GLOBAL FINANCIAL MARKET DYNAMICS Prof Gunter DUFEY gdufeyumich

GLOBAL FINANCIAL MARKET DYNAMICS Prof. Gunter DUFEY <gdufey@umich. edu> Nanyang Business School/ NTU Singapore & The University of Michigan, Ann Arbor, MI USA at ISEAS 19 January 2005 Copyright G. DUFEY Uo. M & NTU/NBS 1

The ‘BIG’ Picture: Technological Change esp. in Data Processing & Communication Globalization/ Internationalization Disintermediation/ Reintermediation Liberalization/ Deregulation Securitization/ Financial Innovation --Engineering Copyright G. DUFEY Uo. M & NTU/NBS 2

Northwestern Public Service Company U. S. $10, 000 Term Loan managed and provided by: Dresdner Bank Aktiengesellschaft Grand Cayman Branch Merrill Lynch International Bank Limited as agent 3

This advertisement appears as a matter of record only Framatome S. A. SFr 35, 000 Term Loan Arranged by Manufacturers Hanover Limited Provided by Banco Central, S. A. Electro Banque Manufacturers Hanover Trust Company London Branch Via Banque ASLK-CGER Bank Caixa Geral de Depõsitos Paris Branch Agent Bank Manufacturers Hanover Limited April 1989 The Investment Banking Group 4

Market Jurisdiction Currency Interest Rates Copyright G. DUFEY Uo. M & NTU/NBS Institutions 5

Market Jurisdiction Currency Interest Rates Copyright G. DUFEY Uo. M & NTU/NBS Institutions 6

Financial Markets n Markets for Payments l Demand Deposits/Cash n Markets for Credit n Markets for Equity Domestic Copyright G. DUFEY Uo. M & NTU/NBS “Global” 7

Conditions for the existence and growth of an external market for intermediated funds 1. Ultimate borrowers and lenders must have freedom to move funds “internationally”. 2. There must be free access to clearing balances (non-resident convertibility). 3. External financial intermediaries (Eurobanks) must have sufficient cost advantages to overcome the risk perceptions of transactors. Copyright G. DUFEY Uo. M & NTU/NBS 8

Eurocurrency Interest Rates and Rates in National Markets U. S. Interest Rate E $ Rate Transaction Cost Exchange Expectations Exchange Risk Cost Control Risks German Interest Rate EDM Rate Transformation of Currency Denomination Cost Control Risks Transformation of Jurisdiction Source: Adapted from G. Dufey and I. H. Giddy, „The Linkages that Tie Together International Interest Rates“. Euromoney Nov. 1978, pp. 122 -132. Copyright G. DUFEY Uo. M & NTU/NBS 9

NEW ISSUE These notes having been sold, this announcement appears as a matter of record only CAPITAL CORPORATION U. S. $1, 800, 000 Zero Coupon Notes due November 15, 2004 Unconditionally Guaranteed by CORPORATION Merrill Lynch Capital Markets Daiwa Europe Limited Crédit Lyonnais Dresdner Bank E. F. Hutton & Company (London) Ltd. Aktiengesellschaft Nomura International Limited Girozentrale Westdeutsche Landesbank Julius Baer International Limited Banca del Gottardo Banque Internationale à Luxembourg S. A. DG BANK Deutsche Genossenshaftsbank Norddeutsche Landesbank Girozentrale November 1984 Copyright G. DUFEY Uo. M & NTU/NBS 10

International Credit Markets: A Schematic Presentation Copyright G. DUFEY Uo. M & NTU/NBS 11

The Eurobond Market (The Market for International Issues) n The fundamental reason for its existence is the basic discrepancy between relatively (A) Tight controls on securities’ issues by foreign borrowers in national markets and (B) Fewer (or unenforceable) restrictions on investors to purchase foreign securities Copyright G. DUFEY Uo. M & NTU/NBS 12

Structure of International Bond Markets in the 2000 s A. National Markets B. Eurobond Market New York (“Yankee”) USD, EURO Swiss foreign bond market CAN, SFR German market Sterling Japanese foreign bond market (“Samurai”) Composite Units (SDR, etc. ) U. K. (Bulldog) Exotics C. Global Bonds Copyright G. DUFEY Uo. M & NTU/NBS 13

The ‘BIG’ Picture: Technological Change esp. in Data Processing & Communication Globalization/ Internationalization Disintermediation/ Reintermediation Liberalization/ Deregulation Securitization/ Financial Innovation --Engineering Copyright G. DUFEY Uo. M & NTU/NBS 14

