International Financial Markets and Their Economic Importance - Essay Example

International Financial Markets Contents Contents 2 Introduction 2 Discussion 3 Financial System Structure 3 Financial markets and their economic importance 4 Importance of Bond Market 6 Importance of Equity Market 8 Importance of Foreign Exchange Market 10 Importance of Derivatives Market 11 Conclusion 12 References 13 Introduction Financial markets are vital for any economy. They channel the funds from firms, households and the governments which they have surplus funds to those who have shortage of funds as they spend more than their level of income. Primarily governments, corporations, households, foreigners have excess funds with them and hence they lend them. They lend such surplus fund to the borrowers like households, businesses, governments who want to finance their personal expenditures like purchase of houses, cars and furniture. This kind of flow of funds form the lenders to the borrowers follows two ways known as direct finance and indirect finance. In the former concept the borrowers have access to the finance from the lenders directly. They do this by selling their fiscal tools which represent a claim on the potential proceeds and assets of the borrower. Financial instruments are assets for individuals who buy them and are liabilities for individuals who sell them. Through this process of buying and selling of securities the flow of money is occurs in the economy which is very vital for the economy. Hence financial markets are the medium through which such transactions happen. The financial markets comprises of equity market, debt market, derivative market and foreign exchange market. Each of this market acts as the medium of flow of fund in the economy. This report will analyse the importance of the financial markets and the role which they play in the development of international trade and economic development. Discussion Financial System Structure The financial system of an economy comprises of three components Financial markets Financial institutions Financial regulators Each of the above components has a specific role in the economy. The financial institutions are important players in the financial markets since they perform the role of an intermediary and hence they determine the flow of funds. The financial regulator’s role is to monitor and regulate the participants of the monetary system. At the heart of this is the fiscal market. It facilitates in the flow of funds in the economy (Cho, 1989, pp. 88-92). Figure 1: Structure of Financial System The financial institutions use financial instruments to regulate the flow of funds in the economy. Financial assets or financial instruments are intangible assets that are expected to provide future benefits to the owner of the instrument in the form of future cash. Some financial instruments are known as securities which include bonds and stocks (Fry and Maxwell, 1995, p. 282). Financial markets and their economic importance Financial market is a place where there is exchange or trading of financial instruments. The major economic functions of the financial markets are Liquidity Price discovery Reduction of transaction costs. Liquidity The financial markets provide an opportunity to the investors to sell their financial instruments. Liquidity means the ability of an investor to sell an asset in the market at its fair market value anytime he wants. Without this liquidity, an investor had to hold on to the financial instrument till the conditions arise to sell it or the issuer of the asset is contractually obligated to clear the obligation (Stiglitz, 1989, pp. 55-61). The liquidity of an equity instrument is until the company is liquidated voluntarily or involuntarily. For a debt instrument liquidity comes when it matures. All international financial markets provide some liquidity to the investors though they have different degrees of liquidity associated with it (King, Robert and Ross, 1993, pp. 717-723). Price discovery It denotes to the determination of the price of a traded asset in a financial market by means of transactions between buyers and sellers. The required rate of return on the invested amount is determined by the participants in the financial market. The demand and supply for such instruments determines the required rate of return of the instrument. These market forces signals how the funds flow from those who want to invest or lend to those who needs such funds. Reduction in the transaction costs Reduction of transaction cost happens when the financial market participants bear the cost of trading the financial instruments. The economic rationale for existence of financial instruments and institutions are related to the transaction costs. Hence the instruments and institutions which survive have the lowest transaction costs (Levine and Ross 1997, pp. 688-696). The financial markets create a strong incentive for investment into the economy which fosters trade and business in the international market thus establishing linkages between them and facilitating technology diffusion and improved use of resources. The financial markets mobilize savings for productive investment and there by facilitates the flow of capital into the market which again stimulates investment into the economy (Saint-Paul, 1992, p. 738-744). The financial market helps channel the savings into productive uses by analysing the informations about investment opportunities. Financial system can improve the efficiency in the corporate sector by monitoring and exerting corporate controls. Both