Module-4

International Financial Market and Instruments

Meaning of International Financial Market
An international financial market is a global marketplace where buyers
and sellers from different countries trade financial assets across national
borders.
Functions of international financial market
1. Price Setting: A pounce of gold and a share of stock cannot be
valued less or more than the amount at which a person is ready to
pay for possessing it. But, the markets can identify the prices at
which the persons are ready to make purchase and sell. Thus,
markets help in discovering the prices of various goods and services.
2. Asset Valuation: The market prices are useful for computing the
value of an organisation and the value of assets and properties of the
organisation. Asset valuation is significant for all business involve
in trading and for all regulators which control such businesses. For
example, an insurer is financially sound, if it values its securities at
the prices it paid in the last year. Thus on estimating its solvency, an
important question is, at what price it would sell its securities to
obtain required cash to pay the claims made in a day.
3. Arbitrage: There are different places, where the commodities and
currencies are traded at various prices. Such places are located in
underdeveloped countries, where the financial markets are not
developed. In these financial markets, traders are making efforts to
derive maximum profit from the fluctuations in the prices. Hence,
the traders are involved in arbitrage process, in which the traders are
purchasing commodities or currencies from one market, where the
prices are low and sell the same commodities or currencies in the
other market, where the prices are high. Through this method, the
 prices tend to move to a constant level. Thus, the financial markets
enable an economy to function in an efficient manner.
4. Raising Capital: It is very common that every organisation needs
funds for different purposes like to construct new amenities, to
substitute machinery or to inflate the business activities. Thus, the
organisations are satisfying their needs with the use of financial
instruments such as shares, bonds, debentures, etc. But in present
time, the financial markets are making constant efforts to increase
the level of capital provided to the people, who are willing to
purchase homes or cars or to enables them to enjoy the service of
credit card.
5. Commercial Transactions: Many of the commercial transactions
in the economy are the result of financial markets because financial
markets provide working capital and a better environment for selling
the product in the domestic country as well as in the foreign country.
With the use of financial instruments (shares, bonds, and money
market instruments), the traders are making profit on surplus fund
and they are gathering such assets on which they can earn income in
future.
6. Risk Management: Financial markets enable the traders to manage
the different types of risks like fluctuation in the exchange rate, the
interest rate, the prices of the commodity, etc. The most common
instruments widely used for risk management are futures, options
and other derivatives contracts.

Structure of International Financial Markets

International forex/financial markets can be classified into three parts:
1. International Money Market
2. International Capital Market
3. Foreign Exchange Market
1. International Money Market: The international money market can be
regarded as the market for short-term financing and investment
instruments that are issued or traded internationally. The core of this
market is the Eurocurrency market, where bank deposits are issued and
traded outside the country that issued the currency.

2. International Capital Market: International capital markets have

become increasingly important as a source of financing for the operations
of MNCs, not only because of the decline in bank financing, but also
largely because of several developments that have increased the
competitiveness, size and sophistication of the financial markets them.
The above two market is classified into:
i) International equity market, and
ii) International bond market.
3. Foreign Exchange Market: Foreign exchange market is merely a part
of the money market in the financial centers. It is a place where foreign
moneys are bought and sold.

