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.

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 Europlace,
International Financial Forum in Tokyo 27 november 2007

Globalisation of capital markets

Speech by Christian Noyer
Governor of the Banque de France

Ladies and gentlemen,

It is a great honour and a pleasure for me to speak before such a distinguished
audience and I am
delighted to be in Tokyo today. In the last decades, global economic growth,
financial innovation and
financial globalisation have progressed hand in hand. This does not exclude, of
course, challenging
episodes of stress, such as the current one.
Financial globalisation is not a new phenomenon, but the scale and speed of the
current phase of
globalisation is unprecedented; cross-border and cross-market links are deeper than
ever before.
Events are still unfolding, but the dynamics of the current crisis has been a live
experiment of how
globalisation has modified the reaction of the financial system to shocks. The
magnitude of possible
losses is, in many respects, contained. Current estimates put the direct cost of
subprime defaults at
around 250 billions USD. It is significant but bearable, especially starting from a
point of very
favourable economic conditions and high profitability.
Still, what began as a sound correction of the undervaluation of risks in the
subprime market unravels
as one of the major financial crisis of the past 10 years. Some scenarios considered
as very remote
crystallised on a large scale, while widely expected break-up points held up well.
Hedge funds, once

considered as a source of systemic risk, fared better than regulated institutions. The
inter-bank market,
traditionally the most liquid and efficient of all markets, has experienced serious
dislocation, while
equity markets were relatively unscathed. The spreading of defiant expectations
from the subprime US
market to other segments, other institutions and other regions has been
unexpected, asymmetric and
2/5

disconnected from the magnitude of the initial shock. It invites us to revisit our
reading of
globalisation and contagion in the light of current events.
The ongoing financial globalisation is underpinned by three main drivers, each of
them strengthening
the two others.
The first driver, and probably the strongest, is financial innovation.
Supported by technological
progress, financial innovation has fostered the emergence of new financial products
and services,
resulting in more complete financial markets. Thanks to advances in financial
technology, it is now
possible to break up the risk of an asset into its constituent parts and to recombine
them as wished, to
fit a specific investors risk profile. The emergence of derivatives, combined with the
appropriate
mathematical tools to price them, has greatly expanded the range of tradable risks,
opening up new
and vast horizons for hedging strategies. Financial institutions are able to actively
manage their
exposures and reallocate certain risks to those players that are most able to bear
them. Overall,
investors are more willing to invest across borders, knowing that they can reach an
improved riskreturn
trade-off.
Simultaneously, economies are becoming more open financially, especially
in the emerging
world. The growth of international capital flows is the consequence both of
domestic policies and
global factors. Domestically, financial liberalisation and deregulation have relaxed
investment
restrictions. More flexible exchange rate policies, liberalisation of capital accounts,
the opening of
domestic stock markets to foreign investors as well as investor-friendly policies
help to attract
foreign investors. Global factors have also played a role, with the abundant global
liquidity
environment as well as the decrease in home bias. By way of example, nonresidents currently hold
46% of French market capitalisation and slightly more than 50% of French
government bonds.

A third driver is the emergence of global financial players, such as large

banks, hedge funds,
private 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
capital
markets;
- They use sophisticated investment strategies;
- They implement advanced risk management practices, and help to spread them
across markets
and countries.
3/5

However, because of their sheer size and potential impact on market equilibria, they
raise some
concerns of transparency as well as questions about their role in fostering, or not,
financial stability.
Those issues warrant being debated.
What are the consequences of the financial globalisation currently
underway for global capital
markets? They are well known, so I will just highlight two of them.
First, globalisation increases the efficiency of financial markets.
Thanks to financial globalisation and technological progress, informational efficiency
of capital
markets has increased over the past few decades. Any new available information is
accurately
processed and impounded in asset prices, leading to more accurate pricing of
assets and risks. And the
permanent quest for arbitrage opportunities has fostered cross-market and crossborder strategies also
leading to more consistent pricing.
Allocative efficiency, that is the markets ability to allocate resources in a way that
maximises the
welfare attained through their use, has also improved: for a given investor, there is
a wider and more
diversified range of investment opportunities than ever before.
Operational efficiency has so far gained from globalisation, since the cost of
financial operations has
quickly fallen, due to productivity gains in the financial sector stemming from the
scale and scope of
economies and the intense competition between markets and intermediaries.
Nevertheless, this overall trend towards efficiency occasionally bumps into puzzles
that are not readily
explained by economic theory. For instance, the longstanding question as to why
capital does not flow,
in net terms, from rich to poor countries has not yet been clarified since it was first
addressed by
Robert Lucas. It has recently been supplemented by the so-called allocation
puzzle, highlighting the
fact that capital seems to flow toward economies with relatively low investment
rates. Convincing

explanations for these puzzles certainly require taking into account market
imperfections (such as
credit constraints), differences in financial infrastructures as well as growth
externalities (such as
human 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 of
world economic growth. The same positive trend is reflected in their financing
conditions. Emerging
market economies increasingly finance themselves in the form of bonds in local
currency at long
4/5

maturities and fixed interest rates. By doing so, they have escaped the curse of
original sin - the
inability to borrow abroad in their own currencies - that made the crises of the
1990s so costly. Their
capital markets have expanded rapidly, both in size and in the range of instruments
available. Asian
stock market capitalisation, for instance, increased five-fold between 2000 and
2005, as against only a
one and a half times increase for the major European and US stock exchanges.
Issuance of bonds and
syndicated loans from emerging market corporates has also accelerated markedly,
and has even
exceeded sovereign issuance in some countries. Lastly, risk premia on emerging
market assets have
fallen significantly, reflecting sound economic fundamentals. For this series of
reasons, emerging
markets have become an attractive asset class for long-term international investors,
as shown by their
rising share in asset allocations. It is therefore not so surprising that they have so
far been relatively
immune to the current subprime crisis, and might even be seen as safe havens!
Let me now turn to some major challenges of financial globalisation.
First, the impact on monetary policy. Some analysts have suggested that,
because of capital market
integration, real interest rates will equalize around the world, thus reducing the
ability of national
Central Banks to control inflation. However, this need not be the case. Indeed, the
classic MundellFleming analysis concludes that monetary policy should be more effective, rather
than less, in the case
of international capital mobility, although it can operate through different channels
of transmission
including the exchange rate. Furthermore, in many emerging countries, strong
capital inflows confront
monetary policy with a dilemma between pursuing internal and external objectives,
in a context of

rising inflationary pressures. Taming capital inflows would call for a relaxation of
monetary policy, at
the risk however of compromising on the domestic objective of maintaining low
inflation. Sterilisation
cannot 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
reserves.
A second question is the potential for global contagion. As a direct
consequence of cross-border
financial integration, local price or liquidity shocks are more likely to spread around
the globe. Largescale
liquidity creation resulting from monetary (or exchange rate) policy in one country
may fuel
asset price bubbles elsewhere. One current example might be seen in carry trades,
which have become
a major driver of a number of currencies, including the yen. Therefore, distant
events can have sharp
impacts, even on local institutions or investors. New contagion channels have
emerged. With more
5/5

