Role of International Financial Markets

This article focuses on the different aspects of the international financial market. There are many influences on the international financial markets, and the article will provide an exploration of the role of international banking, the euro, hedge funds and moral hazards within international financial markets. Financial markets could be defined in two ways, and there are different categories of financial markets.

Keywords Euro; Financial Markets; Hedge Funds; International Banking; International Banking Federation; Letters of Credit (LOCs); Moral Hazard; Multinational Bank; Wire Transfers

Overview

Money is power. A former Treasury Department official has stated that the most significant conflicts countering terrorism following 9/11 took place in the buildings and boardrooms of economic corporations (Taylor, 2007). Taylor, in an interview with USINFO, stated that he believes that "financial issues should be treated jointly with the two other pillars of international relations, military and political" (Anders, n.d.). According to Taylor (2007), finances are a crucial factor in foreign policy. Let's step back and look at the foundation of financial markets, then tie the concept to its role in a global economy.

Financial markets could be defined in two ways. The term could refer to organizations that facilitate the trade of financial products or it can refer to the interaction between buyers and sellers to trade financial products. Many who study the economic field will utilize both definitions, but finance scholars tend to apply the second meaning most often. Economic markets have the potential to be both domestic and foreign.

Financial markets can be explore on an economic basis terms because it focuses on how individuals purchase and sell financial security, assets and other forms of capital with cheap transaction fees and prices that symbolize the efficiency of the markets. The overall objective of a financial market is to gather all of the sellers and put them in one place that they can meet and interact with potential buyers. The goal is to create a process that will make it easy for the two groups to conduct business.

When looking at the concept of "financial markets" from a finance perspective, one could view financial markets as a way to facilitate the process of raising capital, transferring risk and conducting international trade. The overall objective is to provide an opportunity for those who want capital to interact with those who have capital. In most cases, a borrower will issue a copy of the purchase to the borrower agreeing to pay back the finances in full. These receipts are known as securities and are able to be purchased or sold. Lenders expect to be compensated for lending the money. Their compensation tends to be in the form of interest or dividends.

There are different categories of financial markets, and some of them are:

• Capital markets. Capital markets are comprised of primary and secondary markets, and are considered a critical factor in American capitalism. Recently established securities are purchased and sold in the primary market and investors sell their securities in the secondary markets. Companies rely on these markets to raise the funds needed to purchase the equipment required to run a business; conduct research and development; and assist in securing other items needed for the operations of the company.
• Stock markets — In order to raise a large amount of cash at one time, public corporations will sell shares of ownership to investors. Investors gain profits when the corporations increase their earnings. Many view the Dow Jones Industrial Average as the stock market, but it is one of many components. Two other components are the Dow Jones Transportation Average and the Dow Jones Utilities Average. Stocks are traded on world exchanges such as the New York Stock Exchange and NASDAQ.
• Bond markets — Bonds are the opposite of stocks. Usually, when stocks go up, bonds go down. The forms of bonds include Treasury Bonds, corporate bonds, and municipal bonds. Each bond has a crucial influence on mortgage interest rates.
• Commodity markets. Facilitate the trading of raw or primary commodities. The commodities are traded on regulated commodities exchanges. According to Amadeo (n.d.), “the most important commodity to the American economy is oil, and its price is determined in the commodities futures market. Futures are a way to pay for something today that is delivered tomorrow, which helps to remove some of the volatility in the American economy. However, futures also increase the trader's leverage by allowing him to borrow the money to purchase the commodity. This can have a huge impact on the stock market, and the American economy, if the trader guesses wrong” (Amadeo, n.d., “What are commodities”).
• Money markets. Provides short term debt financing and investment. The money market is the international financial market for temporary borrowing and lending. The allow for short-term liquid financing for the international economic system. In most financial markets, borrowers tend to repay their debts after about a year of lending, in most cases. Money markets use “paper” as their instruments in short-term financing.
• Derivatives markets. Provides tools for the administration of economic risk.
• Futures markets Offer standardized contracts for exchanging products in the future.
• Insurance markets. Facilitates the redistribution of different risks.
• Foreign exchange markets. Facilitates the trading of international exchange.
• Hedge fund markets. “Recently, hedge funds have increased in popularity due to their supposed higher returns for high-end investors. Since hedge funds invest heavily in futures, some have argued that they have decreased the volatility of the stock market and therefore the U.S. economy. However, in 1997, the world's largest hedge fund at the time, Long Term Capital Management, practically brought down the U.S. economy” (Amadeo, n.d. “What are hedge funds”).