Foreign portfolio investment

Meaning Foreign portfolio investment
Foreign portfolio investment means a grouping of investment assets that
focuses on securities from foreign markets rather than domestic ones.
Factors affecting foreign portfolio investment
 1. Tax Rates on Interest or Dividends: Investors normally prefer to
invest in a country where the taxes on interest or dividend income
from investments are relatively low. Investors assess their potential
after-tax earnings from investments in foreign securities.
2. Interest Rates: Portfolio investment can also be affected by interest
rates. Money tends to flow to countries with high interest rates, a
long as the local currencies are not expected to weaken.
3. Exchange Rates: When investors invest in a security in a foreign
country, their return is affected by:
i) The change in the value of the security, and
ii) The change in the value of the currency in which the security is
denominated. If a country's home currency is expected to strengthen,
foreign investors may be willing to invest in the country's securities
to benefit from the currency movement.
Modes of foreign portfolio investment
1. Buying foreign securities or depository receipts directly from
the domestic stock exchange if such securities are listed there;
i) Portfolio Equity: This is defined as investment which is made
for the purpose of securing income or capital gains growth rather
than to gain control of an enterprise. Such investments would
normally be held in a range of companies with the aim of
diversifying and reducing risk.
ii) Portfolio Bonds: These are similar to portfolio equity, in that the
aim is to secure a financial return rather to gain control of an
enterprise and that investors would normally hold bonds in a range
of companies. Like portfolio equity they are bought and sold on a
secondary market. The difference is that they are a loan rather than
a share in the company. Bond holders thus receive a predetermined
rate of interest rather than a dividend payment which depends on the
profit performance of the company.
2. Approaching International Mutual Funds: Alternatively, an
investor buys the shares of an internationally diversified mutual fund.
There are many open-ended mutual funds that trade in international
securities on behalf of the individual investor. They prefer liquidity and
try to allocate portfolio in proportion to the market capitalization of the
more important stock exchanges. The mutual funds are normally no-load
funds, but some of them charge upfront fees.
3. Approaching Closed-End Country Funds: The closed-ended funds
are different from the open-ended funds in that the former make
investment initially in international securities and issue shares against the
portfolio. They try to avoid any change in their investment portfolio
depending upon the changes in the response of the investors. Such closed-
ended funds experienced a hey-day in 1980s with the setting-up of Korea
Fund. Now they are popular.
4. Buying Directly The Securities Of Domestic Companies Having
Global Operation: An investor buys shares of domestic company that
operates internationally. It is, in fact, indirect way of participating in the
global economy. In this case, the investor does not have ample scope for
reaping diversification benefits insofar as the systematic risk cannot be
reduced to that extent.
Benefits of Foreign Portfolio Investment
The foreign portfolio investment can benefit the real sector of an economy
in the following ways:
1) The inflow of FPI can provide a developing country non-debt creating
source of foreign investment. The developing countries are capital scarce.
The advent of portfolio investment can supplement domestic saving for
improving the investment rate. By providing foreign exchange to the
developing countries, FPI also reduces the pressure of foreign exchange
gap for the LDCs, thus making imports of necessary investment goods
easy for them.
2) It is suggested by mainstream economists that increased inflow of
foreign capital increases the allocative efficiency of capital in a country.
According to this view, FPI, like FDI, can induce financial resources to
flow from capital-abundant countries, where expected returns are low, to
capital-scarce countries, where expected returns are high. The flow of
resources into the capital-scarce countries reduces their cost of capital,
increases investment, and raises output.
3) The most important way FPI affects the economy is through its various
linkage effects via the domestic capital market. According to the
mainstream view, one of the most important benefits from FPI is that it
gives an upward thrust to the domestic stock market prices. This has an
impact on the price-earning ratios of the firms. A higher P/E ratio leads to
a lower cost of finance, which in turn can lead to a higher amount of
investment. The lower cost of capital and a booming share market can
encourage new equity issues. A higher premium in the new issues will be
the inducing factor here.