risk traded in and through markets, the potential knock-on effects from an erosion
of liquidity in some
segments or for some institutions have multiplied, and we are currently
experiencing how unexpected
this process can be. Risks have become mobile, if I may put it like that, so mobile
that we lose sight
of their true location.
The third and final set of issues relates to global imbalances. The facilitation
of cross-border capital
flows may have relaxed financing constraints for borrowers, making it possible to
finance ever larger
current account deficits. In one sense, the contribution of financial globalisation to
disconnecting
national savings and national investment is a welcome development, to the extent
that it allows for a
more efficient global allocation of savings. However the differences in the
development of financial
markets around the world may also have created, or at least facilitated, global
imbalances. The ability
of countries to produce sound and liquid financial assets is largely disconnected
from their level of
economic growth : rising revenues in the emerging world need to find a home in
sound and liquid
financial markets.
Finally, in any case, the question of sustainability the resilience of capital flows
to the accumulation
of imbalances remains a pressing one. While capital flows tend to move freely
across borders,

exchange rate regimes remain very diverse in their degrees of flexibility. This leads
to asymmetric
adjustments depending on the exchange rate regime, not only between currency
areas, but also inside
the 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 global
capital markets in an environment where such differences persist might not be
sustainable over the
long term. An orderly unwinding of global imbalances might therefore imply greater
flexibility from
countries with large current account surpluses and fixed exchange rates.
I will conclude on a matter of debate for international financial stability for
the future. As I have
said, financial systems have become more efficient as a result of globalisation and
innovation. But
have they become more resilient, that is, more capable of absorbing shocks? None
of us has the
answer to that question now, but it will be interesting for central banks and
regulators to monitor
financial developments in the coming months, in search of clues. Ladies and
gentlemen, thank you for
your attention.

FINANCE
India Inc : Globalization of Capital Markets : Has India Caught This
Wave ?
EVOLUTION OF INDIAN CAPITAL MARKET AS GLOBAL
FINANCIAL POWER HOUSE
Author :
Miss . Kanchan Mishra : I.I.T. Guwahati
Electronics & Communication Engineering:India Institute of Technology:
Guwahati 781039

Mr.S.N.Mishra: Assistant Director

Central Silk Board, Sualkuchi
{ kanchan@iitg.ernet.in, snmishra_csb@yahoo.co.in }
ABSTRACT :
Finance is the study of money. Capital market deals in long term fund of duration
one year or above. Globalization means integration of financial market through out
the world for raising and investing funds. The factors integrating this globalization
are : Liberalization , Technological Advancement and Institutional Investors.
Indian Financial Market has been Globalized during 1990s. Some factors like low

penetration of Indian household investors in capital market, Large investment

opportunities in Indian capital market , India as an attractive destination for
foreign investors, Availability of large labour fource and high growth rate in India,
Ambitions of Indian inc to reach global markets market, Setting up of special
economic zone(SEZ), Productive use of idle cash reserve concept of merger and
acquisition, Venture capital and private equity investments has influenced a lot of
foreign investors to invest in India and has influenced globalization of Indian capital
market.

INTRODUCTION :
Finance is the study of money , its nature , creation , behavior, regulation
and administration. Financial market , facilitates the trading of financial
assets. Financial market play a significant role in transferring surplus fund
from saver ( lender ) to borrowers ( investors ). Financial market is classified
as : Money Market and Capital Market. (i) Money Market : It is the
mechanism where short term instruments maturing within a year are traded.
(ii) Capital Market : It is a market in which lenders or investors provides
long term funds of the duration of above one year in exchange for financial
assets offered by borrowers or holders.
The capital market in India is divided into : Organized and Unorganized
sectors . (i) Indigenous bankers and Money lenders constitutes the
unorganized sector of capital market . (ii) The organized capital market
consists of : Non-Banking institutions like and Public Financial Institutions.
A financial security is a legal instrument that represents either ownership or
creditorship claim. The ownership securities are equity shares and
preference shares. The creditorship securities are bonds and debentures.
1
Globalization of Financial Markets :
Globalization means the integration of financial market through out the
world into an international financial market. Entities in any one country
seeking to raise funds need not be limited to their domestic financial market.
Even investors in a country is not limited to the financial assets issued in
their domestic market. The factors integrating this globalization are :
Liberalization, Technological Advances and Institutional Investors.
(i)Liberalization :Deregulation and liberalization of markets and activities
of market participants in key financial centers of the world. Global
competition has forced governments to deregulate or liberalize various
aspects of their financial markets so that their financial enterprises can
compete effectively around the world.
(ii) Technological Advances: For monitoring world markets, executing
orders and analyzing financial opportunities. Technological advances have
increased the integration and efficiency of the global financial market.

Advances in telecommunication systems link market participants through

out the world with the result that order can be executed within seconds.
Advances in computer technology, coupled with advanced
telecommunication systems, allow the transmission of real-time information
on security prices and other key information to many participants in many
places. Therefore many investors can monitor global markets and
simultaneously assess how this information will impact the risk/reward
profile of their portfolios. Significantly improved computing power allows
the instant manipulation of real-time market information so that attractive
investment opportunities can be identified. On identification of these
opportunities, telecommunication system permits the rapid execution of
orders to capture them.
(iii) Institutional Investors : Increasing institutionalization of financial
markets. The shifting of the role of two types of investors , retail and
institutional investors , in financial markets is the third factor that has led to
the integration of financial markets. The U.S. financial market has sifted
from being dominated by retail investors to being dominated by institutional
investors. Retail investors are: individuals . Institutional investors are :
Financial Institution Pension Funds, Insurance Companies, Investment
Companies, Commercial Banks, Savings & Loan Associations. The shifting
of financial markets in U.S. and other major industrial countries from
dominance by retail investors to institutional investors is referred as
institutionalization of financial markets.
2
Unlike retail investors , institutional investors have been more willing to
transfer funds across national borders to improve the risk/reward
opportunities of a portfolio that includes financial assets of foreign issuers.
The potential portfolio benefits associated with global investing have been
documented in numerous studies, which have highlighted the awareness of
investors about the virtues of global investing . Investors have not limited
their participation in foreign markets to those of developed economies.
There has been increased participation in the financial markets of developing
economies, popularly known as emerging markets.
Indian Financial market have been globalized in 1990s to a good extent.
The global financial market can be divided into three sectors :Domestic
Market, Foreign Market and International Market :
(i) Domestic Market : In domestic market issuers are domiciled in the
country where the securities are issued and where those securities are
subsequently traded.
(ii) Foreign Market :Foreign market of a country is where the securities of

issuers are not domiciled in the country are sold and traded. Rules governing
the issuance of foreign securities are those imposed by regulatory authorities
where the security is issued. Nicknames have been used to describe various
foreign markets : Yankee Market ( USA), Samurai Market (Japan), Bulldog
Market ( United Kingdome), Rembrandt Market ( Netherlands), Matador
Market (Spain).
(iii) International Market : This external market includes securities with
following distinguishing features : at issuance they are offered
simultaneously to investors in number of countries, and they are issued
outside the jurisdiction of any single country . The external market is
commonly referred to as : Offshore Market , Euromarkets.
MATERIAL AND METHODS :
Under this studies the factors influencing globalization of Indian capital
markets have studied. The countries investing in India has also been
identified and the comparative proportion of foreign investment in India in
comparison to China has also been examined.
3
Factors Influencing Globalization of Indian Capital Market :
1)LOW PENETRATION OF INDIAN HOUSE HOLD IN CAPITAL
MARKET: Indian household investors are of the habit of investing chunk
of their amount in financial savings in money market and only a small
amount of their savings are invested in capital market . During last ten years
the investment of savings from Indian households in capital market in terms
of shares and debentures has declined from 14.4 % during 1994-95 to only
about 1.8 % in 2003-2004 at current price level (table-1) and this influences
Indian capital market towards globalization for attracting larger capital
investments.
Table -1- Investment trend of Indian households in Share and debentures.
( Figures in Rupees Crores at current price )
Year TotalHousehold
Savings
Household
Financial Savings
Savings in Shares &
Debentures
%of Shares&
Debentures
1994-95 1,99,358 1,20,733 17,381 14.4
1995-96 2,16,140 1,05,719 9,101 8.6
1996-97 2,33,252 1,41,661 10,407 7.3
1997-98 2,68,437 1,46,777 5,060 3.4
1998-99 3,26,802 1,80,346 6,993 3.8

