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Global aspects of finance

This tutorial was written by
Ken Edge
Head Teacher Social Science
Cardiff High School

Outcomes
Overview
Content
Review exercises
More

Outcomes

HSC Topic: The Global Economy is covered in the Board of Studies NSW Stage 6 Economics Syllabus (1999) on pages 31-33. The specific outcomes for this tutorial are:

H1	demonstrates understanding of economic terms, concepts and relationships
H3	explains the role of markets within the global economy
H7	evaluates the consequences of contemporary economic problems and issues on individuals, firms and governments
H8	applies appropriate terminology, concepts and theories in contemporary and hypothetical economic contexts.

Being up to date and aware of contemporary issues

Students of Economics should be aware of contemporary economic issues. In 2010, the global economy experienced the ongoing effects of the global financial crisis and fragile recovery. This financial crisis created a reduced flow of credit and lending for businesses internationally, leading to global recession. Impacts included a dramatic fall in the value of shares traded on the share-market, falling asset prices such as housing, declining business and consumer confidence. This in turn led to shrinking investment and falling consumer spending, resulting in declining and even negative economic growth, reduced incomes, falling expenditure and increasing unemployment around the world.

The International Monetary Fund (IMF) expected world Gross Domestic Product to grow by 3.9% in 2010, up from earlier predictions of falling growth, but warned that Governments will need to continue to provide stimulus in support of recovery.

To enhance your understanding of the impact of the GFC, go to the ‘More’ section at the end of this tutorial and follow the link to the animation.

Overview

This tutorial will enable students to apply their knowledge and economic skills to analyse statistical information to assess the economic impact of globalisation on finance and the effects of financial flows on the global economy.

Content

Risk management techniques

The growth of international financial flows has played a very important role in the process of globalisation.

Growth in global financial flows is evidenced by growth in foreign currency markets, financial securities trade, and capital flows. It has enabled economic expansion but has also meant that financial risk travels quickly around the globe.

Global trade in financial securities has expanded substantially since the deregulation of financial controls in the 1970s and 1980s. A security is a written contract that is assigned a value and can be traded. Examples include shares, bonds, debentures. Companies sell debt securities such as debentures as a way of borrowing money; investors purchase these securities in order to gain a return – the higher the risk, the greater the rate of return or interest rate. These debt securities are also known as ‘debt instruments’.

International corporations and investors wanting to remove the risks in global trading and investment, especially in the area relating to international currency movements, contributed to the development of what is known as the derivative markets.

A derivative is a tradeable security whose value is derived from the actual or expected future price of an underlying asset such as a commodity (eg. oil), a security (eg. Debenture) or currency (eg.US dollar).

Derivatives can be used as a hedge (that is to reduce risk), or for speculation.

For example, an Australian investor, I.Lean, who purchases shares in a US company through the New York Stock Exchange is exposed to the risk of appreciation of the Australian dollar – if that happens, when the Australian investor wishes to sell the US shares in the future, she will be paid in US dollars and will then find it is more expensive to buy Australian dollars at the higher exchange rate. In this instance, I.Lean could purchase currency futures to lock in the lower exchange rate – that is, a contract that states that when she needs to purchase the Australian dollars in the future, she will get them at the cheaper rate.

Derivatives include:

Futures contracts

Futures contracts are legally binding agreements, to buy or sell a commodity or financial instrument sometime in the future.

Futures contracts are standardised according to the quality, quantity, delivery time and location for each commodity.

Both domestic and international traders use these contracts to protect themselves from unfavourable movements in prices.
Forward contracts

Forward contracts are contracts in which a seller agrees to deliver a specific commodity to a buyer sometime in the future. Forward contracts, in contrast to futures contracts, are privately negotiated and tailor-made between two parties.

They are not standardised according to the quality, quantity, and delivery time and location for each commodity.

Forward contracts on currencies are the most commonly used derivative security.
Collatoralised Debt Obligations (CDO's)

A CDO is an investment security that is actually made up of a number of debt instruments such as mortgage loans, with differing levels of risk (known as tranches). So, a CDO may be made up of loans with a very low risk, loans with a medium risk level, and loans such as sub-prime mortgages which carry a high risk of default (not being repaid). The higher the level of risk included in the CDO, the higher the interest received by the purchaser of the CDO.

