INTERNATIONAL FINANCE

Unit 5 World

International Finance

1. Money 2. Financial Markets 3. Financial Institutions 4. Financial Instruments

Components

• Anything that is generally accepted in payment for goods and services or the repayment of debt

• It is based in the concept of scarcity – Being a scarce resource means it has value – This value and the opportunity that brings will be the basis of the Time

Value of Money – Scarcity will be managed through the money supply

Money

• Upward ad downward movement of aggergate output produced in one given economy will be defined as the business cycle

• Sustained downward movements in the business cycle will be called recession

• Sustained upward movements in the business cycle will be called expansions

• Aggregate price level is the average price of good and services in a given economy

• Inflation can be defined as the continuous rise of this price level • Money supply and Inflation are closely related • Extreme levels of inflation are known as hyperinflation • Negative levels of inflation are known as deflation

Money concepts in brief

• Financial markets allows the transfer of funds between those with excess funds (investors and/or lenders) to those with a shortage of funds (investments and/or borrowers) – These funds include financial securities, commodities and other financial items – A security is the main financial instrument.

• Financial markets includes – Debt – Stock – Foreign Exchange

• Money Markets

• Financial institutions – The institutions that make financial markets work – Allow the exchange of funds between actors in the financial markets

Financial Markets and Institutions

• International Financial Markets provide an opportunity to match the need of lenders and borrowers at an international level.

• The fact that exist liquid International Financial Markets, facilitate: – Source the currency needed to complete international transactions – Source more profitable investment opportunities – Reach new lenders or investors from other countries to diversify the sources of

debt/equity and to potentially achieve savings in the cost of equity or debt. • Global Financial System

– It is the financial system consisting of institutions and regulators acting on the international level

– Main players would be global players like IMF or Bank of International Settlements, Central banks, Financial institutions acting on the global scale, and lately other private global heavyweight institutions

International Financial Markets

• A debt security is a claim on the issuer´s future income or assets • Main debt security are bonds, although there are other debt

securities that will be properly examined. – Promises to make payments for a specified period of time

• Interest rate: – The cost of borrowing/lending – Affects the willingness to spend or save – These can differ between different type of securities

• Depending on term or risk

Debt Market and Interest Rates

• Foreign Bonds are sold in a foreign country and are denominated in that country´s currency (i.e. German issuer selling a bond in USA denominated in USD)

• Eurobonds are bonds denominated in a currency other than that of the country in which it is sold (i.e. a bond denominated in USD sold in London)

• Eurocurrencies are foreign currencies deposited in banks outside the home country. – The more relevant are the Eurodollars (USD deposited in foreign

banks outside the USA or in foreign branches of US banks). – As these receive an interest, they are similar to short term Eurobonds

International Bond Market, Eurobonds and Eurocurrencies

• A common stock, equity or share is a share of ownership in a corporation

• It is a claim on the earnings and assets of the corporation • Allows corporations to raise funds to finance their activities in

exchange of a share of the own earnings and assets • Return from stock can be earned

– Dividends – Price stock rise

• Ownership gives certain rights: – Residual claimant: Claim on all assets and income left over after all

claimants have been satisfied – Right to vote

Stock Market or Equity Market

• Stock certificates, differently than bonds does not include: – Maturity Date – Face value – Interest rate

Stock certificates

• There are 2 types of stock: – Common Stock

• Right to vote • Entitled to received dividends • The rights above can be different along different types of shareholders and

common stock in the same company (type A, type B, …) – Preferred Stock

• Received a fixed dividend that never changes, so in many ways looks like a bond rather than a stock

• As dividend does not change, price is expected to be less volatile than stocks • Usually, vote is restricted • Have a claim on assets prior over the claim of common shareholders, but

after creditors • Being considered capital, not debt, not subject to tax deductions for the firm

Common vs Preferred Stock

• A Blue chip is the jargon name for a stock of a well established and with a healthy financial situation

• Showed resilience to downturns in the economy and can remain profitable even in adverse economic cycles.

