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The globalization of world financial markets.

Investors and managers now have many more worldwide opportunities to make and lose money in the trading game.

The term "globalization" has become the business buzzword of the eighties, and it appears likely to be the key word for describing business practices into the 1990s. The word globalization indicates international integration. It causes one to visualize firms obtaining raw materials from one national market and financial capital from another, producing goods with labor and capital equipment in a third, and selling the finished product in yet other national markets.

In particular, the eighties have brought a rapid integration of international capital markets. Corporations obtain financing from major money centers around the world in many different currencies to finance their global operations. Global operations force the treasurer's office to establish international banking relationships, place short-term funds in several currency denominations, and effectively manage foreign exchange risk. Additionally, investors have begun to take advantage of the better performance potential from internationally diversified portfolios of financial assets. This article will trace the development of the global financial markets and describe the major security groups, their uses, and some emerging trends.

BACKGROUND

The underlying economic implication of globalization is that profitable market opportunities exist for those with the necessary expertise. For this to be true, imperfections or inefficiencies in national product markets, factors of production, or financial markets must exist. This implies that national markets are to a degree segmented from one another, even if they are locally efficient. National market segmentation can persist because of a number of factors: language barriers, legal restrictions, a lack of relevant investment information, excessive tariffs or transaction costs, discriminatory taxation, political risks, and exchange rate uncertainty. If the costs of overcoming these barriers are high enough to prevent profitable international business, markets will remain segmented and the benefits arising from international trade and investment will not be captured.

Such severe segmentation is not the case, however, as is suggested by the volume of world trade and by large multinational corporations (MNCs). Forbes in 1988 listed the 100 largest U.S. MNCs. To qualify for the list, a corporation had to generate foreign revenues of at least $1 billion in 1987. Most of the firms are household names-Exxon IBM, Ford, Coca-Cola, and General Electric. Many derived more than 40 percent of their total sales revenue from foreign operations and had 25 percent or more of their total assets overseas. Similarly, Fortune (1988) published a list of the world's 50 largest industrial corporations ranked by 1987 sales revenue. Thirty of these firms are foreign and have a major presence in U.S. product markets-Toyota, Daimler-Benz, Volkswagen, Nestle, Samsung, Bayer, and Honda, for example.

The growing ability of MNCs to capture market share in foreign product markets illustrates the globalization process. Aggregate statistics, however, provide a fuller and clearer picture of the extent of globalization. During the ten-year period ending in 1988, Americans increased their investment overseas by about 180 percent. During the same period, foreigners increased their investment in the U.S. by about 380 percent. At the end of 1988, foreign assets in the U.S. totaled $1,786 billion. Of this, $329 billion was direct investment. Of the remainder, most was invested in financial assets: U.S. corporate bonds, U.S. government securities, and claims on U.S. banks. By comparison, U.S. assets abroad registered $1,254 billion. Of this total, $327 billion was direct investment, $604 billion was in bank loans, and $157 billion was investment in foreign bonds and stocks.

These numbers tell an interesting story about the degree of globalization. First, since 1985 the U.S. has been a net international debtor nation. Second, the U.S. has about the same direct investment abroad as there is foreign direct investment in the U.S.; however, the investment is not evenly distributed. The lion's share is captured by three nations: the United Kingdom ($102 billion), Japan ($53 billion), and the Netherlands ($49 billion). On the U.S. side, three-quarters of direct investment abroad is in developed countries. The largest amount ($61 billion) is in Canada, followed by Great Britain ($48 billion) and West Germany ($22 billion). Investment in Japan accounts for only

$17 billion. Direct investment by MNCs has contributed to the globalization of product and factor markets.

Of more importance, perhaps, is the flow of portfolio investment in financial assets and the amount of bank lending overseas revealed by the figures. This is important because inefficiencies in financial markets can be arbitraged much more rapidly than imperfections in product markets. Indeed, one of the major trends of the eighties has been the increasing integration of the international capital markets, caused in part by the recent liberalization of some domestic capital markets.