Application

Influences on the International Financial Markets

There are many influences on the international financial markets. This section will discuss three of them: The euro, moral hazard, and hedge funds.

1. The Euro.

"Economic and monetary union (EMU) prompted some speculation as to the future international role of the new European currency" (Detken & Hartmann, 2002). Many had speculated that the euro would challenge the dollar's dominance as the number one currency in the world while others were skeptical that the euro would last. “The emergence of one currency as a medium of exchange in currency trading is an important dimension of a currency's role in international financial markets, and is related to a currency's trading volume and trading costs” (Detken & Hartmann, 1998, p. 564). Detken and Hartmann (2002) found that the euro's role is similar to the deutschemark before EMU and features a prominent position in spot trading in the Nordic and other Central European nations. The euro was severly tested during the euro-zone crisis, as first Greece and then Italy sank under economic pressures and required financial assistance from stronger EU members. Fields & Vernengo (2013) contended that despite predictions of euro supremacy, the dollar would remain the hegemonic international currency for the foreseeable future.

2. Moral Hazard.

Moral hazard in international financial markets has received considerable attention in the past years. Moral hazard refers to "the possibility that the provision of insurance, by diminishing the incentives to prevent a particular outcome, may actually lead to a rise in the incident of that outcome" (Kamin, 2004, p. 26). Many believe that efforts to stall financial crises were unsuccessful and moral hazard has developed as a result of when the IMF started to offer large funding packages to emerging market countries.

Multinational corporations (MNC) are looking for growth opportunities, and they are finding them in emerging markets. According to a study of multinational corporations, "two thirds of the respondents believed investment in emerging markets is likely to continue to grow, with three quarters claiming to be actively investing in Central and Eastern Europe" (Credit Control, 2005, p. 43). Antoine van Agtmael, a senior executive at World Bank Group, was the first person to use the term "emerging markets". (Jana, 2007). Many of the new ventures can be found in developing countries such as Brazil, Russia, India, and China, which are known as the BRIC economies. The combined GDP of the BRIC countries in 2012 was close to $14 trillion, almost equal to the annual GDP of the United States (Van Agtmael, 2012). The significance of emerging markets has reached a point where corporations have recognized their influence on the corporations' bottom line. For example, Coca-Cola expected the BRIC countries to contribute 41 percent to its soft drink growth in 2008 (Chakravarty, 2004). Ford Motors predicts that the emerging markets (i.e. Asian countries) will contribute 80 percent to its automotive sales growth (Ford Motor, 2003). Emerging markets have become an important source of revenue.

The Altradius survey reported that the highest percentage of respondents from the multinational corporations was investing as follows: 74% invested in Central and Eastern Europe, 43% invested in China, and 35% invested in India and Southeast Asia. The countries that received the most funding in Central and Eastern Europe include Poland (60%), Czech Republic (46%), Russia (40%) followed by other EU accession countries. In Southeast Asia, India was the top choice followed by Malaysia, Thailand, and Indonesia (“Survey reveals major risks,” 2005, ¶ 11).

With the growth of investment in these emerging markets, there is a pressure to determine whether or not the right thing is being done when offering financial packages. Kamin (2004) wrote a paper and provided evidence on “whether anticipations of IMF assistance by investors have distorted the price and quantity of private capital being offered to emerging market countries” (Kamin, 2004, p. 53). He sought to find out if IMF programs had an effect on creditor moral hazard. His research begins by establishing the point that before the Mexican crisis, investors did not expect bail out packages to be awarded to countries struggling financially. As a result, one can assume that the pre-1995 period represents a period where there is no moral hazard.

