should move closely together and not rates should move closely together and not differ too greatly.differ too greatly.

Countries with long-standing open capital Countries with long-standing open capital market show an approximate equality market show an approximate equality between onshore and offshore interest rates.between onshore and offshore interest rates.



4.The Efficiency of the Foreign Exchange 4.The Efficiency of the Foreign Exchange MarketMarket

Studies of the foreign exchange market’s Studies of the foreign exchange market’s use of available information are potentially use of available information are potentially important in judging whether the important in judging whether the international capital market is sending the international capital market is sending the right signals to markets .right signals to markets .

Studies based on interest parityStudies based on interest parity The interest parity condition is :RThe interest parity condition is :R tt – R – Rtt

* =* = (E(Et+1t+1

ee – E – Ett)/E)/Ett

ΙΙ Statistical studies of the relationship Statistical studies of the relationship between interest rate differences between interest rate differences and actual depreciation rates show that the and actual depreciation rates show that the interest difference has been a very bad interest difference has been a very bad predictor .predictor .


Ⅱ Ⅱ Forecast error in predicting depreciation , uForecast error in predicting depreciation , u t+1 t+1 , , can be expressed as : ucan be expressed as : u t+1 t+1 = (E = (Et+1t+1 – E – Ett)/E)/Et t - (E- (Et+1t+1

ee – E– Ett)/E)/Et t = (E= (Et+1t+1 – E – Ett)/E)/Et t – (R– (Rtt – R – Rtt

* * ) )

A number of researches have shown that A number of researches have shown that forecast errors , defined above , can be forecast errors , defined above , can be predicted .predicted .

These two tests prove that the foreign These two tests prove that the foreign exchange market is not doing a good job of exchange market is not doing a good job of using current information to forecast exchange using current information to forecast exchange rates.rates.


How Well Has the International Capital Market Performed ? The role of risk premiumsThe role of risk premiumsIf the people are risk-adverse and bonds If the people are risk-adverse and bonds

denominated in different currencies are denominated in different currencies are imperfect substitutes , the interest rate imperfect substitutes , the interest rate difference equals expected currency difference equals expected currency depreciation plus a risk premium , depreciation plus a risk premium , ρρtt , ,

RRtt – R – Rtt* =* = (E (Et+1t+1

ee – E – Ett)/E)/Ett+ + ρρtt

The reasons for why the interest difference has The reasons for why the interest difference has been a very bad predictor:been a very bad predictor:

ΙΙRisk premiums are important in exchange Risk premiums are important in exchange rate determination . ( It awaits solid rate determination . ( It awaits solid statistical confirmation. )statistical confirmation. )

ⅡⅡThe foreign exchange market has been The foreign exchange market has been ignoring the opportunity to profit from easily ignoring the opportunity to profit from easily available information . ( It seems unlikely in available information . ( It seems unlikely in the light of foreign exchange traders’ the light of foreign exchange traders’ powerful incentives to make profits.)powerful incentives to make profits.)


How Well Has the International Capital Market Performed ? Tests for excessive volatilityTests for excessive volatility

Exchange rates have been excessively Exchange rates have been excessively volatile perhaps because the foreign volatile perhaps because the foreign exchange market overreacts to events . exchange market overreacts to events . How volatile must an exchange rate be How volatile must an exchange rate be before its volatility becomes excessive?before its volatility becomes excessive?

There are some underlying factors that move exchange rates – such as money supplies , national outputs and fiscal variables . Attempts to compare exchange rates’ volatilities with those of their underlying determinants have produced inconclusive results . It is very hard to test the excessive volatility .



The bottom lineThe bottom lineThe ambiguous evidence on the foreign exchange market’s The ambiguous evidence on the foreign exchange market’s

performance warrants an open-minded view . performance warrants an open-minded view . The stakes are high , and more researches and experience The stakes are high , and more researches and experience

are needed before a firm conclusion can be reached . are needed before a firm conclusion can be reached .

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Chapter21 The Global Capital Market