Impact of Globalization of World Financial Markets - Essay Example

Running Head: Does globalization Of world financial markets Does globalization of world financial markets make international diversification of portfolios more or less desirable? [Name of the writer] [Name of the institution] Does globalization of world financial markets make international diversification of portfolios more or less desirable? Introduction There were many discussions regarding the benefits and detrimental consequences οf financial liberalizations, however the issue is still subject to continuous debates and no ultimate solution have been reached at. The main issue οf the debate is that there are significant positive effects οf international capital surges into developing economies, but negative consequences can quickly overshadow these benefits if short-term inflows are allowed to reach unsustainable levels. The potential costs, and possible solutions to such problems, must be weighed against the benefits in order to determine whether short-term capital should be allowed to flow, without restriction, over international boundaries. Basically capital account transactions are classified into portfolio investment and direct investment. Portfolio investment encompasses trade in securities like stocks, bonds, bank loans, derivatives, and various forms οf credit (commercial, financial, guarantees). Direct investment involves the purchase οf real estate, production facilities, or substantial equity investment. To answer the question whether financial liberalization is good or bad we need to analyze arguments given by both opponents and proponents οf financial liberalization. First we will consider arguments against financial liberalization followed by arguments supporting the view οf financial liberalization. Research Research finding proving the detrimental effect οf liberalization on the financial system. The Wyplosz research paper says that the evidence based on studies οf the experience with liberalization in a sample οf 27 developing and developed economies seems to be converging to the view that liberalization contributes to both banking and currency crisis. A study by Eichengreen, Andrew Rose and Wyplosz (1995) found that the presence οf capital controls reduces the possibility οf a currency crisis. This result has been confirmed in a 1999 study by Marco Rossi (IMF working paper WP/99/66) for a sample that includes developing countries According to Wyplosz study, liberalization οf financial markets may be desirable in the long term, but it is risky in the short to medium term, and developing countries should approach this as a delicate step calling for cautious policy reactions, according to a research study for the Group οf 24 on International Monetary Affairs, the developing country grouping at the IMF and the World Bank. In theory the liberalization οf capital accounts and financial markets, promoted and pushed by the International Monetary Fund and the international financial institutions (IFIs) is different from the push at the World Trade Organization for liberalization οf trade in financial services. However, whether it be through capital account liberalization or via the liberalization οf trade in financial services, the effect on developing countries could be the same, particularly in the absence οf major reforms to the international monetary and financial systems. In and by itself, the study finds that liberalization does not pose a lethal threat to the balance-of-payments and may carry significant long-term gains. However, he also stated that the positive influence οf liberalization is not easily confirmed and most recent studies find little or no effect though some early results suggest that fast growth and financial development go hand in hand, In the case οf capital account liberalization, the peak to trough decline in the output gap exceeds 20 percent. No other shock ever seems responsible for such a massive contraction. The boom exceeds the bust in magnitude, but not in length. Thus liberalization brings about an overall gain in terms οf output. With the increasing globalization activities, the foreign exchange rate risk becomes an important part management may have to think about. Based on the survey data by Bodnar from 1995,( Bodnar, Hayt, Marston and Smithson, 1995) foreign exchange rate risk seems closely related to firm cash flows volatility. In 2001, Allayannis and Ihrig’s theory (Allayannis and Ihrig, 2001) suggested that firm cash flows volatility is determined by the nature οf firms. But because it’s difficult to analyze most firms’ cost structure, this way didn’t figure out the relationship successfully. Even different studies are applied; the empirical evidence we got is still too weak to support this opinion till now. In 1999, the Euro is introduced as a common currency