4) FPI also has the virtue of stimulating the development of the domestic
stock market. The catalyst for this development is competition from
foreign financial institutions. This competition necessitates the
importation of more sophisticated financial technology, adaptation of the
technology to local environment, and greater investment in information
processing and financial services.
Limitations of Foreign Portfolio Investment
1. Unfavorable Exchange Rate Movement: An investor cannot
ignore the possibility of exchange rate changes. In a floating-rate
regime, the exchange rate changes are a normal phenomenon. A
 change influences the value of the foreign portfolio as well as the
earnings therefrom both directly and indirectly. Suppose an
American investor invests in Indian securities. If the Indian rupee
depreciates, the value of Indian securities in terms of U.S. dollars
will be lower. At the same time, the amount of earning too shall be
lower in terms of U.S. dollars. This may be said to be a direct impact
of the exchange rate changes. Exchange rate changes have an
indirect impact on international portfolio too. Since the foreign
exchange market and the securities market are closely interlinked,
any depreciation of domestic currency, the rupee in our example,
will have an adverse effect on the security market index. The value
of the securities in which the American investor has invested will be
lower in rupee terms also.
2. Frictions in International Financial Market Market: there are
market frictions manifesting in Governmental controls, varying tax
laws and explicit and implicit transaction costs, Governments often
try to administer international Financial flows through different
forms of control mechanisms, such as multiple exchange rates, taxes
on international flows, and restrictions on the outflow of funds. If
such controls persist, foreign investment inflow is hampered despite
ample returns/low risk. Again, varying tax laws and varying tax
rates come in the way of international investment. In many countries,
capital gains, dividend, and interest income are taxed and there is
tax also on financial transactions. If the rates are high, post-tax
returns are obviously low. There are, of course, treaties to help in
avoiding double taxation, even then taxes limit the scope of
international portfolio investment.
3. Manipulation of Security Prices: It is true that in a perfectly
competitive financial market, no investor can influence the market
price of securities. But in the real world, it is the Government and
also the big brokers that influence the security prices. The
 Government influences them through its monetary and fiscal
policies. It can change interest rates, tax rates, etc. It can change the
regulatory provisions. The manipulation is often large when the
public sector financial institutions and banks hold big chunk of the
securities traded on the stock exchange. In such cases, the asset
portfolio lacks the desired liquidity with the result that the foreign
portfolio investment becomes a costly and difficult proposition.
4. Unequal Access to Information: It is the wide cross-cultural
differences that inhibit international portfolio investment.
Accounting practices and the disclosure system vary among
countries. The language varies from one country to the other. As a
result, it is difficult for the international investors to collect
information. In absence of desired information, it is difficult for
them to act rationally.
International Bond Market
Meaning
The international bond market may be defined as a market for bonds,
which are sold anywhere in the world but not in the geo-graphical
territory of the country in which it is denominated.
Types of international Bond Market
1. Foreign Bond Market
2. Eurobond Market
Foreign Bond Market
The foreign bond market is that in which bonds are brought-out by
foreign borrowers. The foreign bonds are normally designated in the
local currency. The local market authorities look after the issuing
and selling of foreign bonds. The foreign bonds are traded in the
foreign bond markets which constituted a significant portion of the
international bond market until a few decades ago.
Features of Foreign Bond Market
1) Issuers are normally governments and private sector utilities such
as the railway companies
2) It was standard practice to underwrite as well as organize
underwriting risk
3) Issues were pledged by the retail investors and the institutional
investors
4) The structure of a foreign bond at that time is similar to the
present day foreign bonds
5) Continental private banks and old merchant houses in London
connected the investors and the issuers.

Eurobond Market (Euromarket)

Eurobonds constitute a major source of borrowing in the
Eurocurrency market. A bond is a debt security issued by the
borrower, which is purchased by the investor and it involves in the
process some intermediaries like underwriters merchant bankers etc.
Eurobonds are bonds of international borrowers sold in different
markets simultaneously by a group of international banks. The
bonds are issued on behalf of governments, big multinational
corporations, etc.

Eurobonds are unsecured securities and hence normally issued by

Govendents, Governmental Corporations, and Local Bodies which
are generally guaranteed by the governments of the countries
concerned and big multinational borrowers of good credit rating.
The bonds are sold by a group of international banks, which form a
syndicate. The lead banks in the syndicate advises the issuer of the
bond on the size of the issue, terms and conditions. timing of the
 issue etc. and take up the assistance of co-managing banks. Each
issue is underwritten by a group of underwriters and then is sold.

