Topic: International Financial Markets

Group 1

PGDM FS (2013-15)

International Financial Markets

Group 1

Sagar Shetty (51)

Shrey Shetty (52)

Anish Singh (53)

Shridhar Taparia (54)

Kaustubh Tapi (55)

Sherwin Cherian (56)

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International Financial Markets

Introduction to International Financial Markets

In daily life, we find ourselves in constant contact with internationally traded goods. If you enjoy

music, you may play a U.S. manufactured CD of music by a Polish composer through a Japanese

amplifier and British speakers. You may be wearing clothing made in China or eating fruit from

Chile. As you drive to work, you will see cars manufactured in half a dozen different countries

on the streets.

Less visible in daily life is the international trade in financial assets, but its dollar volume is

much greater. This trade takes place in the international financial markets. When international

trade in financial assets is easy and reliable—due to low transactions costs in liquid markets—we

say international financial markets are characterized by high capital mobility.

Financial capital was highly mobile in the nineteenth century. The early twentieth century

brought two world wars and the Great Depression. Many governments implemented controls on

international capital flows, which fragmented the international financial markets and reduced

capital mobility. Postwar efforts to increase the stability and integration of markets for goods and

services included the creation of the General Agreement on Tariffs and Trade (the GATT, the

precursor to the World Trade Organization, or WTO).

Financial innovations, such as the Eurocurrency markets, undermined the effectiveness of capital

controls. Technological innovations lowered the costs of international transactions. These

factors, combined with the liberalizations of capital controls in the 1970s and 1980s, led to the

development of highly integrated world financial markets. Economists have responded to this

“globalization” of financial markets, and they now usually adopt perfect capital mobility as a

reasonable approximation of conditions in the international financial markets.

Global financial markets can be broadly classified into:

Foreign exchange market,

Eurocurrency market,

Eurocredit market,

Eurobond market, and

International stock markets

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Introduction to Foreign Exchange Market

The foreign exchange market (forex, FX, or currency market) is a global decentralized

market for the trading of currencies. In terms of volume of trading, it is by far the largest market

in the world. The main participants in this market are the larger international banks. Financial

centers around the world function as anchors of trading between a wide range of multiple types

of buyers and sellers around the clock, with the exception of weekends.

The foreign exchange market determines the relative values of different currencies.  The foreign

exchange market works through financial institutions, and it operates on several levels. Behind

the scenes banks turn to a smaller number of financial firms known as “dealers,” who are

actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers

are banks, so this behind-the-scenes market is sometimes called the “interbank market”,

although a few insurance companies and other kinds of financial firms are involved. Trades

between foreign exchange dealers can be very large, involving hundreds of millions of dollars.

Because of the sovereignty issue when involving two currencies, Forex has little (if any)

supervisory entity regulating its actions. The foreign exchange market assists international trade

and investments by enabling currency conversion.

For example, it permits a business in the United States to import goods from the European Union

member states, especially Eurozone members, and pay Euros, even though its income is

in United States dollars. It also supports direct speculation and evaluation relative to the value of

currencies, and the carry trade, speculation based on the interest rate differential between two

currencies. In a typical foreign exchange transaction, a party purchases some quantity of one

currency by paying for some quantity of another currency.

The modern foreign exchange market began forming during the 1970s after three decades of

government restrictions on foreign exchange transactions (the Bretton Woods system of

monetary management established the rules for commercial and financial relations among the

world's major industrial states after World War II), when countries gradually switched

to floating exchange rates from the previous exchange rate regime, which remained fixed as per

the Bretton Woods system.

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The foreign exchange market is unique because of the following characteristics:

its huge trading volume representing the largest asset class in the world leading to

high liquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on

Sunday (Sydney) until 22:00 GMT Friday (New York);

the variety of factors that affect exchange rates;

the low margins of relative profit compared with other markets of fixed income; and

The use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition,

notwithstanding currency intervention by central banks. According to the Bank for International

Settlements, the preliminary global results from the 2013 Triennial Central Bank Survey of

Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign exchange

markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010

and $3.3 trillion in April 2007.