the private as well as public sector operators uses the various financial instruments to raise and invest the short term funds so that it can be easily liquidated to meet their short term needs. The Central government can borrow money from the public to finance their long-term investment projects. They do this by issuing the treasury notes and bonds (Filer, Hanousek and Campos, 1999, p. 11). The government uses the proceeds from the bonds to construct roads, build public hospitals, airports, provide public transports, construct dams and build other social infrastructures. This helps the creation of national wealth for economic growth. Importance of Bond Market Bond market is a type of a monetary market where the investors buy and sell debt instruments. It is an instrument which promises to pay the owner of the instrument a fixed income for a specified period of time. There are mainly five types of bond markets in the world. Government Bonds Corporate Bonds Municipal Bonds Funding Mortgage backed securities and collateralized debt obligation. An efficient bond market conveys market discipline to the international trade and thus in the economy. For an economy to have a real bond market the interference from the government must be zero. The investors must be liberated to make their decisions on the economic criteria alone like risk and expected return of the instrument. There shouldn’t be any pressure on the bond investors or bond prices due to industrial policy (Sokoler, 2001, p. 125). The most important constituent in an efficient bond market is the fiscal reporting system of the companies which is dependable, pertinent and appropriate. The British, U.S. and Australian accounting system are closet to the ideal. It is important for the potential investors since with advancements in the fiscal statement of the borrower company the sounder will be the decisions making process for the investors. An efficient corporate bond market is definite to improve the economic welfare since it encompasses a wide range of liquid financial debt instruments with diverse maturities and having default jeopardises ranging from very high to very low (Driffil, 2010, p. 12). A smooth bond market results in the presence of a mechanism of efficient reorganization in case of bankruptcy or default. Such a device gives a suffering organization shield from its creditors while the firm works out a plan for liquidation or rehabilitation. The creditors can expect partial restoration in securities or cash. This lack of fair and efficient reorganization mechanism appear to be responsible for the slowness of Japan is dealing with the nonperforming loans (Hakansson, 1999, p. 11). The chief entities accountable for the amplification in the demand for bonds are assurance companies as well as the pension funds which aim to focus on the long term needs. These institutions are undergoing a rapid growth in Europe. These institutional investors spend slight or no leverage. It will shed an advantageous effect on the systematic risk (Mishkin and Eakins, 2012, p. 86). Importance of Equity Market Equity market is also known as the Stock market. Equity market is a public or private market for the company stock and the derivatives of the company stock. Common stock of a company represents the ownership share in that company. Issuing shares and selling it to the public is the process through which corporations raise funds so that they can finance their activities (Bank for International Settlement, 2012, p. 116). USA is the world’s biggest stock market followed by Canada, China and India (Levine, 1996, p. 7). In the past decade, the global equity markets have seen explosive growth. The overall capitalization rose to $ 15.2 trillion from $ 4.7 trillion globally (Andriansyah and Messinis, 2007, p. 16). It has been seen that stock markets have lower the charge of channelling the cutbacks and thus have facilitated investments in the productive technologies. In 1994 Obstfeld has shown that international risk sharing by the internationally assimilated stock markets consequences in advanced resource allocation and accelerated growth. Liquidity in the equity market plays a crucial role in the economic growth. Though profitable investments needs long run commitment to the capital, savers prefer not to leave the control of their savings for long periods of time. This problem is eased by the presence of liquid equity markets. It provides assets to the savers which are easily liquidated whenever they need (Altman and Kishore, 2010, pp. 57-62). On the other hand it permits the organizations lasting admittance to capital which is raised through processes like issuing of equity. Thus by facilitating longer-term gainful ventures in the liquid markets, the distribution of capital is developed and it enhances the prospects of long-term economic growth and trade (Lettau, Ludvigson and Wachter, 2006, p. 11). Making the investment more profitable and less risky, the liquidity in the stock market can also result in more investment in the economy from outside the country in the form of Foreign Institutional investor and foreign direct investment. There are alternate views to it which argues that a very liquid market will result in investor myopia. The investors who are dissatisfied can easily sell the stocks and move out. Hence it can weaken the investors’ commitment and thus reduce the investors’ incentives to exert corporate control. Hence improved stock market liquidity can actually hurt the international trade and economic growth (Nishat and Shaheen, 2010, p. 6). However there is