Features of Euro Bond Market

1) Like the eurocurrency market, the eurobond market is an off shore
operation not subject to national controls, which most countries have
over domestic issues of securities denominated in local currency.
2) Euro bond issues are not subject to the costly and time-consuming
registration procedure. Disclosure requirements are also less
stringent than those which apply to domestic issues. This feature
appeals to many MNCs, which often do not wish to disclose detailed
and highly sensitive information.
3) Euro bonds are issued in bearer form, which facilitates their
negotiation in the secondary market. This feature also means that the
country of the ultimate owner of the bond is not a matter of public
record.
4) Euro bonds offer investors, exemption from tax-withholding
provisions applicable to domestic and foreign bonds. This feature
allows US MNCs to reduce their borrowing cost by having their
offshore financing subsidiaries issue Eurodollar bonds, with
payment of interest and principal guaranteed by the parent company.
International Bonds instruments
1. Domestic Bonds: Domestic bonds are brought out on a local
basis and domestic borrowers are responsible for issuing the local
bonds. Domestic bonds are normally designated in the local
currency.
2. Foreign Bonds: Foreign bonds are issued by foreign issuers in a
foreign national market and are denominated in the currency of
that market. For example, a yen-denominated bond sold by a non-
 Japanese issuer (such as a French company) in Japan, or a US
dollar denominated bond sold by a German company in the US.
3. Euro Bonds: A Eurobond is a bond issued outside the home
country of the issuer through an international syndicate and sold
to investors residing in various countries. Eurobonds are usually
denominated in a currency other than that of the country of
placement. A bond denominated in Japanese Yen and issued in
the UK, or a bond denominated in US dollars and issued in France
or the UK are all examples of Eurobonds.
4. Global Bonds: These are bonds that are denominated in a foreign
currency i.e. a currency that is different from the domestic
currency of the country in which the bond is issued. For example,
a German company issuing a Japanese yen-denominated bond in
London, or a German company issuing bonds denominated in the
US dollar and offering it to investors in both the US and Japan.
5. Floating Rate Bonds: A floating rate note (FRN) is a debt
instrument whose coupon rate is tied to a benchmark rate such as
LIBOR or the US Treasury Bill rate. Thus, the coupon rate on a
floating rate note is variable. It is typically composed of a variable
benchmark rate + a fixed spread. The rate is adjusted monthly or
quarterly in relation to the benchmark. The maturity period of
FRN's vary but are typically in the range of two to five years.
6. Zero Coupon Bonds: A zero-coupon bond is a bond with no
coupon payments, bought at a price lower than its face value, with
the face value repaid at the time of maturity.
7. Straight Bonds: The straight bonds are the traditional type of
bonds. In this case, interest rate is fixed. The interest rate is
known as coupon rate. It is fixed with reference to rates on
treasury bonds for comparable maturity.
8. Convertible Bonds: International bonds are also convertible
bonds meaning that these variants are convertible into equity
 shares. Some of the convertible bonds have detachable warrants
involving acquisition rights. In other cases, there is automatic
convertibility into a specified number of shares.
9. Cocktail Bonds: Bonds are often denominated in a mixture of
currency. Such bonds are known as cocktail bonds. The SDR
bonds represent a weighted average of five currencies. The
investors purchasing the cocktail bonds get automatically the
currency diversification benefits. The foreign exchange risk on
account of depreciation of any one currency is off-set by
appreciation of another currency.
10. Dual Currency Bonds: Dual currency bonds are debt
securities that pay coupon interest in a different denomination
than the one in which the bond is issued. For example, a dual
currency bond denominated in U.S. dollars might pay interest in
Euros, or vice versa. The exchange rate for currencies may be
specified on the bond. In other words, a dual-currency bond is a
straight fixed-rate bond which is issued in one currency and pays
coupon interest in that same currency. At maturity, the principal
is repaid in a second currency.

INTERNATIONAL EQUITY MARKET

Meaning:
International equity market is the worldwide markets of funds for equity
financing the stock exchanges throughout the world where investors and
firm meets to buy and sell shares of stocks.
Types of International Equity Market
1. Euro Currency Market
2. Euro Credit Market