Foreign exchange swaps were the most actively traded instruments in April 2013, at $2.2 trillion

per day, followed by spot trading at $2.0 trillion. According to the Bank for International

Settlements, as of April 2010, average daily turnover in global foreign exchange markets is

estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume

as of April 2007. Some firms specializing on foreign exchange market had put the average daily

turnover in excess of US$4 trillion. The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions

$475 billion in outright forwards

$1.765 trillion in foreign exchange swaps

$43 billion currency swaps

$207 billion in options and other products

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Most traded currencies by valueCurrency distribution of global foreign exchange market turnover

Rank Currency (Symbol)  % daily share

(April 2013)

1  United States dollar USD ($) 87%

2  Euro EUR (€) 33%

3  Japanese yen JPY (¥) 23%

4  Pound sterling GBP (£) 12%

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Top 10 Currency Traders% of overall volume, May 2014

Rank Name Market share

1  Citi 16.04%

2  Deutsche Bank 15.67%

3  Barclays Investment Bank 10.91%

4   UBS AG 10.88%

5  HSBC 7.12%

6  JPMorgan 5.55%

7  Bank of America Merrill Lynch 4.38%

8  Royal Bank of Scotland 3.25%

9  BNP Paribas 3.10%

10  Goldman Sachs 2.53%

Source: Bank for International Settlements.

International Financial Markets

5  Australian dollar AUD ($) 8.6%

6  Swiss franc CHF (Fr) 5.2%

7  Canadian dollar CAD ($) 4.6%

8  Mexican peso MXN ($) 2.5%

9  Chinese yuan CNY (¥) 2.2%

10  New Zealand dollar NZD ($) 2.0%

11  Swedish krona SEK (kr) 1.8%

12  Russian ruble RUB ( )₽ 1.6%

13  Hong Kong dollar HKD ($) 1.4%

14  Singapore dollar SGD ($) 1.4%

15  Turkish lira TRY ( )₺ 1.3%

16  Indian rupee INR ( )₹ 1.3%

17  Brazilian real BRL (R$) 1.3%

18  Norwegian krone NOK (kr) 1.3%

19  Danish krone DKK (kr) 1.3%

20  Israeli new shekel ILS (₪) 1.3%

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21  South Korean won KRW (₩) 1.3%

22  South African rand ZAR (R) 1.3%

Other 12%

Total # 200%

# The total sum is 200% because each currency trade always involves a currency

pair

Determinants of exchange rates

The following theories explain the fluctuations in exchange rates in a floating exchange

rate regime (In a fixed exchange rate regime, rates are decided by its government):

1. International parity conditions: Relative purchasing power parity, interest rate parity,

Domestic Fisher effect, International Fisher effect. Though to some extent the above

theories provide logical explanation for the fluctuations in exchange rates, yet these

theories falter as they are based on challengeable assumptions [e.g., free flow of goods,

services and capital] which seldom hold true in the real world.

2. Balance of payments model: This model, however, focuses largely on tradable goods

and services, ignoring the increasing role of global capital flows. It failed to provide any

explanation for continuous appreciation of dollar during the 1980s and most part of the

1990s in face of soaring US current account deficit.

3. Asset market model: views currencies as an important asset class for constructing

investment portfolios. Assets prices are influenced mostly by people's willingness to hold

the existing quantities of assets, which in turn depends on their expectations on the future

worth of these assets. The asset market model of exchange rate determination states that

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Source: 2013 Triennial Central Bank Survey, Bank for International Settlements.

International Financial Markets

“the exchange rate between two currencies represents the price that just balances the

relative supplies of, and demand for, assets denominated in those currencies.”

4. Economic factors: These include: (a) economic policy, disseminated by government

agencies and central banks, (b) economic conditions, generally revealed through

economic reports, and other economic indicators.

