The Global Structure of Financial Markets

Dilip K. Ghosh, Dilip K Ghosh*Cnp*, Edgar Ortiz

• Publisher: Routledge
• Year: 2005
• ISBN:
  9781134779482
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

This volume uses the original research of experienced contributors to explore recent changes in financial markets. Areas discussed include Latin America, Europe, the USA, Mexico and India. The book updates issues including: * Risk and its minimization
* Business enterprise on world markets
* Capital flows and capital flight
* Offshore markets
* Central bank intervention

1

INTRODUCTION

The global structure of financial markets: an overview

Dilip K. Ghosh and Edgar Ortiz

The global structure of financial markets is a major and yet a topical issue because of its practical importance and theoretical significance. The world economy was bom with the dawn of international trade, and foreign exchange has had its own role in that economic activity from that time on. The Gold Standard, however, made the world economy effectively a domestic economy in terms of transaction units of money – the so-called numéraire. With the collapse of that system in the early 1930s, the blizzard in currency convertibility forced trading nations to invent and accept the Bretton Woods system. Tranquillity replacing turbulence of the 1930s ruled the international markets until the early 1970s. Anarchy and volatility induced by the breakdown of the Bretton Woods system and the Gold Pool that anchored the value of the dollar in the foreign exchange market devastated financial and trade transactions (Baillie and McMahon 1989). The conditions for the free fall of the American dollar, which was significantly realized in this period, finally gave way to financial stability, and the new global structure of financial markets emerged.

What is the global structure of financial markets? There is no unique answer to this question, and yet there are good answers, which we have tried to provide in this chapter. It is hard, maybe impossible, to identify the birth of the global structure of financial markets as we know it today. It almost always existed as it does now. Yet, on a serious note, one has to recognize the period when cross-listing of securities in different markets such as New York, London, Tokyo, Singapore, and so on, and simultaneous trading of those assets, came into being under floating exchange rates. The beginning of this structure can be identified with the visible forces of market integration or the disappearance of market segmentation. The dynamics of arbitrage make it impossible to derive any yield differential across national markets in a truly structured and integrated market set-up. That means a CDE equity traded both in Tokyo and London should and usually will give the same yield in both markets at the same point of time. Interspacial price discrimination on cross-listed securities are thus ruled out by the forces of competition, given the fundamental uniformity in the national laws of different countries in regard to market operations or regulations. In fact, in such an integrated market structure, a dollar will bring the same rate of return regardless of its investment in one national market or in another and whether that dollar is put to use in one line of financial product or another.

The follow-up question then is: how well-integrated are these markets across nations? A series of serious studies (see, for example, Ghosh and Khaksari 1993, Koch and Koch 1993, Stansell 1993, to note a few only) examining the degree of market integration, or absence thereof, are already in existence, and the burgeoning literature on this question is never on the wane. All these studies and research notwithstanding, we do not have convincing evidence that we operate under a uniquely defined global market. Most appropriately perhaps, we should characterize our environment as the global structure of financial markets – a network of many markets – in which individuals and institutions, micro agents, and macro players access to any or almost any market independent of its national jurisdiction on a regular basis.

This global structure stands on the terra firma of several building blocks. In the broad sense, it consists of global capital markets, global foreign exchange markets, and a global banking network of institutions. We use the word global to highlight the interconnectedness of these markets and institutions, and here that signifies a distinction from the domestic markets per se. Originally, most equity markets traded securities of the domestic corporations, and foreign investors or corporations were barred from participating in such markets by laws and traditions. Several such markets still exist in several regions, but many of the markets are open to trade regardless of the traders’ citizenship or residency. Exchange rate convertibility and hedging instruments have created climates of covered arbitrage and, as a result, most markets irrespective of their locations have become truly global. Offshore markets, eurocurrency, eurobonds and the like have tied the world together quite neatly, and virtually free capital flows have colored the landscape of financial markets. Although in many respects eurobonds are the replica of domestic bonds in basic features, differences exist underneath the indentures. Domestic bonds issued by domestic borrowers are issued within the jurisdiction of the domestic currency. A US bond (denominated in US dollars) is traded in the United States as a British bond (denominated in pounds sterling), is traded in the United Kingdom. A foreign bond is a debt instrument denominated in a foreign currency and issued by a foreign borrower in the country which is not the home of the borrower. If a German firm issues bonds in dollar terms in New York, it should be considered as a foreign bond. A eurobond, by contrast, is a bond issued, say, by a French corporation in the United States in the denomination of French francs. Currently, it is estimated that eurobonds are the largest and least-restricted sources of long-term debt capital for public corporations. Still, a large percentage of this market is populated by fixed-rate straight issues that characterize the traditional domestic and foreign bond markets, but the growing number of these assets, approximately 25 percent of the issues, are floating-rate notes, and around 20 percent of the total issues are linked with equity. International equity markets, another component of the global capital market, consist mostly of the world's major stock markets and the emerging stock markets. Table 1.1 and Table 1.2 give the overview of these markets. As already noted at the outset, all these stock markets are primarily national exchanges as most of the turnover stems from intra-country trading. But, in the changing economic environment conditioned by speed of transaction and financial technologies, it has become as simple for an Australian mutual fund to buy and sell AT&T stock in New York as it is for a Chicago investment company. Differrent currencies, time zones, and different national regulations create some barriers in such transaction structures, but overall frictions or impediments are so minor that essentially markets appear closely linked and integrated. The British “Big Bang” of reforms and the introduction of Stock Exchange Automated Quotations (SEAQ) have removed many restrictions on trading rules and facilitated flows of securities exchange in London. Cross-listing of many securities in New York, London, Tokyo, Paris, Singapore, and so on has globalized the equity market significantly. In the academic literature, it has been repeatedly pointed out that global diversification yields better returns and lower risk for a portfolio compared to a domestic portfolio, and investment houses have recognized this academic research result through their regular practices. International capital asset pricing models have become common jargon in the global marketplace.

