47
International financial markets This chapter provided a general profile of the markets and instruments that currently exist for facilitating financial capital flows among nations. International bank lending and international transactions in bonds and stocks are now of huge size and take place in financial centers worldwide. Within these markets, a wide variety of specific instruments, including many different kinds of derivatives, has emerged. These instruments enable international investors, particularly in eurocurrency markets, to unbundle the various aspects of risk associated with the instruments in order to better distribute and hedge the risks. A key aspect of modern lending technology is the ability to separate the currency of denomination of a particular financial instrument from its respective jurisdiction. Thus, the characteristics of a eurocurrency instrument can be separated or unbundled and repackaged in a manner that is more profitable and/or contains a risk profile that is more suitable to the individual investor. The wide array of instruments for dealing with the risk associated with exchange rates, interest rates, and equity prices clearly appears to be playing an important role in improving the efficiency of rapidly globalizing international financial markets. Types of financial markets[edit] Within the financial sector, the term "financial markets" is often used to refer just to the markets that are used to raise finance: for long term finance, the Capital markets; for short term finance, the Money markets. Another common use of the term is as a catchall for all the markets in the financial sector, as per examples in the breakdown below. Capital markets which consist of: Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof. Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof. Commodity markets, which facilitate the trading of commodities. Money markets, which provide short term debt financing and investment. Derivatives markets, which provide instruments for the management of financial risk. Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market. Insurance markets, which facilitate the redistribution of various risks.

International Financial Markets

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Page 1: International Financial Markets

International financial markets

This chapter provided a general profile of the markets and instruments that currently exist for facilitating financial capital flows among nations International bank lending and international transactions in bonds and stocks are now of huge size and take place in financial centers worldwide Within these markets a wide variety of specific instruments including many different kinds of derivatives has emerged These instruments enable international investors particularly in eurocurrency markets to unbundle the various aspects of risk associated with the instruments in order to better distribute and hedge the risks A key aspect of modern lending technology is the ability to separate the currency of denomination of a particular financial instrument from its respective jurisdiction Thus the characteristics of a eurocurrency instrument can be separated or unbundled and repackaged in a manner that is more profitable andor contains a risk profile that is more suitable to the individual investor The wide array of instruments for dealing with the risk associated with exchange rates interest rates and equity prices clearly appears to be playing an important role in improving the efficiency of rapidly globalizing international financial markets

Types of financial markets[edit]

Within the financial sector the term financial markets is often used to refer just to the markets that are

used to raise finance for long term finance the Capital markets for short term finance the Money

markets Another common use of the term is as a catchall for all the markets in the financial sector as per

examples in the breakdown below

Capital markets which consist of

Stock markets which provide financing through the issuance of shares or common stock and

enable the subsequent trading thereof

Bond markets which provide financing through the issuance of bonds and enable the

subsequent trading thereof

Commodity markets which facilitate the trading of commodities

Money markets which provide short term debt financing and investment

Derivatives markets which provide instruments for the management of financial risk

Futures markets which provide standardized forward contracts for trading products at some future

date see also forward market

Insurance markets which facilitate the redistribution of various risks

Foreign exchange markets which facilitate the trading of foreign exchange

The capital markets may also be divided into primary markets and secondary markets Newly formed

(issued) securities are bought or sold in primary markets such as during initial public offerings

Secondary markets allow investors to buy and sell existing securities The transactions in primary markets

exist between issuers and investors while in secondary market transactions exist among investors

Liquidity is a crucial aspect of securities that are traded in secondary markets Liquidity refers to the ease

with which a security can be sold without a loss of value Securities with an active secondary market

mean that there are many buyers and sellers at a given point in time Investors benefit from liquid

securities because they can sell their assets whenever they want an illiquid security may force the seller

to get rid of their asset at a large discount

Paris EuroplaceInternational Financial Forum in Tokyo ndash 27 november 2007

ldquoGlobalisation of capital marketsrdquoSpeech by Christian NoyerGovernor of the Banque de FranceLadies and gentlemenIt is a great honour and a pleasure for me to speak before such a distinguished audience and I amdelighted to be in Tokyo today In the last decades global economic growth financial innovation andfinancial globalisation have progressed hand in hand This does not exclude of course challengingepisodes of stress such as the current oneFinancial globalisation is not a new phenomenon but the scale and speed of the current phase ofglobalisation is unprecedented cross-border and cross-market links are deeper than ever beforeEvents are still unfolding but the dynamics of the current crisis has been a live experiment of howglobalisation has modified the reaction of the financial system to shocks The magnitude of possiblelosses is in many respects contained Current estimates put the direct cost of subprime defaults ataround 250 billions USD It is significant but bearable especially starting from a point of veryfavourable economic conditions and high profitabilityStill what began as a sound correction of the undervaluation of risks in the subprime market unravelsas one of the major financial crisis of the past 10 years Some scenarios considered as very remotecrystallised on a large scale while widely expected break-up points held up well Hedge funds onceconsidered as a source of systemic risk fared better than regulated institutions The inter-bank markettraditionally the most liquid and efficient of all markets has experienced serious dislocation whileequity markets were relatively unscathed The spreading of defiant expectations from the subprime USmarket to other segments other institutions and other regions has been unexpected asymmetric and25

disconnected from the magnitude of the initial shock It invites us to revisit our reading ofglobalisation and contagion in the light of current eventsThe ongoing financial globalisation is underpinned by three main drivers each of them strengtheningthe two othersThe first driver and probably the strongest is financial innovation Supported by technologicalprogress financial innovation has fostered the emergence of new financial products and servicesresulting in more complete financial markets Thanks to advances in financial technology it is nowpossible to break up the risk of an asset into its constituent parts and to recombine them as wished tofit a specific investorrsquos risk profile The emergence of derivatives combined with the appropriatemathematical tools to price them has greatly expanded the range of tradable risks opening up newand vast horizons for hedging strategies Financial institutions are able to actively manage theirexposures and reallocate certain risks to those players that are most able to bear them Overallinvestors are more willing to invest across borders knowing that they can reach an improved riskreturntrade-offSimultaneously economies are becoming more open financially especially in the emergingworld The growth of international capital flows is the consequence both of domestic policies andglobal factors Domestically financial liberalisation and deregulation have relaxed investmentrestrictions More flexible exchange rate policies liberalisation of capital accounts the opening ofdomestic stock markets to foreign investors as well as lsquoinvestor-friendlyrsquo policies help to attractforeign investors Global factors have also played a role with the abundant global liquidityenvironment as well as the decrease in home bias By way of example non-residents currently hold46 of French market capitalisation and slightly more than 50 of French government bondsA third driver is the emergence of global financial players such as large banks hedge fundsprivate equity funds and more recently sovereign wealth funds They all share common characteristics- They play an important role in fostering market efficiency and provide liquidity to capitalmarkets- They use sophisticated investment strategies

- They implement advanced risk management practices and help to spread them across marketsand countries35However because of their sheer size and potential impact on market equilibria they raise someconcerns of transparency as well as questions about their role in fostering or not financial stabilityThose issues warrant being debatedWhat are the consequences of the financial globalisation currently underway for global capitalmarkets They are well known so I will just highlight two of themFirst globalisation increases the efficiency of financial marketsThanks to financial globalisation and technological progress informational efficiency of capitalmarkets has increased over the past few decades Any new available information is accuratelyprocessed and impounded in asset prices leading to more accurate pricing of assets and risks And thepermanent quest for arbitrage opportunities has fostered cross-market and cross-border strategies alsoleading to more consistent pricingAllocative efficiency that is the marketrsquos ability to allocate resources in a way that maximises thewelfare attained through their use has also improved for a given investor there is a wider and morediversified range of investment opportunities than ever beforeOperational efficiency has so far gained from globalisation since the cost of financial operations hasquickly fallen due to productivity gains in the financial sector stemming from the scale and scope ofeconomies and the intense competition between markets and intermediariesNevertheless this overall trend towards efficiency occasionally bumps into puzzles that are not readilyexplained by economic theory For instance the longstanding question as to why capital does not flowin net terms from rich to poor countries has not yet been clarified since it was first addressed byRobert Lucas It has recently been supplemented by the so-called ldquoallocation puzzlerdquo highlighting thefact that capital seems to flow toward economies with relatively low investment rates Convincingexplanations for these puzzles certainly require taking into account market imperfections (such ascredit constraints) differences in financial infrastructures as well as growth externalities (such ashuman capital)Another salient feature of financial globalisation is the rapid maturing of emerging economies

and markets In 2007 and 2008 the IMF expects emerging countries to account for more than half ofworld economic growth The same positive trend is reflected in their financing conditions Emergingmarket economies increasingly finance themselves in the form of bonds in local currency at long45maturities and fixed interest rates By doing so they have escaped the curse of ldquooriginal sinrdquo - theinability to borrow abroad in their own currencies - that made the crises of the 1990s so costly Theircapital markets have expanded rapidly both in size and in the range of instruments available Asianstock market capitalisation for instance increased five-fold between 2000 and 2005 as against only aone and a half times increase for the major European and US stock exchanges Issuance of bonds andsyndicated loans from emerging market corporates has also accelerated markedly and has evenexceeded sovereign issuance in some countries Lastly risk premia on emerging market assets havefallen significantly reflecting sound economic fundamentals For this series of reasons emergingmarkets have become an attractive asset class for long-term international investors as shown by theirrising share in asset allocations It is therefore not so surprising that they have so far been relativelyimmune to the current subprime crisis and might even be seen as ldquosafe havensrdquoLet me now turn to some major challenges of financial globalisationFirst the impact on monetary policy Some analysts have suggested that because of capital marketintegration real interest rates will equalize around the world thus reducing the ability of nationalCentral Banks to control inflation However this need not be the case Indeed the classic Mundell-Fleming analysis concludes that monetary policy should be more effective rather than less in the caseof international capital mobility although it can operate through different channels of transmissionincluding the exchange rate Furthermore in many emerging countries strong capital inflows confrontmonetary policy with a dilemma between pursuing internal and external objectives in a context ofrising inflationary pressures Taming capital inflows would call for a relaxation of monetary policy atthe risk however of compromising on the domestic objective of maintaining low inflation Sterilisationcannot always be relied upon to resolve this dilemma as it is likely to be ineffective in the long term

and fuel other imbalances such as excessive accumulation of foreign exchange reservesA second question is the potential for global contagion As a direct consequence of cross-borderfinancial integration local price or liquidity shocks are more likely to spread around the globe Largescaleliquidity creation resulting from monetary (or exchange rate) policy in one country may fuelasset price bubbles elsewhere One current example might be seen in carry trades which have becomea major driver of a number of currencies including the yen Therefore distant events can have sharpimpacts even on local institutions or investors New contagion channels have emerged With more55risk traded in and through markets the potential knock-on effects from an erosion of liquidity in somesegments or for some institutions have multiplied and we are currently experiencing how unexpectedthis process can be Risks have become ldquomobilerdquo if I may put it like that so mobile that we lose sightof their true locationThe third and final set of issues relates to global imbalances The facilitation of cross-border capitalflows may have relaxed financing constraints for borrowers making it possible to finance ever largercurrent account deficits In one sense the contribution of financial globalisation to disconnectingnational savings and national investment is a welcome development to the extent that it allows for amore efficient global allocation of savings However the differences in the development of financialmarkets around the world may also have created or at least facilitated global imbalances The abilityof countries to produce sound and liquid financial assets is largely disconnected from their level ofeconomic growth rising revenues in the emerging world need to ldquofind a homerdquo in sound and liquidfinancial marketsFinally in any case the question of sustainability ndash the resilience of capital flows to the accumulationof imbalances ndash remains a pressing one While capital flows tend to move freely across bordersexchange rate regimes remain very diverse in their degrees of flexibility This leads to asymmetricadjustments depending on the exchange rate regime not only between currency areas but also insidethe same region such as in Asia Overall some of the main floating currencies may end up bearing a

higher share of the adjustment on their shoulders than they should Maintaining integrated globalcapital markets in an environment where such differences persist might not be sustainable over thelong term An orderly unwinding of global imbalances might therefore imply greater flexibility fromcountries with large current account surpluses and fixed exchange ratesI will conclude on a matter of debate for international financial stability for the future As I havesaid financial systems have become more efficient as a result of globalisation and innovation Buthave they become more resilient that is more capable of absorbing shocks None of us has theanswer to that question now but it will be interesting for central banks and regulators to monitorfinancial developments in the coming months in search of clues Ladies and gentlemen thank you foryour attention