5. Political Conditions: Internal, regional, and international political conditions and events

can have a profound effect on currency markets. All exchange rates are susceptible to

political instability and anticipations about the new ruling party. Political upheaval and

instability can have a negative impact on a nation's economy.

6. Market psychology: Flights to quality: Unsettling international events can lead to a

"flight-to-quality", a type of capital flight whereby investors move their assets to a

perceived "safe haven". There will be a greater demand, thus a higher price, for

currencies perceived as stronger over their relatively weaker counterparts. The US dollar,

Swiss franc and gold have been traditional safe havens during times of political or

economic uncertainty.

Financial Instruments for FX

1. Spot

A spot transaction is a two-day delivery transaction (except in the case of trades between the US

dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which settle the next business day),

as opposed to the futures contracts, which are usually three months. This trade represents a

“direct exchange” between two currencies, has the shortest time frame, involves cash rather than

a contract, and interest is not included in the agreed-upon transaction.

Spot trading is one of the most common types of Forex Trading. Often, a forex broker will

charge a small fee to the client to roll-over the expiring transaction into a new identical

transaction for a continuum of the trade. This roll-over fee is known as the "Swap" fee.

2. Swap

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The most common type of forward transaction is the foreign exchange swap. In a swap, two

parties exchange currencies for a certain length of time and agree to reverse the transaction at a

later date. These are not standardized contracts and are not traded through an exchange. A

deposit is often required in order to hold the position open until the transaction is completed.

3. Futures

Futures are standardized forward contracts and are usually traded on an exchange created for this

purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive

of any interest amounts.

Currency futures contracts are contracts specifying a standard volume of a particular currency to

be exchanged on a specific settlement date. Thus the currency futures contracts are similar to

forward contracts in terms of their obligation, but differ from forward contracts in the way they

are traded. They are commonly used by MNCs to hedge their currency positions. In addition they

are traded by speculators who hope to capitalize on their expectations of exchange rate

movements.

4. Option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the

owner has the right but not the obligation to exchange money denominated in one currency into

another currency at a pre-agreed exchange rate on a specified date. The FX options market is the

deepest, largest and most liquid market for options of any kind in the world.

Currency Carry Trade 

The currency carry trade is an uncovered interest arbitrage. The term carry trade, without

further modification, refers to currency carry trade: investors borrow low-yielding currencies and

lend (invest in) high-yielding currencies. It is thought to correlate with global financial

and exchange rate stability and retracts in use during global liquidity shortages, but the carry

trade is often blamed for rapid currency value collapse and appreciation.

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A risk in carry trading is that foreign exchange rates may change in such a way that the investor

would have to pay back more expensive currency with less valuable currency. In theory,

according to uncovered interest rate parity, carry trades should not yield a

predictable profit because the difference in interest rates between two countries should equal the

rate at which investors expect the low-interest-rate currency to rise against the high-interest-rate

one. However, carry trades weaken the currency that is borrowed, because investors sell the

borrowed money by converting it to other currencies.

By early year 2007, it was estimated that some US$1 trillion may have been staked on

the yen carry trade. Since the mid-90's, the Bank of Japan has set Japanese interest rates at very

low levels making it profitable to borrow Japanese yen to fund activities in other currencies.

These activities include subprime lending in the USA, and funding of emerging markets,

especially BRIC countries and resource rich countries. The trade largely collapsed in 2008

particularly in regard to the yen.

Most research on carry trade profitability was done using a large sample size of currencies.

However, small retail traders have access to limited currency pairs, which are mostly composed

of the major G20 currencies, and experience reductions in yields after factoring in various costs

and spreads.

