Concept of Financial Deregulation and Capital Control - Essay Example

?Finance and Accounting Table of Contents Introduction 3 2.Role of Financial Deregulation and Capital Control on Financial Globalization and International Diversification 4 2.1.Concept of Financial Deregulation and Capital Control 4 2.2.Drivers of Financial Deregulation and Capital Control 5 2.3.Opportunities and Challenges in Financial Globalization and International Diversification 6 3.Financial Innovations and Technology on International Investments 7 3.1.Product Innovation in Finance 7 3.2.Contribution of Technology 8 3.3.Present Scenario of Emerging International Investments 8 4.Carry Trade Strategy 9 4.1.Mechanism of Carry Trade Strategy 9 4.2.Benefits and Risks in Carry Trade Strategy 10 5.Role of International Capital Markets in Increasing Share Price and Reducing Cost of Capital 11 5.1.Mechanism of International Capital Markets 11 5.2.Determinants of Share Price and Cost of Capital 11 5.3.International Capital Market Influencing Share Price and Cost of Capital 12 6.Conclusion 13 7.Reference 14 1. Introduction The global financial have been experiencing a rapid growth in last two decades and considering the present scenario of the global market, it can be claimed the market is emerging with major developments. The globalization of financial market has been passing constant developments which have been led by the concept of globalization and internationalization. Globalization has influenced the entire human activities including their culture and life style. In case of the business, the globalization has led to bring significant improvement including the process of management. The thought process of managers and owners has changed as they have started to realize their responsibilities. On the other, with this internationalization of business, the entire global business is also suffering from complexities and intensified competition. However, in order to cope with these complexities and competition, the business organizations have also developed a number of effective tools and techniques. In the same manner, the global financial markets have also emerged as an important and developed industry. Finance always has been a vital area for the every individual and institution. With the increasing the globalization of business, the necessity of financial services has also been frequently. The global the financial institutions and companies have realized the underlying opportunities in global platform and they keep expanding their market. In this course of development in the global financial markets, there are certain influencing factors. This paper will attempt to discuss important aspects of international financial markets which have led to bring such development. The overall discussion will be presented in four major sections followed by a concluding remark. The first will address the role of financial deregulation and capital control in international diversification. The next section will offer s discussion the two major drivers of financial i.e. technology and innovation in global financial market and it will be followed by a description and mechanism of carry trade strategy. Finally, the influence of international capital market on share price and cost of capital will be explained followed by an overall conclusion. 2. Role of Financial Deregulation and Capital Control on Financial Globalization and International Diversification 2.1. Concept of Financial Deregulation and Capital Control The importance of the financial deregulation has started to rise with increasing opportunities in the global market place. Financial deregulation can be referred as abolishment of restrictive laws that often cause barriers for the financial institutions. Financial deregulations are important and similar as the free trade policies. Both, the financial deregulation and free trade policy strive to bring development in the market by increasing competition Hope and Maeleng have defined the free trade policies as “competitor-enhancing device” as it is meant to discard the unnecessary restriction and barriers by offer better opportunities to the international as well as the domestic business organizations (Hope and Maeleng, p.61). In the same manner, the financial deregulation strives to offer freedom to the financial institutions for the better performance of industry that will further bring a positive impact on the entire economy. On the other hand, the capital control is the process of the taking necessary steps for regulating the limits of the capital inflow as well as outflow. In order to implement capital control within an economy, the regulatory bodies uses the certain economic tools like taxes, interest, FDIs, volume restrictions, tariffs and other market based forces. The capital control have an direct impact on the financial assets classes like bonds, equities, mutual funds, foreign exchange rates etc. Many economists have argued that it leads to limit the growth of an economy by restricting the capital flows which very important in this emerging economic development (Quirk, p.10). 