Special Topics in Banking & Finance Ch 6

8/9/2019 Special Topics in Banking & Finance Ch 6

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Chapter 6: Financial Globalization


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Ke yword : AssetsAn asset is a resource with economic value that an

individual, corporation or country owns or controls

with the expectation that it will provide future benet !• Assets can be classied as either:

1. Debt instruments

– "xamples include bonds and deposits!

– #hey specify that the issuer must repay a fxed amountre$ardless of economic conditions!

or

2. Equity instruments

– "xamples include stoc%s or a title to real estate &propertyconsistin$ of land or buildin$s'!

– #hey specify ownership &e(uity ) ownership' of variable prots or returns, which vary accordin$ to economicconditions!


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Ke y w or d : Fi na nc i a l * e cu r i t yA fnancial security is a tradable asset o any

kind. *ecurities are broadly cate$orized into:

1. Debt securities, such as deposits and bond a debtinvestment in which an investor loans money to anentity &corporate or $overnmental' that borrows thefunds for a dened period of time at a xed interest

rate-!2. Equity securities, such as common stoc%s &a

security that represents ownership in a corporation or areal estate'!

3. Derivative contracts: a derivative is a security

whose price is dependent upon the price of another

underlyin$ assets, such as &.' futures, &/' forwards, &0'

options and &1' swaps!


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.2 Futures Contracts• A uture contract is a nancial contract obligating the buyer

to purchase an asset &or the seller to sell an asset', such as a

physical commodity or a nancial instrument, at a

predetermined future date and price!

• Futures can be used either to hed$e &to loc% in a certain

price and reduce ris%' or to speculate on the price

movement of the underlyin$ asset! For example, a producer

of corn could sell a future contract to hed$e!


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/2 Forwards Contracts• A customized contract between two parties to buy or sell an

asset at a specied price on a future date! A forward

contract can be used for hed$in$ or speculation, althou$h

its non2standardized nature ma%es it particularly apt for

hed$in$!

• 3nli%e standard futures contracts, a forward contract can be

customized to any commodity, amount and delivery date!


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02 4ptions Contracts• A buyer purchase an option contract to hold the ri$ht of

carryin$ out a certain transaction in a predetermined

period of time and price 2 hence the name! For example,let5s say you purchase an otion on shares of ntel &7#C'with a stri%e price of 819 and an expiration date of April .6! #his option would $ive you the ri$ht to purchase .99shares of ntel at a price of 819 on April .6 &the ri$ht to do

this, of course, will be valuable only if ntel is tradin$ above819 per share at that point in time'!

• !"e seller "as t"e obligation to sell t"e underlying

asset to the buyer at a specied price by a specied date! eanwhile, the buyer of an options contract hasthe ri$ht, but not the obli$ation, to complete thetransaction by a specied date! ;hen an option expires, ifit is not in the buyer5s best interest to exercise the option,

then he or she is not obli$ated to do anythin$!


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12 *waps Contracts• A swap is a derivative in which two counterparties exchan$e

cash


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Keyword: Financial ar%ets

Financial mar%ets are a $roup of mar%ets &in=ondon, #o%yo, 7ew Dor%, *in$apore, and othernancial cities' that trade di>erent types ofnancial and physical assets &capital',

includin$: – stoc%s

– bonds &$overnment and private sector'

– deposits denominated in di>erent currencies

– commodities &e!$!, petroleum, wheat, bauxite, $old'

– derivative contracts & e!$!, forward contracts, futurescontracts, swaps, options contracts'

– real estate and land

– factories and e(uipment


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Financial Globalization 2Eenition

!"e term fnancial globali%ation reers to

t"e rocess by #"ic" fnancial markets o

various countries o t"e globe are

integrated as one.

&inancial globali%ation may also be defned

as a ree movement o fnance acrossnational boundaries #it"out acing any

restrictions.


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Gains From #rade

• ow have international capital mar%ets

increased the $ains from trade

• ;hen a buyer and a seller en$a$e in avoluntary transaction, both receive somethin$

that they want and both can be in a betterposition!