Financial Market Liberalization: A Miracle! n n n It is easy to identify the forces that resist liberalization: The politicians and bureaucracy loose power and influence Established competitors -- once they have adjusted to the regulatory regime -- find that it provides effective protection against competition from new entrants -both domestic and foreign So what changes the balance of power? Domestic ‘players’ change their attitude toward liberalization when their customers go abroad for fin. services and ‘reciprocity’ starts to kick in Copyright G. DUFEY Uo. M & NTU/NBS 15

EMERGING ISSUES IN REGULATION Privacy and Consumerism n “New” issues: Money laundering, drugs and terrorists -- and what really matters: TAXES n Compliance and intl. power-plays n “Value adding” vs. “value destroying” regulation n n Principles of consumer/investor protection: - Disclosure vs. legal protection? - What are “appropriate” investments? - Who takes the risks of criminal activity? - Ethics? Copyright G. DUFEY Uo. M & NTU/NBS 16

The ‘BIG’ Picture: Technological Change esp. in Data Processing & Communication Globalization/ Internationalization Disintermediation/ Reintermediation Liberalization/ Deregulation Securitization/ Financial Innovation --Engineering Copyright G. DUFEY Uo. M & NTU/NBS 17

Financial Innovation I Stripping a Term Loan (Fixed Rate) What are its elements? v. Provisions of Cash v. Availability Guarantee v. Interest Rate Guarantee v. Credit Risk v. Interest Rate Option v. Options on the Collateral Copyright G. DUFEY Uo. M & NTU/NBS 18

This announcement appears as a matter of record only. The Notes are not being registered for offer as sales in the United States. Offers and sales of the Notes in the United States or to the United States nationals and residents will not be made as part of the distribution and might constitute a violation of United States Law if made. Sears, Roebuck and Co. and Sears Roebuck Acceptance Corp. U. S. $5000, 000 Revolving Underwriting Facility with Continuous Tender Panel Banca Commerciale Italiana Lead Managers Chicago Branch Banco di Roma Banque Paribas DG BANK Deutsche Genossenschaftsbank Girozentrale und Bank der österreichischen Banque Nationale de Paris Credit Commercial de France Dresdner Bank AG, Chicago Branch Westpac Banking Corporation Sparkassen Aktiengesellschaft Banca Nazionale dell’Agricoltura Manager New York Branch Banco di Sicilia – New York Branch CIC-Union Européenne International et Cie. Banca Popolare di Milano Banca Nazionale del Lavoro Banco di Napoli – New York Branch Banque Internationale à Luxembourg Kansallis-Osake-Pankki Co-Managers New York Branch Bank of China, New York Branch Banque Générale du Luxembourg S. A. Malayan Banking Berhad Banco di Santo Spirito (Luxembourg) Bank of New Zealand Berliner Handels- und Frankfurter Bank Monte dei Paschi di Siena Arranger and CTP Manager Dean Witter Capital Markets-International May 1985 19

Financial Innovation II Securitization & Structured Finance n Innovative product trends such as securitization of future export receivables, dollar denominated mortgages, credit card receipts, commodities and similar cash flows from other than emerging markets. n Issuer considerations such as reasons for implementing a securitization program, resources necessary, evaluating risk, servicing options, financial guarantees, credit enhancement, I. e. value creation. n Organizational issues such as choice of a legal structure or where to locate your securitization special purpose vehicle. n Regulatory matters including local legal rules can facilitate or hinder transactions. n Tax and accounting considerations such as sale vs. financial treatment, after tax analysis and valuation, cross-border tax issues Copyright G. DUFEY Uo. M & NTU/NBS 20

How Swaps Link the International Capital Markets Copyright G. DUFEY Uo. M & NTU/NBS 21

A swap is a (conditional) exchange of future cash flows between two parties. Cash flows may be based on periodic interest payments (“coupons”), or principal when relevant. Swaps will differ in terms of reference rates (e. g. , LIBOR, treasuries, etc. ) and/or currencies. While the expected value of the cash flows at the initiation of a swap is the same, the actual value of the respective cash flow obligation will change over time. In line with changes in different bases for rates of interest and relative currency values (exchange rates). Such changes give rise to default risk in a swap transaction. Thus, a swap of whatever nature is simply a technique to change the characteristics of cash flows (outflows on the liability side or inflows on assets). The technique must be carefully distinguished from the use of swaps, I. e. when is it useful to change the characteristics of cash flows? Cash flows can be changed not only via a swap but also by the direct method: repay liabilities and borrow one with different cash flow characteristics. Thus: swaps permit the separation of funding (investing) from cash flow characteristics. Implications: what is good for the investor is not necessarily good for the borrower. Minimize head-on conflict, e. g. allows for securitization (standardizing liquid claims). Copyright G. DUFEY Uo. M & NTU/NBS 22

