International Capital Markets Essays - Foreign Exchange Market, Bank

International Capital Markets International capital markets are a group of markets (in London, Tokyo, New York, Singapore, and other financial cities) that trade different types of financial and physical capital (assets), including Stocks, bonds (government and corporate), bank deposits denominated in different currencies,commodities (like petroleum, wheat, bauxite, gold)forward contracts, futures contracts, swaps, options contracts ,real estate and land,factories and equipment Gains from Trade ?How have international capital markets increased the gains from trade? ?When a buyer and a seller engage in a voluntary transaction, both receive something that they want and both can be made better off. ?A buyer and seller can trade goods or services for other goods or services,goods or services for assets,assets for assets ?The theory of comparative advantage describes the gains from trade of goods and services for other goods and services: ?with a finite amount of resources and time, use those resources and time to produce what you are most productive at (compared to alternatives), then trade those products for goods and services that you want. be a specialist in production, while enjoying many goods and services as a consumer through trade ?The theory of intertemporal trade describes the gains from trade of goods and services for assets, of goods and services today for claims to goods and services in the future (today?s assets). ?Savers want to buy assets (future goods and services) and borrowers want to use assets (wealth) to consume or invest in more goods and services than they can buy with current income. ?Savers earn a rate of return on their assets, while borrowers are able to use goods and services when they want to use them: they both can be made better off. ?The theory of portfolio diversification describes the gains from trade of assets for assets, of assets with one type of risk with assets of another type of risk. ?Many times in economics (though not in Las Vegas) people want to avoid risk: they would rather have a sure gain of wealth than invest in risky assets. ?Economists say that investors often display risk aversion: they are averse to risk. ?Diversifying or ?mixing up? a portfolio of assets is a way for investors to avoid or reduce risk. Portfolio Diversification Suppose that 2 countries have an asset of farmland that yields a crop, depending on the weather. The yield (return) of the asset is uncertain, but with bad weather the land can produce 20 tonnes of potatoes, while with good weather the land can produce 100 tonnes of potatoes. On average, the land will produce 1/2 * 20 + 1/2 * 100 = 60 tonnes if bad weather and good weather are equally likely (both with a probability of 1/2). The expected value of the yield is 60 tonnes Suppose that historical records show that when the domestic country has good weather (high yields), the foreign country has bad weather (low yields). What could the two countries do to make sure they do not have to suffer from a bad potato crop? Sell 50% of one?s assets to the other party and buy 50% of the other party?s assets: diversify the portfolios of assets so that both countries always achieve the portfolios? expected (average) values. With portfolio diversification, both countries could always enjoy a moderate potato yield and not experience the vicissitudes of feast and famine. If the domestic country?s yield is 20 and the foreign country?s yield is 100 then both countries receive: 50%*20 + 50%*100 = 60. If the domestic country?s yield is 100 and the foreign country?s yield is 20 then both countries receive: 50%*100 + 50%*20 = 60. If both countries are risk averse, then both countries could be made better off through portfolio diversification. Classification of Assets Claims on assets (?instruments?) are classified as either 1.Debt instruments ?Examples include bonds and bank deposits ?They specify that the issuer of the instrument must repay a fixed value regardless of economic circumstances. 2.Equity instruments ?Examples include stocks or a title to real estate ?They specify ownership (equity = ownership) of variable profits or returns, which vary according to economic conditions. International Capital Markets The participants: 1.Commercial banks and other depository institutions: ?accept deposits ?lend to governments, corporations, other banks, and/or individuals ?buy and sell bonds and other assets ?Some commercial banks underwrite stocks and bonds by agreeing to find buyers for those assets at a specified price. 2.Non bank financial institutions: pension funds,