International Finance: Recent Trends in Financial Market

Financial markets have experienced many changes during the last two decades. Technological advances in computers and telecommunications, along with the globalization of banking and commerce, have led to deregulation, and this has increased competition throughout the world. The result is a much more efficient, internationally linked market, but one that is far more complex than existed a few years ago. While these developments have been largely positive, they have also created problems for policy makers. At a recent conference, Board Chairman, World Bank stated that modern financial markets “expose national economies to shocks from new and unexpected sources, and with little if any lag.” He went on to say that central banks must develop new ways to evaluate and limit risks to the financial system. Large amounts of capital move quickly around the world in response to changes in interest and exchange rates, and these movements can disrupt local institutions and economies.

With globalization has come the need for greater cooperation among regulators at the international level. Various committees are currently working to improve coordination, but the task is not easy.

Factors that complicate coordination include:

(i) the differing structures among nations’ banking and securities industries,

(ii) the trend in Europe toward financial service conglomerates,

(iii) a reluctance on the part of individual countries to give up control over their national monetary policies.

Still, regulators are unanimous about the need to close the gaps in the supervision of worldwide markets.

Another important trend in recent years has been the increased use of derivatives. A derivative is any security whose value is derived from the price of some other “underlying” asset. An option to buy IBM stock is a derivative, as is a contract to buy Indian rupees six months from now. The value of the IBM option depends on the price of IBM’s stock, and the value of the Indian rupees “future” depends on the exchange rate between Indian rupees and dollars. The market for derivatives has grown faster than any other market in recent years, providing corporations with new opportunities but also exposing them to new risks.

Derivatives can be used either to reduce risks or to speculate. Suppose an importer’s net income tends to fall whenever the dollar falls relative to the Indian rupees. That company could reduce its risk by purchasing derivatives that increase in value whenever the dollar declines. This would be called a hedging operation, and its purpose is to reduce risk exposure. Speculation, on the other hand, is done in the hope of high returns, but it raises risk exposure. For example, Procter & Gamble recently disclosed that it lost $150 million on derivative investments, and Orange County (California) went bankrupt as a result of its treasurer’s speculation in derivatives.

The size and complexity of derivatives transactions concern regulators, academics, and members of Congress. Experts of International Finance noted that, in theory, derivatives should allow companies to manage risk better, but that it is not clear whether recent innovations have “increased or decreased the inherent stability of the financial system.”