Euro Currency Market

The term Eurocurrency describes deposits of currency, which are owned
by non-residents of the country, whose legal tender the Currency is and
which are lent by the owners. For example, a bank in Japan, whose
account with a New York Bank is credited with U.S.; dollar from an
external source, would be in possession of Euro-Dollar. The Japanese
bank would be in position to lend it anywhere in the world at a
comparatively higher rate of interest to those who would like to borrow
dollars. To be used in this way, the currencies must be freed of restriction
as the use. The Eurocurrency markets came into existence in late 50's
when major European countries greatly relaxed the exchange control
regulations and made their currencies convertible for non-residents.
Hence pound sterling deposits held by Banks in U.S.A. are called Euro-
Sterling. Deutsche mark held by banks in France is Euro-marks and so on.
They are all Euro currencies. Euro dollars are the main Euro currencies
and are the most traded Currencies. Hence Euro Currency market is
known as Euro-dollar market.
The main difference between Euro markets and their domestic
counterparts is that Euro markets are free from regulations like cash
reserves, deposit insurance, maximum ceiling on interest etc., which
effectively bring down the cost of funds. Similarly Eurobonds are free
from regulations like credit rating and disclosure norms. These
differences account for Euro markets occupying special place in the field
of international finance.
Characteristics of Euro Currency Market
1. Coins and Banknotes: All euro coins have a common side and a
national side chosen by the respective national authorities. The euro
is divided into 100 cents (sometimes referred to as euro-cents,
especially when distinguishing them from other currencies). All
circulating coins have a common side showing the denomination or
value and a map in the background.
2. Payments Clearing, Electronic Funds Transfer: All intra-EU
transfers in euro are considered as domestic payments and bear the
corresponding domestic transfer costs. This includes all member
States of the EU, even those outside the Eurozone providing the
transactions are carried out in euro. Credit/debit card charging and
ATM withdrawals within the Eurozone are also charged as domestic,
however, paper-based payment orders, like cheques, have not been
standardized so these are still domestic-based. The ECB has also set
up a clearing system, target, for large euro transactions.
3. Currency Sign: A special euro currency sign () was designed after
a public survey had narrowed the original ten proposals down to two.
The European Commission then chose the design created by the
Belgian Alain Billiet. The European Commission also specified a
euro logo with exact proportions and foreground/background color
tones. While the Commission intended the logo to be a prescribed
glyph shape, font designers made it clear that they intended to design
their own variants instead. Typewriters lacking the euro sign can
create it by typing a capital 'C', backspacing and over-striking it with
the equal ('=') sign. Placement of the currency sign relative to the
numeric amount varies from nation to nation and there is no official
recommendation on the issue. Transactions in a currency take place
outside the country where the currency is a legal tender.
4. Regulatory Authorities: Eurocurrencies are outside the direct
control of the regulatory authorities but still they are subject to
indirect controls by authorities since all the settlements in the
currency have to take place in the country of issue.
5. Provide Free Access to New Entrants: Eurocurrency markets are
highly sophisticated and provide free access to new entrants. This
resulted in competition of the highest order and the players in the market
operate on very thin margins. Margin means the spread between the
borrowing and lending interest rates.
6. Floating Interest Rate: Another interesting feature of Eurocurrencies
markets is the floating interest rate concept. Under this, the rate of interest
on the borrowings and lending are linked to a base rate called London
Inter-bank Offered Rate (LIBOR). The interest rate will be reviewed at
periodical intervals, say 6 months and changed in line with the LIBOR.
Reasons for Growth of Euro-Currency Market
1) Large deficit in US balance of payments leading to accumulation of
dollars outside the US since the 60s.
2) Restrictions in the USA to stem capital outflows-they were removed in
1974. Even US MNCs invested in Europe.
3) OPEC surpluses, due to a sharp increase in oil prices in 1973 and again
in 1980.
4) The efficiency and lower cost of the Eurodollar market. Being a
wholesale funds market, operating free of restrictions at a substantially
lower cost than its counterpart in the USA, the Euro-currency market has
been able to attract dollar deposits by offering higher interest rates as well
as making dollar loans available to borrowers at lower interest rates.
5) Progressive removal of restrictions on capital movements. Japan and
the UK scrapped them in 1979. Remaining European controls disappeared
in late 1980s. Countries like India are gradually removing restrictions on
capital account transactions and allow foreign currency deposits in their
own banks.
6) Developments of new financial instruments that help borrowers cope
with the risks resulting from the increased interest rate and exchange rate
volatility. Caused by the competitive atmosphere, these new instruments
reduce the effective risks and costs of international financial operations.
7) Competition has reduced the cost of dealing spreads and fees.
Benefits of Euro Currency Market
1) It has provided global short-term capital market, owing to a high degree
of mobility of the Euro-dollars.
2) Euro-dollars are useful for the financing of foreign trade.
3) It has enabled the financial institutions to have greater elasticity in
adjusting their cash and liquidity positions.
4) It has enabled importers and exporters to obtain credit for financing
trade at cheaper charge than otherwise available.
5) It has helped in plummet the profit margins between deposit rates and
lending rates.
6) It has promoted international monetary cooperation.
7) It is a major source of short-term loans to finance corporate working
capital needs and foreign trade.
8) Euro-currency markets are becoming a major source of long-term
investment capital for MNCs.
Limitations of Euro Currency Market
1) When depositors use a regulated banking system, they know that
the probability of a bank failure that would cause them to lose their
deposits is very low. Regulation maintains the liquidity of the banking
system. In an unregulated system such as the eurocurrency market, the
probability of a bank failure that would cause depositors to lose their
money is greater (although in absolute terms, still low). Thus, the lower
interest rate received on home-country deposits reflects the costs of
insuring against bank failure. Some depositors are more comfortable with
the security of such a system and are willing to pay the price.
2) Borrowing funds internationally can expose a company to foreign
exchange risk. For example, consider a US company that uses the euro
currency market to borrow euro-pounds--perhaps because it can pay a
lower interest rate on euro-pound loans than on dollar loans. Imagine,
however, that the British pound subsequently appreciates against the
dollar. This would increase the dollar cost of repaying the euro-pound loan
and thus the company's cost of capital. This possibility can be insured
against by using the forward exchange but the forward exchange market
does not offer perfect domestic currency to avoid foreign exchange risk,
even though the euro currency markets may offer more attractive interest
rates.
Euro Credit Market
Euro credit market is the market where financial banking institutions
provide banking services denominated in foreign currencies. They may
medium-term loans, unlike loans made in the Eurocurrency market. Euro
accept deposits and provide loans. Loans provided in this market are credit
market comprises banks that accept deposits and provide loans in large
denominations and in a variety of currencies. The banks that constitute
this market are the same banks that constitute the Eurocurrency market;
the difference is that Euro credit loans are longer-term than so-called
Eurocurrency loans. Banks participating in the Euro credit market
generally also participate in the Eurocurrency market.