used among Europe countries. It’s a hypothesis that a common currency could reduce transaction costs, and exchange rate risk. (Jurgen schrempp, Newsweek Special Issue 9/1998-2/1999) It’s because the trade across countries avoiding the dealing οf foreign currencies, then both οf traders do not suffer the unexpected foreign exchange rate changes. The transaction cost occurred during the dealing οf foreign currencies is eliminated as well. Then the relationship between foreign exchange rate and firm value could be observed through examining the affect οf Euro on firms to check whether this hypothesis is feasible. In order to do so, there are three points need to be proved:After the launching οf Euro, for many countries, stock market volatility increases. Compared to non-Euro countries and outside οf Europe, those firms within Euro area due to higher exposure οf Euro currency may experience lower increase. The introduction οf Euro leads to the reduction οf market risk, no matter this country is located in or outside οf Europe. This point may testify that the nature οf foreign exchange rate is non-diversifiable. Even though incremental foreign exchange rate exposures appeared in some firms, actually net absolute decreasing foreign exchange rate happened in the left 90% firms. Then Euro could be stated have impact on foreign exchange rate exposure, because it arose the reduction οf foreign exchange rate exposure. Excluding the above 3 points, the market beta and foreign exchange rate beta οf multinationals is turned out to be determined by the firm’s characteristics, which refers to total sales, and foreign sales take place in Europe. Then the foreign exchange rate exposure reduced significantly for those multinationals with low total sales, but high foreign sales in Europe. In addition, geography and industry competition is relevant to foreign exchange rate beta as well. Compared to non-Euro Europe, market beta and foreign exchange rate beta in Euro area changed obviously larger because οf the high exposure οf Euro currency. High competition industries have larger reduction in foreign exchange rate beta than low competition industries. The reduction οf market beta and foreign exchange rate beta means that both the market changes and foreign exchange rate changes have smaller effect on firms. The high exposure οf Euro currency enables firm experiencing lower market risk, eliminating the cost οf capital, more capacity bearing higher business risk, and increasing firms’ value. Except the using οf Euro state the relationship between firm value and foreign exchange rate exposure, lots οf studies have stated the launching οf Euro have other impacts on financial market. For example, the introduction οf Euro increases the net debt issues in European bond markets (Rajan and Zingales, 2003), has significant positive effect on European capital market (Galati and Tsatsaronis, 2003), and drives the integration οf equity markets (Fratzscher, 2002). In the following part, we would focus on impact οf single currency on both financial and non financial firms no matter where they locate in or outside Europe. We will also look in to the finding οf empirical research conducted to analyze the Exchange rate risk, and then on the general impact οf euro on the business and economy. In the end a conclusion will be given the impact οf Euro. Impact οf Euro:Exchange Rate Risk:The empirical research work conducted by “Sohnke Bartram and G Andrew karolytlie” using regression technique on the sample companies around the world suggest that despite exchange rate stabilization due to introduction οf euro, the stock return has become more volatile, thus providing no evidence οf lowering in the volatility οf stock for the foreign businesses operating in Europe. However introduction οf Euro has significantly decreased the market risk for the companies having sales and asset in European countries. Thus allowing them to take high business risk and can sustain high financial leverage. The argument is supported by Bartov , Bodnar and Kaul (1996), as they provide evidence on increased financial risk for US multinational firms after breakdown οf the Bretton woods system. The results οf research conducted is in line with the finding in study οf European firms by Bris ,Koskinen, and Nilsson(2003), which provide evidence that the introduction οf Euro is accompanied by substantial increase in Tobin’s Q. (the impact οf introduction οf Euro on foreign exchange rate risk exposure by sohnke and Andrew)Jeff Madura (2003) describes the elimination οf exchange rate risk in the participating countries as the major advantage οf euro. It encourages trade across European borders. Introduction οf single currency has also reduced the transaction cost associated with transaction between European countries. Euro has forced the interest rate offered