• Usually with a large market capitalization, and due to this fact is generally component of main market indexes. – GE – IBM – Coca Cola – McDonald-s – Wal-mart – …

Blue chips

• A profit made when selling stock at a higher price than they paid for it. Most people buy stock to make money from capital gains. – For example, if you buy 100 shares of Company XYZ at $100.00 a share

(a total $10,000 investment) and sold it for $125.00 a share ($12,500), you’ve realized a capital gain of $25.00 a share, or $2,500.00

• Dividends are the distribution of profits from a company to the stockholders – Investors buy stock for the dividend payments. – For example, if Company XYZ declares an annual dividend of $10.00 a

share and you own 100 shares, you’ll earn $1000.00 a year, or, $250.00 paid each quarter.

• Dividend Stocks versus Growth Stocks

Stocks and Returns

Factors affecting stock prices

• Market sentiment – Supply and demand

• Industry performance – Stock prices same industry tend to move together (Correlation)

• Government policies – Changes in economic policies, inflation, deflation, interest rates or

global economic conditions • Company news

– Company specific factors • Market capitalization • External factors

– Geopolitical – Natural disasters

• Bull: attacks by thrusting horns up (positive) – Optimistic outlook, investor confidence – Prices rising or expected to rise – Can apply to anything that is traded

• Bear: attacks by swiping paw down (negative) – Prices falling or expected to fall – Enter a downturn of 15-20% in multiple indexes

• Psychological effects & speculation

Bull and Bear

• Each exchange calculates an index, or benchmark, based on the activity of its member companies' stock prices.

• "The market's up" or “the market's down," refers to the Dow Jones Industrial Average. It is considered a reliable indicator of the strength - or weakness - of stocks in general, as the US stock market is the largest and more liquid worldwide.

• Usually at least includes 30 companies (diversification bar)

Indexes

• ETFs are formed when a basket of securities is purchased and a stock is created based in this basket that is traded on an exchange

• Usually they share these characteristics: – They are listed and traded as individual stocks on a stock exchange. – They are indexed rather than actively managed. – Their value is based on the underlying net asset value of the stocks held

in the index basket. The exact content of the basket is public so that intraday arbitrage keeps the ETF price close to the implied value.

• ETFs are similar to stock index mutual funds, but ETFs trade like stocks – Allow imit orders, short sales, stop-losses orders, buy on margin. – Lower management fees, but have to pay a brokerage commission – Diamonds (Dow Jone Industrial Average), Spiders (S&P 500), Qubes

(NASDAQ)

Exchange traded Funds

American Depository Receipts

• Foreign stocks often trade on U.S. exchanges as ADRs. • It is a receipt that represents the number of foreign shares that are

deposited at a U.S. bank. • The bank serves as a transfer agent for the ADRs • It allows US investors to invest in foreign shares but not running

with the troublesome of managing the foreign exchange by themselves. – All flows are USD denominated

American Depository Receipts

• 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. – Trades clear in three business days to do US equities whereas

settlement practices for the underlying stock vary in foreign currencies – ADR price quotes are in USD – Most underlying stocks are bearer securities, the ADRs are registered

(except Rule 144A issues). – ADR investment can be sold by trading to another investor in the US

stock market or the underlying shares can be sold in the local stock market.

– ADR frequently a multiple of underlying share rather than one for one.

• 2 types of ADRs: – SPONSORED: created by a bank at the request of the foreign company

that issued the underlying security • Fees paid by foreign company

– NON-SPONSORED: created at the request of a US investment banking firm without direct involvement by the foreign issuing firm • Fees usually paid by investors

• Usually only sponsored ADRs trade on NASDAQ or major stock exchanges

American Depositary Receipts

• Refers to a firm having its equity shares listed on one or more foreign exchanges

• The number of firms doing this has grown significantly in recent years – Provides mean for expanding the investor base for firm´s stock – Establishes name recognition of the company in a new capital market,

paving the way for the firm to source new equity or debt capital from local investors

– Brings the firm´s name before more investor and consumer groups. – Cross listing into developed capital markets with strict securities

regulations and information disclosure requirements may be seen as a signal of improved corporate governance

– Mitigate the possibility of a hostile takeover of the firm

Cross Listing of Shares

• Merge Daimler Benz AG and Chrysler Corporation • Simultaneously created a new type of equity share called Global

Registered Shares (GRS) – Shares that are traded globally – GRSs fully fungible (shares bought in one stock exchange can be sold on

another) – Global share registrar to facilitate clearing – More expensive to run than ADRs (because register and clearing)

Global registered Shares

• Following the Securities Act of 1934 in the US, and in many other countries thereafter, a series of regulations were stated to: – Require firms to tell the truth about their businesses – Require brokers, dealers and exchanges to treat investors fairly.