The globalization of product, factor, and financial markets promises to continue into the nineties. Japan has promised to adopt a more globalized economic posture. As this unfolds, the yen will play an increasing worldwide role as an international currency, in keeping with Japan's strong economic stature. Wider use of the yen will also require Tokyo's capital markets to develop greater depth and diversity, as have New York's in response to the worldwide use of the dollar. Additionally, the nineties will bring major changes to Europe. In 1992, Europe is scheduled to create a single market. Barriers to the free flow of trade, capital, and people among the 12 members of the European Economic Community (EEC) are to be eliminated. Ideally, Western Europe hopes this move will strengthen its economic position relative to the U.S. and Japan; it will also provide the opportunity for each country's markets to equalize in strength and operational efficiency. The potential is certainly there. Western Europe shares a common culture, a high level of education, and a high standard of living On the other hand, deep-rooted nationalism is centuries old; even staunch Europeanists, who believe Europe will succeed in creating a unified trading market, are skeptical of the chances that Europe will be able to reach the political unity necessary to become a major global economic power. Nevertheless, 1992 will be another step along the path of globalization. This is especially true for the capital markets. In preparation for 1992, ". . some 400 banks and finance firms across Europe have merged, taken shares in one another, or cooked up joint marketing ventures to sell stocks, mutual funds insurance, and other financial instruments" (Reimer et al. 1988). Moreover, major financial institutions from the U.S., Japan, and Switzerland are establishing their own operations to capture a piece of the action.

As business becomes more global, changes in the chief executive suite will take place. Today's corporate CEO has typically started out in finance and has been trained as an accountant. He has worked his way up through a divisional controller's office, to running the division, then to the top job. The global manager of tomorrow will likely have an undergraduate liberal arts degree, a joint M.B.A. /technical degree, and will have started out in research. He will have traveled extensively, be fluent in at least one foreign language, and will have held several different positions. According to Ed Dunn, corporate vice president of Whirlpool Corporation, the global corporate chief "must have a multi-environment, multi-country, multi-functional, maybe even multi-company, multi-industry experience" (Bennett 1989).

THE EUROCURRENCY AND EUROLOANS MARKETS

An early factor in the growth of international investment, and the world economy in general, was the development of the Eurocurrency market. A Eurocurrency is a dollar or other freely traded currency deposited in a bank outside the country of origin. The Eurocurrency market encompasses those banks that seek deposits and make loans of foreign currency.

The origin of this market can be traced back to the late fifties and early sixties, when a number of Soviet-bloc countries had accumulated a large stock of dollars as a result of trade in gold and commodities with the U.S. and European countries. Because of anti-Soviet and anti-communist sentiment in the United States, the Soviets were afraid of depositing these funds in the U.S. where they could be seized. The French bank the Soviets chose had the telex address EURO-BANK. In time, all offshore dollar deposits came to be referred to as Eurodollars, and the banks that accepted these deposits and made loans from them became Eurobanks. An Asian version of this market operates out of the money center banks of Singapore, Tokyo and Hong Kong.

The size of the Eurocurrency market has grown rapidly. In the ten-year period ending in 1987, total net deposits have increased from $478 billion to $2,377 billion. Dollar-denominated deposits account for the largest share of the market-66 percent at the end of 1987. In dollar terms of roughly $1,569 billion, this compares with a total figure of $2,376 billion held domestically in the U.S. by commercial banks and thrift institutions in savings, time, and demand deposits.

The rapid growth of this market stems in part from the demand for U.S. dollars as an international currency, in part from the lack of government regulation, and in part from the tremendous flows of "petrodollars" into international banks from the Oil Producing Export Countries during the mid-seventies and early eighties. Eurodollar deposits are not subject to Federal Reserve reserve requirements. Consequently, the deposit rate is typically higher and the borrowing rate lower compared with U.S. domestic rates.

The growth of Eurocurrency deposits has facilitated Eurodollar loans. These are made on a floating-rate basis, with the base rate being the London Interbank Offer Rate (LIBOR). LIBOR is the market rate at which a Eurobank would be willing to place a dollar deposit with another Eurobank. Commercial loans are priced at LIBOR plus a margin dependent upon the credit-worthiness of the borrower. Eurodollar and other Eurocurrency loans have helped foster international trade and short-term investment.

