UNIT 7.

GLOBAL CAPTIAL MARKETS AND GAINS FROM TRADE

International capital markets are a group of closed interconnected markets (London, Tokyo, New

York, Singapore and other financial cities) in which residents of different countries trade different

types of financial and physical capital (assets).

1. GAINS FROM TRADE

1.1. TYPES OF TRANSACTIONS

International capital markets have significantly amplified the benefits derived from trade. When

buyers and sellers engage in voluntary transactions, both parties obtain something they desire,

thereby enhancing their welfare. These exchanges fall into three distinct categories:

I. Trades of goods or services for other goods and services.

II. Trades of goods or services for assets.

III. Trades of assets for assets.

1.2. TYPES OF GAINS

Comparative advantage. The theory of comparative advantage describes the gains from trade

of goods and services for other goods and services. It operates on the principle that with finite

resources and time, individuals or nations should allocate these resources towards producing

what they are most efficient at compared to alternatives. By specializing in the production of

these goods and services, individuals or nations are allowed to become experts in certain areas

of production, while still accessing a diverse range of goods and services as customers through

trade.

Intertemporal trade. The theory of intertemporal trade describes the grains obtained from

trading goods and services for assets, involving the exchange of goods and services today for

claims to goods and services in the future (today’s assets).

- Savers are motivated to acquire assets, representing claims to future goods and

services.
 - Borrowers seek to utilize assets, or wealth, to consume or invest in more goods and

services than they can currently afford with their income.

Through this exchange, savers receive a rate of return on their assets. Meanwhile, borrowers

gain immediate access to goods and services, which they can utilize for consumption or

investment purposes.

A country engages in trade over time primarily through borrowing and lending. When a country

borrows, it essentially acquires the right to purchase a certain quantity of consumption goods or

services at present. In return for this immediate access to consumption, the borrowing country

agrees to repay a larger quantity of goods and services in the future.

Portfolio diversification. The theory of portfolio diversification describes the benefits derived

from trading assets for assets, particularly in terms of managing different types of risks

associated with those assets.

In many economic contexts, individuals tend to avoid risk, preferring a certain gain of wealth over

investing in assets with uncertain outcomes. This aversion to risk, named as risk aversion, is a

common phenomenon observed among investors. Rather than solely focusing on the expected

return of an investment, investors prioritize minimizing risk when making investment decisions.

By diversifying or “mixing up” their portfolio with a variety of assets, investors can spread their

risk across different investments.

1.3. GROWTH OF CAPITAL MARKET

The rapid expansion of the capital market can be attributed to three drivers:

- The proliferation of information technology, including the internet and computer power,

has revolutionized the way financial markets operate.

- Deregulation initiatives, including the dismantling of national capital controls and the

promotion of free market principles, have played a significant role in fostering the growth

of the capital market. By reducing barriers to the movement of capital across borders and

promoting competition, deregulation has encouraged investment flows and expanded

market access for both investors and borrowers.

- The introduction of new financial instruments, such as securitization.

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2. PORTFOLIO DIVERSIFICATIONS

2.1. RISK AVERSION

A risk aversion is the risk associated with a trade of assets that is shared when assets are

traded internationally. When people are risk averse, countries can gain through the exchange of

risky assets. International capital markets make these trades possible.

A portfolio is a collection of securities held by individuals or institutional investors. Diversification

is the allocation of investment funds to a variety of instruments. The rationale for diversification is

that investors can greatly reduce risk without adversely affecting return.

2.2. RISK REDUCTION

International portfolio diversification can allow residents of all countries to reduce the variability

of their wealth. International capital markets make this diversification possible; it divides wealth in

a larger number of assets and reduces its risk.

If we only invest in domestic shares, then we are limited by the types of companies on offer in

hour home market. By investing internationally, we have a more diverse range of investment

opportunities.

Global capital market has increased the correlation between different stock markets reducing the

benefit of international diversification. In fact, movements of stock prices across countries are not

perfectly correlated. Reflects two factors: countries pursue different macroeconomic policies and

face different economic conditions, different stock markets are segmented by capital controls.