1999-00 4,04,401 2,05,743 18,188 8.8

2000-01 4,52,268 2,16,774 10,214 4.7
2001-02 5,13,100 2,53,964 7,777 3.1
2002-03 5,74,681 2,54,439 5,504 2.2
2003-04 6,71,692 3,14,261 5,699 1.8

2)LARGE INVESTMENT OPPORTUNITIES IN INDIAN CAPITAL

MARKET:It is boom for investors in Indian stock markets, the benchmark
Bombay Stock Exchanges Sensex is virtually sprinting from 7000-7800 in
just 32 trading days. The surge is being driven by a flus h of liquidity brought
about by bullish foreign institutional investors (FII s) . The coming up
current public issues opportunities : Both initial public offerings(IPO s) and
the Follow-up Public Offerings (FPO s) is estimated to be Rs: 72,814 crores
(around $ 16.54 billion) . The amount to be raised in next 12 month is bigger
than , what companies have raised , cumulatively, over the last decades,
right up to March this year. To meet this requirement India has to look
towards globalization and foreign investors.
4
3)INDIA AN ATTRACTIVE DESTINATION FOR FOREIGN
INVESTORS:Emerging market in India continue to be an attractive
destination for Foreign Institutional Investors (FII) , with total FII inflow
into Indian equities already exceeding $ 6 billion th is year till July 2005, at
this rate FII inflow is expected to exceed $ 10 billion by the end of year
2005.The FII inflow last year 2004 was $ 8.5 billion and that during the year
2003 was $ 6.4 billion.
4)AVAILABILITY OF LARGE LABOUR FORCE AND HIGHER
GROWTH RATE IN INDIA IS SUPPORTING GLOBALISATION OF
INDIAN CAPITAL MARKET: India has a large labour force , 2nd largest
in the world 482.2 million during the year 2004. This labour force has
contributed to more than 9 % growth rate in manufacturing and service
sector . This will in evolving Indian capital market as global power house in
coming years. As the comperative GDP growth rate in comparison to USA
and EU where the GDP growth rate is 3.6 and 1.2 respectively. This
globalization is gradually supporting in increasing employment and
productivity.
5) GLOBALISATION OF INDIAN CAPITAL MARKET HELPS
INDIAN INC TO REACH GLOBAL MARKETS: Foreign direct
investment is a mirror that reflects the extent to which a country and its
companies have integrated globally . Going by the logic , it must be a
painful sight for most Indian companies to held a mirror to their balance
sheets. Once again the characteristic timidity of the Indian Inc is clearly

visible on both sides : Whether it is incoming FDI or Outgoing FDI.

The comparative FDI in Asian countries is indicated in Table -2.
Table-2- FDI to and from Asian countries ( $ billion ) Source: IMF
Country Inward FDI Outward FDI
2003 2004 2003 2004
China+Hongkong 13.6 34.0 -0.2 1.8
India 4.3 5.3 0.9 2.3
Singapore 9.3 16.1 3.7 10.7
Japan 28.8 31.0 6.3 7.8
Korea 3.4 4.8 3.5 8.2
5
6)SPECIAL ECONOMIC ZONE (SEZ) SUPPORTS
GLOBALISATION:SEZ is an area having economic policies and laws
which are typically different from the laws prevailing within the main land.
China has established a number of SEZ each with an average area of 145 sq
km , while India has only 8 active SEZ with an average area of 9 sq km.
China has attracted large FDI in its SEZ , but this has not su cceeded in India
so far.
7)GLOBALISATION SUPPORTS PRODUCTIVE USE OF SURPLUS
& IDLE CASH RESERVE , MERGERS AND ACQUISITIONS:A few
years ago , Aziz Premji of Wipro and his former vice-chairman Vivek Paul
were considering a big ticket acquisition in US to catapulate Wipro into IT
and consulting big league at one stroke . They had a war chest of $ 800
million , yet Wipro got the jitters at last minute and backed out. Around the
same time a virtually unknown PC maker from China , Lenovo was nursing
global ambitions. Lenovo did not get the jitters . It ended up buying the out
the global PC business of IBM , the mother of all IT companies in a deal
worth more than $ 2 billion.
In April 2005, there was cheers as Indias fastest growing home grown
bank, ICICI , acquired the Russian bank IKB . It finally looked as if Indian
companies were looking seriously at globalization . Let us look at inside
story . ICICIs net profits in 2004-05 was Rs 20 billion . The cash balance of
ICICI Bank in the same period were about 150 billion . The price tag ICICI
paid for IKB : a small Rs 18 million . Around the same time big foreign
banks like Citi,ABN Amro,HSBC,Stanchart has lined up more than Rs 50
billion to ramp up their Indian operations. Indian companies are yet to
match their global counterparts in leveraging cash holds to muscle their way
into international market.
Investments in Mergers & Acquisition during year Jan-Jun 2005 , Japan has
invested more than $ 100 billion , China has invested $ 17 billion and India

has invested only around $ 8 billion. The investment in mergers and

acquisitions is an indicator towards globalization of capital market.
8)GLOBALISATION OF INDIAN STOCK MARKET HAS
MOTIVATED VENTURE CAPITAL/PRIVATE EQUITY
INVESTMENT IN INDIA: In last 10 years after globalization of Indian
capital market the venture capital investment in India has increased 100
times. The companies like 3i, Texas Pacific Group, The Blackstone, The
Carlyle Group are new internets in globalized Indian capital markets. The
venture capital/Private equity/ Risk capital investment in 1996-97 was $ 20
million , during 2004 -05 it attracted $ 1,750 million in IT sectors of India as
result of globalization. 6
THE SOURCES OF FOREIGN INVESTORS COMING TO INVEST
IN INDIAN CAPITAL MARKET
The Indian stock market is attracting foreign institutional investors(FII) of
all types. Of the total of $ 37 billion FII investments in India since 1994, a
fifth has flowed in during first eight months of 2005 . During this year 123
FII from 20 countries have registered . The country wise they are : USA 37,
Canada 3, Port of Spain 1, UK 22, Luxembourg 12, France 6, Switzerland 4,
Australia 6, Singapore 9, Hongkong 2, Taiwan 2, Japan 2, Korea 2. The
sectored investment in prominent areas are : Pension Trusts 16%, Insurance
Companies 4%, Government Bodies 3.2%, Banks 14.4%, Capital Investment
and Asset Management Company 62.4%.
RESULTS & SUGGESTIONS :
China opened its economy in 1980 and since then China had received $ 500
billion worth of foreign investment of these nearly $ 60 billion name in
calendar year 2004. However so India could attract only around $ 50 billion
foreign investment since 1980 and during 2004 it was less than $ 6 billion.
That means the speed of globalization of the Indian stock market is only
10% of China.
Now it is essential that like Indian commercial banks Indian stock exchanges
has to open its branches in various parts of India and in foreign country to
provide quick liquidity to capital instrument and on the spot investment and
allotment of instruments to investors. The term broker or dalal should be
changed to agent or service personel.