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(Anish)Note Issuance Facilities

A note issuance facility (NIF) is a medium-term commitment under which a borrower can issue

short-term paper in its own name. The NIF commitment is typically made for a few years, while

the paper is issued on a revolving basis, most frequently for maturities of three or six months. A

broader range of maturities, however, is available, ranging from seven days up to one year. Most

euro notes are denominated in US dollars and are issued in large denominations. They may or

may not involve underwriting services. When they do, they are sometimes referred to as RUFs

(revolving underwriting facilities). When they do not, they are often called euro-commercial

paper programs (ECPs). When underwriting services are included in the contract, the

underwriting banks are committed either to purchase any notes the borrower is unable to sell, or

to provide standby credit.

NIFs have some features of the US commercial paper market and some features of commercial

lines of credit or loan commitments by banks. Like commercial paper, notes issued under NIFs

are short-term, non-secured, debt of large corporations with high credit ratings. Like loan

commitment contracts, NIFs generally include multiple pricing components for various contract

features, including a market based interest rate and fees known as participation, facility, and

underwriting fees. The interest on notes issued is generally a floating rate based on LIBOR, the

London Interbank Offered Rate, but occasionally other bases are used. The contract often

includes a series of clauses or covenants that allow the NIF provider to revoke the arrangements

under certain circumstances. These may have to do with deteriorations in the borrower’s

creditworthiness or external changes that affect the costs to the NIF providers.

The provider of NIFs agrees to accept notes issued by the borrower throughout the term of the

contract and to distribute them either at a fixed margin or on a “best efforts” basis to

investors. The notes are distributed under pre-arranged terms. Underwriting services in the NIF

means that the borrower is assured a given interest rate and rapid access to funds. Like

underwriting arrangements in other markets, NIFs are provided by a lead manager who puts

together a tender panel of banks. These then purchase `member are determined in the

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underwriting agreement. The panel members usually agree to take up notes that cannot be placed

or to extend automatically short-term loans to the issuer in place of such notes.

There are several variations on the basic product. A decade ago banks introduced NIFs with an

issuer-set margin, where the issuer determines the margin (spread over LIBOR) at which notes

will be offered. Notes not taken up (at the issuer set margin) are allocated to the underwriters at a

pre-set cap rate. During the same period the multiple component facility (MCF) was introduced

as another major development in the market for euro notes. This type of facility allows the

borrower to draw funds in several currencies or in several forms, including short-term advances,

swing line credits, etc. The borrower gains greater flexibility, choosing the maturity, loan form

and interest rate base of his credit utilization.

A growing proportion of new facilities have included extra borrowing options. The most popular

option has been short-term advances, enabling borrowers to draw in any of several forms of

instruments. Options for such alternatives were included in around 50 percent (by value) of the

underwritten facilities arranged since 1986. One of the most popular has been swing lines, which

enable borrowers to draw at short notice (generally same-day funds) to cover any delay in

issuing notes.

While in the early 1980s most NIFs did include some form of underwriting service, more

recently a growing number of NIFs have been arranged partly or entirely without underwriting

commitments. Non-underwritten NIFs expanded from about 33 percent in 1985 to 70 percent in

1992. Most of these facilities, known today as euro-commercial paper (ECP), are similar to

underwritten NIFs except that they do not include underwriting guarantees or standby credit in

case notes cannot be sold. The borrowers under such facilities have been of the highest credit

rating. They are presumably confident in their ability to sell notes without underwriting services.

As a result they are able to save the cost of underwriting.

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Euro Note

The euro banknotes are the banknotes of the euro, the currency of the Eurozone. The first series

has been in circulation since 2002. They are issued by the National Central Banks of the Euro

system or the European Central Bank. In 1999 the euro was born virtually, and in 2002 notes

and coins began to circulate. The euro rapidly took over from the former national currencies and

slowly expanded around the European Union.

Denominations of the notes range from €5 to €500, and unlike euro coins, the design is identical

across the whole of the Eurozone, although they are issued and printed in various member states.