• A buyer and seller can trade: – $oods &a material possession which HcontainsH value

such as an automobile' or services for other $oods orservices &intan$ible activities'!

– $oods or services for assets!

– assets for assets


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Gains from #rade &cont!'

• Gains from trade of $oods and services for other$oods and services are described by t"e t"eoryo comarative advantage:

– ;ith a nite amount of resources and time, use thoseresources and time to produce what you are mostproductive at &compared to alternatives', then tradethose products for $oods and services that you want!

– @e a specialist in production, while enIoyin$ many $oods

and services as a consumer throu$h trade!


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Gains From #rade &cont!'

• !"e t"eory o intertemoral trade describesthe $ains from trade of $oods and services forassets, of $oods and services today for claims to$oods and services in the future &todays assets':

– *avers want to buy assets &claims to future $oods andservices' and borrowers want to use assets to consume orinvest in more $oods and services than they can buy withcurrent income!

–

*avers earn a rate of return on their assets, whileborrowers are able to use $oods and services when theywant to use them: they both can be in a better position!


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Gains From #rade &cont!'• !"e t"eory o ortolio diversifcation describes

the $ains from trade of assets for assets, of assets with

one type of ris% for assets with another type of ris%!

– nvestin$ in a diverse set, or portfolio, of assets is a way for

investors to avoid or reduce ris%!

– ost people most of the time want to avoid ris%: they would

rather have a sure $ain of wealth than invest in ris%y assets

when other factors are constant!

• 'eole usually dislay risk aversion( t"ey

are usually averse )"esitant,

unent"usiastic * to risk.


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Jortfolio Eiversication

• *uppose that / countries have an asset of farmlandthat yields a crop &capacity of Jroduction', dependin$on the weather!

• #he yield &return' of the asset is uncertain, but withbad weather the land can produce /9 tons of potatoes,

while with $ood weather the land can produce .99 tonsof potatoes!

• 4n avera$e, the land will produce ./ x /9 L ./ x .99) 69 tons if bad weather and $ood weather are e(uallyli%ely &both with a probability of ./'!

– #he expected value of the yield is 69 tons!

• *uppose that historical records show that when thedomestic country has $ood weather &hi$h yields', theforei$n country has bad weather &low yields'!

– and that we can assume that the future will be li%e the past!


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Jortfolio Eiversication &cont!'

+"at could t"e t#o countries doto avoid suering rom a badotato cro-


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J tf li Ei i ti


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• ;ith portfolio diversication, both countries could always enIoy amoderate potato yield and not experience the vicissitudes of feastand famine &food *horta$e'!

– f the domestic countrys yield is /9 and the forei$ncountrys yield is .99, then both countries receive

9B x /9 L 9B x .99 ) 69!

– f the domestic countrys yield is .99 and the forei$ncountrys yield is /9, then both countries receive

9B x .99 L 9B x /9 ) 69!

– f both countries are ris% averse, then both countriescould be made better o> throu$h portfolio diversication!

Jortfolio Eiversication&cont!'


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#he Jarticipants in Financial ar%ets

.! Commercial ban%s and other depository

institutions:

– Accept deposits!

– =end to commercial businesses, other ban%s,

$overnments, andor individuals!

– @uy and sell bonds and other assets!


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/! 7onban% nancial institutions such as securitiesrms, pension funds, insurance companies,mutual funds:

– *ecurities rms specialize in under#riting stoc%s and

bonds &a$reein$ to nd buyers for those assets at aspecied price' and in ma%in$ various investments!

– Jension funds accept funds from wor%ers and investthem until the wor%ers retire!

– nsurance companies accept premiums from policyholders and invest them until an accident or anotherunexpected event occurs!

– utual funds accept funds from investors and investthem in a diversied portfolio of stoc%s!

#he Jarticipants in Financial ar%ets&con'


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0! Jrivate rms:

– Corporations may issue stoc%, may issue bonds, or mayborrow to ac(uire funds for investment purposes!

– 4ther private rms may issue bonds or may borrow

from commercial ban%s!

1! Central ban%s and $overnment a$encies:

– Central ban%s sometimes intervene in forei$nexchan$e mar%ets!