Chapter 1
Financial Innovations and the Dynamics of Emerging
Capital Markets
Laurent L. Jacque
Fletcher School of Law and Diplomacy, Tufts University and HEC School of Management

Key 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 and
emerged markets according to a decreasing national cost of capital criterion. Newly emerging
countries are handicapped by a high cost of capital because of incomplete and inefficient financial
markets. As capital markets graduate to higher level of emergedness, their national firms avail
themselves of a lower cost of capital that makes them more competitive in the global economy and spurs
economic growth. This chapter argues that the dynamics of emerging markets are driven by: 1) the
skillful transfer of financial innovations to emerging markets committed to deregulating their financial
sector, 2) disintermediation of traditional financial intermediaries (mostly commercial banks) in favor of
a more cost effective commercial paper market, and 3) securitization of consumer finance which reduces
households cost of living.

1. INTRODUCTION
Financial innovation is often blamed for what is perceived as an increase in systemic risk the
Asian and Latin American crises being the latest cases in point. Yet financial innovation in the
form of different types of derivatives products or financial engineering technologies generally
provide low-cost and highly efficient methods of mitigating rather than exacerbating risk by
completing emerging capital markets.1 This introductory chapter argues that financial
innovations nurture the emergence process of capital markets in developing countries by
bringing about a lower national cost of capital that in turn enhances the wealth of nations.
If one can visualize emerging national capital markets positioned along a continuum ranging
from recently hatched or embryonic to truly mature markets one can hypothesize that the race
along this continuum is indeed beneficial as ascending countries avail themselves of a lower
national cost of capital; arguably this process is welfare-enhancing as it improves living standards
and make national firms more competitive in the global marketplace. The quintessential question
is thus to identify the drivers of this process: I would suggest that deregulation, disintermediation,
securitization and the transfer of financial innovations are critical to this process.
This first chapter is organized as follows: the first two sections set the stage by defining financial
innovations and mapping the emergence concept as it relates to the capital market
segmentation/integration; Sections 3, 4 and 5 show how disintermediation, deregulation and
securitization energize the emergence process.

2. DEFINING FINANCIAL INNOVATION

Financial innovation refers to any new development in a national financial system or the
international financial system that:
enhances the allocational efficiency of the financial intermediation process and
improves the operational efficiency of the financial system by reducing the costs and/or
risk of transactions in the primary and secondary markets in which financial instruments
are traded.
The last 25 years have witnessed an acceleration in the process of financial innovation. This
has been spurred largely by increased volatility of exchange rates, interest rates and commodity
prices and an increase in the pace of tax and regulatory change. The resulting financial
innovations may be classified as:
new financial intermediaries (e.g. venture capital funds)
new financial instruments (e.g. collateralized mortgage obligations or credit derivatives)
new financial markets (e.g. insurance derivatives)
new financial services (e.g. e-trading or e-banking)
new financial techniques (e.g. V@R or LBOs)
Such financial innovations and their globally reaching migration from mature to emerging
markets are generally construed as beneficial to host financial sectors because their bring about a
lower national cost of capital; presumably by allowing the transfer of risk from firms less able to
bear risk to those which are better equipped to bear it (division of labor), financial intermediation
is improved and national welfare is enhanced. In the best of finance theory tradition, however,

one cannot talk about a lower cost of capital or a higher yield without raising the question of risk.
Of course we have to stretch the concept of portfolio theory somewhat to talk about the risk
presumably systemic of a national financial system. Let me venture a simple proposition:
transfer of financial innovation is truly welfare-enhancing if it brings about a reduction in the cost
of capital without a commensurate increase in systemic risk (see Figure 1). 2
Figure 1. Welfare-Enhancing Emergence Path
Cost of
Capital
Systemic
Risk
High
High
Low
Low

Welfare-enhancing emergence

Here the analogy made by the Nobel laureate Robert Merton (1993) between emerging financial
systems and a newly engineered high-speed passenger train traveling along a track unable to sustain
the speed is helpful; the track is the existing regulatory infrastructure - often obsolete in emerging
financial systems - within which financial innovations are imported and which are in dire need of
repair and upgrade. If the new high-speed passenger train is allowed to travel at its peak
performance speed it may crash, thereby destroying or severely damaging the track system; freight
operators who use the track for a different purpose would no longer be able to rely on it. Regulators
may thus choose to set a safe but low speed policy with the unfortunate consequence of depriving
the country of the benefits of the imported innovation (high speed train); alternatively, regulators
may upgrade the speed limit as soon as the infrastructure is improved and the technological
imbalance between the product and its infrastructure is corrected. 3

3. MAPPING THE CAPITAL MARKET EMERGENCE PROCESS4

Most emerging capital markets are segmented from one another, at least to some degree, thus
allowing for differences in the effective cost of capital among different countries. For this reason,
rather than thinking in terms of a clear-cut dichotomy between segmented and integrated national
capital markets, it is more useful to position each country along a continuum ranging from
extreme segmentation to complete integration.
As illustrated in Figure 2, such an emergence continuum would show the newly hatched
Tashkent or Ulaanbaatar or Ho Chi Minh City stock exchanges at its segmentation extremum
whereas the Paris Bourse and the Tokyo Stock Exchange would appear at the opposite extremum
close to the final destination point the New York Stock Exchange. The practical question of
positioning a particular capital market along this continuum can be resolved by relying on a
multidimensional scale that could include the following variables:
1. Market Capitalization(MCAP)/Gross Disposable Income (GDP) index as a proxy for the
country financial sector deepness/maturity;
2. Disintermediation index as a measure of the percentage of aggregate financing channeled by
financial markets as opposed to traditional financial intermediation provided by commercial
banks; presumably the allocational and operational efficiency are enhanced by a greater
reliance on financial markets (especially the commercial paper market) than on financial
institutions;
3. American Depositary Receipts (ADRs)5 index as a measure of the offshore market
capitalization of national firms traded on the New-York or London stock exchange as opposed
to total market capitalization (see Box 1, p.5). For example Santiago (Chile) through a handful
of major Chilean firms whose ADRs are trading on the New York Stock Exchange may be
characterized by an index as high as 35% indicating a significant degree of market integration;

when such firms are simultaneously traded on both exchanges they force on the otherwise
relatively segmented market of Santiago valuation rules more closely aligned with the highly
efficient New York stock exchange;
4. Market Completedness index6 measuring the degree of coverage of the matrix market/product
(cf. Figure 3). As capital markets avail themselves of a fuller range of financial products, they
benefit from a higher level of both allocational and operational efficiency that is welfareenhancing.
For example if we arbitrarily allocate equal weights of 0.04 (out of a maximum of
1) to each cell of the market, Bangkok would receive a score of 0.2 whereas Sao Paulo would
get 0.48 out of a maximum of 1 for markets such as New York or London.
Figure 2. Capital market emergence continuum