The euro banknotes are pure cotton fibre, which improves their durability as well as giving the

banknotes a distinctive feel. They measure from 120 by 62 millimetres (4.7 in × 2.4 in) to 160 by

82 millimetres (6.3 in × 3.2 in) and have a variety of colour schemes. The euro notes contain

many complex security features such as watermarks, invisible ink, holograms and micro

printing that document their authenticity. While euro coins have a national side indicating the

country of issue (although not necessarily of minting), euro notes lack this. Instead, this

information is encoded within the first character of each note's serial number

There are seven different denominations of the euro banknotes €5, €10, €20, €50, €100, €200 and

€500, each having a distinctive colour and size. The designs for each of them have a common

theme of European architecture in various artistic eras. The obverse of the banknote features

windows or gateways while the reverse bears different types of bridges. The architectural

examples are stylised illustrations, not representations of existing monuments

Security features

The European Central Bank has described some of the basic security features of the euro notes

that allow the general public to recognise the authenticity of their currency at a glance:

For the first series: the firm and crisp paper, the raised print, the watermark, the security thread,

the see-through number, the hologram, the micro-perforations, the glossy stripe for €20 and

below, the color-changing number for €50 and above, UV light, infrared and the microprint.

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For the Europa series €5 and €10: the firm and crisp paper, the raised print, the

portrait watermark, the security thread, the emerald number, the portrait hologram, UV and UV-

C, infrared and the microprint.

However, in the interest of advanced security of the euro notes, the full list of these features is a

closely guarded secret of the European Central Bank and the National Central Banks of the

Eurosystem.

Still, between the official descriptions and independent discoveries made by observant users, it is

thought that the euro notes have at least eleven different security features, which are:

Holograms – The lower value notes carry a holographic band to the right of the obverse. This

band contains the denomination, the euro sign, the stars of the EU flag and perforations in the

shape of the euro sign. In the Europa series €5 banknote, there is Europa, a gate, 'EURO' and the

euro sign, the number 5 and perforations in the shape of a euro sign. The higher-value notes

include a holographic decal containing the denomination, the obverse illustration, micro printing,

and perforations in the shape of the euro sign.

Variable colour ink – This appears on the lower right-hand side corner of the reverse of the

higher-value notes. When observed from different angles, the colour will change from purple to

olive green or brown. The ink is also on the left bottom on the Europa series €5 note.

Checksum – Each note has a unique serial number. The remainder from dividing the serial

number by 9 gives checksum corresponding to the initial letter indicated on the note. Using a

variation of the divisibility rule shortcut, the remainder from division by 9 can easily be found by

adding the constituent digits and, if the sum still does not make the remainder obvious, adding

the digits of the sum. Alternatively, substituting the letter with its ASCII value makes the

resulting number exactly divisible by 9. Taking the same example, Z10708476264, the ASCII

code for Z is 90, so the resulting number is 9010708476264. Dividing by 9 yields a remainder of

0. Using the divisibility rule again, the result can be checked speedily since the addition of all

digits gives 54; 5 + 4 = 9—so the number is divisible by 9, or 9010708476264 modulo 9 is 0.

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EURion constellation – Euro banknotes contain a pattern known as the EURion constellation that

can be used to detect their identity as banknotes to prevent copying and counterfeiting. Some

photocopiers are programmed to reject images containing this pattern.

Watermarks – There are possibly four watermarks on the euro notes.They are:

Standard watermark – Each denomination is printed on uniquely watermarked paper.

This may be observed by holding the note up to the light. In the first series, the standard

watermark is a gate/window that is depicted on the note and the denomination for the €5

of the Europa series, it is the face of Europa and the denomination as well

Digital watermark – Like the EURion constellation, a Digimarc digital watermark is

embedded in the banknotes' designs. Recent versions of image editors, such as Adobe

Photoshop or Paint Shop Pro refuse to process banknotes. This system is called

Counterfeit Deterrence System (CDS) and was developed by the Central Bank

Counterfeit Deterrence Group.

Infrared and ultraviolet watermarks – When seen in the near infrared, the banknotes will

show darker areas in different zones depending on the denomination. Ultraviolet light

will make the EURion constellation show in sharper contrast, and also some

fluorescent threads stand out.

