GLOBAL

International Financial Institutions

An international financial institution (IFI) is a financial institution that has been established (or chartered) by more than one country, and hence is subject to international law. Its owners or shareholders are generally national governments, although other international institutions and other organizations occasionally figure as shareholders. The most prominent IFIs are creations of multiple nations, although some bilateral financial institutions (created by two countries) exist and are technically IFIS. The best known IFIs were established after World War

managing the global financial system.

Types of International Financial Institutions

  • Multilateral Development Banks - A multilateral development bank (MDB) is an institution, created by a group of countries, that provides financing and professional advice to enhance development. An MDB has many members, including developed donor countries and developing borrower countries. MDBs finance projects through long-term loans at market rates, very-long-term loans below market rates (also known as credits), and grants.
  • There are also several "sub-regional" multilateral development banks. Their membership typically includes only borrowing nations. The banks lend to their members, borrowing from the international capital markets. Because there is effectively shared responsibility for repayment, the banks can often borrow more cheaply than could any one-member nation.
  • There are also several multilateral financial institutions (MFIs). MFIs are similar to MDBs but they are sometimes separated since they have more limited memberships and often focus on financing certain types of projects.
  • Bretton Woods Institutions - The best-known IFIs were established after World War II to assist in the reconstruction of Europe and provide mechanisms for international cooperation in managing the global financial system. They include the World Bank, the IMF, and the International Finance Corporation. Today the largest IFI in the world is the European Investment Bank which lent 61 billion euros to global projects in 2011. Regional Development Banks - The regional development banks consist of several regional institutions that have functions similar to the World Bank group's activities, but with particular focus on a specific region. Shareholders usually consist of the regional countries plus the major donor countries. The best-known of these regional banks cover regions that roughly correspond to United Nations regional groupings, including the Inter- American Development Bank, the Asian Development Bank; the African Development Bank; the Central American Bank for Economic Integration; and the European Bank for Reconstruction and Development. The Islamic Development Bank is among the leading multilateral development banks. IsDB is the only multilateral development bank after the World Bank that is global in terms of its membership. 56 member countries of IsDB are spread over Asia, Africa, Europe and Latin America.
  • Bilateral Development Banks and Agencies - A bilateral development bank is a financial institution set up by one individual country to finance development projects in a developing country and its emerging market, hence the term bilateral, as opposed to multilateral.
  • Other Regional Financial Institutions - Financial institutions of neighboring countries established themselves internationally to pursue and finance activities in areas of mutual interest; most of them are central banks, followed by development and investment banks.

International Bond Markets

Beginning from the 1980s, the international bond market grew aggressively. It today constitutes a large share in the total outstanding of the global bond market. The international bond market is a market for bonds that are traded beyond national boundaries. They pull together investors from different countries. The bonds which are traded in international bond markets are called international bonds. Normally, though not always, these bonds are issued in the issuer's domestic currency. In fact, it depends on where the subscription is expected. In such a situation the issuer may issue bonds denominated in US Dollar or Euro. Also, international bonds like most other types of bonds, attract interest payments at regular intervals and the investor gets the principal amount back upon maturity of the bond.

Classifications of International Bond Markets

  1. Foreign Bonds. In foreign bonds, the issuer is from one country but he issues the bonds in some other country. The issuer issues these bonds in the local currency of the country where he is issuing bonds. An example of a foreign bond will be a US company issuing bonds to raise capital in India. The US company will issue the bonds in Indian Rupee. As a result, Indian investors will not be subject to the ups and downs of the foreign exchange market. They will invest in Indian Rupee, earn interest in Indian Rupee, and will get their principal back in Indian Rupee. An Indian company can also issue bonds in India in Indian Rupee. But these bonds will be called Domestic Bonds. So, for a bond to classify as Foreign Bond, it must come from a foreign issuer.
  2. Euro Bond. In Euro Bond, a foreign entity issues a bond in the domestic market. The issuer issues bonds in a currency which is not the domestic currency of that country. So, a Eurobond in US currency can be issued in any country other than the US. If a US company issues bonds in Japan in Pound sterling, it will also be an example of a Eurobond. Eurobond is a result of unfavorable tax regimes of the 1960s in the US. This led to the US companies issuing bonds in US dollars outside of the USA. Here, the investors will be subject to ups and downs in the foreign exchange rate.
  3. Global Bonds. Apart from foreign bonds and euro bonds, some companies, though rarely, issue global bonds. In global bonds, bonds are issued in multiple countries at a go and often in multiple currencies. Usually, large multinational corporations' issue global bonds.

