International Finance

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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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 reliabledue to low transactions costs in liquid marketswe
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

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International stock markets

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
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$1.765 trillion in foreign exchange swaps
$43 billion currency swaps
$207 billion in options and other products

Top 10 Currency Traders

% of overall volume, May 2014

Rank

Name

Market share

Citi

16.04%

Deutsche Bank

15.67%

Barclays Investment Bank

10.91%

UBS AG

10.88%

HSBC

7.12%

JPMorgan

5.55%

Bank of America Merrill Lynch

4.38%

Royal Bank of Scotland

3.25%

BNP Paribas

3.10%

10

Goldman Sachs

2.53%

Source: Bank for International Settlements.

Most traded currencies by value

Currency distribution of global foreign exchange market turnover

Ran

Currency

(Symbol)

% daily share
(April 2013)

United States dollar

USD ($)

87%

Euro

EUR ()

33%

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Japanese yen

JPY ()

23%

Pound sterling

GBP ()

12%

Australian dollar

AUD ($)

8.6%

CHF (Fr)

5.2%

Swiss franc

Canadian dollar

CAD ($)

4.6%

Mexican peso

MXN ($)

2.5%

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%

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

Source: 2013 Triennial Central Bank Survey, Bank for International

Settlements.

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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
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.

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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
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

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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.
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

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

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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.

(Anish)Note Issuance Facilities

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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 borrowers
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

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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.
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 UVC, 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
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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 = 9so the number is divisible by 9, or 9010708476264 modulo 9 is 0.
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.
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Microprinting The texture lines to the bottom, like those aligned to the right of
mark on the 5 note, consist of the sequence "EURO " in microprinting.

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.

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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