Alternatively one can map this segmentation/ integration continuum in a three dimensional
space by decomposing the worlds 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 transmission
belt between national segments of the first two. Unlike industrialized nations, which have
efficient and well functioning capital markets, emerging capital markets have burgeoning equity
markets, barely existing debt markets (with relatively short tenors) and mildly controlled foreign
exchange markets. As discussed further below, in such emerging markets, debt financing
Hong Kong
Singapore
So Paulo
Mexico City
Bangkok
Jakarta
Bombay
Shanghai
Budapest
Colombo

Emerged
Pre-Emerging Ulaanbaatar
NYC, London, Tokyo
Cost of Capital =
f (Innovation, Disintermediation,
Securitization, Deregulation)
Tashkent
Seoul
Kiev
Ho Chi Minh City

Emerging
continues to be provided predominantly by commercial banks and finance companies (which may
also be major providers of equity financing).
Forwards Futures Swaps Options Other
Derivatives
Foreign Exchange BKK, SP BKK, SP BKK, SP BKK, SP SP
Interest Rate SP SP
Commodities BKK, SP SP
Bonds
Stock SP SP SP
Figure 3. Matrix of market completedness

3.1 Equity Market Segmentation

A national capital equity market is defined as segmented to the extent a given securitys rate
of return in that particular market differs from that of other comparably risky securities traded in
other national markets. Why are national equity markets segmented from one another?

Segmentation may result from differences in government tax policies, regulatory obstacles to the
introduction of financial innovations, foreign exchange controls on capital account transactions
(especially for the purpose of international portfolio investment), restrictions on the amount of
corporate control exercised by large investors and other forms of regulatory interference with the
efficient functioning of national equity markets. Segmentation can also be caused by differences
in investors expectations stemming from informational barriers and differences in disclosure
requirements among national equity markets. For many emerging capital markets most notably
those in Latin America rapidly growing ADR markets anchored in the New York Stock
Exchange or the NASDAQ are providing a shadow market, which is acting as a catalyst for the
emergence process (see Box 1).

3.2 Debt Market Segmentation

In efficient and integrated money markets, interest rates are free to adjust to changing
expectations. As a result, they tend to respond so quickly to new information that opportunities
for profitable arbitrage are quickly bid away. This is true of most industrialized with complete
Box 1. ADRs and the segmentation of capital markets. American Depositary Receipts
(ADRs) are US dollar denominated negotiable instruments issued in the US by a depositary
bank. The investor in an ADR enjoys the benefits of share ownership in a foreign corporation
without facing the cumbersome and otherwise onerous costs of investing directly in a foreign
equity markets. Such obstacles include costly currency conversions, opaque tax regulations,
unreliable custody and settlement in a foreign country. Such ADRs programs offer also
several advantages for the issuing company often domiciled in an emerging market. Creation
of a larger and geographically more diversified shareholder basis generally stabilizes share
prices and provide additional liquidity. Raising of additional equity capital is also facilitated
if the firms home market cannot absorb a new issue. More exacting reporting and disclosure
requirements enhances the profile and the attractiveness of the firms stock from investors
perspective. In sum it is generally believed that ADRs program results into a lower cost of
capital.
financial markets (with well functioning currency and interest rate futures, forward, swaps and
options markets) and fully convertible currencies.
In such markets, a condition known as Interest Rate Parity is likely to prevail whereby large
sophisticated borrowers and lenders such as commercial banks and money-market mutual funds
should be indifferent between borrowing or lending in the domestic or the foreign currency (when
exchange risk is eliminated). Expected real interest rates for identical debt securities may still
differ across currencies, but such differences should be effectively offset by anticipated
depreciation of the currency with the lower real rates a theory known as the International
Fisher Effect.
By contrast, segmented money markets are characterized by interest rate rigidities resulting
from government-imposed distortions and controls such as interest rate ceilings and mandatory
credit allocations. When interest rate controls are coupled with exchange rate controls, arbitrage
motivated market forces that lead to the International Fisher Effects are blocked thus allowing for
abnormal arbitrage opportunities to persist until the controls are lifted. As an example, the
abolition of interest rate controls in 1990 by the Central Bank of Thailand failed to end the
interest rate differential between the Thai baht whose rate ranged between 16 and 18%, and
eurodollars in Singapore and Hong Kong with rates between 6 and 8%: somehow quotas imposed
on offshore borrowing by Thai commercial banks and major corporations must have accounted
for the continued interest rate difference.
Even among closely integrated financial markets, a tiering of credit markets between onshore
(or domestic) and off-shore (or euro-currency) segments continues to produce small but

non-negligible segmentation residuals both within and acoss currency habitats. By and large,
lower taxes, the absence of reserve banking requirements, and the reduced presence of other such
market imperfections almost always lead to a greater degree of capital market integration in the
offshore than in the onshore components of given debt markets.

3.3 Foreign Exchange Market Segmentation

In 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 year
approaching 25% or more. The dollar itself has depreciated by as much as 50% in a single year
against the Japanese yen. It is not uncommon for the price of a single currency to vary as much as
10% in a single day as we witness during the recent Asian financial crisis.
Perhaps more perplexing than volatility itself is the increasing evidence of prolonged periods
of exchange rate over(under)shooting. Currency over(under)shooting for the purpose of this
chapter is defined as long-term deviations of nominal exchange rates from their intrinsic
equilibrium levels generally approximated by exchange rates consistent with Purchasing Power
Parity (PPP holds when exchange rate changes between two currencies are explained entirely by
differences in underlying inflation rates over the same time period). In the case of the US dollar,
such overshooting has been most dramatic in relation to foreign currencies such as the yen, the
pound and the euro.
Most segmented capital market countries suffer from chronic balance-of-payments problems
that are typically suppressed by an intricate web of exchange controls. In many newly
industrializing countries the quasi-convertible status of the currencies continue to be shrouded by
a pervasive web of exchange controls which run the gamut from light restrictions on visible
trade transactions to byzantine controls on capital account transactions. Such restrictions also
sometimes takes the form of two-tier and multiple-tier exchange rates or, in the case of
hyperinflationary economies crawling pegs.