FINANCEIndia Inc Globalization of Capital Markets Has India Caught ThisWave EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBALFINANCIAL POWER HOUSEAuthor Miss Kanchan Mishra IIT GuwahatiElectronics amp Communication EngineeringIndia Institute of TechnologyGuwahati ndash781039MrSNMishra Assistant DirectorCentral Silk Board Sualkuchi kanchaniitgernetin snmishra_csbyahoocoin ABSTRACT Finance is the study of money Capital market deals in long term fund of durationone year or above Globalization means integration of financial market through outthe world for raising and investing funds The factors integrating this globalizationare Liberalization Technological Advancement and Institutional InvestorsIndian Financial Market has been Globalized during 1990rsquos Some factors like lowpenetration of Indian household investors in capital market Large investmentopportunities in Indian capital market India as an attractive destination forforeign investors Availability of large labour fource and high growth rate in IndiaAmbitions of Indian inc to reach global markets market Setting up of specialeconomic zone(SEZ) Productive use of idle cash reserve ndash concept of merger andacquisition Venture capital and private equity investments has influenced a lot of

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 2: International Financial Markets

mean that there are many buyers and sellers at a given point in time Investors benefit from liquid

securities because they can sell their assets whenever they want an illiquid security may force the seller

to get rid of their asset at a large discount

Paris EuroplaceInternational Financial Forum in Tokyo ndash 27 november 2007

ldquoGlobalisation of capital marketsrdquoSpeech by Christian NoyerGovernor of the Banque de FranceLadies and gentlemenIt is a great honour and a pleasure for me to speak before such a distinguished audience and I amdelighted to be in Tokyo today In the last decades global economic growth financial innovation andfinancial globalisation have progressed hand in hand This does not exclude of course challengingepisodes of stress such as the current oneFinancial globalisation is not a new phenomenon but the scale and speed of the current phase ofglobalisation is unprecedented cross-border and cross-market links are deeper than ever beforeEvents are still unfolding but the dynamics of the current crisis has been a live experiment of howglobalisation has modified the reaction of the financial system to shocks The magnitude of possiblelosses is in many respects contained Current estimates put the direct cost of subprime defaults ataround 250 billions USD It is significant but bearable especially starting from a point of veryfavourable economic conditions and high profitabilityStill what began as a sound correction of the undervaluation of risks in the subprime market unravelsas one of the major financial crisis of the past 10 years Some scenarios considered as very remotecrystallised on a large scale while widely expected break-up points held up well Hedge funds onceconsidered as a source of systemic risk fared better than regulated institutions The inter-bank markettraditionally the most liquid and efficient of all markets has experienced serious dislocation whileequity markets were relatively unscathed The spreading of defiant expectations from the subprime USmarket to other segments other institutions and other regions has been unexpected asymmetric and25

disconnected from the magnitude of the initial shock It invites us to revisit our reading ofglobalisation and contagion in the light of current eventsThe ongoing financial globalisation is underpinned by three main drivers each of them strengtheningthe two othersThe first driver and probably the strongest is financial innovation Supported by technologicalprogress financial innovation has fostered the emergence of new financial products and servicesresulting in more complete financial markets Thanks to advances in financial technology it is nowpossible to break up the risk of an asset into its constituent parts and to recombine them as wished tofit a specific investorrsquos risk profile The emergence of derivatives combined with the appropriatemathematical tools to price them has greatly expanded the range of tradable risks opening up newand vast horizons for hedging strategies Financial institutions are able to actively manage theirexposures and reallocate certain risks to those players that are most able to bear them Overallinvestors are more willing to invest across borders knowing that they can reach an improved riskreturntrade-offSimultaneously economies are becoming more open financially especially in the emergingworld The growth of international capital flows is the consequence both of domestic policies andglobal factors Domestically financial liberalisation and deregulation have relaxed investmentrestrictions More flexible exchange rate policies liberalisation of capital accounts the opening ofdomestic stock markets to foreign investors as well as lsquoinvestor-friendlyrsquo policies help to attractforeign investors Global factors have also played a role with the abundant global liquidityenvironment as well as the decrease in home bias By way of example non-residents currently hold46 of French market capitalisation and slightly more than 50 of French government bondsA third driver is the emergence of global financial players such as large banks hedge fundsprivate equity funds and more recently sovereign wealth funds They all share common characteristics- They play an important role in fostering market efficiency and provide liquidity to capitalmarkets- They use sophisticated investment strategies

- They implement advanced risk management practices and help to spread them across marketsand countries35However because of their sheer size and potential impact on market equilibria they raise someconcerns of transparency as well as questions about their role in fostering or not financial stabilityThose issues warrant being debatedWhat are the consequences of the financial globalisation currently underway for global capitalmarkets They are well known so I will just highlight two of themFirst globalisation increases the efficiency of financial marketsThanks to financial globalisation and technological progress informational efficiency of capitalmarkets has increased over the past few decades Any new available information is accuratelyprocessed and impounded in asset prices leading to more accurate pricing of assets and risks And thepermanent quest for arbitrage opportunities has fostered cross-market and cross-border strategies alsoleading to more consistent pricingAllocative efficiency that is the marketrsquos ability to allocate resources in a way that maximises thewelfare attained through their use has also improved for a given investor there is a wider and morediversified range of investment opportunities than ever beforeOperational efficiency has so far gained from globalisation since the cost of financial operations hasquickly fallen due to productivity gains in the financial sector stemming from the scale and scope ofeconomies and the intense competition between markets and intermediariesNevertheless this overall trend towards efficiency occasionally bumps into puzzles that are not readilyexplained by economic theory For instance the longstanding question as to why capital does not flowin net terms from rich to poor countries has not yet been clarified since it was first addressed byRobert Lucas It has recently been supplemented by the so-called ldquoallocation puzzlerdquo highlighting thefact that capital seems to flow toward economies with relatively low investment rates Convincingexplanations for these puzzles certainly require taking into account market imperfections (such ascredit constraints) differences in financial infrastructures as well as growth externalities (such ashuman capital)Another salient feature of financial globalisation is the rapid maturing of emerging economies

and markets In 2007 and 2008 the IMF expects emerging countries to account for more than half ofworld economic growth The same positive trend is reflected in their financing conditions Emergingmarket economies increasingly finance themselves in the form of bonds in local currency at long45maturities and fixed interest rates By doing so they have escaped the curse of ldquooriginal sinrdquo - theinability to borrow abroad in their own currencies - that made the crises of the 1990s so costly Theircapital markets have expanded rapidly both in size and in the range of instruments available Asianstock market capitalisation for instance increased five-fold between 2000 and 2005 as against only aone and a half times increase for the major European and US stock exchanges Issuance of bonds andsyndicated loans from emerging market corporates has also accelerated markedly and has evenexceeded sovereign issuance in some countries Lastly risk premia on emerging market assets havefallen significantly reflecting sound economic fundamentals For this series of reasons emergingmarkets have become an attractive asset class for long-term international investors as shown by theirrising share in asset allocations It is therefore not so surprising that they have so far been relativelyimmune to the current subprime crisis and might even be seen as ldquosafe havensrdquoLet me now turn to some major challenges of financial globalisationFirst the impact on monetary policy Some analysts have suggested that because of capital marketintegration real interest rates will equalize around the world thus reducing the ability of nationalCentral Banks to control inflation However this need not be the case Indeed the classic Mundell-Fleming analysis concludes that monetary policy should be more effective rather than less in the caseof international capital mobility although it can operate through different channels of transmissionincluding the exchange rate Furthermore in many emerging countries strong capital inflows confrontmonetary policy with a dilemma between pursuing internal and external objectives in a context ofrising inflationary pressures Taming capital inflows would call for a relaxation of monetary policy atthe risk however of compromising on the domestic objective of maintaining low inflation Sterilisationcannot always be relied upon to resolve this dilemma as it is likely to be ineffective in the long term

and fuel other imbalances such as excessive accumulation of foreign exchange reservesA second question is the potential for global contagion As a direct consequence of cross-borderfinancial integration local price or liquidity shocks are more likely to spread around the globe Largescaleliquidity creation resulting from monetary (or exchange rate) policy in one country may fuelasset price bubbles elsewhere One current example might be seen in carry trades which have becomea major driver of a number of currencies including the yen Therefore distant events can have sharpimpacts even on local institutions or investors New contagion channels have emerged With more55risk traded in and through markets the potential knock-on effects from an erosion of liquidity in somesegments or for some institutions have multiplied and we are currently experiencing how unexpectedthis process can be Risks have become ldquomobilerdquo if I may put it like that so mobile that we lose sightof their true locationThe third and final set of issues relates to global imbalances The facilitation of cross-border capitalflows may have relaxed financing constraints for borrowers making it possible to finance ever largercurrent account deficits In one sense the contribution of financial globalisation to disconnectingnational savings and national investment is a welcome development to the extent that it allows for amore efficient global allocation of savings However the differences in the development of financialmarkets around the world may also have created or at least facilitated global imbalances The abilityof countries to produce sound and liquid financial assets is largely disconnected from their level ofeconomic growth rising revenues in the emerging world need to ldquofind a homerdquo in sound and liquidfinancial marketsFinally in any case the question of sustainability ndash the resilience of capital flows to the accumulationof imbalances ndash remains a pressing one While capital flows tend to move freely across bordersexchange rate regimes remain very diverse in their degrees of flexibility This leads to asymmetricadjustments depending on the exchange rate regime not only between currency areas but also insidethe same region such as in Asia Overall some of the main floating currencies may end up bearing a

higher share of the adjustment on their shoulders than they should Maintaining integrated globalcapital markets in an environment where such differences persist might not be sustainable over thelong term An orderly unwinding of global imbalances might therefore imply greater flexibility fromcountries with large current account surpluses and fixed exchange ratesI will conclude on a matter of debate for international financial stability for the future As I havesaid financial systems have become more efficient as a result of globalisation and innovation Buthave they become more resilient that is more capable of absorbing shocks None of us has theanswer to that question now but it will be interesting for central banks and regulators to monitorfinancial developments in the coming months in search of clues Ladies and gentlemen thank you foryour attention

FINANCEIndia Inc Globalization of Capital Markets Has India Caught ThisWave EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBALFINANCIAL POWER HOUSEAuthor Miss Kanchan Mishra IIT GuwahatiElectronics amp Communication EngineeringIndia Institute of TechnologyGuwahati ndash781039MrSNMishra Assistant DirectorCentral Silk Board Sualkuchi kanchaniitgernetin snmishra_csbyahoocoin ABSTRACT Finance is the study of money Capital market deals in long term fund of durationone year or above Globalization means integration of financial market through outthe world for raising and investing funds The factors integrating this globalizationare Liberalization Technological Advancement and Institutional InvestorsIndian Financial Market has been Globalized during 1990rsquos Some factors like lowpenetration of Indian household investors in capital market Large investmentopportunities in Indian capital market India as an attractive destination forforeign investors Availability of large labour fource and high growth rate in IndiaAmbitions of Indian inc to reach global markets market Setting up of specialeconomic zone(SEZ) Productive use of idle cash reserve ndash concept of merger andacquisition Venture capital and private equity investments has influenced a lot of