2.2. Drivers of Financial Deregulation and Capital Control The steps for implementing financial deregulation and capital control are mainly taken by the policy makers of an economy. However, assuming the logical and rational behaviors of these economic policy makers, the financial deregulations and capital control policies are imposed to bring the economic enhancement. Therefore, the financial and economic related policies are mainly driven by the urge for bring economic stability within a market. In this broad reason of economic enhancement, there are also certain specific drivers for the financial deregulation and capital control. In these regard three major drives should be given priority i.e. financial stability of the financial market, monetary policies and financial liberalizing. Financial stability has become a major concern for the entire world economy after the severe financial crisis of 2007-2008. The reason behind the latest financial crisis was the misuse of the financial deregulation and failure of regulatory bodies. However, prior this sever crisis, the U.S. market was proved to be one of the fasted growing global financial market. Now, the regulators have realized to control the financial deregulation. Besides, the financial deregulations and capital control also have a direct impact on the macroeconomic variables like domestic monetary control. Financial deregulations and capital control influences the interest rates of the loan market which finally influence the monetary supply within an economy (Grauwe, p.387-390). Financial liberation is the core concept in financial deregulations. Financial liberalization can be divided into two group i.e. internal and external financial liberalization that strive to offer liberalization for the domestic and international financial institutions (Ghosh, p.4). 2.3. Opportunities and Challenges in Financial Globalization and International Diversification In the course of the internationalization of the financial market and international diversification led by the financial deregulations, a number of opportunities and challenges can be identified in the prevailing scenario. In case of financial globalization, the latest development includes the new ways of capital inflows and outflows, and internationalization of the financial services. After the financial deregulations, the frequencies of the FDIs the developing as well as in the developed countries has increased by offering better economic developments. In developing countries like China, India, Korea, Taiwan etc the FDIs have played a crucial role in their economic development. Besides, the multinational enterprises also enjoy a better opportunities for expanding their market share in global markets. Moreover, the foreign investors have the opportunities to invest in a host county by means of making investments in equity, bond, banks and other related borrowing systems. Secondly, the importance of the international financial service has also increased international financial intermediaries are playing a crucial role in host countries investment and borrowing activities. Currently, financial markets like bonds and stock are offering better opportunities for making better return on their investments (Schmukler, p.4-6). On the hand, the financial global markets is also suffering from the certain significant challenges like microeconomic risks that may cause fatal consequences for the economy like increased inflations, exploitation of domestic market, financial crisis etc. Takatoshi Kato, Deputy Managing Director of International Monetary Fund have claimed the latest financial turmoil still remains a great threat for financial markets including the asset management industry for the Asia Pacific regions, and he has also mentioned to learn the lesson for this crisis (Kato, “International Monetary Fund”). Schmukler (2001) has also given similar argument for and commented that global financial market needs more regulatory actions. He also pointed out that the due to the emergence of international financial market, the exposure to the foreign shocks have become higher. Due to frequently transaction between two economies, the interdependency has increased and thus, “real linkages that cause contagion have generally been associated with trade and/or FDI” (Schmukler, p.11). 3. Financial Innovations and Technology on International Investments 3.1. Product Innovation in Finance The innovation in the financial market in terms of product development in very frequent and attractive as the innovative financial products strive to bring better flexibilities for the investors as well as for the borrowers. Apart from the traditional the financial products like bonds, loans, equities etc, there have a numbers of financial products have been evolved e.g. mortgage loans, options, mutual funds, different types of insurance products and other investment opportunities etc. There is a great debate over the usefulness of the financial innovation in case of product development. The first group of scholars advocates the product innovation in the financial market; whereas, the other group argues that product innovation often leads to financial instability by pointing out the past evidences of financial crises. However, the fact is behind this debate is the financial innovation is necessary but in most of the cases, product innovations by the financial institutions are not being scanned by the regulators. The past experiences have given enough evidences that innovation are indispensible but improper regulations of the financial innovate product has also led to major financial crises (Reuter, “economics”). 3.2. Contribution of Technology The previous section has described the innovation in financial product which has been often criticized for bringing threat to the stability of financial market. However, in case of technological innovation in financial market, it has given a new rise of the international financial investments. Currently, the use of technology has become inevitable tools for multiple purposes in financial sectors i.e. for trading, for analyzing, for transactions and for better market communication. In case of global retail banking sectors, the technology has played very significant role in increasing the productivity and profitability. Prasad and Harker have studied the impact of IT on banking sector of U.S. and they have found that IT labor has been proved crucial in enhancing the efficiency of the banks by proper controlling and designing (Prasad and Harker, p.28). With the significant development in the technologies, the procedures of investment in domestic and international market become quite very flexible and easier. In this respect, IT and technology have made very pertinent contributions. Today, the entire trading activities of equities, bonds, mutual funds, commodities etc can be conducted through using internet and investors and clients can avail their necessary services on 24/7 operations basis offered by the financial institutions (Phillips, “Technology - the power behind investment banking”). 