For example, a whole range of individuals and firms have borrowed money from ‘Big Bank’ worth a combined value of $1million – some are low risk mortgages and investment loans made to borrowers with good credit worthiness; some are medium risk and some are high risk mortgages made to low income earners. Big Bank combines these loans into a single security called a CDO. Big Bank then sells this CDO to an investor called Mr. Great, at a high interest rate. Mr. Great is effectively taking on the loans – it might be risky but Mr. Great isn’t concerned about that and doesn’t look too closely at the loans anyway – the attraction of the high interest rate is what concerns him. If Mr.Great decides he doesn’t want the CDO any more, he knows he can sell it to another investor Ms I. Know. That is, of course, if Ms I. Know believes the security is not too risky.

These are the types of financial instruments that lead to the global financial crisis. The crisis started in the United States. A number of US investment banks such as Lehman Brothers, Bear Stearns and other banks provided sub-prime loans to house buyers with poor credit worthiness (eg. Low incomes and unlikely to be able to repay the loans if interest rates rise or they lose their jobs). The loans were parcelled up with other loans to borrowers with good credit worthiness, to make a very large loan (for say 100,000 home mortgages). These loans were then divided up and sold to investors as CDOs for a high interest rate. The investment banks made commissions and fees on these loans. Eventually when the ‘sub-prime’ home buyers could not pay back their loans, banks could not pay the investors back their principle or interest. The loans were worth nothing and the CDOs became ‘toxic assets’ which could not be sold on. Some $US4 trillion worth of these loans were sold to investors, who lost their money. This tipped the financial system into crisis.

You can watch a video of CDO's on youtube at: http://www.youtube.com/watch?v="XjoJ9UF2hqg&feature=SeriesPlayList&p=945E4F0ED131E4D1
Options

A contract giving the holder the right but not the obligation to trade in a commodity, a share, or currency on some future date at a certain price.

There are a variety of option types including put options (the right to sell) and call options (the right to buy).

Options are traded on the Australian Stock Exchange and may be investigated on the Australian Stock Exchange web site www.asx.com.au
Swaps

These can take the form of an interest rate, currency and even commodity swaps.

A currency swap is an agreement to exchange a certain amount of money e. g. AUD$100 million now for Japanese Yen and to reverse the exchange in two months.

The Reserve Bank of Australia (RBA 1999) used a currency swap to cover the shortage of cash in the economy during the Telstra 2 float in October 1999.

Review

Exercise 1

Hypothetical: Health company, Nice-n-Natural Ltd, imports massage oils from a business in New York.

On the 31/12/2009, an import order worth $US50 000 was made by Nice-n-Natural Ltd. The existing exchange rate was A$1 = US$0.896. The payment date, however, was 8/2/2010.

On the 8/2/2010 the exchange rate had depreciated to A$1 = US$0.866.

Calculate the value of the US$50 000 import contract at the old exchange rate and the new exchange rate. Explain what has happened to the cost of the imported products to Nice-n-Natural Ltd. Answer
Describe one appropriate method that the company could use to reduce the financial risks in global trading. Answer

Exercise 2

Use the information in this tutorial, your knowledge of Economics and the animation What’s a Credit Crunch? to answer the question below.
http://blogs.abcnews.com/theworldnewser/2008/09/whats-a-credit.html

Briefly explain the impact of the sub-prime mortgage crisis in the US on the global economy. Answer

Australian Stock Exchange web site has very detailed information on financial securities trading.

The Chicago Board of Trade web site has an excellent glossary and information relating to futures trading.

Community Aid Abroad’s Nike Watch Campaign web page has some good press releases on the operation of the company in China, Vietnam and Indonesia.

Sydney Morning Herald web site.

Search the archives for articles relating to the corporate collapses of One Tel and Ansett Airlines. Research the impact of the corporate failure on the workforce and how recent labour market reforms in Australia may have contributed to the problem.