The total risk of a portfolio depends on: the number of securities in the portfolio, the level of

risk for each component security, the degree to which component risks are correlated.

The Case for International Diversification. The basic rule of portfolio diversification is that the

broad the diversification the more stable the return and the more diffuse the risks. International

diversification helps to improve the risk-adjusted performance of a purely domestic portfolio.

3. CLASSIFICATION OF ASSETS

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International portfolio diversification can be carried out through the exchange of different types of

assets (instruments), which are classified as either:

I. Debt instruments such as bonds and bank deposits. They specify that the issuer of

the instrument must repay a fixed value regardless of economic circumstances.

II. Equity instruments like stocks or a title to real estate. They specify ownership of

variable profits or returns, which vary according to economic conditions.

3.1. WHY DO BOND MARKETS MATTER?

Markets determine what it costs a government to borrow. When a government wants to raise

new money it issues new bonds. Those bonds have to pay an interest rate which is close to the

current yield for bonds which it has issued earlier and are now being traded in the market.

So if a crisis of confidence drives up market yields the government has to pay more for new

borrowings –possibly a lot more.

4. PARTICIPANTS

Commercial banks and other depository institutions. Accept deposits. Lend to governments,

corporations, other banks, and/or individuals. They buy and sell bonds and other assets. Some

commercial banks underwrite stocks and bonds by agreeing to find buyers for those assets at a

specified price.

Non bank financial institutions.

- Pension funds accept funds from workers and invest them until the workers retire.

- Insurance companies accept premiums from policy holders and invest them until an

accident or another unexpected event occurs.

- Mutual funds accept funds from investors and invest them in a diversified portfolio of

stocks,

- Investment banks specialize in underwriting stocks and bonds and perform various types

of investments.

Private firms.

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 - Corporations may issue stock, may issue bonds or may borrow from commercial banks

or other lenders to acquire funds for investment purposes.

- Other private firms may issue bonds or borrow from commercial banks.

- Companies seeking to issue stock in the country: use stock and options as a form of

employee incentives, satisfy local ownership requirements, create funding for future

acquisitions, increase the visibility of the company.

Central banks and government agencies. Central banks sometimes intervene in foreign

exchange markets. Government agencies issue bonds to acquire funds, and may borrow from

commercial or investment banks.

- Nations are more vulnerable to speculative capital flows because of lack of knowledge:

potential destabilization of economies and lack of quality information.

5. INTERNATIONAL CAPITAL MARKETS AND GOVERNMENTAL POLICIES

Because of international capital markets, policy makers generally have a choice of 2 of the

following 3 policies: a fixed exchange rate, monetary policy aimed at achieving domestic

economic goals, free international flows of financial capital.

A fixed exchange rate and an independent monetary policy can exist if restrictions on flows of

financial capital prevent speculation and capital flight. Independent monetary policy and free

flows of financial capital can exist when the exchange rate fluctuates. A fixed exchange rate and

free flows of financial capital can exist if the central bank gives up its domestic goals and

maintains the fixed exchange rate.

5.1. THE TRILEMMA IN EUROPE

Denmark has adopted a fixed exchange rate regime, pegging the Danish krone to the euro. This

implies that Denmark has scarified its monetary policy autonomy. If Denmark wanted monetary

policy autonomy, it has two options: sacrifice either: the fixed exchange rate, or international

capital mobility.

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The United Kingdom has opted to sacrifice the first one in order to achieve monetary policy

autonomy. Based on the model, nominal interest rates in Denmark should move with those in the

Eurozone. For the United Kingdom however, this need not be the case.

5.2. NEWS AND THE FOREIGN EXCHANGE MARKET

During wartime, there is a greater likelihood of observing dramatic changes in the exchange rate.

This happens because:

- Governments often finance war through printing money, generating inflation.

- The uncertainty associated with war allow for dramatic changes in money demand, as

there is a risk that currency may be converted into another currency unit, or eliminated

altogether.