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 3: International Financial Markets

disconnected from the magnitude of the initial shock It invites us to revisit our reading ofglobalisation and contagion in the light of current eventsThe ongoing financial globalisation is underpinned by three main drivers each of them strengtheningthe two othersThe first driver and probably the strongest is financial innovation Supported by technologicalprogress financial innovation has fostered the emergence of new financial products and servicesresulting in more complete financial markets Thanks to advances in financial technology it is nowpossible to break up the risk of an asset into its constituent parts and to recombine them as wished tofit a specific investorrsquos risk profile The emergence of derivatives combined with the appropriatemathematical tools to price them has greatly expanded the range of tradable risks opening up newand vast horizons for hedging strategies Financial institutions are able to actively manage theirexposures and reallocate certain risks to those players that are most able to bear them Overallinvestors are more willing to invest across borders knowing that they can reach an improved riskreturntrade-offSimultaneously economies are becoming more open financially especially in the emergingworld The growth of international capital flows is the consequence both of domestic policies andglobal factors Domestically financial liberalisation and deregulation have relaxed investmentrestrictions More flexible exchange rate policies liberalisation of capital accounts the opening ofdomestic stock markets to foreign investors as well as lsquoinvestor-friendlyrsquo policies help to attractforeign investors Global factors have also played a role with the abundant global liquidityenvironment as well as the decrease in home bias By way of example non-residents currently hold46 of French market capitalisation and slightly more than 50 of French government bondsA third driver is the emergence of global financial players such as large banks hedge fundsprivate equity funds and more recently sovereign wealth funds They all share common characteristics- They play an important role in fostering market efficiency and provide liquidity to capitalmarkets- They use sophisticated investment strategies

- They implement advanced risk management practices and help to spread them across marketsand countries35However because of their sheer size and potential impact on market equilibria they raise someconcerns of transparency as well as questions about their role in fostering or not financial stabilityThose issues warrant being debatedWhat are the consequences of the financial globalisation currently underway for global capitalmarkets They are well known so I will just highlight two of themFirst globalisation increases the efficiency of financial marketsThanks to financial globalisation and technological progress informational efficiency of capitalmarkets has increased over the past few decades Any new available information is accuratelyprocessed and impounded in asset prices leading to more accurate pricing of assets and risks And thepermanent quest for arbitrage opportunities has fostered cross-market and cross-border strategies alsoleading to more consistent pricingAllocative efficiency that is the marketrsquos ability to allocate resources in a way that maximises thewelfare attained through their use has also improved for a given investor there is a wider and morediversified range of investment opportunities than ever beforeOperational efficiency has so far gained from globalisation since the cost of financial operations hasquickly fallen due to productivity gains in the financial sector stemming from the scale and scope ofeconomies and the intense competition between markets and intermediariesNevertheless this overall trend towards efficiency occasionally bumps into puzzles that are not readilyexplained by economic theory For instance the longstanding question as to why capital does not flowin net terms from rich to poor countries has not yet been clarified since it was first addressed byRobert Lucas It has recently been supplemented by the so-called ldquoallocation puzzlerdquo highlighting thefact that capital seems to flow toward economies with relatively low investment rates Convincingexplanations for these puzzles certainly require taking into account market imperfections (such ascredit constraints) differences in financial infrastructures as well as growth externalities (such ashuman capital)Another salient feature of financial globalisation is the rapid maturing of emerging economies

and markets In 2007 and 2008 the IMF expects emerging countries to account for more than half ofworld economic growth The same positive trend is reflected in their financing conditions Emergingmarket economies increasingly finance themselves in the form of bonds in local currency at long45maturities and fixed interest rates By doing so they have escaped the curse of ldquooriginal sinrdquo - theinability to borrow abroad in their own currencies - that made the crises of the 1990s so costly Theircapital markets have expanded rapidly both in size and in the range of instruments available Asianstock market capitalisation for instance increased five-fold between 2000 and 2005 as against only aone and a half times increase for the major European and US stock exchanges Issuance of bonds andsyndicated loans from emerging market corporates has also accelerated markedly and has evenexceeded sovereign issuance in some countries Lastly risk premia on emerging market assets havefallen significantly reflecting sound economic fundamentals For this series of reasons emergingmarkets have become an attractive asset class for long-term international investors as shown by theirrising share in asset allocations It is therefore not so surprising that they have so far been relativelyimmune to the current subprime crisis and might even be seen as ldquosafe havensrdquoLet me now turn to some major challenges of financial globalisationFirst the impact on monetary policy Some analysts have suggested that because of capital marketintegration real interest rates will equalize around the world thus reducing the ability of nationalCentral Banks to control inflation However this need not be the case Indeed the classic Mundell-Fleming analysis concludes that monetary policy should be more effective rather than less in the caseof international capital mobility although it can operate through different channels of transmissionincluding the exchange rate Furthermore in many emerging countries strong capital inflows confrontmonetary policy with a dilemma between pursuing internal and external objectives in a context ofrising inflationary pressures Taming capital inflows would call for a relaxation of monetary policy atthe risk however of compromising on the domestic objective of maintaining low inflation Sterilisationcannot always be relied upon to resolve this dilemma as it is likely to be ineffective in the long term

and fuel other imbalances such as excessive accumulation of foreign exchange reservesA second question is the potential for global contagion As a direct consequence of cross-borderfinancial integration local price or liquidity shocks are more likely to spread around the globe Largescaleliquidity creation resulting from monetary (or exchange rate) policy in one country may fuelasset price bubbles elsewhere One current example might be seen in carry trades which have becomea major driver of a number of currencies including the yen Therefore distant events can have sharpimpacts even on local institutions or investors New contagion channels have emerged With more55risk traded in and through markets the potential knock-on effects from an erosion of liquidity in somesegments or for some institutions have multiplied and we are currently experiencing how unexpectedthis process can be Risks have become ldquomobilerdquo if I may put it like that so mobile that we lose sightof their true locationThe third and final set of issues relates to global imbalances The facilitation of cross-border capitalflows may have relaxed financing constraints for borrowers making it possible to finance ever largercurrent account deficits In one sense the contribution of financial globalisation to disconnectingnational savings and national investment is a welcome development to the extent that it allows for amore efficient global allocation of savings However the differences in the development of financialmarkets around the world may also have created or at least facilitated global imbalances The abilityof countries to produce sound and liquid financial assets is largely disconnected from their level ofeconomic growth rising revenues in the emerging world need to ldquofind a homerdquo in sound and liquidfinancial marketsFinally in any case the question of sustainability ndash the resilience of capital flows to the accumulationof imbalances ndash remains a pressing one While capital flows tend to move freely across bordersexchange rate regimes remain very diverse in their degrees of flexibility This leads to asymmetricadjustments depending on the exchange rate regime not only between currency areas but also insidethe same region such as in Asia Overall some of the main floating currencies may end up bearing a

higher share of the adjustment on their shoulders than they should Maintaining integrated globalcapital markets in an environment where such differences persist might not be sustainable over thelong term An orderly unwinding of global imbalances might therefore imply greater flexibility fromcountries with large current account surpluses and fixed exchange ratesI will conclude on a matter of debate for international financial stability for the future As I havesaid financial systems have become more efficient as a result of globalisation and innovation Buthave they become more resilient that is more capable of absorbing shocks None of us has theanswer to that question now but it will be interesting for central banks and regulators to monitorfinancial developments in the coming months in search of clues Ladies and gentlemen thank you foryour attention

FINANCEIndia Inc Globalization of Capital Markets Has India Caught ThisWave EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBALFINANCIAL POWER HOUSEAuthor Miss Kanchan Mishra IIT GuwahatiElectronics amp Communication EngineeringIndia Institute of TechnologyGuwahati ndash781039MrSNMishra Assistant DirectorCentral Silk Board Sualkuchi kanchaniitgernetin snmishra_csbyahoocoin ABSTRACT Finance is the study of money Capital market deals in long term fund of durationone year or above Globalization means integration of financial market through outthe world for raising and investing funds The factors integrating this globalizationare Liberalization Technological Advancement and Institutional InvestorsIndian Financial Market has been Globalized during 1990rsquos Some factors like lowpenetration of Indian household investors in capital market Large investmentopportunities in Indian capital market India as an attractive destination forforeign investors Availability of large labour fource and high growth rate in IndiaAmbitions of Indian inc to reach global markets market Setting up of specialeconomic zone(SEZ) Productive use of idle cash reserve ndash concept of merger andacquisition Venture capital and private equity investments has influenced a lot of

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 4: International Financial Markets

- They implement advanced risk management practices and help to spread them across marketsand countries35However because of their sheer size and potential impact on market equilibria they raise someconcerns of transparency as well as questions about their role in fostering or not financial stabilityThose issues warrant being debatedWhat are the consequences of the financial globalisation currently underway for global capitalmarkets They are well known so I will just highlight two of themFirst globalisation increases the efficiency of financial marketsThanks to financial globalisation and technological progress informational efficiency of capitalmarkets has increased over the past few decades Any new available information is accuratelyprocessed and impounded in asset prices leading to more accurate pricing of assets and risks And thepermanent quest for arbitrage opportunities has fostered cross-market and cross-border strategies alsoleading to more consistent pricingAllocative efficiency that is the marketrsquos ability to allocate resources in a way that maximises thewelfare attained through their use has also improved for a given investor there is a wider and morediversified range of investment opportunities than ever beforeOperational efficiency has so far gained from globalisation since the cost of financial operations hasquickly fallen due to productivity gains in the financial sector stemming from the scale and scope ofeconomies and the intense competition between markets and intermediariesNevertheless this overall trend towards efficiency occasionally bumps into puzzles that are not readilyexplained by economic theory For instance the longstanding question as to why capital does not flowin net terms from rich to poor countries has not yet been clarified since it was first addressed byRobert Lucas It has recently been supplemented by the so-called ldquoallocation puzzlerdquo highlighting thefact that capital seems to flow toward economies with relatively low investment rates Convincingexplanations for these puzzles certainly require taking into account market imperfections (such ascredit constraints) differences in financial infrastructures as well as growth externalities (such ashuman capital)Another salient feature of financial globalisation is the rapid maturing of emerging economies

and markets In 2007 and 2008 the IMF expects emerging countries to account for more than half ofworld economic growth The same positive trend is reflected in their financing conditions Emergingmarket economies increasingly finance themselves in the form of bonds in local currency at long45maturities and fixed interest rates By doing so they have escaped the curse of ldquooriginal sinrdquo - theinability to borrow abroad in their own currencies - that made the crises of the 1990s so costly Theircapital markets have expanded rapidly both in size and in the range of instruments available Asianstock market capitalisation for instance increased five-fold between 2000 and 2005 as against only aone and a half times increase for the major European and US stock exchanges Issuance of bonds andsyndicated loans from emerging market corporates has also accelerated markedly and has evenexceeded sovereign issuance in some countries Lastly risk premia on emerging market assets havefallen significantly reflecting sound economic fundamentals For this series of reasons emergingmarkets have become an attractive asset class for long-term international investors as shown by theirrising share in asset allocations It is therefore not so surprising that they have so far been relativelyimmune to the current subprime crisis and might even be seen as ldquosafe havensrdquoLet me now turn to some major challenges of financial globalisationFirst the impact on monetary policy Some analysts have suggested that because of capital marketintegration real interest rates will equalize around the world thus reducing the ability of nationalCentral Banks to control inflation However this need not be the case Indeed the classic Mundell-Fleming analysis concludes that monetary policy should be more effective rather than less in the caseof international capital mobility although it can operate through different channels of transmissionincluding the exchange rate Furthermore in many emerging countries strong capital inflows confrontmonetary policy with a dilemma between pursuing internal and external objectives in a context ofrising inflationary pressures Taming capital inflows would call for a relaxation of monetary policy atthe risk however of compromising on the domestic objective of maintaining low inflation Sterilisationcannot always be relied upon to resolve this dilemma as it is likely to be ineffective in the long term