LIBOR, not a household word at present, soon could become one. During 1988, several U.S. lenders began issuing adjustable-rate mortgages linked to LIBOR instead of domestic indices, such as the one-year Treasury-bill rate. The push for this came from foreign banks and thrift institutions that buy mortgages in bulk and desire having assets linked to the LIBOR base they pay to raise money. LIBOR-linked loans are not a large part of the market at present, but it is estimated they could climb to 20 percent of new adjustable-rate mortgages within three years.

U.S. banks currently cannot accept foreign currency deposits. However, the Federal Reserve has decided to allow foreign currency deposits effective December 31,1989. This change should facilitate trade for small firms doing business overseas; a foreign currency deposit can be used to hedge the risk of a depreciating dollar. For the same reason, it should also prove helpful to small investors who are planning to invest in retirement or mutual funds overseas.

THE INTERNATIONAL BOND MARKET

The international bond market gives borrowers, including multinational and domestic corporations, sovereign governments, governmental organizations and financial institutions, a source for medium and long-term funds. It also gives investors a way to diversify their portfolios over several currencies. The market can be broadly broken into Eurobonds and foreign bonds. Eurobonds are bonds denominated in one or more currencies other than the currency of the country in which they are sold. In contrast, foreign bonds are denominated in the currency of the country in which they are sold; the issuer, however, is from another country. For example, bonds denominated in yen, but sold by a Japanese firm outside of Japan, would be classified as Eurobonds-more specifically, Euroyen bonds. If the same Japanese company issued dollar-denominated bonds to investors in the U.S., they would be considered foreign bonds-more specifically, "Yankee" bonds. Many foreign bonds have colorful nicknames; foreign bonds sold in Japan are "Samurai" bonds; foreign bonds sold in the United Kingdom are "Bulldogs."

The international bond market is exceedingly large. At 1985 year end, the total nominal value of international bonds outstanding was equivalent to $499 billion, or about 8 percent of the $5,933 billion value of the entire world bond market. New issues in 1985 and 1986 were, respectively, $164.5 and $221.5 billion. The market, however, slipped after 1986 (for reasons to be discussed shortly) and registered a total of $175.6 billion in 1987.

In recent years the Eurobond segment has accounted for more than 80 percent of the total of new issues. Most trading in Eurobonds is conducted in London. The Eurobond market began in the early sixties and has grown much more rapidly than the foreign bond market. This growth is attributable to several unique features. Eurobond issues are not subject to the regulatory authorities of the country in whose currency they are denominated. Consequently, Eurobond issues can be brought to market more quickly and with less disclosure than would be required by, say, the U.S. Securities and Exchange Commission (SEC). This gives the issuer greater flexibility to take advantage of favorable market conditions. Eurobonds also offer favorable tax status. They are usually issued in bearer form, meaning the owner's name and residence are not on the bond certificate; holders desiring anonymity can thus receive interest payments without revealing their identity. Additionally, interest on Eurobonds is not generally subject to an income withholding tax. These two features facilitate tax avoidance and, as one might guess, tax evasion.

Because of their unique features, investors are willing to accept a lower yield from Eurobonds than from securities of comparable risk but lacking the favorable tax status. Nevertheless, name recognition of the borrower and an impeccable credit rating are important to successful issuance in the Eurobond market. The lower yield translates into a cost savings for the borrower. Historically, for example, highest-quality Eurodollar bonds could be issued at a lower rate than the market yield on similar maturity U.S. Treasury bonds.