– Government a$encies issue bonds to ac(uire funds,and may borrow from commercial ban%s or securitiesrms!

#he Jarticipants in Financial ar%ets&con'

4 > h @ % i


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4 > s h o r e @ a n % i n $

4>shore ban%in$ refers to ban%in$ outside of theboundaries of a country!

• #here are at least 0 types of o>shore ban%in$institutions, which are re$ulated di>erently:

.! An agency oce in a forei$n country ma%es loans andtransfers, but does not accept deposits, and is therefore notsubIect to depository re$ulations in either the domestic orforei$n country!

/! A subsidiary &auxiliary' bank in a forei$n country followsthe re$ulations of the forei$n country, not the domesticre$ulations of the domestic parent!

0! A oreign branc" of a domestic ban% is often subIect to bothdomestic and forei$n re$ulations, but sometimes may choosethe more lax re$ulations of the two!

? l ti f t ti l @ %i


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?e$ulation of nternational @an%in$

• @an%s fail because they do not have enou$h or the ri$ht %ind of

assets to pay for their liabilities!

– #he principal liability for commercial ban%s and other

depository institutions is the value of deposits, and ban%s

fail when they cannot pay their depositors!

– f the value of assets decline, say because many loans $o

into default, &failure to pay' then liabilities could become

$reater than the value of assets and ban%ruptcy could result!


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?e$ulation of nternational @an%in$ &cont!'

n many countries there are several types of

re$ulations to avoid ban% failure or its e>ects:.! Eeposit nsurance

– Jrotection provided usually by a $overnmenta$ency to depositors a$ainst ris% of loss arisin$

from failure of a ban% or other depositoryinstitution!n the 3!*! the deposit insurance covers only a xedmaximum amount per account holder &8/9,999'!

/! ?eserve ?e(uirements

– @an%s re(uired to maintain some deposits on

reserve at the central ban% in case they need cash!

? l ti f t ti l @ %i & t '


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3. Capital Requirements and Asset Restrictions

– i$her ban% capital &net worth' means ban%s have more funds

available to cover the cost of failed assets! – Asset restrictions reduce ris%y investments by preventin$ a ban%

from holdin$ too many ris%y assets and encoura$e diversication bypreventin$ a ban% from holdin$ too much of one asset!

4. Bank Examination

– ?e$ular examination prevents ban%s from en$a$in$ in ris%yactivities!

! =ender of =ast 4ption – n the 3!*!, the Federal ?eserve *ystem may lend to ban%s with

inade(uate reserves &cash'!

– Jrevents ban% panics!

– Acts as insurance for depositors and ban%s, in addition to depositinsurance!


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6! Government24r$anized @ailouts

– Failin$ all else, the central ban% or scal authorities may

or$anize the purchase of a failin$ ban% by healthier

institutions, sometimes throwin$ their own money into the

deal as a sweetener!

– n this case, ban%ruptcy is avoided than%s to the

$overnments intervention as a crisis mana$er, but perhaps

at public expense!

•. *afe$uards were not nearly suMcient to prevent the

nancial crisis of /99NO/99P!


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EiMculties in ?e$ulatin$ nternational @an%in$

.! Eeposit insurance in the 3!*! covers losses up to

8/9,999, but since the size of deposits in

international ban%in$ is often much lar$er, the amount

of insurance is often minimal!

/! ?eserve re(uirements also act as a form of insurance

for depositors, but countries cannot impose reserve

re(uirements on forei$n currency deposits in a$ency

oMces, forei$n branches, or subsidiary ban%s of

domestic ban%s!

EiMculties in ?e$ulatin$ nternational @an%in$


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EiMculties in ?e$ulatin$ nternational @an%in$&cont!'

0! @an% examination, capital re(uirements, and assetrestrictions are more diMcult internationally!

– Eistance and lan$ua$e barriers ma%e monitorin$ diMcult!

– Ei>erent assets with di>erent characteristics &ex!, ris%' exist in

di>erent countries, ma%in$ Iud$ment diMcult!