and fuel other imbalances such as excessive accumulation of foreign exchange reservesA second question is the potential for global contagion As a direct consequence of cross-borderfinancial integration local price or liquidity shocks are more likely to spread around the globe Largescaleliquidity creation resulting from monetary (or exchange rate) policy in one country may fuelasset price bubbles elsewhere One current example might be seen in carry trades which have becomea major driver of a number of currencies including the yen Therefore distant events can have sharpimpacts even on local institutions or investors New contagion channels have emerged With more55risk traded in and through markets the potential knock-on effects from an erosion of liquidity in somesegments or for some institutions have multiplied and we are currently experiencing how unexpectedthis process can be Risks have become ldquomobilerdquo if I may put it like that so mobile that we lose sightof their true locationThe third and final set of issues relates to global imbalances The facilitation of cross-border capitalflows may have relaxed financing constraints for borrowers making it possible to finance ever largercurrent account deficits In one sense the contribution of financial globalisation to disconnectingnational savings and national investment is a welcome development to the extent that it allows for amore efficient global allocation of savings However the differences in the development of financialmarkets around the world may also have created or at least facilitated global imbalances The abilityof countries to produce sound and liquid financial assets is largely disconnected from their level ofeconomic growth rising revenues in the emerging world need to ldquofind a homerdquo in sound and liquidfinancial marketsFinally in any case the question of sustainability ndash the resilience of capital flows to the accumulationof imbalances ndash remains a pressing one While capital flows tend to move freely across bordersexchange rate regimes remain very diverse in their degrees of flexibility This leads to asymmetricadjustments depending on the exchange rate regime not only between currency areas but also insidethe same region such as in Asia Overall some of the main floating currencies may end up bearing a

higher share of the adjustment on their shoulders than they should Maintaining integrated globalcapital markets in an environment where such differences persist might not be sustainable over thelong term An orderly unwinding of global imbalances might therefore imply greater flexibility fromcountries with large current account surpluses and fixed exchange ratesI will conclude on a matter of debate for international financial stability for the future As I havesaid financial systems have become more efficient as a result of globalisation and innovation Buthave they become more resilient that is more capable of absorbing shocks None of us has theanswer to that question now but it will be interesting for central banks and regulators to monitorfinancial developments in the coming months in search of clues Ladies and gentlemen thank you foryour attention

FINANCEIndia Inc Globalization of Capital Markets Has India Caught ThisWave EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBALFINANCIAL POWER HOUSEAuthor Miss Kanchan Mishra IIT GuwahatiElectronics amp Communication EngineeringIndia Institute of TechnologyGuwahati ndash781039MrSNMishra Assistant DirectorCentral Silk Board Sualkuchi kanchaniitgernetin snmishra_csbyahoocoin ABSTRACT Finance is the study of money Capital market deals in long term fund of durationone year or above Globalization means integration of financial market through outthe world for raising and investing funds The factors integrating this globalizationare Liberalization Technological Advancement and Institutional InvestorsIndian Financial Market has been Globalized during 1990rsquos Some factors like lowpenetration of Indian household investors in capital market Large investmentopportunities in Indian capital market India as an attractive destination forforeign investors Availability of large labour fource and high growth rate in IndiaAmbitions of Indian inc to reach global markets market Setting up of specialeconomic zone(SEZ) Productive use of idle cash reserve ndash concept of merger andacquisition Venture capital and private equity investments has influenced a lot of

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 5: International Financial Markets

and markets In 2007 and 2008 the IMF expects emerging countries to account for more than half ofworld economic growth The same positive trend is reflected in their financing conditions Emergingmarket economies increasingly finance themselves in the form of bonds in local currency at long45maturities and fixed interest rates By doing so they have escaped the curse of ldquooriginal sinrdquo - theinability to borrow abroad in their own currencies - that made the crises of the 1990s so costly Theircapital markets have expanded rapidly both in size and in the range of instruments available Asianstock market capitalisation for instance increased five-fold between 2000 and 2005 as against only aone and a half times increase for the major European and US stock exchanges Issuance of bonds andsyndicated loans from emerging market corporates has also accelerated markedly and has evenexceeded sovereign issuance in some countries Lastly risk premia on emerging market assets havefallen significantly reflecting sound economic fundamentals For this series of reasons emergingmarkets have become an attractive asset class for long-term international investors as shown by theirrising share in asset allocations It is therefore not so surprising that they have so far been relativelyimmune to the current subprime crisis and might even be seen as ldquosafe havensrdquoLet me now turn to some major challenges of financial globalisationFirst the impact on monetary policy Some analysts have suggested that because of capital marketintegration real interest rates will equalize around the world thus reducing the ability of nationalCentral Banks to control inflation However this need not be the case Indeed the classic Mundell-Fleming analysis concludes that monetary policy should be more effective rather than less in the caseof international capital mobility although it can operate through different channels of transmissionincluding the exchange rate Furthermore in many emerging countries strong capital inflows confrontmonetary policy with a dilemma between pursuing internal and external objectives in a context ofrising inflationary pressures Taming capital inflows would call for a relaxation of monetary policy atthe risk however of compromising on the domestic objective of maintaining low inflation Sterilisationcannot always be relied upon to resolve this dilemma as it is likely to be ineffective in the long term

and fuel other imbalances such as excessive accumulation of foreign exchange reservesA second question is the potential for global contagion As a direct consequence of cross-borderfinancial integration local price or liquidity shocks are more likely to spread around the globe Largescaleliquidity creation resulting from monetary (or exchange rate) policy in one country may fuelasset price bubbles elsewhere One current example might be seen in carry trades which have becomea major driver of a number of currencies including the yen Therefore distant events can have sharpimpacts even on local institutions or investors New contagion channels have emerged With more55risk traded in and through markets the potential knock-on effects from an erosion of liquidity in somesegments or for some institutions have multiplied and we are currently experiencing how unexpectedthis process can be Risks have become ldquomobilerdquo if I may put it like that so mobile that we lose sightof their true locationThe third and final set of issues relates to global imbalances The facilitation of cross-border capitalflows may have relaxed financing constraints for borrowers making it possible to finance ever largercurrent account deficits In one sense the contribution of financial globalisation to disconnectingnational savings and national investment is a welcome development to the extent that it allows for amore efficient global allocation of savings However the differences in the development of financialmarkets around the world may also have created or at least facilitated global imbalances The abilityof countries to produce sound and liquid financial assets is largely disconnected from their level ofeconomic growth rising revenues in the emerging world need to ldquofind a homerdquo in sound and liquidfinancial marketsFinally in any case the question of sustainability ndash the resilience of capital flows to the accumulationof imbalances ndash remains a pressing one While capital flows tend to move freely across bordersexchange rate regimes remain very diverse in their degrees of flexibility This leads to asymmetricadjustments depending on the exchange rate regime not only between currency areas but also insidethe same region such as in Asia Overall some of the main floating currencies may end up bearing a

higher share of the adjustment on their shoulders than they should Maintaining integrated globalcapital markets in an environment where such differences persist might not be sustainable over thelong term An orderly unwinding of global imbalances might therefore imply greater flexibility fromcountries with large current account surpluses and fixed exchange ratesI will conclude on a matter of debate for international financial stability for the future As I havesaid financial systems have become more efficient as a result of globalisation and innovation Buthave they become more resilient that is more capable of absorbing shocks None of us has theanswer to that question now but it will be interesting for central banks and regulators to monitorfinancial developments in the coming months in search of clues Ladies and gentlemen thank you foryour attention

FINANCEIndia Inc Globalization of Capital Markets Has India Caught ThisWave EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBALFINANCIAL POWER HOUSEAuthor Miss Kanchan Mishra IIT GuwahatiElectronics amp Communication EngineeringIndia Institute of TechnologyGuwahati ndash781039MrSNMishra Assistant DirectorCentral Silk Board Sualkuchi kanchaniitgernetin snmishra_csbyahoocoin ABSTRACT Finance is the study of money Capital market deals in long term fund of durationone year or above Globalization means integration of financial market through outthe world for raising and investing funds The factors integrating this globalizationare Liberalization Technological Advancement and Institutional InvestorsIndian Financial Market has been Globalized during 1990rsquos Some factors like lowpenetration of Indian household investors in capital market Large investmentopportunities in Indian capital market India as an attractive destination forforeign investors Availability of large labour fource and high growth rate in IndiaAmbitions of Indian inc to reach global markets market Setting up of specialeconomic zone(SEZ) Productive use of idle cash reserve ndash concept of merger andacquisition Venture capital and private equity investments has influenced a lot of

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 6: International Financial Markets

and fuel other imbalances such as excessive accumulation of foreign exchange reservesA second question is the potential for global contagion As a direct consequence of cross-borderfinancial integration local price or liquidity shocks are more likely to spread around the globe Largescaleliquidity creation resulting from monetary (or exchange rate) policy in one country may fuelasset price bubbles elsewhere One current example might be seen in carry trades which have becomea major driver of a number of currencies including the yen Therefore distant events can have sharpimpacts even on local institutions or investors New contagion channels have emerged With more55risk traded in and through markets the potential knock-on effects from an erosion of liquidity in somesegments or for some institutions have multiplied and we are currently experiencing how unexpectedthis process can be Risks have become ldquomobilerdquo if I may put it like that so mobile that we lose sightof their true locationThe third and final set of issues relates to global imbalances The facilitation of cross-border capitalflows may have relaxed financing constraints for borrowers making it possible to finance ever largercurrent account deficits In one sense the contribution of financial globalisation to disconnectingnational savings and national investment is a welcome development to the extent that it allows for amore efficient global allocation of savings However the differences in the development of financialmarkets around the world may also have created or at least facilitated global imbalances The abilityof countries to produce sound and liquid financial assets is largely disconnected from their level ofeconomic growth rising revenues in the emerging world need to ldquofind a homerdquo in sound and liquidfinancial marketsFinally in any case the question of sustainability ndash the resilience of capital flows to the accumulationof imbalances ndash remains a pressing one While capital flows tend to move freely across bordersexchange rate regimes remain very diverse in their degrees of flexibility This leads to asymmetricadjustments depending on the exchange rate regime not only between currency areas but also insidethe same region such as in Asia Overall some of the main floating currencies may end up bearing a

higher share of the adjustment on their shoulders than they should Maintaining integrated globalcapital markets in an environment where such differences persist might not be sustainable over thelong term An orderly unwinding of global imbalances might therefore imply greater flexibility fromcountries with large current account surpluses and fixed exchange ratesI will conclude on a matter of debate for international financial stability for the future As I havesaid financial systems have become more efficient as a result of globalisation and innovation Buthave they become more resilient that is more capable of absorbing shocks None of us has theanswer to that question now but it will be interesting for central banks and regulators to monitorfinancial developments in the coming months in search of clues Ladies and gentlemen thank you foryour attention

FINANCEIndia Inc Globalization of Capital Markets Has India Caught ThisWave EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBALFINANCIAL POWER HOUSEAuthor Miss Kanchan Mishra IIT GuwahatiElectronics amp Communication EngineeringIndia Institute of TechnologyGuwahati ndash781039MrSNMishra Assistant DirectorCentral Silk Board Sualkuchi kanchaniitgernetin snmishra_csbyahoocoin ABSTRACT Finance is the study of money Capital market deals in long term fund of durationone year or above Globalization means integration of financial market through outthe world for raising and investing funds The factors integrating this globalizationare Liberalization Technological Advancement and Institutional InvestorsIndian Financial Market has been Globalized during 1990rsquos Some factors like lowpenetration of Indian household investors in capital market Large investmentopportunities in Indian capital market India as an attractive destination forforeign investors Availability of large labour fource and high growth rate in IndiaAmbitions of Indian inc to reach global markets market Setting up of specialeconomic zone(SEZ) Productive use of idle cash reserve ndash concept of merger andacquisition Venture capital and private equity investments has influenced a lot of