The largest part of the Eurobond market has historically been and remains today Eurodollar bonds. In 1982, more than 85 percent of the value of new issues was dollar denominated. This figure fell to about 40 percent in 1987, a main reason for what has been termed the slump in the Eurobond market. Examination of the statistics suggests this decline is primarily a dollar problem. Between 1986 and 1987, new issues of non-dollar Eurobonds increased from $69.7 billion to $83.8 billion; Eurodollar bonds declined from $118.1 to $56.7 billion. One reason for the decline in new issues of Eurodollar bonds is the dollar's weakness over the last couple of years. When foreign investors wish to diversify out of dollar-denominated assets, the Eurodollar bond market will be one of the first hit. Other reasons relate to regulatory changes in the U.S. making domestic dollar bonds relatively more attractive. In 1984, the U.S. withholding tax on interest paid to foreigners was repealed, thus neutralizing a feature of the favorable tax status for Eurodollar bondholders. This eliminated some of the cost savings to Eurodollar bond issuers, as the yield demanded by investors in top-ranked issues increased to a level in excess of the Treasury yield. Additionally, in 1982 the SEC introduced shelf registration, which allows firms to register securities and sell them to the investing public for two years after registration. This increased the flexibility and ease of issuing domestic bonds, making the market more competitive with the Eurobond market.

Because of the recent weakness of the dollar, other currencies have gained an increased share of the Eurobond market-particularly the Japanese yen. Facilitating this were two actions by the japanese government. In 1984, it relaxed regulations to allow Japanese financial institutions to participate in the placement of Euroyen bonds issued by private non-Japanese corporations. Without the participation of local financial institutions, an offshore issue will fail. Additionally, in 1985 Japan eliminated the withholding tax on interest paid to foreign bondholders by Japanese corporations. Both of these moves have been interpreted as efforts by japan to open its capital markets and show a willingness to make the yen a major international currency. New issues of Euroyen bonds increased from less than a quarter billion dollars in 1983 to $23.1 billion (a 16.5 percent share of the Eurobond market) in 1987.

Also growing in the Eurobond market are issues denominated in the European Currency Unit (ECU) of the European Monetary System. The ECU is a composite (often called a "cocktail" or "basket") of nine Western European currencies that are pegged to one another but float against the dollar. Euro-ECU bonds offer the safety of currency diversification to borrowers and investors, particularly within the European Monetary System, and a hedge against a depreciating dollar. In 1987, Euro-ECU bonds accounted for about 5 percent of new Eurobond issues.

Most Eurobond issues are fixed-rate bonds. However, floating-rate notes (FRN) have become a substantial portion of the market, especially in periods of volatile interest rates. The coupon on Euro-FRN issues is indexed to some variable interest rate and adjusted periodically. Numerous variations exist. The largest part of the FRN market segment has been for dollar-denominated bonds, which are typically indexed to the six-month LIBOR. Obviously, the interest rate risk of Euro-FRNs is minimal, as they will always be priced close to par value. Floating-rate issues are attractive to borrowers with floating-rate assets and to investors desiring an investment with little price variability.

Perhaps the primary reason for the growth in the Eurobond market over the past few years has been a technique known as the swap. A swap is a financial transaction in which one party agrees to exchange with the other the interest obligations of the respective issues or, carrying it further, the entire debt service obligations (principal and interest). A swap allows the parties to raise funds under one interest rate structure or currency, and swap to another. It has been estimated that 70 percent of Eurobond issues are swapped. A swap allows the parties to arbitrage the comparative advantage each may have, perhaps because of name recognition in different currency or market segments. The swap produces a cost savings for each party and, in the case where currencies are swapped, the potential for reducing long-term transaction exposure if cash inflows are denominated in the same currency as the debt service obligations.

The secondary market for Eurobonds has historically lacked depth. However, in recent years the increased number of financial institutions trading Eurobonds for their portfolios has increased its depth, making its liquidity second only to that of the U.S. domestic bond market. This is important to investors because of the recent increased volatility in the bond and currency markets. Previously, under more stable conditions, investors were willing to hold bonds to maturity. Long maturity issues, in particular, still experience some liquidity problems.

The Eurobond market, although presently in somewhat of a slump, is by no means on its deathbed. As long as advantages continue to exist for both borrowers and investors, this market will remain a major segment of the international capital markets. Nevertheless, it seems safe to predict that yen and ECU-denominated issues will gain in market share relative to dollar-denominated issues as the yen becomes a major international currency and preparations are made for 1992.

