International Capital Markets and Finance - Assignment Example

International Capital Markets and Finance Question It would appear that currency volatility in 2008 is increasing and it is possible that some countries may see very substantial changes in the value of their currency as a result of the current global financial crisis. (a) Identify the main participants in the forward exchange market. Forward Exchange Market Forward market is one of the various tools available to mitigate the risks involved in foreign exchange risk. Forward market is an OTC market where traders can buy or sell currency at a pre-specified rate for delivery on a pre-specified date. The exporter can sell the forward contract to hedge his/her receivables and the importer can buy forward contract to hedge his/her payables. In a foreign exchange contract one member agrees to sell and the other agrees to buy at a future date at an exchange rate which is prevailing at the time of agreement. Such contracts can involve a foreign currency of the party involved against the domestic currency or any other foreign currency as might be found appropriate. Generally, in a forward exchange contract the two parties in consideration are the concerned bank and the customer. While forward exchange contracts are generally accepted, currency futures are preferred more due to their innate characteristic of flexibility which we will take up subsequently. The forward currency market is comprised of the following players. "A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract" (Securities Market). Participants 1. Banks 2. Speculators 3. Hedgers 4. Arbitrageurs 5. Market makers (b) Critically evaluate the potential risks each of these participants face when dealing in the forward exchange markets, particularly in the current financial crisis, and discuss what strategies can be used to manage such risks. The following problems/risks are common to all forward market across the world. Lack of centralization of trading, Illiquidity, and Counterparty risk The basic problem/risk with forward contract is that they are neither standardized nor liquid. This results in too much flexibility and generality and lack of confidence among participants. A forward contract for a currency can be made by any two parties on the basis of their mutual understanding. The counter party risk arises from this non-standardized form of agreement. The high chance of counter party risk of this form of derivative made to think about alternative tools like options and futures. In a forward exchange contract, when one of the two parties to the transaction is declared bankruptcy, the other is bound to suffer. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue. Banks Banks play a major role in the derivative trading of a country. In a forward market for currencies, banks role is to grant short term financial arrangements to the original parties involved in the transaction. In a forward exchange market, the buyer undertakes to purchase a certain amount of a foreign currency against his/her domestic currency at an agreed exchange rate. In case the rate is not favourable to him in the future, he will incur an opportunity loss, which ultimately affects the banks from where the buyer arranged the financial resource. Speculators They are traders with a view and objective of making profits. They are willing to take risks on the anticipation of making profit out of the exchange rate fluctuations. They are making the scene most badly as their involvement will affect the genuine transactions and parties. The risk involved in their participation is that they also incur losses in case the rates come to their expectations. They need not be always purchasers, rather sellers can also speculate on foreign exchange rate. "If a speculator has information or analysis, which forecasts an upturn in a price, then he can go long on the forward market instead of the cash market. The speculator would go long on the forward, wait for the price to go up, and then take a reversing transaction to book profits. Speculators may well be required to deposit a margin upfront" (Securities Market). Hedgers The aim of these kinds of players is to lessen/eliminate the risk. Hedgers are not in the derivatives market to make profits. They want to make sure that their position is safe and risk less. Apart from forward markets, hedging is common in the equity markets where fluctuations in the index rate have to be taken care of in the purchase and sale of equities. Arbitrageurs The objective of arbitrageurs in the forward market is to make risk less profit. Their activities include buying in one market and selling in another at different prices at the same time or at different time points and making the profit out of the rate differences. They have the chance to make money even without investing their own money. They are always alert in forecasting and identifying the rate differences and catching the profitable position as soon as the situations arise. Market Makers The role of a market maker is that of a facilitator. He is the one (bank or brokerage) that stands ready always to purchase or sell currencies. The phrase market maker is used to denote the role of a market maker. When a broker or banker purchases a certain currency for the forward market, it is not necessary that there are buyers for the said currency. The market maker therefore takes the role of a maker of a market for the currencies and finds sellers (or purchasers). Market Makers must be rewarded for the risk they take. To prevent the loss from the unanticipated price fluctuation in the exchange rate, the market maker keeps a spread on each transaction he deals in. On the significance of forward exchange contract, the following statement remarks that "Forward contracts are very useful in hedging and speculation. The classic hedging application would be that of an exporter who expects to receive payment in dollars three months later. He is exposed to the risk of exchange rate fluctuations. By using the currency forward market to sell dollars forward, he can lock on to a rate today and reduce his uncertainty. Similarly an importer who is required to make a payment in dollars two months hence can reduce his exposure to exchange rate fluctuations by buying dollars forward" (Securities Market). Question 2. Over the last decade a growing number of investment managers and institutions have invested funds in developing economies to take advantage of higher returns and to diversify risk. (a) Comment on the linkages between emerging markets and developed economies stock markets. Stock Market Integration or Stock Market Interdependence means, that investors can buy and sell shares in those markets without restriction and that identical securities can be issued and traded at the same price across the markets after foreign exchange adjustment. Approaches of Stock Market Integration Contagion Contagion can be described as the co-movement of asset markets not caused by a common movement of fundamentals (Wolf, 1998). Contagion is not measurable in itself, but rather estimated with the residual from the co-movement that is not explained by fundamentals. There are two broad factors that may become the cause of such contagion, one is informational factors and the other is institutional factors Economic Integration There are two broad categories of economic variables that influence the degree of stock market interdependence. First, the economic interdependence or bilateral trade, and second, several macroeconomic variables, e.g., interest rates, inflation etc. The stronger the bilateral trade ties between two countries, the higher the degree of co-movement should be between their stock markets. Again, macroeconomic