Chapter 1 The World of Finance Keith Pilbeam

Chapter 1 The World of Finance Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Learning Objectives Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Development Factors � the globalization of financial markets � the impact of technology � the deregulation of financial services industry � the importance of product innovation Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Financial Centres � competitive financial centre can be an important foreign exchange earner provide employment for substantial number of people aid an economy by channelling investors’ funds into the bestperforming investments and businesses � recycle funds from surplus to deficit agents as efficiently as possible Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Role of a Financial Centre Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Difficulty of Financial Intermediation �surplus agents are risk-averse �deficit agents are risk-takers short-term time horizons tend to invest in a fairly low-risk financial instruments medium- and long-term time horizons frequently require funds to undertake risky ventures Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Characteristics of a Major Financial Centre � a large number of both domestic and foreign banks, with a reasonable share of international bank lending � a substantial amount of foreign exchange business � a significant offshore market � well capitalized stock market with high degree of liquidity � a major market for corporate finance, domestic bonds, foreign bonds and perhaps Eurobonds � a range of financial institutions and associated services in addition to commercial banks eg: investment banks, insurance companies, securities houses, brokers, accountancy firms, commercial law firms, consultancy services, etc. � a significant presence in derivative markets – futures, options and swaps Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Means of Finance Recycling The transfer of funds in the financial system is carried out by several means. Various countries attach different priority to each of these means, but the three key ones are: �money market – transfer of funds for less than a year �capital market – stocks & bonds [US and UK] �banking system [Germany and Japan] Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Key Financial Centres USA and Japan are more domestically oriented while UK is heavily dependent on international business � London: by far the biggest financial centre foreign exchange trading and for trading in over-the-counter derivative contracts � New York: a dominant player in terms of institutional funds under management, with its pension funds and mutual funds of roughly equal significance as institutional investors � Tokyo: more significant banking and insurance industry Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Global Stockmarkets end 2016 Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Global Debt Securities 2016 Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Largest Banking Centres 2015 Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The importance of different financial centres Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Conventional Investment Assets Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Annual Number of Derivative Contracts by Region Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Growth of Exchange Traded Derivatives by Volume of Contracts Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

The Growth of Sharia Compliant Assets Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Globalization the tendency of financial institutions and their customers to move beyond their domestic markets to other markets around the globe Bretton Woods a fixed but adjustable exchange rate regime (1947 -71) whereby the major currencies were pegged to the US dollar within a ± 1% band; the dollar was pegged to gold at $35 per ounce Factors: � the growth of international trade has outpaced the economic growth rates of most countries, making them more tradedependent � the demand for trade-finance products has increased � the breakdown of Bretton Woods system made currencies more volatile � Investors have sought the benefits of international portfolio diversification Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Globalization Benefits: Pitfalls: � borrowers are no longer � the loss of local knowledge limited purely to their national markets � agents with surplus funds can take advantage of investment opportunities in other countries � financial institutions seek to have global presence both as a means of expansion and to retain their existing customers (Latin American crisis, 1970 searly 80 s) � problems in detecting wrongdoing such as ponzi schemes eg: Bernie Madoff � increased interactions and spillovers between markets (Asian crisis, 1997) � stock markets and bond markets move increasingly in synch with each other Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Technology � The adoption of new technology has created more efficient financial services industry increased speed [screen-based real-time trading] reduced costs [business relocation] broader range of services [ATMs, internet banking] � Issues to be considered remain: security and reliability large capital investments while adequate returns are uncertain backward compatibility – the need for new information technology, such as computers and software, to work with older technology in order to service existing clients change of balance between fixed and variable costs structure made the market share an increasingly important aspect Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Regulation � Aim: investor protection from misinformation, misuse of their funds, prevention of banking and financial crises � Problems: o increases costs to meet compliance o can prevent the introduction of innovative products o redirects the businesses to less regulated markets o too much protection can create a problem of moral hazard - when the existence of insurance policy makes the insured event more likely to occur than in the absence of insurance policy Basel Accords: three agreements, emanating from the Bank for International Settlements in 1988, 2004, 2016. Originally required large international banks to set aside capital reserves against potential losses equivalent to 8% of their risk-adjusted assets. Today larger capital requirements and also liquidity requirements. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Deregulation the reduction or elimination of regulations designed to increase competition and reduce prices facing consumers UK policies in the 1980 s : range of tax breaks for savers such as TESSAs (tax exempt special savings accounts) and PEPs (personal equity plans) shift of tax structure from tax on income to tax on expenditure privatization programme increased indirect taxes on goods and services while financial products remained largely untaxed Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Financial Innovation the design of new financial instruments or the packaging together of existing ones 1970 s: breakdown of Bretton Woods, first oil shock in 1973 1980 s: introduction of highly sophisticated computers Types market-broadening innovations 2. risk-management innovations 3. arbitraging innovations 4. pricing innovations 5. marketing innovations 1. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Emerging Markets countries with rapid economic growth and in the process of industrialization � rise in significance since the 1980 s: Regions like Southeast Asia Latin America have increasingly attracted investors from industrialized countries � in recent years: the newly independent countries of Eastern Europe that have emerged from the breakdown of the Soviet bloc in the 1990 s have also attracted international investors � lessons learned: overexposure to a single emerging market is a risky business, but this does not necessarily apply to exposure to a portfolio of emerging markets Keith Pilbeam ©: Finance and Financial Markets 4 th Edition

Problems of Investing in Emerging Markets � Poor accounting standards � Governance of companies � Information costs � Political risks � Foreign exchange risks � Control of foreign investments � Higher transaction costs Frontier markets countries with stock markets that are less developed than emerging markets, eg: Argentina, Bulgaria, Cyprus, Romania, Sri Lanka, Vietnam, etc. Keith Pilbeam ©: Finance and Financial Markets 4 th Edition