3.4 A Mapping Paradigm for Emerging Capital Markets

As national capital markets loosen up the regulatory shackles that creates segmentation by
dismantling controls in the debt and exchange markets, by creating an institutional setting that
reduces equity market imperfections, and by encouraging the securitization process (see the
discussion of THAI CARS in Section 6) the cost of capital should gradually edge lower towards
its equilibrium value approximated by the US cost of capital thus bringing about a truly integrated
global capital market. But, until that process nears completion, world capital markets will
continue to exhibit pockets of segmentation.
Figure 4. Space mapping of capital market segmentation

In Figure 4, we provide a map of capital market segmentation in a three-dimensional space by

defining the origin as the integration point. Each of the three axes corresponds to one of the three
major financial markets currency, debt and equity in the following fashion:
1) An index of currency over(under)valuation equal to 1 S/S* where S measures the
nominal local currency price of one US dollar with S* being the Purchasing Power Parity
equilibrium exchange rate similarly defined. If the currency is overvalued, S < S*, the exchange
market will be positioned between 0 and 1 and between 0 and -1 when undervalued. If the
exchange rate is fairly priced, and thus capital markets are integrated (at least in an international
sense), the exchange market will be positioned at the origin of the axis.
Currencies such as the Argentine peso and the Brazilian cruzeiro would typically be
overvalued, whereas the Korean won or the Taiwanese dollar may at times be undervalued. For
example, the Mexican peso in December 1994 and the Thai baht in July 1997 immediately before
their respective financial crisis were respectively overvalued by 20 and 35 percent. Even fully
convertible currencies such as the Japanese yen or the euro may experience prolonged periods of

overshooting or undershooting against their benchmark Purchasing Power Parity equilibrium

value.7
2) An index of domestic interest rate overpricing/underpricing 1 i/i*, where i denotes the
controlled interest rate or nominal cost of debt financing (reflecting local debt market
imperfections) and i* the underlying equilibrium cost of capital. The latter assumes the removal
1
1
1

Equity Market
Money Market
FX Market
Mexico
Integrated
Capital Market
.20
.60
-.24

of interest rate controls of any kind as well as an institutional setting approaching conditions of
market perfection. Such an index would range from a mildly negative to a positive number
depending on local market conditions.
3) An index of relative market portfolio volatility, defined as 1- w/i where i and w denote
respectively the standard deviation of the market portfolio of a segmented emerging capital
market i (i) and the standard deviation of the world capital market portfolio (w). Alternatively
the ratio of relative market portfolio volatility could be captured as the country beta which
measures the covariance of the local market portfolio with the world portfolio. As i w the
segmented capital markets market portfolio broadens and deepens and its volatility should
decrease approaching the volatility of the world market portfolio; similarly as the local capital
market becomes better integrated its beta would tend toward one. An additional gauge of equity
market integration would be found in the proportion of equity trading that takes place in the form
of ADRs: clearly, as the ratio of domestic shares traded as ADRs on the New York Stock
Exchange 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 the
ratio of offshore ADR market capitalization MCAP(ADR) to the home market capitalization
MCAP(i) :
MCAP(ADR)/MCAP(i)
For example, the volatility of the Mexican market could be estimated at i = 0.46 as
compared to a world market volatility of w = 0.16, resulting in an index of equity market
segmentation of (1 - 0.16/0.46). Thus as illustrated with the case of Mexico, our map of capital
market segmentation would allow us to position each country in a three-dimensional space.
The second policy question is the identification of the levers driving this emergence process;
as we argued before moving gradually along this continuum would bring about a lower cost of
capital which is truly welfare-enhancing: what can policy makers initiate in order to nurture this
process. The consensus points towards economic liberalization/deregulation, disintermediation
and securitization as the major forces propelling capital markets toward higher level of
emergedness.

4. DEREGULATION
The last decade has experienced an accelerating worldwide effort at deregulating economic
activity with financial markets being a major beneficiary of this trend. A financially repressed
system is generally defined as a system in which the amount and the price at which credit is
allocated is determined directly or indirectly by the government; deregulation is thus
characterized as the process of allowing market forces to progressively determine who gets and

grants credit and at what price (Williamson and Mahar, 1998). This process will typically develop
along six dimensions:
Relaxation of credit controls
Deregulation of interest rates
Relaxation of international capital flows
Floating exchange rates
Free entry into/exit from the financial service industry
Privatization of financial institutions. 8
Each country though has defined its own agenda and has deregulated in its own peculiar way
so much so that, in terms of our three-dimensional map (Figure 4), each country has moved closer
to the integration point by sequencing the process in its idiosyncratic way: Restrictions on capital
movements, loosening of interest rate controls, etc., have proceeded in an imperfect way. We
illustrate next how incomplete markets may trigger regulatory arbitrage which in turns bring
about more complete markets and the dismantling of some not all regulatory walls with the
case study of the Kingdom of Denmarks Bull/ Bear notes.
Kingdom of Denmarks Bull and Bear Notes:9 on September 30, 1986 the Kingdom of
Denmark issued FF 800 million worth of equity linked notes redeemable on 1 st October 1991
(Jacque and Hawawini, 1993). The notes which were listed on the Paris Bourse, were issued at
par with a face value of FF10,000 and an annual coupon rate of 4.5%. The issue consisted of two
separate and equal tranches one called Bulls and the other Bears of FF400 million each. The
redemption value of both tranches was a function of the value of the stock market index. For the
Bulls bonds, the redemption value was directly related to the value of the French stock market
index at the maturity of the notes, whereas the redemption of the bear notes was inversely related
to the value of the index (see Figure 5).
Figure 5. Kingdom of Denmarks Bull-Bear notes

More specifically, each Bear note combined a five-year, FF450 annuity (4.5% of FF10,000 of
face value for five years) and a five year put option on the stock market index with an exercise
price of 896.45 (at the time of the issue, the stock market index stood at 405.97) . The Bull note
consisted of a five year note, FF450 annuity plus a long position in the stock market index minus a
five-year European call option with an exercise price of 896.45 (the latter call option gave the issuer
the right to redeem/call the bull notes at FF23,200 if the stock market reached 896.45, thus
effectively putting a ceiling on the notes value).
Redemption Value (FF)
23200
11600
0 896.40
Bull Tranche (R1)
Total Redemption
Value (R1 + R2)
2
Bear Tranche (R2)
Terminal Value
of the Index
R1 = PAR x 1.05 Terminal Value Index
405.7
Maximum Value of R1 = 2.32 PAR = 23.200
R2 = PAR x 2.32 - R1
Total Value = 1/2 (R1 + R2) = (PAR x 2.32) x 1/2 = 11,600

Although both the Bear and Bull notes are risky equity-linked instruments for investors when
held separately, for the issuer the total issue is riskless (as long as both tranches are fully
subscribed); that is, the cost is fixed. As shown by the dark horizontal line in Figure 5, the average
redemption value of a bull and bear notes is effectively fixed at FF11,600 (or half of FF23,000) per