International Equity Markets

International equity markets are the markets in which shares are issued and traded, either through exchanges or over-the-counter markets. Also known as the stock market, it is one of the most vital areas of a market economy because it gives companies access to capital and investors a slice of ownership in a company with the potential to realize gains based on its future performance. International equity markets are an important platform for global finance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper.

Market Structure, Trading Practices, and Costs

The secondary equity markets provide marketability and share valuation. Investors or traders who purchase shares from the issuing company in the primary market may not desire to own them forever. The secondary market permits the shareholders to reduce the ownership of unwanted shares and lets the purchasers buy the stock.

The secondary market consists of brokers who represent the public buyers and sellers. There are two kinds of orders -

  • Market order - A market order is traded at the best price available in the market, which is the market price. • Limit order - A limit order is held in a limit order book until the desired price is obtained.
    • There are many different designs for secondary markets. A secondary market is structured as a dealer market or an agency market.
    • In a dealer market, the broker takes the trade through the dealer. Public traders do not directly trade with one another in a dealer market. The over-the-counter (OTC) market is a dealer market.
  • In an agency market, the broker gets client's orders via an agent.
    • Not all stock market systems provide continuous trading. For example, the Paris Bourse was traditionally a call market where an agent gathers a batch of orders that are periodically executed throughout the trading day. The major disadvantage of a call market is that the traders do not know the bid and ask quotations prior to the call.
    • Crowd trading is a form of non-continuous trade. In crowd trading, in a trading ring, an agent periodically announces the issue. The traders then announce their bid and ask prices, and look for counterparts to a trade. Unlike a call market which has a common price for all trades, several trades may occur at different prices. Trading in International Equities

A greater global integration of capital markets became apparent for various reasons -

  • First, investors understood the good effects of international trade.
  • Second, the prominent capital markets got more liberalized through the elimination of fixed trading commissions.
  • Third, the internet and information and communication technology facilitated efficient and fair trading in international stocks.
  • Fourth, the MNCs understood the advantages of sourcing new capital internationally.

Cross-listing- Cross-listing refers to having the shares listed on one or more foreign exchanges. In particular, MNCs do this generally, but non-MNCs also cross-list. A firm may decide to cross-list its shares for the following reasons -

  • Cross-listing provides a way to expand the investor's base, thus potentially increasing its demand in a new market.
  • Cross-listing offers recognition of the company in a new capital market, thus allowing the firm to source new equity or debt capital from local investors.
  • Cross-listing offers more investors. International portfolio diversification is possible for investors when they trade on their own stock exchange.
  • Cross-listing may be seen as a signal to investors that improved corporate governance is imminent.
  • Cross-listing diminishes the probability of a hostile takeover of the firm via the broader investor base formed for the firm's shares.

Yankee Stock Offerings

In the 1990s, many international companies, including the Latin Americans, have listed their stocks on U.S. exchanges to prime market for future Yankee stock offerings, that is, the direct sale of new equity capital to U.S. public investors. One of the reasons is the pressure for privatization of companies. Another reason is the rapid growth in the economies. The third reason is the expected large demand for new capital after NAFTA has been approved.

American Depository Receipts (ADR)

An ADR is a receipt that has a number of foreign shares remaining on deposit with the U.S. depository's custodian in the issuer's home market. The bank is a transfer agent for the ADRs that are traded in the United States exchanges or in the OTC market.