• The SEC (Securities Exchange Commission) was established for this purpose

• Includes 5 divisions: – Corporate Finance – Trading and Markets – Investment Management – Enforcement – Economic Risk and Analysis

Regulation of the Stock Market

• The Foreign Exchange Market is where the conversion of different currencies take place. – The price of one country´s currency in term´s of another´s

• Changes in the exchange rate will affect import or exports as well as the attraction or flee of capital investments

Foreign Exchange

• The Money Market is a financial market in which only short term debt instruments are traded – The Capital Market is the market in which long term debt and equity instruments are

traded – The money market comprises trading of all those securities with maturity shorter than 2

years • Money market does not mean that money is actually traded, but instead securities

that given their short term, have a high liquidity and because these characteristics, are very close to being money

• Investors in Money Market: Provides a place for warehousing surplus funds for short periods of time

• Borrowers from money market provide low-cost source of temporary funds • Corporations and U.S. government use these markets because the timing of cash

inflows and outflows are not well synchronized. Money markets provide a way to solve these cash-timing problems.

Money market

• Treasury Bills: T-bills have 28-day maturities through 12- month maturities. – Discounting: When an investor pays less for the security than it will be worth when it matures, and the increase in

price provides a return. This is common to short-term securities because they often mature before the issuer can mail out interest checks.

• Federal Funds: Short-term funds transferred (loaned or borrowed) between financial institutions, usually for a period of one day. – Used by banks to meet short-term needs to meet reserve requirements.

• Repurchase Agreements: These work similar to the market for fed funds, but nonbanks can participate. – A firm sells Treasury securities, but agrees to buy them back at a certain date (usually 3–14 days later) for a certain

price. • Negotiable Certificates of Deposit: A bank-issued security that documents a deposit and specifies the interest rate

and the maturity date • Commercial Paper: Unsecured promissory notes, issued by corporations, that mature in no more than

270 days. – The use of commercial paper increased significantly in the early 1980s because of the rising cost of bank loans.

• Eurodollars: Eurodollars represent Dollar denominated deposits held in foreign banks. – The market is essential since many foreign contracts call for payment is U.S. dollars due to the stability of the dollar, relative to

other currencies.

Money market instruments

• Usually comprises many types of agents – Many of them heavily regulated by the national governments or other

supra national agents • Financial intermediaries are institutions that can borrow funds

to channel this resources as lenders to those agents in need of funds. • This financial system can operate on a global, regional or firm

specific level – Global: the system that encompasses all agents within the global

economy – Regional: the system that operates in a regional level – Firm specific: the procedures to oversee the financial activity at

company level

Structure of the Financial system

• A financial crisis is a major disruption in financial markets • Main characteristics:

– Sharp decline in asset prices – Failures of financial and non financial firms

• Unfortunately has tended to be a recurrent event • The effects of these crisis usually go beyond the financial firms and

is followed by business cycle downturns.

Financial Crises

• The Central Bank is the government agency responsible for the conduct of monetary policy – Major Central Banks includes: US Federal Reserve System, ECB, Bank

of Japan, Bank of England • Monetary Policy involves the management of interest rates and

the quantity of money (money supply) • Their actions will have an impact on interest rates, inflation and/or

business cycles

Central Banks and Monetary Policy

• Banks are financial institutions that accept deposits and make loans. – These includes several different sort of firms like commercial banks,

savings and loan associations, mutual savings banks and credit unions. • Other financial institutions include insurance companies, finance

companies, pension funds, mutual funds, brokerage houses and investment banks.