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 7: International Financial Markets

higher share of the adjustment on their shoulders than they should Maintaining integrated globalcapital markets in an environment where such differences persist might not be sustainable over thelong term An orderly unwinding of global imbalances might therefore imply greater flexibility fromcountries with large current account surpluses and fixed exchange ratesI will conclude on a matter of debate for international financial stability for the future As I havesaid financial systems have become more efficient as a result of globalisation and innovation Buthave they become more resilient that is more capable of absorbing shocks None of us has theanswer to that question now but it will be interesting for central banks and regulators to monitorfinancial developments in the coming months in search of clues Ladies and gentlemen thank you foryour attention

FINANCEIndia Inc Globalization of Capital Markets Has India Caught ThisWave EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBALFINANCIAL POWER HOUSEAuthor Miss Kanchan Mishra IIT GuwahatiElectronics amp Communication EngineeringIndia Institute of TechnologyGuwahati ndash781039MrSNMishra Assistant DirectorCentral Silk Board Sualkuchi kanchaniitgernetin snmishra_csbyahoocoin ABSTRACT Finance is the study of money Capital market deals in long term fund of durationone year or above Globalization means integration of financial market through outthe world for raising and investing funds The factors integrating this globalizationare Liberalization Technological Advancement and Institutional InvestorsIndian Financial Market has been Globalized during 1990rsquos Some factors like lowpenetration of Indian household investors in capital market Large investmentopportunities in Indian capital market India as an attractive destination forforeign investors Availability of large labour fource and high growth rate in IndiaAmbitions of Indian inc to reach global markets market Setting up of specialeconomic zone(SEZ) Productive use of idle cash reserve ndash concept of merger andacquisition Venture capital and private equity investments has influenced a lot of

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 8: International Financial Markets

foreign investors to invest in India and has influenced globalization of Indian capitalmarketINTRODUCTION Finance is the study of money its nature creation behavior regulationand administration Financial market facilitates the trading of financialassets Financial market play a significant role in transferring surplus fundfrom saver ( lender ) to borrowers ( investors ) Financial market is classifiedas Money Market and Capital Market (i) Money Market It is themechanism where short term instruments maturing within a year are traded(ii) Capital Market It is a market in which lenders or investors provideslong term funds of the duration of above one year in exchange for financialassets offered by borrowers or holdersThe capital market in India is divided into Organized and Unorganizedsectors (i) Indigenous bankers and Money lenders constitutes theunorganized sector of capital market (ii) The organized capital marketconsists of Non-Banking institutions like and Public Financial InstitutionsA financial security is a legal instrument that represents either ownership orcreditorship claim The ownership securities are equity shares andpreference shares The creditorship securities are bonds and debentures1Globalization of Financial Markets Globalization means the integration of financial market through out theworld into an international financial market Entities in any one countryseeking to raise funds need not be limited to their domestic financial marketEven investors in a country is not limited to the financial assets issued intheir domestic market The factors integrating this globalization are Liberalization Technological Advances and Institutional Investors(i)Liberalization Deregulation and liberalization of markets and activitiesof market participants in key financial centers of the world Globalcompetition has forced governments to deregulate or liberalize variousaspects of their financial markets so that their financial enterprises cancompete effectively around the world(ii) Technological Advances For monitoring world markets executingorders and analyzing financial opportunities Technological advances haveincreased the integration and efficiency of the global financial marketAdvances in telecommunication systems link market participants throughout the world with the result that order can be executed within secondsAdvances in computer technology coupled with advancedtelecommunication systems allow the transmission of real-time informationon security prices and other key information to many participants in many

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 9: International Financial Markets

places Therefore many investors can monitor global markets andsimultaneously assess how this information will impact the riskrewardprofile of their portfolios Significantly improved computing power allowsthe instant manipulation of real-time market information so that attractiveinvestment opportunities can be identified On identification of theseopportunities telecommunication system permits the rapid execution oforders to capture them(iii) Institutional Investors Increasing institutionalization of financialmarkets The shifting of the role of two types of investors retail andinstitutional investors in financial markets is the third factor that has led tothe integration of financial markets The US financial market has siftedfrom being dominated by retail investors to being dominated by institutionalinvestors Retail investors are individuals Institutional investors are Financial Institution ndashPension Funds Insurance Companies InvestmentCompanies Commercial Banks Savings amp Loan Associations The shiftingof financial markets in US and other major industrial countries fromdominance by retail investors to institutional investors is referred asinstitutionalization of financial markets2Unlike retail investors institutional investors have been more willing totransfer funds across national borders to improve the riskrewardopportunities of a portfolio that includes financial assets of foreign issuersThe potential portfolio benefits associated with global investing have beendocumented in numerous studies which have highlighted the awareness ofinvestors about the virtues of global investing Investors have not limitedtheir participation in foreign markets to those of developed economiesThere has been increased participation in the financial markets of developingeconomies popularly known as emerging marketsIndian Financial market have been globalized in 1990rsquos to a good extentThe global financial market can be divided into three sectors DomesticMarket Foreign Market and International Market (i) Domestic Market In domestic market issuers are domiciled in thecountry where the securities are issued and where those securities aresubsequently traded(ii) Foreign Market Foreign market of a country is where the securities ofissuers are not domiciled in the country are sold and traded Rules governingthe issuance of foreign securities are those imposed by regulatory authoritieswhere the security is issued Nicknames have been used to describe variousforeign markets Yankee Market ( USA) Samurai Market (Japan) BulldogMarket ( United Kingdome) Rembrandt Market ( Netherlands) Matador

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 10: International Financial Markets

Market (Spain)(iii) International Market This external market includes securities withfollowing distinguishing features at issuance they are offeredsimultaneously to investors in number of countries and they are issuedoutside the jurisdiction of any single country The external market iscommonly referred to as Offshore Market EuromarketsMATERIAL AND METHODS Under this studies the factors influencing globalization of Indian capitalmarkets have studied The countries investing in India has also beenidentified and the comparative proportion of foreign investment in India incomparison to China has also been examined3Factors Influencing Globalization of Indian Capital Market 1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITALMARKET Indian household investors are of the habit of investing chunkof their amount in financial savings in money market and only a smallamount of their savings are invested in capital market During last ten yearsthe investment of savings from Indian households in capital market in termsof shares and debentures has declined from 144 during 1994-95 to onlyabout 18 in 2003-2004 at current price level (table-1) and this influencesIndian capital market towards globalization for attracting larger capitalinvestmentsTable -1- Investment trend of Indian households in Share and debentures( Figures in Rupees Crores at current price )Year TotalHouseholdSavingsHouseholdFinancial SavingsSavings in Shares ampDebenturesof SharesampDebentures1994-95 199358 120733 17381 1441995-96 216140 105719 9101 861996-97 233252 141661 10407 731997-98 268437 146777 5060 341998-99 326802 180346 6993 381999-00 404401 205743 18188 882000-01 452268 216774 10214 472001-02 513100 253964 7777 312002-03 574681 254439 5504 222003-04 671692 314261 5699 18

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 11: International Financial Markets

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITALMARKETIt is boom for investors in Indian stock markets the benchmarkBombay Stock Exchangersquos Sensex is virtually sprinting from 7000-7800 injust 32 trading days The surge is being driven by a flus h of liquidity broughtabout by bullish foreign institutional investors (FII s) The coming upcurrent public issues opportunities Both initial public offerings(IPO s) andthe Follow-up Public Offerings (FPO s) is estimated to be Rs 72814 crores(around $ 1654 billion) The amount to be raised in next 12 month is biggerthan what companies have raised cumulatively over the last decadesright up to March this year To meet this requirement India has to looktowards globalization and foreign investors43)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGNINVESTORSEmerging market in India continue to be an attractivedestination for Foreign Institutional Investors (FII) with total FII inflowinto Indian equities already exceeding $ 6 billion th is year till July 2005 atthis rate FII inflow is expected to exceed $ 10 billion by the end of year2005The FII inflow last year 2004 was $ 85 billion and that during the year2003 was $ 64 billion4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHERGROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OFINDIAN CAPITAL MARKET India has a large labour force 2nd largestin the world 4822 million during the year 2004 This labour force hascontributed to more than 9 growth rate in manufacturing and servicesector This will in evolving Indian capital market as global power house incoming years As the comperative GDP growth rate in comparison to USAand EU where the GDP growth rate is 36 and 12 respectively Thisglobalization is gradually supporting in increasing employment andproductivity5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPSINDIAN INC TO REACH GLOBAL MARKETS Foreign directinvestment is a mirror that reflects the extent to which a country and itscompanies have integrated globally Going by the logic it must be apainful sight for most Indian companies to held a mirror to their balancesheets Once again the characteristic timidity of the Indian Inc is clearlyvisible on both sides Whether it is incoming FDI or Outgoing FDIThe comparative FDI in Asian countries is indicated in Table -2Table-2- FDI to and from Asian countries ( $ billion ) Source IMFCountry Inward FDI Outward FDI2003 2004 2003 2004

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 12: International Financial Markets

China+Hongkong 136 340 -02 18India 43 53 09 23Singapore 93 161 37 107Japan 288 310 63 78Korea 34 48 35 8256)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTSGLOBALISATIONSEZ is an area having economic policies and lawswhich are typically different from the laws prevailing within the main landChina has established a number of SEZ each with an average area of 145 sqkm while India has only 8 active SEZ with an average area of 9 sq kmChina has attracted large FDI in its SEZ but this has not su cceeded in Indiaso far7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUSamp IDLE CASH RESERVE MERGERS AND ACQUISITIONSA fewyears ago Aziz Premji of Wipro and his former vice-chairman Vivek Paulwere considering a big ticket acquisition in US to catapulate Wipro into ITand consulting big league at one stroke They had a war chest of $ 800million yet Wipro got the jitters at last minute and backed out Around thesame time a virtually unknown PC maker from China Lenovo was nursingglobal ambitions Lenovo did not get the jitters It ended up buying the outthe global PC business of IBM the mother of all IT companies in a dealworth more than $ 2 billionIn April 2005 there was cheers as Indiarsquos fastest growing home grownbank ICICI acquired the Russian bank IKB It finally looked as if Indiancompanies were looking seriously at globalization Let us look at insidestory ICICIrsquos net profits in 2004-05 was Rs 20 billion The cash balance ofICICI Bank in the same period were about 150 billion The price tag ICICIpaid for IKB a small Rs 18 million Around the same time big foreignbanks like CitiABN AmroHSBCStanchart has lined up more than Rs 50billion to ramp up their Indian operations Indian companies are yet tomatch their global counterparts in leveraging cash holds to muscle their wayinto international marketInvestments in Mergers amp Acquisition during year Jan-Jun 2005 Japan hasinvested more than $ 100 billion China has invested $ 17 billion and Indiahas invested only around $ 8 billion The investment in mergers andacquisitions is an indicator towards globalization of capital market8)GLOBALISATION OF INDIAN STOCK MARKET HASMOTIVATED VENTURE CAPITALPRIVATE EQUITYINVESTMENT IN INDIA In last 10 years after globalization of Indian

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 13: International Financial Markets

capital market the venture capital investment in India has increased 100times The companies like 3i Texas Pacific Group The Blackstone TheCarlyle Group are new internets in globalized Indian capital markets Theventure capitalPrivate equity Risk capital investment in 1996-97 was $ 20million during 2004 -05 it attracted $ 1750 million in IT sectors of India asresult of globalization 6THE SOURCES OF FOREIGN INVESTORS COMING TO INVESTIN INDIAN CAPITAL MARKETThe Indian stock market is attracting foreign institutional investors(FII) ofall types Of the total of $ 37 billion FII investments in India since 1994 afifth has flowed in during first eight months of 2005 During this year 123FII from 20 countries have registered The country wise they are USA 37Canada 3 Port of Spain 1 UK 22 Luxembourg 12 France 6 Switzerland 4Australia 6 Singapore 9 Hongkong 2 Taiwan 2 Japan 2 Korea 2 Thesectored investment in prominent areas are Pension Trusts 16 InsuranceCompanies 4 Government Bodies 32 Banks 144 Capital Investmentand Asset Management Company 624RESULTS amp SUGGESTIONS China opened its economy in 1980 and since then China had received $ 500billion worth of foreign investment of these nearly $ 60 billion name incalendar year 2004 However so India could attract only around $ 50 billionforeign investment since 1980 and during 2004 it was less than $ 6 billionThat means the speed of globalization of the Indian stock market is only10 of ChinaNow it is essential that like Indian commercial banks Indian stock exchangeshas to open its branches in various parts of India and in foreign country toprovide quick liquidity to capital instrument and on the spot investment andallotment of instruments to investors The term broker or dalal should bechanged to agent or service personel