THE INTERNATIONAL MARKET FOR EQUITIES

For years the idea of placing shares in foreign equity markets has been attractive to corporate financial managers. However, the equity markets have, to a great extent, remained outside the globalization process of international financial markets. Typically, the parent firm of a MNC would issue shares in the home market and wholly own foreign subsidiaries, or issue equity shares in a foreign national market, but only to finance the local subsidiary in the country. For these reasons, the globalization of the primary equity markets has lagged behind that of bonds, and in terms of comparative development, it is where the Eurobond market was in the 1960s. Nevertheless, new developments in global communications technology, deregulatory changes in national markets, and a greater awareness by investors of the benefits of international portfolio diversification have rapidly accelerated the integration of secondary equity markets during the 1980s.

Favorable macroeconomic conditions and good growth prospects in a number of countries have caused the market value of the world's equity markets to increase dramatically in recent years. Between 1976 and 1986, world market capitalization increased more than 300 percent from $1,371 billion to $5,642 billion. In order of market size, the five largest national equity markets at the end of 1986 (in billions of U.S. dollars) were the U.S. ($2,203), Japan ($1,746), U.K. ($440), West Germany ($246) and Canada ($166). Particularly good growth in Japan, coupled with an appreciating yen, has caused the Japanese market to grow spectacularly when measured in dollar terms. In 1984 it was $617 billion, versus $1,593 billion for U.S. equities; by early April 1987 it had claimed the number one position, with a value of $2,688 billion versus $2,672 billion for the U.S. market. In general, the large size of the national equity markets suggests opportunities for investors to construct well-diversified international equity portfolios.

Facilitating this opportunity are a number of deregulatory measures recently taken in major national markets. One important change made in 1985 by the Tokyo Stock Exchange was to create ten new seats and admit as members to six of these ten its first foreign brokerage firms. Four of these firms were American: Merrill Lynch, Goldman Sachs, Morgan Stanley, and Citicorp's London-based affiliate, Vickers da Costa. Membership will allow these firms, and the two European firms admitted, to better serve European, American, Mideastern and Asian investors desiring to take positions in Japanese securities. For foreign firms without membership, opportunities are limited. Nonmember firms must develop relationships with Japanese firms or attempt to buy existing seats from small Japanese firms. Membership will provide the opportunity to handle large block trades for Japanese institutional investors. However, this portion of the business may develop slowly; the Big Four of Japanese securities houses-Nomura, Daiwa, Nikko, and Yamaichi-have long, close ties with Japanese financial institutions.

Indeed, Nomura is a competitive force to be reckoned with around the world. It is Japan's most profitable company, with assets of $372 billion, in comparison to Citicorp's $204 billion and Merrill Lynch's $55 billion. With Japan's enormous current account surpluses, the country has become the world's major source of capital, and Nomura is adept at placing investment around the globe. It employs 12,00 people in 38 investment offices in 21 countries. With the exception of New York (to date at least), Nomura has been able to establish a commanding presence in many national securities markets.

Perhaps the most celebrated deregulatory change in recent years occurred in London on October 27,1986, and is known as the "Big Bang." On that date as on "May Day" in 1975 in the U.S., the London Stock Exchange (LSE) eliminated fixed brokerage commissions Additionally, the regulation separating the order-taking function from the market-making function was eliminated. Moreover, in February of 1986 the LSE began admitting foreign corporations as full members of the exchange. In contrast to Japan and the U.S. (by the Glass-Stegall Act), Europe allows financial institutions to perform both investment banking and commercial banking functions; hence London affiliates of foreign commercial banks were eligible for membership to the LSE. These changes were designed to give London the most open and competitive market in the world. Facilitating this is the ideal time zone of London-its geographic location allows it to be the middle link for 24-hour trading between markets in the Far East and New York. Because of the deregulatory changes and the attraction of the London market, foreign financial institutions jumped at the opportunity and rushed to set up operations. As one might guess, volume increased dramatically and profit margins were sliced razor thin. With the October 1987 market correction, trading volume slumped, reducing the profitability of many firms. It now appears that man firms may have expanded their operations too rapidly. Some players will certainly close up shop, and others will scale back or consolidate. Nevertheless, the "Big Bang" is not the "Big Bust" that others have described. The changes made in London will yet prove to be a major factor in further integrating the world's capital markets.