Along with global capital markets one can easily notice global commodity markets. We find that Chicago, London, New York, Tokyo, Johannesburg, and others markets trade commodities like gold, silver, soybeans, oilseeds, wheats, etc. in spot, forward, futures, and options markets. The cost-of-carry theory attempts to set up the basic relationship between the futures and the spot price as follows:

F_t = S₀(1 + r_t + c_t)^t

where F_t = futures price of the commodity for delivery at time t from now; S₀ = spot price of the commodity now; r_t = interest rate for the time t; and c_t = non-interest cost of carry, expressed as a percentage rate. In the global market context, arbitrage involving capital issues and commodities is a powerful investment strategy.

A second major building block is the well-linked foreign exchange market, which has most effectively helped the growth of the global financial markets. Foreign exchange markets are the vehicles for currency trade – the swap of one national money for another money – through informal inter-bank connections or formal exchanges such as the International Monetary Market (IMM) of the Chicago Mercantile Exchange (CME), the London International Financial Futures Exchange (LIFFE), and so on. Like commodities, currencies are traded in spot markets, forward markets, futures markets, options markets, and swap markets. Forward contracts, futures contracts, options contracts, and swap contracts form what is more popularly known as currency derivatives, which have grown enormously over the past quarter of a century. Hedging, arbitrage and speculation have become the regular means to grow in the financial markets.

Table 1.1 Characteristics of major stock markets

	Exchanges (volume)	Execution	Settlement	Regulation
United States	New York (80%), American (15%), Boston, Cincinnati, Midwest, Pacific, Philadelphia, NASDAQ (over-the-counter, screen-based).	Open outcry on exchanges; telephone for OTC. All share in registered form. Commissions negotiable.	Fifth business day after trade date. NYSE trades clear through National Stock Clearing Corporation. Depository Trust Company holds securities for its members.	SEC
United Kingdom	International Stock Exchange (London: includes Birmingham, Manchester, Liverpool, Glasgow, Dublin); Unlisted Securities Market.	Telephone/screen market (SEAQ). Must be through Stock Exchange member. Commissions negotiable. Most shares in registered form; physical delivery is normal.	2–3 week account period. Central clearing system, Talisman, operated by Stock Exchange.	Dept, of Trade
Japan	Tokyo (83%), Osaka, Nagoya, five others. Exchange has three sections: first is large shares (96% of capitalization); second is new or unlisted shares; third is unlisted shares trading over the counter.	By the Zareba (open outcry) method. Must be through member of Japan Securities Dealers Association. All equity is in registered form. Fixed commissions.	Fourth business day after trade. Clearing through Japan Securities Co., subsidiary of Tokyo Stock Exchange.	Ministry of Finance
Germany	Frankfurt (60%), Düsseldorf (20%), Munich, Hamburg, Stuttgart, Hanover, Berlin, Bremen. Official market supplemented by semi-official market with less stringent listing rules. Also OTC market.	Large stocks trade continuously. Smaller stocks dealt at a price set daily.	Two business days (five days by arrangement). Delivery through German banks. Settlement via regional clearing agencies (Wertpapiersammelbanken) or the Auslandskassenverein for foreigh securities.	Stock Exchange Board
France	Paris (95%), Lyons (4%), Bordeaux, Lille, Marseilles, Nancy, Nantes. Three markets: Cote Officielle: large and foreign companies; Second Marche: small and mediumsize; Marche Hors-Cote: over-the-counter market.	Forward market, some trades cash. Automated execution system replacing system of placing orders in pigeonholes. Price movement restrictions: 5% cash, 8% forward.	Forward: last working day of month. Cash: immediately after trading session.	COB
Switzerland	Zurich (60%), Geneva (20%), Basle (10%), Bern, St. Gallen, Lausanne, Neuchâtel. Three markets: Official: on floor of exchanges between members; Semi-official: on floor, in unlisted companies; Unofficial: telephone, interbank trading in unlisted companies and new issues. Registered, bearer, and participation certificates exist.	Open outcry for official/semi-official markets. 70% of trades are for spot settlement, but forward trades up to nine months possible.	Spot: within three days. Forward: last day of month. Stocks deposited in SEGA (centralized clearing house) and book-entry transfers made.	Swiss National Bank
Canada	Toronto (75%), Montreal (20%), Vancouver (5%), Alberta, Winnipeg. Over-the-counter market trades unlisted shares.	On the floor of the exchanges, through member firms. Automated execution for certain trades. Negotiable commissions. Equity is in registered fo...

Table of contents

• Front Cover
• THE GLOBAL STRUCTURE OF FINANCIAL MARKETS
• Title Page
• Copyright
• CONTENTS
• List of figures
• List of tables
• List of contributors
• Preface
• 1 INTRODUCTION: THE GLOBAL STRUCTURE OF FINANCIAL MARKETS: AN OVERVIEW
• PART I GLOBAL CAPITAL MARKETS
• PART II GLOBAL FOREIGN EXCHANGE MARKETS
• PART III GLOBAL BANKING ISSUES
• PART IV CAPITAL FLOWS IN THE GLOBAL STRUCTURE
• Index