Banks and other Financial Institutions

• This includes the development of new financial products, technologies and services

• E-finance includes the improvements in information technology that have led to new financial products and the ability to deliver financial services electronically

• New agents in this field will present a challenge to the traditional financial intermediaries, with the advantages and jeopardies that this new framework may bring

Financial Innovation

• Financial intermediaries, and specially Banks play a key role in the stability of a financial system

• These are specially sensitive at wild fluctuations of interest rates, foreign exchange markets crisis, stock market crisis, economic downturns or failures of other financial institutions

• New financial Technologies and a larger Globalization have made the exposure to shocks and the effects of these even greater

• Managing Risk and the use of sophisticated techniques to manage this risk will deserve special attention and a central role in managing these institutions

Managing Risk in Financial Institutions

• Debt and Equity Markets • Primary and Secondary Markets • Exchanges and OTC markets • Money and Capital Markets

Structure of Financial Markets

• The Primary market is a financial market in which new issues of a security are sold to initial buyers – Usually run by investment banks which does underwriting securities

• The Secondary market is the financial market in which securities that have been previously issued can be resold – Usually takes place in stock markets for stocks, but others may include

foreign exchange markets, futures markets and option markets. – Securities brokers and dealers are key to run this market. Brokers

are agents of investors who match buyers with sellers. Dealers link buyers and sellers by buyng and selling securities at stated prices (either bid or offer).

– Secondary markets are key to bring liquidity to the system as well as to establish fair prices through demand and offer.

Primary and Secondary Markets

Secondary markets are organized through: • Exchanges

– Where buyers and sellers meet to conduct places • Over the Counter Market

– Dealers at different locations who have an inventory of securities stand ready to buy and sell

Exchanges and OTC markets

• International Bond Market, Eurobonds and Eurocurrencies • World Stock Markets

Internationalization Financial Markets

• Indirect Finance • Transaction Costs • Risk sharing • Asymmetric information • Conflicts of Interest

Financial Intermediaries

• Involves a financial intermediary that stands between the lenders and the borrowers and helps transferring funds from one to another

• This process is called financial intermediation • Banks are the key financial intermediaries to have this indirect

finance in place

Indirect finance

• These are the costs incurred carrying out financial transactions • Financial intermediaries have the economies of scale to reduce

the transactions costs as the size of transactions increases • This economies of scales and their reduced transaction costs allows

them to provide customers with liquidity services

Transaction Costs

• Financial intermediaries can help to reduce the exposure of investors to risk

• This is done through the risk sharing – Creating and selling assets with with risk characteristics that investors

may be comfortable with – This is otherwise called asset transformation as the risk profile of a

given instrument is changed – Diversification is a key tool to change the overall risk of a given

portfolio

Risk sharing

• It is the inequality that arises when one party does not have the same information than other to make accurate decisions

• Adverse selection is created by asymmetric information before the transaction occurs – The borrower does not provide all the needed information to complete a

risk profile • Moral hazard is created by asymmetric information after the

transaction occurs – The risk that the borrower might engage in activities that are

undesirable from the lender´s point of view as make les likely that the loan is repaid

Asymmetric information

• These are services provided by financial intermediaries beyond offering bank loans or selling bonds – Economies of scope can lower the cost of information production for

each service by applying one information resource to many different services. Analysts and credit analysts can help to produce this set of information

– Conflicts of interest is a moral hazard arising when an institution has multiple interests and a result it is exposed to the conflicts between those objectives.

Economies of Scope and Conflicts of Interest

• Depository Institutions – Commercial Banks – Savings and Mutual Savings Banks – Credit Unions

• Contractual Savings Institutions – Life Insurance companies – Fire and Casualty companies – Pension Funds and Government Retirement Funds

Types of Financial Intermediaries

• Finance companies • Mutual Funds • Money Market Mutual Funds • Hedge Funds • Investment Banks

Investment intermediaries

• The financial system is heavily regulated – Be careful, not everywhere

• There is an effort to harmonize the accounting standard rules at international level – Some progress, but not yet there

• Two main reasons for this strict control – Increase information available to investors – Ensure the soundness of the financial system

• Different regulatory agencies oversee different subjects (i.e in the USA, you may find the SEC for organized and exchange markets, CFTC for the futures market exchanges, The Office of the Controller of the Currency to control the Federally chartered commercial banks,…)

Regulation of the Financial System

• Restriction on Entry • Disclosure • Restrictions on Assets and Activities • Deposit Insurance • Limits on Competition • Restrictions on Interest Rates

• Arbitraging these between countries may bring imbalances and/or issues for final investors

Soundness of Financial Intermediaries