Security thread – A black magnetic thread in the centre of the note is only seen against

the light. It features the denomination of the note, along with the word "euro" in the Latin

alphabet and the Greek alphabet.

Magnetic ink – Some areas of the euro notes feature magnetic ink. For example, the

rightmost church window on the €20 note is magnetic, as well as the large zero above it.

Microprinting – The texture lines to the bottom, like those aligned to the right of ΕΥΡΩ

mark on the €5 note, consist of the sequence "EURO ΕΥΡΩ" in microprinting.

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Matted surface – The euro sign and the denomination are printed on a vertical band that is

only visible when lighted at an angle of 45°. This only exists for the lower-value notes.

Raised print – On every banknote, the initials of the ECB are in raised print. In the first

series, every banknote has a bar with raised print lines. On the €200 note of the first

series, there are lines at the bottom which are raised to make blind people able to identify

the note. On the €500 note of the first series, these line are on the right-hand side.  On the

€5 note of the Europa series, there are lines on both sides of the banknote.

Bar code – When held up to the light, dark bars can be seen to the right of the watermark.

The amount and width of these bars indicates the denomination of the note. When

scanned, these bars are converted to Manchester code.

Legal information

Legally, both the European Central Bank and the central banks of the Eurozone countries have

the right to issue the 7 different euro banknotes. In practice, only the NCBs of the zone

physically issue and withdraw euro notes. The European Central Bank does not have a cash

office and is not involved in any cash operations. However, the European Central Bank is

responsible for overseeing the activities of national central banks in order to harmonise cash

services in the Eurozone.

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(Kaustubh)

Euro Commercial Paper

An unsecured, short-term loan issued by a bank or corporation in the international money

market, denominated in a currency that differs from the corporation's domestic currency.

For example, if a U.S. corporation issues a short-term bond denominated in Canadian dollars to

finance its inventory through the international money market, it has issued eurocommercial

paper.

A shortterm, unsecured loan issued by a corporation in a currencyother than the one in which the 

corporation operates. Corporation issueeurocommerical papers in order to tap into the internation

al money markets for their financing. Like other commercial papers,euro

commercial papers are rarely for a term longer than a few months and they are usually issued at a 

discount. An example of aeurocommercial paper is a British firm issuing debt in U.S.

dollars to encourage investment from dollarinvestors in international moneymarkets.

Major Differences:

EIFs and Euro-Commercial Paper

1. EIFs Unsecured short-term debt securities denominated in US$ and issued by

corporations and governments.

2. Euro-commercial paper (CP)

EIFs which are not bank underwritten

U.S.Commercial Paper vs. Euro-CPs

1. Average maturity longer (2x) for Euro-CPs

2. Secondary market for Euro not U.S. CPs.

3. Smaller fraction of Euro use credit rating services to rate.

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Asian Currency Markets

 The market developed as a result of fiscal stimuli by the Singapore Government, and it filled an

important gap in international financial transactions in the Asian region. In the late 1960s, a

period of tight credit conditions in the United States, Asian currency market operations involved

mainly the gathering of deposits in the region and their placement in Tokyo and the Eurodollar

market. Since 1970, the main operation has consisted in channeling funds from major capital

markets and from the Asian region into a large number of developing countries in Asia. Another

function of the Asian currency market has been to fill the gap in Eurodollar interest arbitrage

among capital markets in different time zones around the globe. Prior to the increase in oil prices

in 1974, banks participating in the Asian currency market carefully matched the maturities of

their claims and liabilities. However, since 1974, the banks have participated in the recycling of

surplus funds of oil producing countries, which has led to a decrease in the maturity of their

liabilities and an increase in the maturity of their assets. As in the Eurocurrency markets, various

techniques have been used to decrease the risk involved in this maturity transformation. The

paper provides a rough estimate of the contribution of the Asian currency market to real income

in Singapore. This contribution appears to be modest but significant, particularly when the

evaluation includes external economies accruing to other sectors. 

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