INTERNATIONAL FINANCIAL MARKETS
A financial market is one that facilitates the transfer of funds from lenders to borrowers. There are different types of institution which use different types of instruments to facilitate this transfer. When the transfer of funds between parties is confines within the national borders, it is called domestic financial market. When the funds cross the national borders and transfer is between parties residing in different countries then is called international financial market. The parties go to the international financial markets from the domestic financial markets due to the following reasons: -
- Difference in interest rates: Parties like to borrow funds from countries where the interest rate is low compared to the domestic market. Similarly, investors like to invest their funds in countries where the interest rate is higher.
- International diversification: Different countries have different economic conditions and resources which help the investors to reduce the risks associated with a single country. Also, lenders would like to reduce their risk through lending in different countries.
- Economic Growth prospects: The developing countries have a higher potential for growth than the developed countries. These conditions attract the investors and creditors to such economies.
- Exchange rate fluctuations: The exchange rate between countries keeps on changing in the short and long run. If a currency is expected to appreciate, it is advantageous for an investor to purchase securities in foreign currency.
SOURCES OF INTERNATIONAL FUNDS
The funds that flow across the countries can be referred to as international funds. The flow of these funds takes place through certain institutions or agencies like - Multilateral development banks or agencies: Like World Bank and IMF. - Governments/ Governmental agencies - International banks - Securities market.
SEGMENTS OF INTERNATIONAL FINANCIAL MARKET
- International bond market: In this segment the international bonds are bought and sold. The companies may raise long term funds in foreign currency through issue of international bonds. Foreign bonds and euro bonds are the two popular types of international bonds.
- International equity market: A multinational company can raise funds from different countries by issuing shares in those countries. The shares would be listed on the stock exchange of those countries.
- International Money market: it is the market for the borrowing and lending of short term funds.
- International credit market: it is the market where the medium and long term funds are exchanged between the suppliers and borrowers of funds.
- Foreign exchange market: It is the market for the sale and purchase of foreign currencies. INTERNATIONAL MONEY MARKET The money market instruments are used for raising short term funds from the financial markets. When such instruments are used for raising international funds, they are referred to as international money market instruments. Popular money market instruments are used in the international market: treasury bills, Commercial paper, certificate of deposit and bankers acceptances.
Treasury Bills (T- Bills): whenever the Government needs money it can has 2 options: TB’s and Govt Bonds. For long term borrowing – bonds. For ST borrowing – TB’s. T-bill is a bill of finance or a promissory note put by the government of a country. It provides a short term investment option generally for 1 year. They are highly liquid because the guarantee of repayment is on the government. They pay no interest rather they are issued at a discount (reduced price) and are redeemed at par value. Return to investor = difference between face value and issue price. They are issued through auction by the central bank of a country. It can be purchased by individuals, banks, firms, trusts and other institutions.
- Commercial Paper: It is a promissory note issued by a company to raise funds for duration of less than one year. They are issued by companies having a good credit rating in the market and hence are not underwritten. They are issued at discount and redeemed at par and the discount forms the yield of the commercial paper. - Certificates of deposit: It is a certificate issued by banks for deposits received. They are issued by banks for raising short term funds of less than one year duration. The interest is paid along with the principle at maturity. As they are negotiable instruments, they can be traded in the secondary market as well.
- Bankers’ acceptances: They arise during the course of export and import of goods. The exporter draws a bill of exchange on the importers bank which has issued a letter of credit for the transaction and handover the bill of exchange to its bank. The exporters bank after making the payment, presents the bill of exchange along with supporting documents to the importers bank for acceptance. On acceptance by the importers bank, a banker’s acceptance comes into existence. This financial instrument entitles the exporters bank to receive the money. But it is a negotiable instrument and can be sold by the exporter’s bank in the secondary market to raise short term funds before its maturity.
INTERNATIONAL CREDIT MARKET The segment of the international financial market where the medium term funds are exchanged between the suppliers and borrowers is called the international credit market. The medium term loans are generally distributed by the commercial banks as floating rate loans where the interest rate on the loan changes periodically with the movement of some market interest rate like LIBOR. This practice is followed by the banks to avoid the risks arising from asset liability mismatch. Another practice in the international credit market is that of SYNDICATED LOAN. A group of banks under a lead bank joins together to disburse a loan jointly. The lead bank negotiates the terms of the loan with the borrower. These loans help in sharing the risk among the participant banks.
INTERNATIONAL BOND MARKET It is the segment of the market where the international bonds are bought and sold. Companies may raise long term funds in foreign currencies through issue of international bonds. There are three types of such bonds:
- Foreign bonds: They are the bonds issued in a foreign country denominated in the currency of that country. Ex – if an Indian company issues bonds in Japan and if the bonds are denominated in Japanese Yen, they are referred to as foreign bonds. They are subject to the regulations prevailing in the country where they are issued.
- Euro bonds: When the bonds issued in a foreign country are denominated in a currency other than the currency of the country where the bond is issued, then it is called a Euro bond. Ex – If an Indian company issues bonds in US but the bonds are denominated in INR.
- Global bonds: They are the bonds denominated in a foreign currency and are offered for simultaneous placement in different countries.
FUTURES CONTRACT : currency futures are exchange-traded futures contract that specify the price in one currency at which another currency can be bought or sold at a future date. Currency futures contracts are legally binding and counterparties that are still holding the contracts on the expiration date must deliver the currency amount at the specified price on the specified delivery date. Currency futures can be used to hedge other trades or currency risks, or to speculate on price movements in currencies.
OPTIONS CONTRACT: A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller. There are two main types of options, calls and puts.
1.Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall.
2.Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires.
DIFFERENCE BETWEEN OPTIONS AND FUTURES
1. A futures contract is an agreement binding on the counterparties for buying and selling of financial security at a predetermined price at a specific date in the future. On the other hand, an options contract allows the investor the right but not the obligation to exercise buying or selling of a financial instrument on or before the date of expiry.
2. Since the futures contract is binding on the parties, the contract has to be honoured on the pre-decided date and the buyer is locked into the contract. Subsequently, an option contract provides just the option but no obligation for buying or selling the security.
3. For securing a futures contract, apart from the commission amount paid no advance payments are considered as compared to an options contract which makes it essential to make a premium payment. This is done for the purpose of locking the commitment made by the parties.
4. The execution of the futures contract can only be done on the pre-decided date and as per the conditions which have been mentioned. Options contract requires the performance to be done at any time prior to the date of expiry.
5. A futures contract can have no limits amounts of profits/losses to the counterparties whereas options contract have unlimited profits with a cap on the number of losses.
6. No factor of time decay is important in futures contract since the contract is definitely going to be executed. Whether an option contract will be executed will be much clearer while coming closer to the date of expiry, thus making time value of money an important factor. The premium amount paid also considers this factor while calculations.
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