note. And, the effective cost of this debt issue for the Kingdom of Denmark (a AA credit) given
an initial cash inflow of FF10,000 per note, five annual FF450 coupon payments, and an average
final principal payment of FF11,600 turns out to have been 7.27%.
At the same time these notes were issued, the French Government, a AAA credit, was raising
five-year fixed-rate debt at approximately 8% and AA rated French corporate issuer at 8.90%. Thus
by issuing a package of Bull and Bear notes (instead of five-year straight bonds), the Kingdom of
Denmark 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 have
warranted. In short, the market priced the Bull and Bear notes at a premium, resulting in a lower
cost of debt for the issuer.
Anther way to view this financing transaction is that the Kingdom of Denmark was able to sell
separately the components of the package (Bull and Bear notes) for more than the value of the
package itself (the equivalent straight bonds). To understand why this might be possible, consider
the stock market condition in September 1986. Equity prices were rising steadily but market
participants were questioning such abnormal growth rates. Those already into the market needed
protection against reversal; those outside the market wanted to enter with minimum risk.
One possible answer would be futures and options contracts on a French stock market index.
Portfolio managers could protect their diversified holding of French equity by simply buying put
options on a stock market index, and investors wishing to enter the equity market could buy futures
contracts on a stock market index. Unfortunately, French regulatory agencies had not yet approved
the issuance and trading of these instruments: regulation was clearly resulting into incomplete
markets and an inefficient financial intermediation process. If these forbidden instruments could
somehow be supplied to the market in contravention of existing regulation, they would clearly
command a scarcity premium.
This is exactly what the Kingdom of Denmark offered under the guise of the Bull-Bear issue.
Bear notes were simply long-term put options designed for that segment of the market (mostly
wholesale investors) wishing to buy portfolio insurance. Bull notes were equity-linked bonds paying
interest and offering a play on the upward market movement. They were sold to the component of
the market (mainly retail investors) wishing to enter the market with minimum risk.
Thus the issuer was able to lower its cost of debt significantly by selling at a premium close
substitutes to prohibited products for which there was an unmet market demand. The issuer turned
to its advantage a segmented market that was not permitted to offer derivatives instruments on a
stock market index. Had such instruments existed in September 1986, the Bull-Bear issue would
probably not have been brought to market. Therefore it should come as no surprise that,
immediately after the French issue, similar notes were issued in Frankfurt, Zurich, and Tokyo but
none in New York and London. As the reader could guess, derivative instruments on stock market
indices existed in New York and London, but not in the other three markets. Each of the regulated
markets moved one step closer to completedness, along the emergence continuum path

5. DISINTERMEDIATION
The financial systems primary function is to mobilize savings and to allocate those funds
among competing users/investors on the basis of expected risk-return. This process can be carried
out through two competing paths: 1) through financial intermediation; financial intermediaries are
primarily commercial banks which provide credit in the form of loans and institutional investors
such as insurance companies, pension funds and venture capitalists which provide financing in the
form of debt and equity via private placement (clear cells in Figure 6) or 2) through securitization
whose vehicle of choice for converting savings into investments are securities tradable in capital
markets (shaded cells in Figure 6). Over the last 25 years, financial intermediaries have been
steadily loosing market share in the global financial intermediation business to capital markets; this

is know as financial disintermediation that is, the bypassing of financial institutions. This
process has two major implications: 1) The credit risk is borne by the ultimate lender who is
assisted 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 instruments.
This is not really a new phenomenon, with financial markets having traded stocks and bonds for
the last 150 years; what is relatively new is the rise of commercial paper as a lower cost alternative
to bank loans. This should come as no surprise as traditional financial intermediation is an
inherently costly process because the intermediarys balance sheet adds a layer of cost to the
process. Recall that banks convert deposits that are redeemable at par and often on demand into
illiquid loans which are placed at various risk levels of default. Indeed, banks will protect
themselves against such default risk by properly capitalizing themselves, thereby incurring a
significant equity cost of capital in the process. Unfortunately banks often find themselves in the
awkward position of reconciling illiquid assets (recall that during the recent Asian financial crisis
non-performing loans were hovering at around 50% of banks total assets) with liquid liabilities.
Figure 6. Disintermediation and the rise of the commercial paper market

Financial Intermediation
1. Commercial Banks
2. Insurance Companies, Pension
Funds, Venture Capitalists

Bifurcated Intermediation
Pension Funds,
Mutual Funds,
Insurance Co.s
Financial
Markets

Financial Markets
Brokerage
Firms and
Internet?
1. Equity
2. Debt
3. Commercial Paper
4. Hybrids
Households
Firms
Debt and Equity:
Private Placement
Debt (mostly)

Financial Intermediaries
Disintermediated Finance

With the development of the Internet, financial institutions are confronting the virtual threat of
renewed disintermediation. E-banking and e-trading, while not displacing traditional financial
intermediaries, are certainly redefining their production function.

6. SECURITIZATION
First pioneered in the US residential mortgage market more than 25 years ago the technology
of modern securitization has truly revolutionized consumer finance in the United States and the
United Kingdom.10 It is making a slow debut in most other countries in part because of the
sophisticated legal infrastructure that it requires. In this section we review first the architecture of
the technology and explain it economic logic before illustrating its far-reaching potential for
emerging countries.
By repackaging illiquid consumer loans such as residential mortgages, automobile or credit

card receivables - which were traditionally held by commercial banks, thrifts, finance companies
or other financial institutions - into liquid tradable securities, securitization is a more elaborate
form of disintermediation that typically results into a lower cost of consumer finance. It is
generally estimated that prior to securitization (that is prior to 1975) the average yield on a 30
year mortgage for a single family middle-income dwelling was equal to the yield on a 30-year
Treasury bond plus approximately 285 basis points; after a quarter of century of securitization the
premium 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 households budgets and a source of
improvement in their standard of living the Wealth of Nations
As illustrated in Figure 7 a typical securitization transaction is structured around six basic
building blocks:
1. Origination carried out by the financial institution which traditionally financed the
transaction, and which consists of managing the credit-granting process to consumers
applying for a loan to facilitate the purchase of a home, automobile or use of a credit-card;
2. Structuring creating a legal entity generally known as a special purpose vehicle (SPV) for
the sole purpose of the transaction which would use the loans as the asset collateral for issuing
new securities in the capital market. The SPV would typically purchase without recourse the
Box 2: The Thai banking industry as a besieged oligopoly gives way to deregulation and
disintermediation. Through a cozy arrangement between regulators and Thai commercial
banks, the financial sector thrived as a tightly knit oligopoly dominated by Thai financial
institutions. On the eve of the Asian financial crisis, 15 Thai commercial banks controlled 95
percent of the industrys assets through some 2000 branches, whereas 14 foreign banks
each restricted to operating one branch had to console themselves with only 5 percent of the
market. Under the pressure of the Thai banking lobby, regulators effectively froze out of the
market many eager applicants by simply failing to grant them banking licenses. Thus through
highly effective entry barriers of a regulatory nature, the Central Bank of Thailand failed to
spur the healthy competition that foreign financial institutions or entrants would have
undoubtedly exercised on Thai banks. The Asian financial crisis nearly pushed to bankruptcy
most commercial banks in Thailand and salvation could only come through massive
recapitalization or merger/acquisition by foreign banks; the Central Bank had little choice
but to allow the market-driven restructuring process to proceed thereby bringing about a
more efficient financial intermediation and the much needed if still embryonic use of
commercial paper.
receivables from the originators who interestingly enough are often also invited to be also
one of the credit enhancers, admittedly the ultimate incentive in performing as sound
originators;
3. Credit Enhancing improving the credit risk profile of the original loans by procuring
insurance coverage against default from insurance carriers or commercial banks; because
consumer financing loan default can be accurately gauged through actuarial techniques, it is
relatively easy to price credit enhancement. Typically securitization deals are credit enhanced
to the best possible rating which in turn enables the issuer to offer the lowest possible
yield to investors. Presumably the cost of credit enhancement is somewhat lower than the
reduction in the yield courtesy of residual inefficiencies in capital markets.
4,5. Underwriting and Placing the newly-created securities with appropriate investors; and finally
6. Servicing the loans interest and principal repayments to insure the proper cash-flows
disbursement to noteholders.
Figure 7. Structure of securitization transactions