– Qurisdiction is not clear in the case of subsidiary ban%s: for ex!,

if a subsidiary of an talian ban% is located in =ondon butprimarily has o>shore 3!*! dollar deposits, which re$ulators

have Iurisdiction


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EiMculties in ?e$ulatin$ nternational@an%in$ &cont!'

1! 7o international lender of last option for ban%sexists!

– #he nternational onetary Fund &F' sometimes actsa Rlender of last optionS for governments with balance

of payments problems!! #he activities of nonban% nancial institutions

are $rowin$ in international ban%in$, but theylac% the re$ulation and supervision that ban%shave!

6! Eerivatives and securitized assets ma%e itharder to assess nancial stability and ris%because these assets are not accounted for onthe traditional balance sheet!

– A securitized asset is a combination of di>erent illi(uidassets li%e loans that is sold as a security!


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nternational ?e$ulatory Cooperation• /asel accords &in .PTT and /996' provide standard

re$ulations and accountin$ for international nancialinstitutions!

– .PTT accords tried to ma%e ban% capital measurementsstandard across countries!

– #hey developed ris%2based capital re(uirements, where more

ris%y assets re(uire a hi$her amount of ban% capital!

• 0ore rinciles o eective banking suervisionwas developed by the @asel Committee in .PPN forcountries without ade(uate ban%in$ re$ulations and

accountin$ standards!

"xtent of nternational Jortfolio Eiversication


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"xtent of nternational Jortfolio Eiversication

• n .PPP, 3!*!2owned assets in forei$n countriesrepresented about 09B of 3!*! capital, while forei$n

assets in the 3!*! represented about 06B of 3!*! capital!

– #hese percenta$es are about times as lar$e aspercenta$es from .PN9, indicatin$ that international

capital mar%ets have allowed investors to diversify!

• =i%ewise, forei$n assets and liabilities as a percent ofGEJ has $rown for the 3!*! and other countries!

• *till, some economists ar$ue that it would be optimal ifinvestors diversied more by investin$ more in forei$nassets, avoidin$ the Rhome biasS of investment!

"xtent of nternational ntertemporal #rade


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"xtent of nternational ntertemporal #rade

• f some countries borrow for investment proIects &for

future production and consumption' while others lend

to these countries, then national savin$ and investment

levels should not be hi$hly correlated!

– ?ecall that national savin$ O investment ) current account!

– *ome countries should have lar$e current account surpluses as they

save a lot and lend to forei$n countries!

– *ome countries should have lar$e current account decits as they

borrow a lot from forei$n countries!

• n reality, national savin$ and investment levels are

hi$hly correlated!


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"xtent of nternational ntertemporal #rade &cont!'

• Are international capital mar%ets unable to allow

countries to en$a$e in much intertemporal trade

• 7ot necessarily: factors that $enerate a hi$h savin$

rate, such as rapid $rowth in production and income,

may also $enerate a hi$h investment rate!

• Governments may also pass policies to avoid lar$e

current account decits or surpluses!

E$tent o normation !ransmission and &inancial 0aital


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E$tent o normation !ransmission and &inancial 0aitalobility

;e should expect that interest rates on o>shore currency

deposits and those on domestic currency deposits within a

country should be the same if :

– the two types of deposits are treated as perfect

substitutes,

– assets can erences in rates!

n fact, di>erences in interest rates have approached zero as nancialcapital mobility has $rown and information processin$ has becomefaster and cheaper throu$h computers and telecommunications!

G l f ti


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General nformation

+"at is D' )ross Domestic 'roduct*

#he GEJ is one the primary indicators used to $au$e the health of a country5s economy!

t represents the total dollar value of all $oods and services produced over a specic

time period 2 you can thin% of it as the size of the economy!3sually, GEJ is expressed as a comparison to the previous (uarter or year! For example,

if the year2to2year GEJ is up 0B, this is thou$ht to mean that the economy has $rown

by 0B over the last year!

easurin$ GEJ is complicated &which is why we leave it to the economists', but at its

most basic, the calculation can be done in one of two ways: either by addin$ up what

everyone earned in a year &income approach', or by addin$ up what everyone spent

&expenditure method'! =o$ically, both measures should arrive at rou$hly the same total!

Special Topics in Banking & Finance Ch 6

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