3.3. Present Scenario of Emerging International Investments Since the last two decades, the financial markets including the domestic and international, there has been constantly changing. In this regard, the role financial innovation and technological improvement in financial activities have are two major determinants that has brought changed face of present financial markets. In case of successful financial product development, the investors’ portfolios can be maintained more efficiently as currently, there are a number of investment opportunities available in different markets which help them to enjoy the benefit of diversification. On the other hand, the technological innovations have made the entire process of investments very transparent and less time consuming that helps the investors to capture the available market opportunities. The governments and regulators are also becoming more conscious regarding the financial stability and retention of investors’ trust on the market. Hence, due to the above sated factors, the rate of investment made in the foreign market is also increasing significantly (Peiris, p.3-5). 4. Carry Trade Strategy 4.1. Mechanism of Carry Trade Strategy In the case of international financial investment, it is necessary to frame and follow specific and effective strategies as there are a number of risks associated with the process of investments in foreign market. In this regard, the carry trade strategy is very effective. This strategy is becoming more quite popular among the foreign investors for making higher profit within a pre-determined risk level. Carry trade is typically used as an investment strategy exclusively for the investments in the international markets. Carry forward strategy can be used in case of interest rate and currencies. In case of carry trade currencies, an investor borrows the required fund at lower interest currency for lending the borrowed fund at higher interest rate. The difference between the borrowing rate and lending rate determined the return from the investments. Besides, the profitability of the investment in carry trade remains very high due to due to the leverage. In case of the interest parity becomes uncovered; the investors will be expected to earn zero profit (Burnsidey, p.1). Carry trade strategy combines the two major financial aspects to earn the profit i.e. the currency rate and interest rate and this is its unique feature. It aims to diversify the risk of the fluctuating currency rates by clubbing it with the fund borrowed at specific interest rate. 4.2. Benefits and Risks in Carry Trade Strategy The carry trade strategy can also be defined as a tool for speculation that offers return at a specified return at pre-determined risk. Therefore, there are certain benefits and risks in carry trade strategies which are quite similar to other speculative instruments. The most attractive benefit of carry trade strategy is that it defines the amount of risk or loss prior to actual settlement is made. In case of currency carry trade. It involves the interest rate and currency rate. In case of the constant currency rate, the profit will be the return on total investment less the chargeable interest rate. In this case, other major benefit of carry trade strategy is that due to leverage factors, the return on investment remains very high. If properly hedging can be framed, there are higher chances of making profit “from a loss of volatility” (Cofnas, “Volatility”). On the other hand, the multiple types of risks are directly associated with the carry trade strategy. Firstly, the carry trade strategy strives to make profit based on the rate of interest and currency rates. These are two major macroeconomic factors and are subjected to fluctuate with the economic performance. In case of fixed interest rate, the risk is quite low but in case of foreign currency, it is quite uncertain. The loss from the carry trade strategy may be determined but the chances of making losses due to volatile currency rates are very high. 5. Role of International Capital Markets in Increasing Share Price and Reducing Cost of Capital 5.1. Mechanism of International Capital Markets After the rapid financial deregulations and internationalization of financial services intermediates, the international capital market has been evolving very rapidly. The international markets are the different from the domestic capital market on the two major grounds i.e. the capital market law (financial regulations) and scope for the foreign investments. Apart from these two major differences, the investors from any part of the world can make their investment in a foreign capital market if the host country allows foreign investment. Like the domestic capital market, in the international capital market, the investors can get into the transaction and investment of equity, debenture, mutual funds, hedge funds, currencies and other types of the equity trade commodities etc. After the technological improvement, the investments made in the international capital market become more prominent and frequent. Today, the international capital market plays very significant role in economic development by developing microfinance, smoothing consumption, making proper and efficient capital allocation, and it also reduces the economic risk by sharing international risk (Lane, “Economics of Capital Flows”). 