The transfer of the securitization technology to emerging markets has started somewhat
slowly in the early nineties in part because most candidate countries for this new technology lack

the sophisticated legal infrastructure that is quintessential to such transactions. When the ultimate
financier of the transaction happens to be an emerged market-based investor a host of problems
such as country risk and currency risk complicate the architecture of the transaction beyond the
traditional credit risk evaluation. As a backdrop to the discussion we will use the THAI CARS
securitization deal which was completed in August 1996. THAI CARS, a company related to the
Tisco financial company, issued the first public securitized notes of Thai consumer assets. The
transaction secured a AAA rating from the US rating agency Standard & Poors, with the
insurance company MBIA providing guarantees.
As in a domestic securitization transaction, automobile leases and installment loans were
originated by Tisco-leasing (for automobile leases) and Tru-Way (for automobile installment
loans). The loans were then sold to Tru-lease, the SPV that structured the collateral assets into
tradable baht-denominated notes. Up to this point the transaction would be no different from a US
securitization deal. Because the investor tapped to purchase the notes are international eurobond
investors, the transaction required some creative financial engineering to resolve the unique
1
6
Borrower
245
3
Investor
Insurance companies,
Mutual Funds

Credit
Enhancement
Insurance Co.s

Origination
Servicing
Structuring
via Special
Purpose Vehicle

Underwriting
Placement
Mortgages, credit
cards, automobile
loans
Investment
banks
Investment banks,
Brokerages
Periodic cash interest and
principal repayment Initial Notes or Loan

problems raised by currency and credit risk. THAI CARS issued $US250 million of 5.5 year
Floating Rate Notes (FRN) through ING Baring at a mere 32 basis points above 3ML which
translated into a 150 basis points reduction in the cost of baht-consumer financing (see Figure 8).
Figure 8. Securities backed by leases: Thai Cars asset-backed FRN (Source: Adapted from Asia Money,
September 1996.)

Currency risk. Structured barely a year prior to the Asian financial crisis which engulfed the
Thai baht (it depreciated by close to 50% on July 2, 1997) this transaction had to address the
challenge of exchange risk embedded in the transformation of Thai-denominated receivables into
dollar medium term notes. Bankers Trust swapped bahts into yens and yens into dollars; why the
bifurcation into yen first and dollar second rather than a straight swap into dollars? The answer is
to be found in the witholding tax levied by the Thai tax authorities on interest payments. Since
interest rates in yen were close to 1 percent rather than 6 or 7 percent for dollars the amount of
taxes paid would be considerably lower on yen-denominated interest payments; hence the

baht/yen leg of the currency swap.

Credit Risk. Securitization works well for consumer loans with a well-established track record
that makes actuarial forecast of losses reasonably reliable. Such assessments are in turn necessary
for credit enhancement which brought this deal to a AAA rating, thereby lowering its cost of
capital. The credit enhancer MBIA seems to have overlooked the unique characteristics of high
net worth (or highly leveraged) borrowers who could afford luxury automobiles in Thailand (in
the $US250,000 - 400,000 range due to high import taxes): Newly-rich borrowers in Thailand
didnt have much of a track record and time series data on default for such loans must have been
exceedingly short, making it next to impossible to price the credit enhancement service (MBIA
charged a mere 35 basis points).

Car Buyers
& Lessors
1,5 Tisco
Leasing
1,5 TruWay
2A TruLease
Size: US$250 million Term: 5.5 years Coupon: 3ML+22bp
Rating: AAA (S&P) Issue Date: August, 1996
Conditional
assignment
of receivables
2B Thai

Cars
Bankers
Trust Intl
3 MBIA
Insurance
FRN
Baht
INV
ESTORS
Periodic cash interest and
principal repayment Notes, loan and currency swap contracts

Baht
Baht
Baht
/$
$

Fee
Guarantee
ING
Baring

$
Currency
/$ swap

Country Risk. Last but not least, investors had to contend with the possibility of exchange
controls 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 some
special arrangement are made.11 In this particular case, MBIAs guarantee must have provided
some degree of country risk (in addition to credit) enhancement in order for the rating on the deal
to 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 market
economies even though not all conditions were satisfied in this instance. Interestingly, the deal
did survive the Asian financial crisis and the devaluation of the Thai currency.

7. CONCLUSION
National capital markets can be positioned along a continuum ranging from embryonic to
mature and fully-emerged markets according to a decreasing cost of capital criterion. This chapter
argued that newly emerging markets are handicapped by a high cost of capital because of
incomplete and inefficient financial markets. The result is a costly financial intermediation
process.
As markets graduate to higher level of emergedness they avail themselves of a
progressively lower cost of capital, generating higher standards of living due to a lower cost of
consumer finance, and more competitive participation in the global economy as national firms
gain access to a lower cost of capital. Thus a lower cost of capital translates into a higher level of
economic welfare sometimes known as the Wealth of Nations.
The key question thus becomes: How may public policy nurture this welfare-enhancing
process? This chapter argued that: 1) the skillful transfer of financial innovations to emerging
markets will complete markets fostered by deregulation, 2) the disintermediation of traditional
financial intermediaries (mostly commercial banks) in favor of commercial paper markets and 3)
the securitization of consumer finance conjointly fuel the dynamics of emerging markets.

NOTES
1 Even

though it is more fashionable to talk about capital markets, the scope of this chapter encompasses the entire
financial system, of which capital markets are an integral part.
2 See Chapter 2 by A. Persaud for a discussion of systemic risk and how its level is closely linked to creditors and
investors appetite for risk. The regulatory framework needed to harness systemic risk is further discussed in
Chapter 4 by M. Crouhy et al.
3 See Merton, p.21. See also Chapter 3 by P. Christoffersen and V. Errunza for a discussion of the architecture of the
global financial system, and Chapter 5 by S. Gould et al., for the relationship between systemic risk and regulation.
4 This section draws from Jacque and Hawawini (1993).
5 See Chapter 7 by A. Mol and Chapter 8 by O. Kratz for an in-depth discussion of how ADRs are contributing to the
emergence process.
6 See Chapter 15 by E. Briys and F. de Varenne, Chapter 16 by M. Canter et al., and Chapter 17 by R. Neal for a
discussion of how insurance derivatives and credit derivatives complete financial systems.
7 See Jacque (1996), Chapter 5, for further discussion of currency overvaluation.
8 See Chapter 9 by R. Aggarwal and J. Harper for a discussion of how privatization can also accelerate the emergence
process.
9 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 financial
innovation, see Chapter 11 by P. Vaaler.
11 See Chapter 13 by A. Zissu and C. Stone for a discussion of how cross-border securitization transactions can be
structured to circumvent sovereign ceilings. T. Frankel describes the legal context in which cross-border
transactions are carried out in Chapter 10.
12 Most securitizations originated in emerging capital markets are backed by hard currency actual (or future) export

receivables; such receivables are often guaranteed by commodity exports such as oil or copper as well as telephone
payment settlements, electronic worker remittances, etc. In such transactions it is relatively easy to pierce the
country ceiling by structuring the SPV in a tax haven and channeling the currency receivables via the offshore
entity.

MarkowitzModel for
Selection of Optimal
Asset Classes-Asset
Allocation Decision:
Markowitz model is
typically thought of in terms
of selecting portfolios of
individual securities. But
alternatively, it can be used
as a selection
technique for asset classes
and asset allocation.