Chapter 1Financial Innovations and the Dynamics of EmergingCapital MarketsLaurent L JacqueFletcher School of Law and Diplomacy Tufts University and HEC School of ManagementKey words Financial Innovation Emerging Capital Markets Disintermediation Securitization (JEL G15 G29)Abstract National capital markets can be positioned along a continuum ranging from embryonic to mature andemerged markets according to a decreasing lsquonational cost of capitalrsquo criterion Newly emergingcountries are handicapped by a high cost of capital because of lsquoincompletersquo and inefficient financialmarkets As capital markets graduate to higher level of lsquoemergednessrsquo their national firms availthemselves of a lower cost of capital that makes them more competitive in the global economy and spurseconomic growth This chapter argues that the dynamics of emerging markets are driven by 1) theskillful transfer of financial innovations to emerging markets committed to deregulating their financial

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 14: International Financial Markets

sector 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor ofa more cost effective commercial paper market and 3) securitization of consumer finance which reduceshouseholdsrsquo cost of living

1 INTRODUCTIONFinancial innovation is often blamed for what is perceived as an increase in systemic risk ndash theAsian and Latin American crises being the latest cases in point Yet financial innovation in theform of different types of derivatives products or financial engineering technologies generallyprovide low-cost and highly efficient methods of mitigating rather than exacerbating risk bylsquocompletingrsquo emerging capital markets1 This introductory chapter argues that financialinnovations nurture the lsquoemergencersquo process of capital markets in developing countries bybringing about a lower national cost of capital that in turn enhances the wealth of nationsIf one can visualize emerging national capital markets positioned along a continuum rangingfrom recently lsquohatchedrsquo or embryonic to truly mature markets one can hypothesize that the racealong this continuum is indeed beneficial as ascending countries avail themselves of a lowernational cost of capital arguably this process is welfare-enhancing as it improves living standardsand make national firms more competitive in the global marketplace The quintessential questionis thus to identify the drivers of this process I would suggest that deregulation disintermediationsecuritization and the transfer of financial innovations are critical to this processThis first chapter is organized as follows the first two sections set the stage by defining financialinnovations and mapping the lsquoemergencersquo concept as it relates to the capital marketsegmentationintegration Sections 3 4 and 5 show how disintermediation deregulation andsecuritization energize the emergence process2 DEFINING FINANCIAL INNOVATIONFinancial innovation refers to any new development in a national financial system or theinternational financial system thatenhances the allocational efficiency of the financial intermediation process andimproves the operational efficiency of the financial system by reducing the costs andorrisk of transactions in the primary and secondary markets in which financial instrumentsare tradedThe last 25 years have witnessed an acceleration in the process of financial innovation Thishas been spurred largely by increased volatility of exchange rates interest rates and commodityprices and an increase in the pace of tax and regulatory change The resulting financialinnovations may be classified asnew financial intermediaries (eg venture capital funds)new financial instruments (eg collateralized mortgage obligations or credit derivatives)new financial markets (eg insurance derivatives)new financial services (eg e-trading or e-banking)new financial techniques (eg VR or LBOs)Such financial innovations and their globally reaching migration from mature to emergingmarkets are generally construed as beneficial to host financial sectors because their bring about alower national cost of capital presumably by allowing the transfer of risk from firms less able tobear risk to those which are better equipped to bear it (division of labor) financial intermediationis improved and national welfare is enhanced In the best of finance theory tradition howeverone cannot talk about a lower cost of capital or a higher yield without raising the question of riskOf course we have to stretch the concept of portfolio theory somewhat to talk about the risk ndashpresumably systemic ndash of a national financial system Let me venture a simple propositiontransfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the costof capital without a commensurate increase in systemic risk (see Figure 1)2

Figure 1 Welfare-Enhancing Emergence Path

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 15: International Financial Markets

Cost ofCapitalSystemicRiskHighHighLowLowWelfare-enhancing emergenceHere the analogy made by the Nobel laureate Robert Merton (1993) between emerging financialsystems and a newly engineered high-speed passenger train traveling along a track unable to sustainthe speed is helpful the track is the existing regulatory infrastructure - often obsolete in emergingfinancial systems - within which financial innovations are imported and which are in dire need ofrepair and upgrade If the new high-speed passenger train is allowed to travel at its peakperformance speed it may crash thereby destroying or severely damaging the track system freightoperators who use the track for a different purpose would no longer be able to rely on it Regulatorsmay thus choose to set a safe but low speed policy with the unfortunate consequence of deprivingthe country of the benefits of the imported innovation (high speed train) alternatively regulatorsmay upgrade the speed limit as soon as the infrastructure is improved and ldquothe technologicalimbalance between the product and its infrastructure is correctedrdquo3

3 MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another at least to some degree thusallowing for differences in the effective cost of capital among different countries For this reasonrather than thinking in terms of a clear-cut dichotomy between segmented and integrated nationalcapital markets it is more useful to position each country along a continuum ranging fromextreme segmentation to complete integrationAs illustrated in Figure 2 such an emergence continuum would show the newly hatchedTashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its lsquosegmentationrsquo extremumwhereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremumclose to the final destination point ndash the New York Stock Exchange The practical question ofpositioning a particular capital market along this continuum can be resolved by relying on amultidimensional scale that could include the following variables1 Market Capitalization(MCAP)Gross Disposable Income (GDP) index as a proxy for thecountry financial sector deepnessmaturity2 Disintermediation index as a measure of the percentage of aggregate financing channeled byfinancial markets as opposed to traditional financial intermediation provided by commercialbanks presumably the allocational and operational efficiency are enhanced by a greaterreliance on financial markets (especially the commercial paper market) than on financialinstitutions3 American Depositary Receipts (ADRs)5 index as a measure of the offshore marketcapitalization of national firms traded on the New-York or London stock exchange as opposedto total market capitalization (see Box 1 p5) For example Santiago (Chile) through a handfulof major Chilean firms whose ADRs are trading on the New York Stock Exchange may becharacterized by an index as high as 35 indicating a significant degree of market integrationwhen such firms are simultaneously traded on both exchanges they force on the otherwiserelatively segmented market of Santiago valuation rules more closely aligned with the highlyefficient New York stock exchange4 Market Completedness index6 measuring the degree of coverage of the matrix marketproduct(cf Figure 3) As capital markets avail themselves of a fuller range of financial products theybenefit from a higher level of both allocational and operational efficiency that is welfareenhancing

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 16: International Financial Markets

For example if we arbitrarily allocate equal weights of 004 (out of a maximum of1) to each cell of the market Bangkok would receive a score of 02 whereas Sao Paulo wouldget 048 out of a maximum of 1 for markets such as New York or LondonFigure 2 Capital market emergence continuum

Alternatively one can map this segmentation integration continuum in a three dimensionalspace by decomposing the worldrsquos capital into three major components (1) the equity market (2)the debt market and (3) the foreign exchange market which functions as a kind of transmissionbelt between national segments of the first two Unlike industrialized nations which haveefficient and well functioning capital markets emerging capital markets have burgeoning equitymarkets barely existing debt markets (with relatively short tenors) and mildly controlled foreignexchange markets As discussed further below in such emerging markets debt financingHong KongSingaporeSatildeo PauloMexico CityBangkokJakartaBombayShanghaiBudapestColomboEmergedPre-Emerging UlaanbaatarNYC London TokyoCost of Capital =f (Innovation DisintermediationSecuritization Deregulation)TashkentSeoulKievHo Chi Minh CityEmergingcontinues to be provided predominantly by commercial banks and finance companies (which mayalso be major providers of equity financing)Forwards Futures Swaps Options OtherDerivativesForeign Exchange BKK SP BKK SP BKK SP BKK SP SPInterest Rate SP SPCommodities BKK SP SPBondsStock SP SP SPFigure 3 Matrix of market lsquocompletednessrsquo

31 Equity Market SegmentationA national capital equity market is defined as segmented to the extent a given securityrsquos rateof return in that particular market differs from that of other comparably risky securities traded inother national markets Why are national equity markets segmented from one anotherSegmentation may result from differences in government tax policies regulatory obstacles to theintroduction of financial innovations foreign exchange controls on capital account transactions(especially for the purpose of international portfolio investment) restrictions on the amount ofcorporate control exercised by large investors and other forms of regulatory interference with theefficient functioning of national equity markets Segmentation can also be caused by differencesin investors expectations stemming from informational barriers and differences in disclosure

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 17: International Financial Markets

requirements among national equity markets For many emerging capital markets ndash most notablythose in Latin America ndash rapidly growing ADR markets anchored in the New York StockExchange or the NASDAQ are providing a lsquoshadowrsquo market which is acting as a catalyst for theemergence process (see Box 1)32 Debt Market SegmentationIn efficient and integrated money markets interest rates are free to adjust to changingexpectations As a result they tend to respond so quickly to new information that opportunitiesfor profitable arbitrage are quickly bid away This is true of most industrialized with completeBox 1 ADRs and the segmentation of capital markets American Depositary Receipts(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositarybank The investor in an ADR enjoys the benefits of share ownership in a foreign corporationwithout facing the cumbersome and otherwise onerous costs of investing directly in a foreignequity markets Such obstacles include costly currency conversions opaque tax regulationsunreliable custody and settlement in a foreign country Such ADRs programs offer alsoseveral advantages for the issuing company often domiciled in an emerging market Creationof a larger and geographically more diversified shareholder basis generally stabilizes shareprices and provide additional liquidity Raising of additional equity capital is also facilitatedif the firmrsquos home market cannot absorb a new issue More exacting reporting and disclosurerequirements enhances the profile and the attractiveness of the firmrsquos stock from investorsrsquoperspective In sum it is generally believed that ADRs program results into a lower cost ofcapitalfinancial markets (with well functioning currency and interest rate futures forward swaps andoptions markets) and fully convertible currenciesIn such markets a condition known as Interest Rate Parity is likely to prevail whereby largesophisticated borrowers and lenders such as commercial banks and money-market mutual fundsshould be indifferent between borrowing or lending in the domestic or the foreign currency (whenexchange risk is eliminated) Expected real interest rates for identical debt securities may stilldiffer across currencies but such differences should be effectively offset by anticipateddepreciation of the currency with the lower real rates ndash a theory known as the InternationalFisher EffectBy contrast segmented money markets are characterized by interest rate rigidities resultingfrom government-imposed distortions and controls such as interest rate ceilings and mandatorycredit allocations When interest rate controls are coupled with exchange rate controls arbitragemotivated market forces that lead to the International Fisher Effects are blocked thus allowing forabnormal arbitrage opportunities to persist until the controls are lifted As an example theabolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end theinterest rate differential between the Thai baht whose rate ranged between 16 and 18 andeurodollars in Singapore and Hong Kong with rates between 6 and 8 somehow quotas imposedon offshore borrowing by Thai commercial banks and major corporations must have accountedfor the continued interest rate differenceEven among closely integrated financial markets a lsquotieringrsquo of credit markets between onshore(or domestic) and off-shore (or euro-currency) segments continues to produce small butnon-negligible segmentation residuals both within and acoss currency habitats By and largelower taxes the absence of reserve banking requirements and the reduced presence of other suchmarket imperfections almost always lead to a greater degree of capital market integration in theoffshore than in the onshore components of given debt markets33 Foreign Exchange Market SegmentationIn the 25-year history of the current floating exchange rate system bilateral exchange rates