Similar changes to those in London took place in Canada in 1987, and some call it the "Little Bang." On June 30 the Canadian equivalent of the Glass-Stegall Act was eliminated, allowing financial institutions to participate in both commercial and investment banking. Additionally, in 1988 foreign financial institutions were allowed to acquire 100 percent ownership of Canadian brokerage firms in Ontario (the securities industry is regulated by provinces in Canada). Canadians desired these changes to allow its securities industry to participate in the increasing globalization of financial markets. And as mentioned before, 1992 will facilitate the integration process when EEC countries open their borders to the free flow of goods, people, and money.

A trend strengthening the integration of international equity markets is the increasing number of firms listing their stock in foreign stock markets. At the end of 1986, the Tokyo Stock Exchange was trading 55 foreign equity issues from nine countries. Over 500 foreign issues trade on the London Stock Exchange. In the U.S., the shares of about 550 foreign firms are traded. Only about 100 of these are listed on the organized exchanges; the remainder are traded over the counter.

Initiating dual or multiple listing (or trading) can provide many potential advantages for a corporation. To do this the firm must meet the foreign securities market regulations and those of the stock exchange. Foreign listing provides a MNC with a form of advertising for its product brands in the foreign market. Additionally, foreign listing raises the profile of the firm in the foreign capital markets, easing the way for it to raise future financing in foreign national markets. Also, there is some academic evidence that dual listing reduces the firm's cost of capital. The risk to the firm's management of a hostile domestic takeover may also be reduced when equity ownership is diversified internationally.

In the United States, the trading of foreign equity is usually and most conveniently accomplished by means of American Depository Receipts (ADRs). ADRs are special shares of the foreign equity priced in dollars. They are negotiable certificates issued by a U.S. bank representing the underlying foreign shares, which are deposited with the bank's overseas affiliate or custodian. A single ADR represents some multiple of the underlying shares packaged so it will trade at the appropriate price range in the U.S. market. ADRs can be converted to the underlying shares or vice versa. Consequently, arbitrage will cause an ADR to sell for the same price as the equivalent number of underlying foreign shares after exchange rates and transaction costs have been accounted. Dividends are passed through the custodian to the investor in dollars. ADRs, however, do not provide voting rights to the investor. ADRs are either "sponsored" or "unsponsored." Sponsored ADRs are created at the request of the foreign firm desiring to have its stock traded in the U.S. Unsponsored ADRs are created by a U.S. financial institution reacting to U.S. investor demand for trading in the equity of a foreign firm.

Multiple listing of equity shares has helped integrate the world's equity markets; nevertheless, globalization in the sense of the debt markets is a long way off. Only recently have U.S. firms started to sell parts of new issues of equity overseas. The most cited example is Black and Decker, who in 1985 issued 8.5 million new shares. Two million of those were sold to European investors. These "Euro-equity" issues, as they have been dubbed, totalled $1.2 billion in 1984 and $3.5 billion in 1985. The Euro-equity market was expected to double its volume in 1986, but its size is minute compared to the Eurobond market. Perhaps as more firms' shares are listed on foreign stock exchanges, they will consider Euro-equity placements when the need for new equity financing arises. The initial evidence is that Euro-equity issues lower placement costs and bring in a larger, diverse group of investors.

Because national equity markets are not completely integrated, movements between prices of shares traded in different national equity markets are on average not as highly correlated with one another as they are between shares traded in the same national market. Indeed, recent academic evidence documents a strong country factor in correlation coefficients. The less correlated national markets are, the better the opportunities for investors to reduce systematic portfolio risk (for a given level of expected return) through international diversification.