Euro credits are medium and long term loans given by the banks in
currencies which need necessarily be those of the lenders of borrowers.
Participants in Euro Credit Market
American, Japanese, British, Swiss, French, German and Asian (specially
that of Singapore) banks, Chemical Bank, JP Morgan, Citicorp, Bankers
Trust, Chase Manhattan Bank, First National Bank of Chicago, Barclay's
Bank, National Westminster, Credit Lynomais BNP, etc. Among the
borrowers, there are banks, multinational groups, public utilities,
government agencies, local authorities, etc.
Characteristics of Euro Credits
1) A major part (more than 80 per cent) of the Euro-debts is made in US
dollars. The second (but far behind) is pound sterling followed by ECU,
Deutschmark, Japanese yen, Swiss franc and others.
2) Most of the syndicated debts are of the order of $50 million. As far as
the upper limits are concerned, amounts involved are of as high magnitude
as $5 billion and more.
3) On an average, maturity periods are of about five years (in some cases
it is about 20 years). The reimbursement of the loan may take place in one
go (bullet) or in several installments.
4) The interest rate on Euro-debt is calculated with respect to a rate of
reference, increased by a margin (or spread). The rates are variable and
generally renewable (roll over credit) every six months, fixed with
reference to LIBOR. The LIBOR is the rate of money market applicable
to short-term credits among the banks of London. The reference rate can
equally be PIBOR at Paris and FIBOR at Frankfurt, etc. It is revised
regularly.
5) The rates are available and generally renewable (roll over credit) every
six months, fixed with reference to LIBOR.
6) The LIBOR is the rate of money market applicable to short-term credits
among the banks of London. The reference rate can equally be PIBOR at
Paris and FIBOR at Frankfurt, etc. It is revised regularly.
7) The margin depends on the supply and demand of the capital as also on
the degree of the risk of these credits and the rating of borrowers.
Financial institutions are in vigorous competition.
8) There is an active secondary market of Euro debts. Numerous
techniques allow banks to sell their titles in this market.