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 18: International Financial Markets

have fluctuated over a wide range with many appreciations and depreciations in a single yearapproaching 25 or more The dollar itself has depreciated by as much as 50 in a single yearagainst the Japanese yen It is not uncommon for the price of a single currency to vary as much as10 in a single day as we witness during the recent Asian financial crisisPerhaps more perplexing than volatility itself is the increasing evidence of prolonged periodsof exchange rate over(under)shooting Currency over(under)shooting for the purpose of thischapter is defined as long-term deviations of nominal exchange rates from their intrinsicequilibrium levels generally approximated by exchange rates consistent with Purchasing PowerParity (PPP holds when exchange rate changes between two currencies are explained entirely bydifferences in underlying inflation rates over the same time period) In the case of the US dollarsuch overshooting has been most dramatic in relation to foreign currencies such as the yen thepound and the euroMost segmented capital market countries suffer from chronic balance-of-payments problemsthat are typically suppressed by an intricate web of exchange controls In many newlyindustrializing countries the quasi-convertible status of the currencies continue to be shrouded bya pervasive web of exchange controls which run the gamut from light restrictions on lsquovisiblersquotrade transactions to byzantine controls on capital account transactions Such restrictions alsosometimes takes the form of two-tier and multiple-tier exchange rates or in the case ofhyperinflationary economies crawling pegs34 A Mapping Paradigm for Emerging Capital MarketsAs national capital markets loosen up the regulatory shackles that creates segmentation ndash bydismantling controls in the debt and exchange markets by creating an institutional setting thatreduces equity market imperfections and by encouraging the securitization process (see thediscussion of THAI CARS in Section 6) ndash the cost of capital should gradually edge lower towardsits equilibrium value approximated by the US cost of capital thus bringing about a truly integratedglobal capital market But until that process nears completion world capital markets willcontinue to exhibit pockets of segmentationFigure 4 Space mapping of capital market segmentation

In Figure 4 we provide a map of capital market segmentation in a three-dimensional space bydefining the origin as the integration point Each of the three axes corresponds to one of the threemajor financial markets ndash currency debt and equity ndash in the following fashion1) An index of currency over(under)valuation equal to 1 ndash SS where S measures thenominal local currency price of one US dollar with S being the Purchasing Power Parityequilibrium exchange rate similarly defined If the currency is overvalued S lt S the exchangemarket will be positioned between 0 and 1 and between 0 and -1 when undervalued If theexchange rate is fairly priced and thus capital markets are integrated (at least in an internationalsense) the exchange market will be positioned at the origin of the axisCurrencies such as the Argentine peso and the Brazilian cruzeiro would typically beovervalued whereas the Korean won or the Taiwanese dollar may at times be undervalued Forexample the Mexican peso in December 1994 and the Thai baht in July 1997 immediately beforetheir respective financial crisis were respectively overvalued by 20 and 35 percent Even fullyconvertible currencies such as the Japanese yen or the euro may experience prolonged periods ofovershooting or undershooting against their benchmark Purchasing Power Parity equilibriumvalue7

2) An index of domestic interest rate overpricingunderpricing 1 ndash ii where i denotes thecontrolled interest rate or nominal cost of debt financing (reflecting local debt marketimperfections) and i the underlying equilibrium cost of capital The latter assumes the removal11

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 19: International Financial Markets

1Equity MarketMoney MarketFX MarketMexicoIntegratedCapital Market2060-24

of interest rate controls of any kind as well as an institutional setting approaching conditions ofmarket perfection Such an index would range from a mildly negative to a positive numberdepending on local market conditions3) An index of relative market portfolio volatility defined as 1- wi where i and w denoterespectively the standard deviation of the market portfolio of a segmented emerging capitalmarket i (i) and the standard deviation of the world capital market portfolio (w) Alternativelythe ratio of relative market portfolio volatility could be captured as the country beta whichmeasures the covariance of the local market portfolio with the world portfolio As i w thesegmented capital marketrsquos lsquomarket portfoliorsquo broadens and deepens and its volatility shoulddecrease approaching the volatility of the world market portfolio similarly as the local capitalmarket becomes better integrated its beta would tend toward one An additional gauge of equitymarket integration would be found in the proportion of equity trading that takes place in the formof ADRs clearly as the ratio of domestic shares traded as ADRs on the New York StockExchange increases in comparison to local trading the level of integration (if not outright fusion)would be larger and i should get closer to w Such an index would be simply defined as theratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalizationMCAP(i) MCAP(ADR)MCAP(i)For example the volatility of the Mexican market could be estimated at i = 046 ascompared to a world market volatility of w = 016 resulting in an index of equity marketsegmentation of (1 - 016046) Thus as illustrated with the case of Mexico our map of capitalmarket segmentation would allow us to position each country in a three-dimensional spaceThe second policy question is the identification of the levers driving this emergence processas we argued before moving gradually along this continuum would bring about a lower cost ofcapital which is truly welfare-enhancing what can policy makers initiate in order to nurture thisprocess The consensus points towards economic liberalizationderegulation disintermediationand securitization as the major forces propelling capital markets toward higher level oflsquoemergednessrsquo4 DEREGULATIONThe last decade has experienced an accelerating worldwide effort at deregulating economicactivity with financial markets being a major beneficiary of this trend A lsquofinancially repressedrsquosystem is generally defined as a system in which the amount and the price at which credit isallocated is determined directly or indirectly by the government deregulation is thuscharacterized as the process of allowing market forces to progressively determine who gets andgrants credit and at what price (Williamson and Mahar 1998) This process will typically developalong six dimensionsRelaxation of credit controlsDeregulation of interest ratesRelaxation of international capital flowsFloating exchange ratesFree entry intoexit from the financial service industry

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 20: International Financial Markets

Privatization of financial institutions8

Each country though has defined its own agenda and has deregulated in its own peculiar wayso much so that in terms of our three-dimensional map (Figure 4) each country has moved closerto the integration point by sequencing the process in its idiosyncratic way Restrictions on capitalmovements loosening of interest rate controls etc have proceeded in an imperfect way Weillustrate next how lsquoincompletersquo markets may trigger regulatory arbitrage which in turns bringabout more complete markets and the dismantling of some ndash not all ndash regulatory walls with thecase study of the Kingdom of Denmarkrsquos Bull Bear notesKingdom of Denmarkrsquos Bull and Bear Notes9 on September 30 1986 the Kingdom ofDenmark issued FF 800 million worth of equity linked notes redeemable on 1st October 1991(Jacque and Hawawini 1993) The notes which were listed on the Paris Bourse were issued atpar with a face value of FF10000 and an annual coupon rate of 45 The issue consisted of twoseparate and equal tranches ndash one called Bulls and the other Bears ndash of FF400 million each Theredemption value of both tranches was a function of the value of the stock market index For theBulls bonds the redemption value was directly related to the value of the French stock marketindex at the maturity of the notes whereas the redemption of the bear notes was inversely relatedto the value of the index (see Figure 5)Figure 5 Kingdom of Denmarkrsquos Bull-Bear notes

More specifically each Bear note combined a five-year FF450 annuity (45 of FF10000 offace value for five years) and a five year put option on the stock market index with an exerciseprice of 89645 (at the time of the issue the stock market index stood at 40597) The Bull noteconsisted of a five year note FF450 annuity plus a long position in the stock market index minus afive-year European call option with an exercise price of 89645 (the latter call option gave the issuerthe right to redeemcall the bull notes at FF23200 if the stock market reached 89645 thuseffectively putting a ceiling on the notesrsquo value)Redemption Value (FF)23200116000 89640Bull Tranche (R1)Total RedemptionValue (R1 + R2)2Bear Tranche (R2)Terminal Valueof the IndexR1 = PAR x 105 Terminal Value Index4057Maximum Value of R1 = 232 PAR = 23200R2 = PAR x 232 - R1

Total Value = 12 (R1 + R2) = (PAR x 232) x 12 = 11600

Although both the Bear and Bull notes are risky equity-linked instruments for investors whenheld separately for the issuer the total issue is riskless (as long as both tranches are fullysubscribed) that is the cost is fixed As shown by the dark horizontal line in Figure 5 the averageredemption value of a bull and bear notes is effectively fixed at FF11600 (or half of FF23000) pernote And the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) ndash givenan initial cash inflow of FF10000 per note five annual FF450 coupon payments and an averagefinal lsquoprincipalrsquo payment of FF11600 ndash turns out to have been 727At the same time these notes were issued the French Government a AAA credit was raisingfive-year fixed-rate debt at approximately 8 and AA rated French corporate issuer at 890 Thusby issuing a package of Bull and Bear notes (instead of five-year straight bonds) the Kingdom ofDenmark managed to reduce its cost of funds below the prevailing risk-free rate (the cost of debt

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 21: International Financial Markets

faced by the French government) and 163 basis points below what its credit ratings would havewarranted In short the market priced the Bull and Bear notes at a lsquopremiumrsquo resulting in a lowercost of debt for the issuerAnther way to view this financing transaction is that the Kingdom of Denmark was able to sellseparately the components of the package (Bull and Bear notes) for more than the value of thepackage itself (the equivalent straight bonds) To understand why this might be possible considerthe stock market condition in September 1986 Equity prices were rising steadily but marketparticipants were questioning such abnormal growth rates Those already into the market neededprotection against reversal those outside the market wanted to enter with minimum riskOne possible answer would be futures and options contracts on a French stock market indexPortfolio managers could protect their diversified holding of French equity by simply buying putoptions on a stock market index and investors wishing to enter the equity market could buy futurescontracts on a stock market index Unfortunately French regulatory agencies had not yet approvedthe issuance and trading of these instruments regulation was clearly resulting into lsquoincompletersquomarkets and an inefficient financial intermediation process If these forbidden instruments couldsomehow be supplied to the market in contravention of existing regulation they would clearlycommand a lsquoscarcityrsquo premiumThis is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issueBear notes were simply long-term put options designed for that segment of the market (mostlywholesale investors) wishing to buy portfolio insurance Bull notes were equity-linked bonds payinginterest and offering a play on the upward market movement They were sold to the component ofthe market (mainly retail investors) wishing to enter the market with minimum riskThus the issuer was able to lower its cost of debt significantly by selling at a premium closesubstitutes to prohibited products for which there was an unmet market demand The issuer turnedto its advantage a segmented market that was not permitted to offer derivatives instruments on astock market index Had such instruments existed in September 1986 the Bull-Bear issue wouldprobably not have been brought to market Therefore it should come as no surprise thatimmediately after the French issue similar notes were issued in Frankfurt Zurich and Tokyo ndash butnone in New York and London As the reader could guess derivative instruments on stock marketindices existed in New York and London but not in the other three markets Each of the regulatedmarkets moved one step closer to lsquocompletednessrsquo along the emergence continuum pathhellip5 DISINTERMEDIATIONThe financial systemrsquos primary function is to mobilize savings and to allocate those fundsamong competing usersinvestors on the basis of expected risk-return This process can be carriedout through two competing paths 1) through financial intermediation financial intermediaries areprimarily commercial banks which provide credit in the form of loans and institutional investorssuch as insurance companies pension funds and venture capitalists which provide financing in theform of debt and equity via private placement (clear cells in Figure 6) or 2) through securitizationwhose vehicle of choice for converting savings into investments are securities tradable in capitalmarkets (shaded cells in Figure 6) Over the last 25 years financial intermediaries have beensteadily loosing market share in the global financial intermediation business to capital markets thisis know as lsquofinancial disintermediationrsquo ndash that is the bypassing of financial institutions Thisprocess has two major implications 1) The credit risk is borne by the ultimate lender who isassisted by credit-rating agencies in the credit-granting and credit-monitoring process and 2)liquidity is created as secondary markets are created for the financing instrumentsThis is not really a new phenomenon with financial markets having traded stocks and bonds forthe last 150 years what is relatively new is the rise of commercial paper as a lower cost alternativeto bank loans This should come as no surprise as traditional financial intermediation is an