Both individual and institutional investors have become somewhat aware in recent years of the potential benefits internationally diversified portfolios can provide. At present there are at least 50 U.S.-based international mutual funds that invest a significant portion of their assets in foreign securities. New sales of these funds exceeded $7 billion in 1986. This represents more than a threefold increase over the previous year. U.S. pension fund managers are also starting to get into the international action. In 1988, out of approximately $2 trillion in total assets, $60 billion, or 3 percent, was invested abroad. It is projected that by the year 2000, pension funds under management will total $6.3 trillion, of which at least 20 percent will be invested in international markets. Nevertheless, even among portfolio managers, stocks have largely remained outside the globalization trend. It is estimated that shares of about 200 major MNCs are traded in significant volume around the world, and even with these stocks the trading is primarily done in the domestic equity markets.

Further integration of the world's equity markets should occur as investors become increasingly aware of the benefits of international diversification. In the most comprehensive study to date, recent academic evidence has shown that over the ten-year period ending 1986, ten out of 13 U.S.-based international funds had a greater reward-to-variability ratio than the typical domestic portfolio as measured by Standard & Poor's 500 Index. However, the results were mixed over equal-length subperiods of five years. Over the first, all international mutual funds outperformed the U.S. market; in the second subperiod slightly less than half did. Nevertheless, even for the second subperiod it was shown that for more than 80 percent of the funds, some combination of the international fund and investment in the U.S. market would have provided superior performance than solely investing in the U.S. market. This is evidence that global diversification can provide the U.S. investor with beneficial gains.

THE FOREIGN EXCHANGE MARKET

For international trade in goods and investment in financial assets to occur, a market for foreign exchange must exist, since each country has a different currency. As succinctly stated by Eiteman and Stonehill (1989), "The foreign exchange market provides the physical and institutional environment in which foreign exchange is traded, exchange rates are determined, and foreign exchange management is implemented." The underlying purpose of the market is to transfer purchasing power from one currency to another. In the broadest sense, the market encompasses the spot and forward markets and the markets for futures and options on foreign exchange.

Since the final collapse of the fixed-rate, gold exchange standard (known as the Bretton Woods system) in early 1973, the international monetary system under which the world operates is loosely classified as a free-floating, or flexible, exchange rate system. Under this type system, each country's currency price in other currencies is determined by the market forces of supply and demand. More accurately, the system allows the world's major currencies (dollar, British pound, yen) to float versus one another, with periodic central bank intervention in an attempt to adjust relative currency values. It is a system of the monetary union characterized by the ECU-where nine EEC currencies are pegged to one another but float against others-and of pegging currency value to a strong currency or currency composite by many less developed countries.

The floating of major currencies and the increased globalization of business have caused the market for foreign exchange to increase in volume and volatility in recent years. The exact size of the market is difficult to determine, but it is by far the largest and, most likely, one of the most efficient financial markets in the world. One estimate put average daily trading volume at $425 billion in 1987, up from $300 billion in 1986 and $150 billion in 1984; current estimates range up to $1,000 billion per day (Stern 1988; Shapiro 1989). By comparison, the largest single day's volume on the New York Stock Exchange was $21 billion on October 19, 1987, the day of the crash.

The foreign exchange market is not a specific physical place; it is the network of international banks that trade currencies with one another and the foreign exchange brokers and dealers who facilitate these trades. This network spans the globe and is open somewhere in the world 24 hours a day Primary trading centers are London, New York, and Tokyo. Other major trading centers are Sydney, Hong Kong, Singapore, Frankfurt, Zurich, Paris, San Francisco, and Los Angeles. Communication with one another is via computerized dealing systems, telephone, telefax, and telex machines.

Banks, acting as dealers, trade currencies with their corporate and individual clients to help them conduct foreign currency transactions. These trades form the retail or client market. Banks also trade with one another to adjust their inventories of foreign currency (correspondent bank balances in foreign banks) for retail transactions as well as for speculation and arbitrage. Interbank transactions form the wholesale or interbank market, involving transactions of a million or more currency units. A 1986 Federal Reserve study indicated that almost 87 percent of all bank foreign exchange transactions were wholesale trades. Banks (when acting as dealers) and foreign exchange dealers profit by buying foreign currency at the "bid" price and reselling at a higher "ask" price. Because of the many competitors in the market the bid-ask spread is very narrow, attesting to the efficiency of the market. Retail customers are not charged a commission; the bid-ask spread is slightly larger than it is in the wholesale market. When acting as speculators, banks attempt to profit by changes in exchange rates. A typical $5 million position can earn substantial profit if the rate changes by only a small amount. A bank trading room may conduct hundreds of trades in a single day. Many large international banks operate trading rooms around the globe in several money centers to service their corporate clients on a 24-hour basis They also better maintain speculative positions around the clock through trading partnerships. The foreign exchange operations can be extremely profitable for a large international bank. In 1987, Bankers Trust earned $593 million from currency trading, Citicorp earned $453 million, and Chase Manhattan showed $232 million.