on government securities to be similar across the participating countries, thus lowering the risk and encouraging investors. The European countries will be affected by the change other international currencies like US dollar. Gabriele Galati and Kostas Tsatsaronis ( 2001) argues that in foreign exchange market euro does not seem to have changed the market fluctuation in a significant way. The article suggest that euro has resemblance with mark, in terms οf its weight in global foreign exchange market activity, the tightness οf spread, its volatility, and its role as an anchor currency. It furthers argue that it has euro has no obvious impact on foreign exchange market liquidity. Reducing Derivatives:The most efficient way to protect the firms away from foreign exchange rate fluctuation risk so far is hedging. Foreign exchange risks are much more serious when they expose to the multinational companies compare to the domestic firms. The principal goal οf using hedging is the reduction οf foreign exchange rate exposure (Simon and Zvi, 1998). From Sourabhs study, it shows that just for large firms hedging with derivatives could help, in reverse, they cannot make any use. As imperical evidences suggests that introduction οf euro has contributed in reducing foreign exchange rate risk, which in turn has resulted in reducing the use drivatives. In pre euro era, financial instruments was used by the firms for hedging that risk i.e. derivatives, which is a key motive for the corporate to hedge foreign exchange (FX) risk, foreign e.g forward and future option, swaps etc. In post Euro period there is overall decrease in using FX derivatives for hedging the risk with foreign exchange exposure, as adopting euro has decrease the foreign exchange rate exposure which infect reduce firms foreign exchange transaction cost, commission, bid asked spread and cost οf managing foreign exchange risk. Euro was introduced in 1999 when Maastricht called for the establishment οf single currency. Initially 11 countries adopted euro as national currency. The participating countries agreed carry out to in cross border trade and capital flow throughout euro zone with single currency. There is a hypothesis that the introduction οf euro has positive affect on the economies οf participating countries. It’s because the trade across countries avoiding the dealing οf foreign currencies, then both οf traders do not suffer the unexpected foreign exchange rate changes. The transaction cost occurred during the dealing οf foreign currencies is eliminated as well. To check the hypothesis we divided the essay into three sections. We looked into the empirical research work conducted by authors to testify the Impact on exchange rate risk, derivates and general implications οf euro. Conclusion The integration οf money markets is one the major success οf euro. The introduction οf euro has removed the barriers οf trade among the participating countries, provided opportunity for free trade and sharing business. It has also contributed in eliminating the exchange rate risk, thus encouraged the investors and foreign companies to engage in business in European Union. The establishment οf medium size businesses in the region has encouraged competition. The single currency has given the transparency οf prices, and better products for the consumers. The medium and long term stability in the interest rate has given boost to the economy. Thus it can be safely concluded that euro has successfully contributed in reduction οf market risk and exchange rate exposure for non finance firms. Although there is weak evidence οf lowering the volatility οf stock, but overall reduction in market betas, and minimizing exchange rate risk has benefited the non finance and finance firms in or outside Europe. References Allayannis, G., Ihrig, J., 2001. Exposure and markups. Review οf Financial Studies 14 (3), 805-835 Bodnar, G.M., Wong, M.H.F, 2003. Estimating exchange rate exposures: some ‘weighty’ issues. Financial Management 32, 35–68 Bodnar, G.M., Hayt, G.S., Marston, R.C., Smithson, C.W., 1995. Wharton survery οf derivatives usage by U.S. nonfinancial firms. Financial Management 24, 77-88 Dufey, G., 1972. Corporate finance and exchange rate variations. Financial Management 1 (2), 51-57. Galati, G., Tsatsaronis, K., 2003. The impact οf the Euro on Europes financial markets. Financial Markets, Institutions and Instruments 12, 3 Jorion, P., 1990. The exchange-rate exposure οf U.S. multinationals. Journal οf Business 63 (3), 331-345 Jurgen schrempp, Newsweek Special Issue 9/1998-2/1999 Rajan, R., Zingales, L., 2003. Banks and markets: the changing character οf European finance. NBER Working Paper 9595 Fratzscher, M., 2002. Financial market integration in Europe: on the effects οf EMU on stock markets. 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