ADRS offer various investment advantages. These advantages include -

  • ADRs are denominated in dollars, trade on a US stock exchange, and can be purchased through the investor's regular broker. This is easier than purchasing and trading in US stocks by entering the US exchanges.
  • Dividends received on the shares are issued in dollars by the custodian and paid to the ADR investor, and a currency conversion is not required.
  • ADR trades clear in three business days as do U.S. equities, whereas settlement of underlying stocks vary in other countries.
  • ADR price quotes are in U.S. dollars.
  • ADRs are registered securities and they offer protection of ownership rights. Most other underlying stocks are bearer securities.
  • An ADR can be sold by trading the ADR to another investor in the US stock market, and shares can also be sold in the local stock market.
  • ADRs frequently represent a set of underlying shares. This allows the ADR to trade in a price range meant for US investors.
  • ADR owners can provide instructions to the depository bank to vote the rights.

There are two types of ADRs: sponsored and unsponsored.

  • Sponsored ADRs are created by a bank after a request of the foreign company. The sponsoring bank offers lots of services, including investment information and the annual report translation. Sponsored ADRs are listed on the US stock markets. New ADR issues must be sponsored.
  • Unsponsored ADRs are generally created on request of US investment banking firms without any direct participation of the foreign issuing firm.

Global Registered Shares (GRS)

GRS are shares that are traded globally, unlike the ADRs that are receipts of the bank deposits of home- market shares and are traded on foreign markets. The GRS are fully transferable - GRS purchased on one exchange can be sold on another. They usually trade in both US dollars and euros.

The main advantage of GRS over ADRS is that all shareholders have equal status and the direct voting rights.

The main disadvantage is the cost of establishing the global registrar and the clearing facility.

Factors Affecting International Equity Returns

Macroeconomic factors, exchange rates, and industrial structures affect international equity returns.

Interest Rates and Currency Swaps

Swaps are derivative contracts between two parties that involve the exchange of cash flows. One counterparty agrees to receive one set of cash flows while paying the other another set of cash flows. Interest rate swaps involve exchanging interest payments, while currency swaps involve exchanging an amount of cash in one currency for the same amount in another.

Interest Rate Swaps

An interest rate swap is a financial derivative contract in which two parties agree to exchange their interest rate cash flows. The interest rate swap generally involves exchanges between predetermined notional amounts with fixed and floating rates.

  • For example, assume bank ABC owns a $10 million investment, which pays the London Interbank Offered Rate (LIBOR) plus 3% every month. Therefore, this is considered a floating payment because as the LIBOR fluctuates, so does the cash flow.

On the other hand, assume bank DEF owns a $10 million investment which pays a fixed rate of 5% every month. Bank ABC decides it would rather receive a constant monthly payment while bank DEF decides to take a chance on receiving higher payments. Therefore, the two banks agree to enter into an interest rate swap contract. Bank ABC agrees to pay bank DEF the LIBOR plus 3% per month on the notional amount of $10 million. Bank DEF agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of $10 million.

  • As another example, assume Paul prefers a fixed-rate loan and has loans available at a floating rate (LIBOR+0.5%) or at a fixed rate (10.75%). Mary prefers a floating rate loan and has loans available at a floating rate (LIBOR+0.25%) or at a fixed rate (10%). Due to a better credit rating, Mary has an advantage over Paul in both the floating rate market (by 0.25%) and in the fixed-rate market (by 0.75%). Her advantage is greater in the fixed-rate market so she picks up the fixed-rate loan. However, since she prefers the floating rate, she gets into a swap contract with a bank to pay LIBOR and receive a 10% fixed rate. Paul pays (LIBOR+0.5%) to the lender and 10.10% to the bank, and receives LIBOR from the bank. His net payment is 10.6% (fixed). The swap effectively converted his original floating payment to a fixed rate, getting him the most economical rate. Similarly, Mary pays 10% to the lender and LIBOR to the bank and receives 10% from the bank. Her net payment is LIBOR (floating). The swap effectively converted her original fixed payment to the desired floating, getting her the most economical rate. The bank takes a cut of 0.10% from what it receives from Paul and pays to Mary.