variables also influence stock market performance. Since these variables influence stock market returns, the correlation between them will influence the correlation between their stock markets. Apart from the economic variables, several stock market characteristics, such as stock market size, stock market volatility, industrial similarity etc. also influences the extent of stock market correlation. Two markets with more or less same volatility should yield more or less same returns. Therefore to the extent that stock markets volatilities converge diverge, their stock prices should converge diverges. There is also a considerable effect of industrial similarity on stock market correlation. When the markets of two countries are dominated by the same type of industry, their stock market will reveal co-movement, to the extent that the general performance of their stock markets is based on that industry. Thus the extent of industrial similarity between two stock markets increases the extent of their co-movement. (b) Critically examine the concept of international portfolio diversification and analyse its limitations and usefulness for an individual and fund managers, especially in the light of current global financial crisis. Diversification is commonly understood as the strategy of combining distinct asset classes in a portfolio in order to reduce overall portfolio risk. In other words, diversification is the process of selecting the asset mix so as to reduce the uncertainty in the return of a portfolio. Diversification helps to reduce risks because different investments may rise and fall independent of each other. The combinations of these assets will nullify the impact of fluctuation, thereby reducing risk. Most financial assets are not held in isolation, rather they are held as part of portfolios. Banks, pension funds, insurance companies, mutual funds and other financial institutions are required to hold diversified portfolio. Diversification in a portfolio can be achieved in many different ways. One can diversify the investment in various stocks of the firms in the same industry, or portfolio of stocks of different industries can be constructed, or diversification can be made across the geographical regions. International Diversification Investment in companies whose operations are in the same country is exposed to same kind and intensity of risk in respect of natural disasters, state or local tax rate changes. These risks can be eliminated /reduced, if the investment is made in companies which are from different part of the world. If any portfolio manager tries to diversify his/her portfolio by investing across the countries, the diversification is known as international diversification. For an individual investor, it is quite difficult to adopt this kind of diversification because of the regulation of these countries and the high transition costs attached in dealing with foreign investment. Even for al fund managers, it is not possible to implement international diversification due to regulatory constraints attached to it. Issues in International Diversification Given the enormous opportunities available around the world, international diversification can be a beneficial strategy for big investors. To analyse this kind of diversification, we have to consider the following factors: 1. Return available in different countries 2. The risk attached to each foreign market 3. The correlation coefficients across international markets The return from a foreign investment depends upon the return on the assets within its domestic market and the change in the exchange rates between asset's own currency and the currency of the buyer's home country. Therefore, the return on the asset for a foreign buyer can differ according to the domicile of the buyer. For example, assume that the stock of Microsoft earns a return of 20 percent for a US investor, but the real return for investors in the UK or any other country will depend upon the corresponding exchange rate between two countries. If the pound sterling is depreciating against the US dollar, the investment in Microsoft will yield greater return; however, if the pound sterling is appreciating against dollar, the return from such investment will produce lower return to the UK investor. Thus, the exchange rate between security's country and the country of the purchaser plays an important role in deciding the actual return available to the international purchaser. Sources of Risk The return from a foreign investment could be segregated into the return in the security's home market and return from the changes in exchange rate. Therefore, there are two sources of risk attached to an international diversified portfolio. 1. The return on investment in foreign securities fluctuates due to changes in security prices within the security domestic market- Domestic Risk 2. The risk attached to the variation in the exchange rate over the investment holding period- Exchange Risk The risk of investing in foreign securities can be assessed using the standard deviation of securities and correlation coefficient between two security markets. The correlation coefficient between the markets of countries, where investment has been made, plays a significant role in deciding the risk of international portfolio. If a fund manager in the UK invests in the US and Japanese stocks, the correlation coefficient between the US and Japanese market should be taken into account while calculating the risk of the portfolio consisting the US and Japanese stocks. Therefore, the total risk of any international portfolio can be split into two categories, namely Domestic risk and Exchange risk. Domestic risk is indicated in the standard deviation of return, when returns are calculated in the domestic currency. Exchange risk can be measured by assessing the variation in the exchange rates. If a UK investor has invested money in the US stock, the risk of investment can be represented by the standard deviation of the US stock price changes in dollars and the standard deviation of the changes in the sterling-dollar exchange rate. It should be noted here that variability of exchange rate can be should be calculated by assessing the variability of each currency with respect to domestic currency. Use of hedging technique by any international investor can protect his/her portfolio against exchange risk. If the UK investor enters into a forward contract, he can protect the value of the fund. Apart from the exchange risk, there are several issues attached with international portfolio. For example, if the tax rate imposed on the foreign investment differs greatly from the domestic investment, the risk of international portfolio will increase. Higher transaction cost in international investment compared to the domestic investment can cause lower return from the international investment. Controls sometimes do not allow an international investor to drive the full benefit. Bibliography Bergin Paul R. and Amir A. Amadi, Understanding International Portfolio Diversification and Turnover Rates, viewed 30 December 2008, Currency Forward, Financial Dictionary, Investopedia, investopedia.com, viewed 31 December 2008 Kevin, Currency Forwards, keralauniversity.edu, viewed 31 December 2008 Securities Market, Securities Market Basic Module, NCFM, National Stock Exchange, viewed 31 December 2008 Suret Jean-Marc and Jean-Claude Cossert, 1995, Political Risk and the benefits of international portfolio diversification, A Journal Article Excerpt, Volume 26, 1995, viewed 30 December, 2008 Yavas Burhan F., Benefits of International Portfolio Diversification, A Journal of Relevant Business Information and Analysis, pepperdine.edu, viewed 30 December 2008 Read More