Essay: International Financial Markets and Institutions

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International Financial Markets and Institutions

During the past decades, a trend of increased volume and mobility of capital flows has been observed in the global financial markets. According to a rough estimate, global GNPs annual value is now less than financial transactions' volume in all the financial markets of the world. Increase in financial mobility can be attributed as a result as well as cause of the increased financial integration of the economy of the world. Increased financial integration also plays a vital role in creating an impact on the domestic financial markets. Some powerful economies' governments held negotiations among themselves so as to focus on the policy stances of each other with regard to interest rate, monetary and the exchange rate.

In earlier years, the capital flows (as a result of differentials in interest rates) were not directed well towards industrial countries. But, in 1990s', these capital flows made emerging markets as their destinations. According to an estimate, the capital flows were only $15 billion in 1990s which increased to more than $100 billion in 1993. This rapid change in capital flows was the result of following three reasons. One of the most important reasons for this change in trend was that the developing countries having high account surpluses and growth rate became very attractive for investment as they possess a very high potential for appreciation in currency and capital gains. Secondly, the interest rates of industrial countries decreased due to recession. Last, but not the least, major U.S. industrial investors adopted diversification of investment to international due to increased potential for capital gains and growth. (Tornell and Martinez 2003 pp.110-112)

In early years, the regulation of domestic financial market was a very successful act as it was in line with effective and efficient economic performance. Financial conditions in other countries are dependent on the change in interest rate of a country. In order to increase the financial & capital flows between countries, control of interest rate must be considered in these circumstances. Thus, monetary policy instruments' efficacy is limited which is generally aimed at macroeconomic balances domestically.

Financial deregulation was started by countries because regulation of financial markets was not achieving the expected results due to increase in financial integration partly, and partly because these regulations started to create hindrances in efficient functioning of the financial markets; while the same regulations were serving their purpose efficiently earlier. It should be kept in mind that deregulation is not without challenges. It resulted in increased interdependence and decreased functioning of macro-economy in ways which are beyond human understanding. Behavior of interest rates, exchange rates and capital flows has been affected by financial deregulation in an unanticipated manner. (Tornell and Westermann 2005 pp.43)

The adoption of financial deregulation by emerging markets resulted in increased efficiency of these markets by reaping the benefits, on one hand, and paying the costs of being linked to the global capital market, on the other hand. Capital flows are directly proportional to the economic prospects of a country. With the betterment of economic prospects, the capital flows increases; thus making the growth & investment opportunities wider and resources scarce. On the expense of export industries competitiveness, increase in capital flows result in currency appreciation or it can also result in domestic credit expansion; thus making inflation rates higher. Financial integration of global capital market have made the policy options way diverse from before.

Definition of Terms

Financial globalization is the process of creating one market through integration of all the markets of the world.

International diversification is a risk reducing technique aimed at investing in more than one markets.

Cost of capital is defined as the rate which a company can get if it invests in some other project with the same exposure to risk.

Cost of equity is the rate of return which a company gives to its stockholders.

Cost of debt is the interest rate which a company pays on its debts.

The Impacts of Financial Deregulation and Capital Control on Financial Globalization and International Diversification

Increased penetration of financial deregulation and capital controls have resulted in diversification and globalization of financial markets. Financial deregulation and capital controls have also pawed way to financial market growth which in turn have resulted in more competitive, restructured and low cost financial services industry. Along with this, the fast-paced deregulation has made the volume of financial transactions more than the international trade in goods and services. The resulting economic instability and uncertainty posed threats to the international diversification of capital flows. Global financial markets are open 24/7 and are so quickly responding to the changes that the danger for chain reaction is growing which in turn can result in precipitation of the global financial market.

A prime example of an economic activity are financial markets in which capital controls and regulations can result in inefficiency, distortions, etc. rather than promoting effectiveness and efficiency. These markets have the potential to adopt and adjust to changes rapidly and efficiently. Fungible assets are generally traded in these markets. "Due to improvements in computer technology and communication, fungibility of assets is prevailing on global level; with minimized costs of transactions." (Schneider and Tornell 2004 pp.883-913) This assets fungibility does not depend on the currency denominations. This type of financial environment encourages swift price changes affects all assets, creating an impact on the global market. Market equilibrium can easily be restored with these swiftly changing prices due to changing financial conditions.

Still, financial services industry represents only a single segment of any economy. In this industry, there is too much emphasis on expectations, trust and confidence with a sudden impact on influencing reactions and actions, than any other segment of economy. One of the main reasons for regulating the financial markets is to maintain the level of trust in financial agents. This activity has resulted in objectives of economic policy which are broader as compared to the past; thus subordinating the financial markets. For example, credit controls and interest rates served monetary policy, exchange rate stabilization through capital controls. Thus, we can say that controls and regulation of financial markets have supported in reduction of financial volatility feedbacks on further factor markets. This remained calm till early 80s when encroachment of public sector on economic activities emerged as a concern for industrial countries. This was a major concern and was also discussed intellectually in the classical economist's theories of 19th century. Reformist stance of free-market was also promoted for policy makers and governments of the top industrial economies.

Due to this reason, the deregulation of economic activities took place. The focus of deregulation was the financial markets as it was more rapid and pronounced in these markets. Competition was stimulated with related substantia due to fast paced innovation and resulting financial activities liberalization. Capital market efficiency gains, due to liberalization, increased with more liquidity. Also there is a reduction in financial intermediation costs. Short-term liability and asset management have been improved due to introduction of risk-minimization techniques. Last, but not the least, this liberalization and deregulation have resulted in improved ability of withstanding risks and capitalization. (Ranciere and Westermann 2006 pp.65)

These recent transformations of global capital market have resulted in increased financial and economic costs as well. Risks associated with off-balance sheet emerged due to security lending by the commercial banks. Future solvency of banks could be mortgaged by these off-balance sheet risks. On the other hand, monetary policy implementation was made complicated by the increased volatility of global financial market, together with heightened substitutability of money for financial instruments.

Generally speaking, the worst impact of financial deregulation is the disconnection of other economy sectors and the financial markets. The growth of financial service industry is more fast-paced as compared to other segments of the economy in major industrial economies. This in turn results in increased transaction volume of financial capital flows. The increased financial market volatility poses risks of destabilization for other sectors of the economy.

Impact Of Financial Innovations And Technology On International Investments

Financial innovations and technology play a vital role in enhancement of international investments by businesses. Businesses have utilized innovations in financial markets to generate streams of revenues and future capital gains; thus maximizing the overall profits. Indexed mutual funds, money market funds, securitized investments and exchange traded funds are the examples of international investments purchased by companies to maximize their profits. New financial investments are also the result of financial innovations. Instruments like CDS and CDOs are the examples of investments in international financial market. Most of the businesses are interested to invest in these instruments if and only if they get the surety that the risks in these investments are less than the amount of capital/financial gains from these investments.

The widespread implementation of computer and communication technology can be attributed to be the product of recent structural changes and innovation in financial market. "Worldwide information accessibility and launch of new service firms are the gains from this innovation and technology implementation." (Ranciere and… [END OF PREVIEW]

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