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 22: International Financial Markets

inherently costly process because the intermediaryrsquos balance sheet adds a layer of cost to theprocess Recall that banks convert deposits that are redeemable at par and often on demand intoilliquid loans which are placed at various risk levels of default Indeed banks will protectthemselves against such default risk by properly capitalizing themselves thereby incurring asignificant equity cost of capital in the process Unfortunately banks often find themselves in theawkward position of reconciling illiquid assets (recall that during the recent Asian financial crisisnon-performing loans were hovering at around 50 of banksrsquo total assets) with liquid liabilitiesFigure 6 Disintermediation and the rise of the commercial paper market

Financial Intermediation1 Commercial Banks2 Insurance Companies PensionFunds Venture CapitalistsBifurcated IntermediationPension FundsMutual FundsInsurance CorsquosFinancialMarketsFinancial MarketsBrokerageFirms andInternet1 Equity2 Debt3 Commercial Paper4 HybridsHouseholdsFirmsDebt and EquityPrivate PlacementDebt (mostly)

Financial IntermediariesDisintermediated FinanceWith the development of the Internet financial institutions are confronting the virtual threat ofrenewed disintermediation lsquoE-bankingrsquo and lsquoe-tradingrsquo while not displacing traditional financialintermediaries are certainly redefining their production function6 SECURITIZATIONFirst pioneered in the US residential mortgage market more than 25 years ago the technologyof modern securitization has truly revolutionized consumer finance in the United States and theUnited Kingdom10 It is making a slow debut in most other countries in part because of thesophisticated legal infrastructure that it requires In this section we review first the architecture ofthe technology and explain it economic logic before illustrating its far-reaching potential foremerging countriesBy repackaging illiquid consumer loans such as residential mortgages automobile or creditcard receivables - which were traditionally held by commercial banks thrifts finance companiesor other financial institutions - into liquid tradable securities securitization is a more elaborateform of disintermediation that typically results into a lower cost of consumer finance It isgenerally estimated that prior to securitization (that is prior to 1975) the average yield on a 30year mortgage for a single family middle-income dwelling was equal to the yield on a 30-yearTreasury bond plus approximately 285 basis points after a quarter of century of securitization thepremium is down to less than 100 basis points which amounts to gigantic savings in the cost of

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 23: International Financial Markets

home financing admittedly a major component of individual householdsrsquo budgets and a source ofimprovement in their standard of living ndash the Wealth of NationshellipAs illustrated in Figure 7 a typical securitization transaction is structured around six basicbuilding blocks1 Origination ndash carried out by the financial institution which traditionally financed thetransaction and which consists of managing the credit-granting process to consumersapplying for a loan to facilitate the purchase of a home automobile or use of a credit-card2 Structuring ndash creating a legal entity generally known as a special purpose vehicle (SPV) forthe sole purpose of the transaction which would use the loans as the asset collateral for issuingnew securities in the capital market The SPV would typically purchase without recourse theBox 2 The Thai banking industry as a besieged oligopoly gives way to deregulation anddisintermediation Through a cozy arrangement between regulators and Thai commercialbanks the financial sector thrived as a tightly knit oligopoly dominated by Thai financialinstitutions On the eve of the Asian financial crisis 15 Thai commercial banks controlled 95percent of the industryrsquos assets through some 2000 branches whereas 14 foreign banks ndasheach restricted to operating one branch ndash had to console themselves with only 5 percent of themarket Under the pressure of the Thai banking lobby regulators effectively froze out of themarket many eager applicants by simply failing to grant them banking licenses Thus throughhighly effective entry barriers of a regulatory nature the Central Bank of Thailand failed tospur the healthy competition that foreign financial institutions or entrants would haveundoubtedly exercised on Thai banks The Asian financial crisis nearly pushed to bankruptcymost commercial banks in Thailand and salvation could only come through massiverecapitalization or mergeracquisition by foreign banks the Central Bank had little choicebut to allow the market-driven restructuring process to proceed thereby bringing about amore efficient financial intermediation and the much needed ndash if still embryonic ndash use ofcommercial paperreceivables from the originators who ndash interestingly enough ndash are often also invited to be alsoone of the credit enhancers admittedly the ultimate incentive in performing as soundoriginators3 Credit Enhancing ndash improving the credit risk profile of the original loans by procuringinsurance coverage against default from insurance carriers or commercial banks becauseconsumer financing loan default can be accurately gauged through actuarial techniques it isrelatively easy to price credit enhancement Typically securitization deals are credit enhancedto the best possible rating which ndash in turn ndash enables the issuer to offer the lowest possibleyield to investors Presumably the cost of credit enhancement is somewhat lower than thereduction in the yield courtesy of residual inefficiencies in capital markets45 Underwriting and Placing the newly-created securities with appropriate investors and finally6 Servicing the loansrsquo interest and principal repayments to insure the proper cash-flowsdisbursement to noteholdersFigure 7 Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhatslowly in the early nineties in part because most candidate countries for this new technology lackthe sophisticated legal infrastructure that is quintessential to such transactions When the ultimatefinancier of the transaction happens to be an emerged market-based investor a host of problemssuch as country risk and currency risk complicate the architecture of the transaction beyond thetraditional credit risk evaluation As a backdrop to the discussion we will use the THAI CARSsecuritization deal which was completed in August 1996 THAI CARS a company related to theTisco financial company issued the first public securitized notes of Thai consumer assets Thetransaction secured a AAA rating from the US rating agency Standard amp Poorrsquos with the

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 24: International Financial Markets

insurance company MBIA providing guaranteesAs in a domestic securitization transaction automobile leases and installment loans wereoriginated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installmentloans) The loans were then sold to Tru-lease the SPV that structured the collateral assets intotradable baht-denominated notes Up to this point the transaction would be no different from a USsecuritization deal Because the investor tapped to purchase the notes are international eurobondinvestors the transaction required some creative financial engineering to resolve the unique16Borrower2 4 53InvestorInsurance companiesMutual FundsCreditEnhancementInsurance CorsquosOriginationServicingStructuringvia SpecialPurpose VehicleUnderwritingPlacementMortgages creditcards automobileloansInvestmentbanksInvestment banksBrokeragesPeriodic cash interest andprincipal repayment Initial Notes or Loan

problems raised by currency and credit risk THAI CARS issued $US250 million of 55 yearFloating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML whichtranslated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8)Figure 8 Securities backed by leases Thai Carrsquos asset-backed FRN (Source Adapted from Asia MoneySeptember 1996)

Currency risk Structured barely a year prior to the Asian financial crisis which engulfed theThai baht (it depreciated by close to 50 on July 2 1997) this transaction had to address thechallenge of exchange risk embedded in the transformation of Thai-denominated receivables intodollar medium term notes Bankers Trust swapped bahts into yens and yens into dollars why thebifurcation into yen first and dollar second rather than a straight swap into dollars The answer isto be found in the witholding tax levied by the Thai tax authorities on interest payments Sinceinterest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount oftaxes paid would be considerably lower on yen-denominated interest payments hence thebahtyen leg of the currency swapCredit Risk Securitization works well for consumer loans with a well-established track recordthat makes actuarial forecast of losses reasonably reliable Such assessments are in turn necessaryfor credit enhancement which brought this deal to a AAA rating thereby lowering its cost ofcapital The credit enhancer MBIA seems to have overlooked the unique characteristics of highnet worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (inthe $US250000 - 400000 range due to high import taxes) Newly-rich borrowers in Thailand

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 25: International Financial Markets

didnrsquot have much of a track record and time series data on default for such loans must have beenexceedingly short making it next to impossible to price the credit enhancement service (MBIAcharged a mere 35 basis points)Car Buyersamp Lessors15 TiscoLeasing15 Tru-Way2A Tru-LeaseSize US$250 million Term 55 years Coupon 3ML+22bpRating AAA (SampP) Issue Date August 1996Conditionalassignmentof receivables2B ThaiCarsBankersTrust Intrsquol3 MBIAInsuranceFRNBahtINVESTORSPeriodic cash interest andprincipal repayment Notes loan and currency swap contracts

BahtBahtBahtyen$$FeeGuaranteeINGBaring4

$Currencyyen$ swap

yenCountry Risk Last but not least investors had to contend with the possibility of exchangecontrols whereby the Central Bank of Thailand would block the timely payment of interest and

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 26: International Financial Markets

principal This is why such deals cannot be rated more highly than their sovereign unless somespecial arrangement are made11 In this particular case MBIArsquos guarantee must have providedsome degree of country risk (in addition to credit) enhancement in order for the rating on the dealto have been seven notches higher than the sovereign ceiling (Thailand was single B-rated )12

This transaction clearly illustrates the benefits of securitization for emerging marketeconomies even though not all conditions were satisfied in this instance Interestingly the dealdid survive the Asian financial crisis and the devaluation of the Thai currency7 CONCLUSIONNational capital markets can be positioned along a continuum ranging from embryonic tomature and fully-emerged markets according to a decreasing cost of capital criterion This chapterargued that newly emerging markets are handicapped by a high cost of capital because ofincomplete and inefficient financial markets The result is a costly financial intermediationprocessAs markets graduate to higher level of lsquoemergednessrsquo they avail themselves of aprogressively lower cost of capital generating higher standards of living due to a lower cost ofconsumer finance and more competitive participation in the global economy as national firmsgain access to a lower cost of capital Thus a lower cost of capital translates into a higher level ofeconomic welfare ndash sometimes known as lsquothe Wealth of NationsrsquoThe key question thus becomes How may public policy nurture this welfare-enhancingprocess This chapter argued that 1) the skillful transfer of financial innovations to emergingmarkets will lsquocompletersquo markets fostered by deregulation 2) the disintermediation of traditionalfinancial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)the securitization of consumer finance conjointly fuel the dynamics of emerging marketsNOTES1 Even though it is more fashionable to talk about capital markets the scope of this chapter encompasses the entirefinancial system of which capital markets are an integral part2 See Chapter 2 by A Persaud for a discussion of systemic risk and how its level is closely linked to creditorsrsquo andinvestorsrsquo appetite for risk The regulatory framework needed to harness systemic risk is further discussed inChapter 4 by M Crouhy et al3 See Merton p21 See also Chapter 3 by P Christoffersen and V Errunza for a discussion of the architecture of theglobal financial system and Chapter 5 by S Gould et al for the relationship between systemic risk and regulation4 This section draws from Jacque and Hawawini (1993)5 See Chapter 7 by A Moeumll and Chapter 8 by O Kratz for an in-depth discussion of how ADRs are contributing to theemergence process6 See Chapter 15 by E Briys and F de Varenne Chapter 16 by M Canter et al and Chapter 17 by R Neal for adiscussion of how insurance derivatives and credit derivatives complete financial systems7 See Jacque (1996) Chapter 5 for further discussion of currency overvaluation8 See Chapter 9 by R Aggarwal and J Harper for a discussion of how privatization can also accelerate the emergenceprocess9 This case was developed by G Hawawini (see Jacque and Hawawini (1993))10 For examples of historical and early forms of securitization and a further discussion of securitization as a financialinnovation see Chapter 11 by P Vaaler11 See Chapter 13 by A Zissu and C Stone for a discussion of how cross-border securitization transactions can bestructured to circumvent sovereign ceilings T Frankel describes the legal context in which cross-bordertransactions are carried out in Chapter 1012 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) exportreceivables such receivables are often guaranteed by commodity exports such as oil or copper as well as telephonepayment settlements electronic worker remittances etc In such transactions it is relatively easy to pierce thecountry ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshoreentity

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]
Page 27: International Financial Markets

MarkowitzModel for Selection of OptimalAsset Classes-Asset Allocation Decision10487081048708 Markowitz model is typically thought of in termsof selecting portfolios of individual securities Butalternatively it can be used as a selectiontechnique for asset classes and asset allocation

  • Types of financial markets[edit]