Currency Swaps

Conversely, currency swaps are a foreign exchange agreement between two parties to exchange cash flow streams in one currency to another. While currency swaps involve two currencies, interest rate swaps only deal with one currency.

  • For example, assume bank XYZ operates in the United States and deals only with U.S. dollars, while bank QRS operates in Russia and deals only with rubles. Suppose bank QRS has investments in the United States worth $5 million. Assume the two banks agree to enter into a currency swap. Bank XYZ agrees to pay bank DEF the LIBOR plus 1% per month on the notional amount of $5 million. Bank QRS agrees to pay bank ABC a fixed 5% monthly rate on the notional amount of 253,697,500 Russian rubles, assuming $1 is equal to 50.74 rubles.

By agreeing to a swap, both firms were able to secure low-cost loans and hedge against interest rate fluctuations. Variations also exist in currency swaps, including fixed vs. floating and floating vs. floating. In sum, parties are able to hedge against volatility in forex rates, secure improved lending rates, and receive foreign capital.

International Foreign Investments

International foreign investments (IFF) or Foreign portfolio investment (FPI) involves an investor purchasing foreign financial assets. The transaction of foreign securities generally occurs at an organized formal securities exchange or through an over-the-counter market transaction.

Foreign portfolio investing is popular among several different types of investors. Common transactors of foreign portfolio investment include:

  • Individuals
  • Companies
  • Foreign governments

Benefits of Foreign Portfolio Investment

The primary benefits of foreign portfolio investment are:

  1. Portfolio diversification - Foreign portfolio investment provides investors with an easy opportunity to diversify their portfolio internationally. An investor would diversify their investment portfolio to achieve a higher risk- adjusted return, which is ultimately done to help generate alpha.
  2. International credit - Investors may be able to access an increased amount of credit in foreign countries, allowing the investor to utilize more leverage and generate a higher return on their equity investment.
  3. Access to markets with different risk-return characteristics - If investors are seeking out greater returns, they must be willing to take on greater risk. Emerging markets can offer investors a different risk-return profile.
  4. Increases the liquidity of domestic capital markets - As markets become more liquid, they become deeper and broader, and a wider range of investments can be financed. Savers can invest with the assurance that they will be able to manage their portfolio or sell their financial securities quickly if they need access to their savings.
  5. Promotes the development of equity markets - Increased competition for financing will lead to the market rewarding superior performance, prospects, and corporate governance. As the market's liquidity and functionality develop, equity prices will become value-relevant for investors, ultimately driving market efficiency.

Risks of Foreign Portfolio Investment (FPI)

The primary risks faced by a foreign portfolio investor are:

  1. Volatile asset pricing - Across international financial markets, some are riskier than others.
  • For example, consider the Deutscher Aktienindex (DAX). The DAX is a stock market index of 30 major German companies trading on the Frankfurt Stock Exchange. The DAX is historically more volatile than the S&P 500 Index.
  1. Jurisdictional risk - Jurisdictional risk can result from investing in a foreign country.
  • For example, if a foreign country that you were invested in drastically changes its laws, it could result in a material impact on the investment's returns.

Moreover, many countries struggle with financial crime, such as money laundering. Investing in countries where money laundering is prevalent increases the jurisdictional risk faced by the investor.

Financial Assets for Foreign Portfolio Investments

The typical financial assets that can be purchased through foreign portfolio investment include equities, bonds, and derivative instruments. These securities can be purchased for many reasons; however, generally, foreign portfolio investment is positively influenced by high rates of return and reduction of risk through geographic diversification.

Policies for Foreign Portfolio Investment

Foreign portfolio investment is inherently volatile, and rigorously regulated financial markets are needed to manage the risk effectively. Furthermore, the financial system must be capable of identifying and mitigating risks for prudent and efficient allocation of foreign or domestic capital flows.

Economic growth and development are enabled by successful financial intermediation and the efficient allocation of credit. Financial systems can maintain their health through the identification and management of business risks. Moreover, the financial system must also withstand economic shocks.