evidence which suggest that with improved stock market liquidity economic growth improves. There are three measures of liquidity in the stock market.. Over a long period of time, the value of the equity transactions as percentage of the GDP is likely to vary with ease of trading. This ratio was utilized to categorise 38 countries according to their stock market liquidity (Bosworth, 1999, p. 21). Figure 2: Chart showing Growth of GDP in relation to the liquidity of the stock market The above chart depicts that the nations which enjoyed liquid form of markets in 1976 grew much faster for the next 18 years as compared to nations with not so liquid markets. The second measure is the charge of stocks which are traded as a proportion of the entire capitalization in the market. The turnover ratio depicts trading comparative to extent of the equity market. It was seen that the more liquid the market is the faster is the growth of the economy (Johnson, 1993, p. 291). The third measure is the value-traded-ratio divided by the volatility in the prices of the stocks. It can be seen that markets which are more liquid can easily deal with heavy trading without much fluctuations in the price. All these show that there is strong connection between development of the stock market and outlook of the economy in the long run with international trade (Bekaert, Harvey and Lundlad, 2003, pp. 275-280). Importance of Foreign Exchange Market The market for foreign exchange deals with the procurement and trade of the national currencies. It exists because the economies employ national currencies. It is primarily an over the counter market. It is hard to forecast the actual dimension of the foreign exchange market since it is traded in many markets. In 1998, Fed estimated that the turnover of foreign exchange is $ 351 billion per day which is 43 percent increase over 1995. The daily trading volumes in the foreign exchange market exceeds $ 1 trillion which is much larger than the volumes on the New York Stock Exchange (Barker, 2007, p. 10). Figure 3: Foreign Exchange Turnover by Currency and Region Figure 4: Global Average Daily Trading Volume in Foreign Exchange The trading amounts in the foreign exchange market have increased as the obstacles to market admittance and the cost of dealing in the foreign exchange market have taken the downward sloping curve (John, 2003, p. 168). With larger trading volumes, broader range of market participants and rising ticket numbers the liquidity of most currency pairs have improved. This increased market participants has resulted in more diversified opinion in the market. Foreign exchange currency market is open. With more cash flow between the countries it gives the economy a boost and the balance of payment crisis will not happen. Whenever a government suffers from balance of payment the economy is in crises, it has to borrow from the external banks like World Bank at high interest rates (Valdez and Molyneux, 2010, p. 286). Importance of Derivatives Market Derivatives instrument allows the redistribution or sharing of the risk. They are used to protect or hedge against specific exposure of a company like protecting the firm against interest rate change, movements in the asset prices, or default of a creditor. It can also be used by the market participants who can speculate on the movement of price of the underlying assets without even owning the assets (Chui, 2010, p. 5). It allows a company to effectively manage the exposures it has due to the external influences over which it has no control. For example the aviation sector is exposed to fuel prices. British Airways has 32 percent of the operating expenses spent on fuel in 2009. Hence this disclosure through the exercise of derivatives permits the firm to spotlight on their core business (Fabozzi, Modigliani and Jones, 2012, p. 64). Hence by using future derivatives to procure its fuel in advance at a set price the firms are sheltered against any rise in the price of fuel which may take place in the near future. Some market participants have criticised that it is a tool for speculation. In Derivative, one party reduces its risk while other takes on the risk (Clark, 2002, p. 128). Thus the parties can speculate on the price of the underlying asset without necessarily having to have possession of the asset. The derivatives can be used as a speculative tool and lack of transparency may incline the investors to take on high risks and it can contribute in destabilizing the market (Madura, 2012, p. 89). Conclusion The financial markets are vital for any economy. They channel the funds from firms, households and the governments which they have surplus funds to those who have scarcity of finances as they pay out in excess of their level of earnings. It is seen that economy of a country depends on the financial markets. The economic growth of a country depends on the stock, debt, foreign exchange and derivatives market. Each has its own significance in the way it contributes to the development of the economy. They also contribute to the improvement of international trade across the border. Hence every country needs to promote and develop their financial markets so that they can grow at a faster rate in this globalized economy. References Altman, E.I. and Kishore, V. M. 2010. “Almost Everything You Wanted to Know about Recoveries on Defaulted Bonds,” Financial Analysts Journal, Vol. 52 (6), pp. 57-62. Andriansyah and Messinis, G. 2007. Equity markets and economic development: Does the primary market matter? 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