Some investment banking house have recently joined the action. It is estimated that Morgan Stanley and Goldman Sachs earned about $50 million each from speculative foreign exchange market trading in 1987. Many large MNCs have their own trading rooms and trade in the wholesale market. These are cost centers when the MNC conducts its own foreign exchange transactions and profit centers when taking speculative positions. Central banks and treasuries also trade in the wholesale market to acquire or spend foreign exchange reserves and intervene in the market's determination of exchange rates.

A transaction in the spot market involves almost immediate delivery of foreign exchange. (This market is not the same as the bank note, or cash market for small transactions with which many vacationers are familiar. A spot exchange rate represents the current price of one currency in terms of another. Spot transactions account for about 60 percent of interbank transactions.)

A forward trade is a contract involving delivery of foreign exchange at some future date. Typical delivery date are one, two, three, six, and twelve months into the future. However, intermediate dates and, especially for major clients, contracts with maturities longer than one year are available. The forward exchange rate is the contractual price for delivery of foreign exchange on the delivery date. It may be higher or lower than the spot rate, depending upon whether the market anticipates the foreign currency to appreciate or depreciate in value relative to the currency used for quotation. Forward contracts allow for hedging the volatile exchange rates that exist under a free-floating international monetary system. MNCs, for example, can lock in the purchase price of foreign exchange needed to meet a forthcoming liability by the forward buying of foreign currency. Further, the sale price of foreign exchange to be received in the future can be locked in by the sale of a forward contract.

Similar to forward contracts are futures contracts, which allow for the future purchase or sale of foreign currency. Futures contracts differ, however, from forward contracts in that the terms of the contract (face amount and maturity) are standardized. They are also traded on organized futures exchanges. The largest futures exchange for foreign exchange is the International Monetary Market (IMM) division of the Chicago Mercantile Exchange. Contracts currently trade for the British pound, Canadian dollar, West German mark, Swiss franc, French franc, Japanese yen, Australian dollar, and ECU. Since 1985 interchangeable contracts have traded on the Singapore International Monetary Exchange (SIMEX), thus allowing more global trading. The IMM and SIMEX also trade a Eurodollar interest rate futures contract based on three-month LIBOR. This contract helps MNC treasurers and international banks hedge interest rate risk. In 1987 it unseated the U.S. Treasury bond contract to become the U.S.'s most highly traded futures contract. Other, non-interchangeable, currency and Eurodollar futures contracts are traded on the London International Financial Futures Exchange.

Options also provide a means of hedging foreign exchange risk. A call option allows the purchase of a certain amount of foreign exchange at a contractual exchange rate over a specified period of time. A put option provides for the sale of foreign exchange. Unlike forward and futures contracts, an option contract does not have to be exercised if the spot price of foreign exchange is more favorable to the option holder than the contractual exchange rate. A premium must be paid to purchase an option, however. Standardized exchange-traded options on the same currencies as the IMM futures contracts became available in 1982 when trading began at the Philadelphia Stock Exchange. Other exchanges throughout the world also trade currency options. Additionally, international banks offer over-the-counter currency options with tailor-made terms to their commercial customers. And, the IMM offers exchange-traded options on its currency futures contracts.

All of the international financial markets have grown extensively in the eighties, as business has become more global and national markets have become more integrated. Many new securities exist today that were not present as little as a decade ago. Further developments should be expected in the nineties and into the next century as continued integration takes place.

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Date:Nov 1, 1989
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