Ranking of the BBA Credit Derivatives Survey What are the applications for credit derivatives in global markets in 2005? · Management of credit lines · Diversification · Management of economic capital · Investment · Management of regulatory capital · Balance sheet optimization · Product structuring Copyright G. DUFEY Uo. M & NTU/NBS 23

The ‘BIG’ Picture: Technological Change esp. in Data Processing & Communication Globalization/ Internationalization Disintermediation/ Reintermediation Liberalization/ Deregulation Securitization/ Financial Innovation --Engineering Copyright G. DUFEY Uo. M & NTU/NBS 24

Trends in Shaping Financial Intermediaries in Asia The 97 crisis has been a defining moment for financial institutions in Asia. The reaction comprised the following aspects: 1) More professional management, esp. better risk management 2) Improved supervisory environment (rules and enforcement) 3) Some improvement of governance and credit environment, enhanced ability to collect. 4) Foreign ownership and competition improves system - not because of better technology but because of independence from political pressures. However post-colonial hang-ups and loss of political favors impose limits. 5) First time shift from business and gov. lending to consumer services including private banking -- with some ‘teething’ problems. 6) Push for asset management and other non-credit services including capital market activities. Copyright G. DUFEY Uo. M & NTU/NBS 25

Pensions and Financial Market Developments The confluence of a) rapid increase in standards of living (GDP/capita), b) lower birth rates and c) longer life spans puts strains on pension arrangements in all countries n Europe: relying on PAYG to replace approx. 60 -70 of last years’ income. Modest employer pensions and savings. System under extreme stress due to confluence of a) and b). n USA: modest SS system, middle class relies on pension systems, individual savings tax supported ret. savings (IRA’s). Strong trend from defined benefits to defined contribution. Tendency for co’s to default on pension promises and putting burden on PBGC. n Asia: Individual savings and extended family system gives way to employer funded pension arrangements, modest SS systems if any, with beginnings of segregated pension fund arrangements (Singapore, Malaysia, GPF in Thailand) n Copyright G. DUFEY Uo. M & NTU/NBS 26

Special CG Issues in Asia In international comparisons, Asian companies fare worst v Asian co’s pay a steep price in terms of cost and availability of capital (see Mc. Kinsey study). WHY? v Experience of first generation entrepreneurs causes perception of property rights to be precarious: loading up with credit from gov. controlled banks provides insurance against political risk v Disclosure and transparency of information is dangerous. v Disprop. representation of minority groups in business class of most SE Asian countries leads to defensive-aggressive behavior! v Fair business practices -- what is fair price in a small market? v Minority shareholders are viewed as stupid and impudent - give money away and want it back with return! Lack of regulatory provision and compliance monitoring Copyright G. DUFEY Uo. M & NTU/NBS 27

The Evolving Financial System Households NBFIs with Equity Banks (DDs and TDs) Direct (Insurance/ Finance Companies) Non-financial Enterprises Modified from Allen, Franklin and Douglas, Gale, Comparative Financial Systems: Competition versus Insurance, Unpublished, 1998, by G. Dufey, Uof. M BS 2001. Copyright G. DUFEY Uo. M & NTU/NBS 28

The Evolving Financial System Households NBFIs with Equity Banks (DDs and TDs) (Insurance/ Finance Companies) NBFIs without equity (Mutual Funds/ Investment Co. ) Non-financial Enterprises Modified from Allen, Franklin and Douglas, Gale, Comparative Financial Systems: Competition versus Insurance, by G. Dufey, 2001. Copyright G. DUFEY Uo. M & NTU/NBS 29

Implications for Singapore Recognize that competition is not regional but global n Increasing the distance between politics and financial markets n Regulatory environment that balances safety and innovation n Improve corp. gov. framework. n Foster an agglomeration of talent -local and foreign n Copyright G. DUFEY Uo. M & NTU/NBS 30

Implications for all of us The financial markets of the future will provide ample opportunities for intelligent, ethical people who have acquired a thorough understanding of the techniques, as well as the dynamics that determine (1) the regulatory environment, (2) the innovative products and (3) the institutions of the future. Copyright G. DUFEY Uo. M & NTU/NBS 31