Kamin's second step was to compare “recent measures of spreads and capital flows to emerging market countries with those prevailing in the pre-1995 period. He found some evidence indicating that credit was very easy to obtain during the mid-1996 through mid-1998 period” (Kamin, 2004, p. 24). However, this practice did not last long. The final step was to determine whether or not countries that were designated to receive a large sum of IMF funding had easier access to credit than countries who were not in the same financial situation. Kamin concluded that moral hazard did not correlate with distortions in the international capital markets. It is notable, however, that Brazil, China, and India were almost alone among major economies to experience growth during the global financial crisis, while Iceland, Ireland, Portugal, Greece, Italy, and Spain struggled with implosions in their financial institutions and economies. The U.K and Netherlands bore the cost of Iceland's largest bank default, bailing out their own nationals who had invested in the Icelandic bank and going unreimbursed by Icelanders who refused to repay the two larger governments for the failure of a "bad bank." (Touryalai, 2011). By 2010 the European Central Bank was arranging rescues for banks in Ireland and Portugal (Richards & Sinclair, 2010). Bailouts for Greece, Italy, and Spain were already on the horizon (Tora, 2012). Though Touryalai predicted in Forbes that Iceland would rue its revolt, Greenstein reported in the same magazine in 2013 that Iceland was the only troubled economy in Europe to have landed softly (Greenstein, 2013).

Hedge Funds.

Hedge funds have become popular over the last years due to their ability to take both short (sold) and long (bought) positions (Lubochinsky, Fitzgerald & McGinty, 2002). In other words, positions are "market neutral" but with leverage (Edwards, 1999). The funds are well received because they have the ability to utilize "active management skills to earn positive returns on capital regardless of the market direction" (Lubochinsky, Fitzgerald & McGinty, 2002, p. 33).

Most hedge funds have two distinct features. First, the funds have to be what is called absolute return funds. The goal is not to acquire additional returns over a prescribed benchmark, but to acquire the proper absolute returns for the risk that is involved. The other aspect is the funds’ use of leverage. The level of leverage used by hedge funds tends to vary. There are three main mechanisms that hedge funds can use to leverage new asset positions. They are (Lobochinsky, Fitzgerald, & McGinty, 2002):

• Traditional margin loans extended by prime brokers to their clients.
• Fixed income hedge funds that extensively use repurchase agreements.
• The use of all types of derivative positions including future contracts, total return swaps, and options.

Viewpoint

The Role of International Banking

One of the focal points for many multinational corporations is to have the ability to perform financial transactions outside of the United States. These corporations have identified a need to participate in the international trade process. "The burgeoning impact of technology, the globalization of trade, and the general trends towards political and regulatory liberalization is highlighted by the emergence and growth of the multinational bank (MNB)" (Moshirian, Sadeh, & Zein, 2004, p. 351). Some of the key banking services that are needed include letters of credit, wire transfers, collections, and foreign exchange (Teller Sense, 2003). It is important for organizations to have the ability to wire deposits in a timely manner, have the credibility for banks to provide a letter of credit on their behalf, and collect payments quickly and easily.

"The establishment of multinational banks across national boundaries, together with the increasing importance of other international capital mechanisms has meant that the growth of a given economy is no longer constrained by its ability to maintain surplus capital above its own gross national expenditure" (Moshirian, Sadeh, & Zein, 2004, p. 351). In March of 2004, the International Banking Federation was established when the banking associations from Europe, the United States, Australia, and Canada united. The headquarters for the group was London. The purpose of this consortium was to provide an international forum to address issues such as legislation, regulations and other issues that affected the countries and the global banking system. One of the main objectives of the group was to accentuate the efficiency of the banking industry's reaction to national and international affairs (Teller Vision, 2004).

One issue that this group may discuss is the ability for the market to absorb shocks in times of financial crises such as the crash of 1987, the Asian crisis of 1997, and the Russian crisis of 1998. One of the effects of globalization in the financial industry is that the banking sectors across the world have become interdependent across borders (Elyasiani & Mansur, 2003). Given the fact that the banking systems in different countries are not the same in structure and regulatory constraints, it is important that the international financial community is responsible and collaborate on what type of plan should be in place for the global financial market. Organizations such as the International Banking Federation need to develop a plan of action to address these types of events so that the members are not adversely affected when a crisis happens. They are responsible for minimizing the risk of the occurrence of a domino effect.

Conclusion

A former Treasury Department official has stated that some of the most significant battles opposing terrorism after 9/11 have occurred in the workrooms and boardrooms of economic companies (Taylor, 2007). There are many influences on the international financial markets, and the article will provide an exploration of the role of international banking, the euro, hedge funds and moral hazards in international financial markets. Financial markets could be defined in two ways, and there are different categories of financial markets.