5.2. Determinants of Share Price and Cost of Capital The stock prices and the cost of capital are toe important aspect for the investors as well as for the listed companies. The price of a share is very useful for making economic decision and for managing a portfolio. However, due to fluctuation in the share prices, the shares become riskier. There are a number of determinant that determines the price of at a specific point of time. Primarily, there are two major factors which influence the price of share i.e. demand and supply but these two factors are mainly influenced by a number of factors i.e. dividend, performance of company, leverage, earning per share, GDP, national income, interest rates, behavioral finance, available information, foreign currency etc (Nirmala, Sanju and Ramachandran, p.1). Cost of capital is necessary for estimating the required rate of return from the any investment made in a listed company. The cost of capital is computed using the capital structure that generally includes equity, debt and preference. Therefore, weighs and cost of these capital items are major determinant of cost of capital. The cost of each capital items are varies with the industry and country. In case of a country with higher business and other types of risks, the required rate of return should be higher as investors face a greater risk. The cost debt mainly depends on the interest rate set by the government which is later adjusted as per their risk class (Patterson, p.2-3). 5.3. International Capital Market Influencing Share Price and Cost of Capital In the previous section, the mechanism of international capital market has been described which has a direct influence on multiple aspect of an economy. Basically, the international capital market strives to bring major developments in the economy by making efficient allocation of capital and by sharing the financial risks. In the course of these, the share prices and cost of capital are also influenced by the activities of international capital market. When foreign investors make indirect investments in stock market of a host country, the price of share goes up due to increase in the demand of shares. The international capital market has a direct influence on the on the asset pricing which influencing the expected rate of return causing constant adjustments in the demand and supply curve. Based on the international asset pricing, the investor can enjoy a greater international diversification benefits and cost can also be diversified. Better access of the global market allows the firms to reduce the cost of capital. Moreover, in case of FDI, the MNCs often seek the lower cost of capital. Besides, “competitive cost of capital depends on firm-specific characteristics that attract international portfolio investors and the liberalization of markets where companies have the freedom to source capital in liquid markets” (Jeffus, “Global Cost of Capital”). 6. Conclusion This paper has presented important aspect of international finance by focusing on the certain specific areas. The emergence of international finance is led by the globalization and international trade. With the passage of time, the economies have realized its growing importance and hence, they bring the financial deregulation which provides better platform to perform; whereas, the capital control is often blamed for restricting economic development. The process of the expansion of international financial market becomes rapid due to constant financial product development and contribution of the technology in the financial activities. Carry trade strategy is similar to derivative instruments which have a defined risks and it mainly involves the interest rates and foreign currency rates. The international financial capital market plays a very significant role in bringing development within an economy and it also influences share price and cost of capital. 7. Reference Burnsidey, C. July 2008. Carry Trades and Currency Crashes: A Comment. July 6, 2011. . Cofnas, A. “Volatility”. The Forex Options Course: A Self-Study Guide to Trading Currency Options. John Wiley and Sons. 2008. Ghosh, J. October 2005. The Economic and Social Effects of Financial Liberalization: A Primer for Developing Countries. July 6, 2011. . Grauwe, P. D. 1987. Financial Deregulation in Developing Countries. July 6, 2011. . Hope, E. and Maeleng, P. Competition and trade policies: coherence or conflict. Routledge. 1998. Jeffus, W. D. “Global Cost of Capital”. No date. International Capital Markets, Asset Pricing and Financing the Firm. July 6, 2011. . Kato, T. “International Monetary Fund”. December 12, 2007. Challenges and Opportunities from Financial Globalization for Fund Managers and Policy Makers in the Asia-Pacific Region. July 6, 2011. . Lane, P. R. “Economics of Capital Flows”. February 2010. International Capital Markets: MSc. July 6, 2011. . Nirmal, P. S., Sanju, P. S. and Ramachandran, M. 2011. Determinants of Share Prices in India. July 6, 2011. . Patterson, C. S. The cost of capital: theory and estimation. Greenwood Publishing Group. 1995. Peiris, S. J. April 2010. Foreign Participation in Emerging Markets’ Local Currency Bond Markets. July 6, 2011. . Phillips. “Technology - the power behind investment banking”. 2006. Working in Information Technology, Business Sectors: Investment Banking. July 6, 2011. . Prasad, B. and Harker, P. T. 1997. Examining the Contribution of Information Technology Toward Productivity and Profitability in U.S. Retail Banking. July 6, 2011. . Quirk, P. J. Capital account convertibility: review of experience and implications for IMF policies. International Monetary Fund. 1995. Reuter. “economics”. April 11, 2010. How financial innovation causes crises. July 6, 2011. . Schmukler, S. L. May 30, 2001. Financial Globalization: Opportunities and Challenges for Developing Countries. July 6, 2011. . Read More