Detken & Hartmann's (2002) study found that:

• The euro dominated spot interbank trading in the Nordic countries and several Central and Eastern European countries.
• In Denmark and Norway, the euro share increased to 83% and 93%, respectively, compared to 1998; in Sweden it almost remained constant at around 80%.
• Large euro shares between 80% and 98% existed in the Czech Republic, Hungary, the Slovak Republic and Slovenia, with a fundamental change in Hungary from a dollar dominated market in 1998 to a euro dominated market in 2001.
• The dollar continued to dominate in regions such as Asia, the Middle East, North and Latin America (Detken & Hartmann, 2002, p. 564).

Lobochinsky, Fitzgerald, & McGinty (2002) conducted a study of hedge funds and arrived at the following conclusions:

• During the period of 1990-2000, the performance of a composite hedge fund index showed a significant superior risk-return profile to traditional asset categories such as equities and bonds.
• Greater diversification benefits could be obtained by introducing individual hedge fund styles rather than via the composite index. In this case, arbitrage and relative value strategies played a specific role.
• Even a small addition of hedge funds investments to a traditional asset mix produced consistent return benefits at all levels of risk (p. 53).

Terms & Concepts

Euro: The single currency for Europeans.

Hedge Funds: Funds that take short (or sold) positions in the securities as well as the long (or bought) positions. Funds aiming to utilize active management abilities to receive positive returns on capital despite which direction the market heads in.

International Banking: Banking transactions crossing national boundaries.

International Banking Federation: A consortium of banking institutions from Europe, the United States, Australia, and Canada charged with addressing financial service issues on a national and international level.

Financial Markets: A market for the trading of capital and credit, such as money and capital markets.

Letters of Credit (LOCs): A document issued by banks in the event that a customer wants to purchase goods from an overseas supplier. The supplier is guaranteed being paid because the bank’s credit sponsors the customer.

Moral Hazard: The prospect that being insured from risk might promote a different behavior than might be expected if it were completely exposed to the risk.

Wire Transfers: Wire transfers are forms of transferring and moving money from one individual or corporation to another. A customer can usually purchase, sell, or wire transfer any form of currency in 48 hours or less.

Bibliography

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Retrieved July 31, 2007, from http://usinfo.state.gov/xarchives/display.html?p=washfile-english&y=2007&m=January&x=20070122135539zjsredna5.479068e-02

Amadeo, K. (n.d.) An introduction to the financial markets. Retrieved on July 31, 2007, from http://useconomy.about.com/od/themarkets/a/capital%5fmarkets.htm.

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Edwards, F. (1999). Hedge funds and the collapse of long term capital management. Journal of Economic Perspective, 13, 189-210.

Elyasiani, E., & Mansur, I. (2003). International spillover of risk and return among major banking institutions: A bivariate GARCH model. Journal of Accounting, Auditing & Finance, 18, 303-330. Retrieved July 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9669216&site=ehost-live

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Kamin, S. (2004). Identifying the role of moral hazard in international financial markets. International Finance, 7, 25-59. Retrieved July 31, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=13801464&site=ehost-live

Lubochinsky, C., Fitzgerald, M., & McGinty, L. (2002). The role of hedge funds in international financial markets. Banca Monte dei Paschi di Siena SpA, 31, 33-57.

Moshirian, F., Sadeh, I., & Zein, J. (2004). International financial services: Determinants of banks' foreign assets held by non-banks. Journal of International Financial Markets, Institutions and Money, 14, 351-365.

Richards, J., & Sinclair, R. (2010). Europe mobilises rescue bonds as ECB escalates buying barrage. Euroweek, (1183), 63. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=57428371&site=ehost-live

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Taylor, J. (2007). Global financial warriors: The untold story of international finance in the post 9/11 world. New York: W.W. Norton.

Tora, B. (2012). Groundhog Day. Money Marketing, 18. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=78319623&site=ehost-live

Touryalai, H. (2011). Iceland's stand against bailout repayment will hurt. Forbes.Com, 28. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=65418540&site=ehost-live

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Suggested Reading

Bordo, M., & Murshid, A. (2006). Globalization and changing patterns in the international transmission of shocks in financial markets. Journal of International Money & Finance, 25, 655-674.

Claessens, S., & Schmukler, S. (2007). International financial integration through equity markets: Which firms from which countries go global? Journal of International Money & Finance, 26, 788-813.

Lin, A., & Swanson, P. (2004). International equity flows and developing markets: The Asian financial market crisis revisited. Journal of International Financial Markets, Institutions & Money, 14, 55.