Cross-Border Trading Essay ⋆ Business Essay Examples ⋆ EssayEmpire

The role and importance of international financial markets and the traders who work in the industry has grown during the past decades. Professional traders are highly visible, especially in the media. They tend to be in a position to exploit market imperfections and have access to privileged information, critical mass, or proprietary knowledge and models.

Financial markets can be defined in two ways. The term can refer to organizations that facilitate the trade of financial products or it can refer to the interaction between buyers and sellers to trade financial products. Many who study the field of finance use both definitions, but economics scholars tend to use the second meaning. Financial markets can be both domestic and international.

Financial markets can be seen as an economics term because it highlights how individuals buy and sell financial securities, commodities, and other items at low transaction costs and prices that reflect efficient markets. The overall objective of the process is to gather all of the sellers and put them in one place so that they can meet and interact with potential buyers. The goal is to create a process that will make it easy for the two groups to conduct business.

When looking at the concept of “financial markets” from a finance perspective, one could view financial markets as a way to facilitate the process of raising capital, transferring risk, and conducting international trade. The overall objective is to provide an opportunity for those who want capital to interact with those who have capital. In most cases, a borrower will issue a receipt to the lender promising to pay back the capital. These receipts are called securities and can be bought or sold. Lenders expect to be compensated for lending the money. Their compensation tends to be in the form of interest or dividends.

Traders

Trader activities can be divided into three categories, which are trading on behalf of the customer, market making, and propriety trading. Traders with the least amount of risk are the ones who act on behalf of the customer. At the other end of the spectrum are proprietary traders, who take on the greatest risk. Regardless of the category, traders must utilize a set of strategies and approaches in order to make a profit. Four of the main strategies include the following:

Insider strategy: The trader achieves the advantage by exploiting privileged access to information. However, the trader must be cautious because some techniques may be illegal. For example, information about company earnings and potential takeovers could be considered illegally obtained information. Insider strategies give the trader an opportunity to anticipate market movements.
Technical strategy: Some traders attempt to exploit market imperfections by analyzing past price information. One form of technical strategy involves the use of patterns in price data in order to identify potential turning points in price trends. This is referred to as charting. Traders attempt to identify trends early, buy into those trends, and exit before the trend breaks. There are a number of traders who use the technical strategy to complement other techniques.
Fundamental strategy: Fundamental strategies focus on the fundamental relationship between the economic value of the underlying asset and the market price. Traders use this strategy to seek expertise and information in order to obtain an accurate valuation of securities. There is an assumption that market values will converge to theoretical values.
Flow strategy: This strategy predicts prices as a function of demand and supply for securities in the market.

Swaps

In the world of finance, a swap can be defined as an agreement between two parties, who are referred to as counterparties. The counterparties exchange cash flows over a period of time in the future. The cash flows are calculated based on a notional principal amount, which is not exchanged between the counterparties. As a result, the swaps can be used to create unfunded exposures to an underlying asset. The value of a swap is the net present value (NPV) of all the future cash flows. Most swaps are traded over the counter (OTC) for the counterparties. There are five basic types of swaps: interest rate swaps, currency swaps, credit swaps, commodity swaps, and equity swaps.

An interest rate swap is one in which the counterparties exchange cash flows of a floating rate for cash flows of a fixed rate or vice versa. Although notional principal does not change hands, it is based on a referenced amount against which interest is calculated. Interest rate swaps can be international or domestic. Counterparties may participate in an interest rate swap if (1) there are changes in financial markets that may cause interest rates to change, (2) borrowers have different credit ratings in different countries, or (3) borrowers have different preferences for debt service payment schedules. Interest rate swaps tend to be organized by international banks acting as swap brokers. These transactions allow borrowers to receive a lower cost of debt service payments and lenders can obtain profit guarantees.

A currency swap is one in which one party provides a certain principal in one currency to its counterparty in exchange for an equivalent amount in a different currency. Principal exchange is not redundant with currency swaps. The exchange of principal on the notional amounts is done at market rates, and tends to use the same rate for the transfer at inception as is used at maturity. Currency swaps allow organizations to have extra flexibility in order to take advantage of their comparative advantage in their respective borrowing markets. These swaps start with a net present value of zero. However, over the life of the instrument, the currency swap can go in-the-money, out-of-the-money, or stay at-the-money.

A credit swap occurs when two parties enter into an agreement and one counterparty pays the other a fixed periodic coupon for the specified life of the agreement. The other party does not make any payments unless a specified credit event occurs. Examples of credit events include a material default, bankruptcy, or debt restructuring for a specified reference asset. If one of these types of credit events occurs, the counterparty is required to make a payment to the first party, and the swap is terminated. As a rule, the size of the payment tends to be linked to the decline in the reference asset’s market value following the credit event.

A commodity swap is where exchanged cash flows are dependent on the price of an underlying commodity. This is usually used to hedge against the price of the commodity. There are two types of commodity swaps, which are fixed-floating swaps and commodity for interest swaps. Fixed-floating swaps are similar to the fixed-floating swaps in the interest rate swap market. However, both indices are commodity based indices. Two popular market indices in the commodities market are the Goldman Sachs Commodities Index and the Commodities Research Board Index. These two indices place different emphasis on the various commodities in order to meet the swap agent’s requirements.

Commodity for interest swaps are similar to equity swaps in which a total return on the commodity in question is exchanged for a designated money market rate. Swap agents using this type of swap must take into consideration (1) the cost of hedging, (2) the institutional structure of the particular commodity market in question, (3) the liquidity of the underlying commodity market, (4) seasonality and its effects on the underlying commodity market, (5) the variability of the futures bid/offer spread, (6) brokerage fees, and (7) credit risk, as well as capital costs and administrative costs.

The last type is the equity swap, exchanges of cash flows in which at least one of the indices is an equity index. An equity index is a measure of the performance of an individual stock or a basket of stocks. Common equity indices include Standard & Poor’s 500 Index, the Dow Jones Industrial Average, and the Toronto Stock Exchange Index. Equity swaps makes the index trading strategy easy, especially for the passive investment manager and emerging markets fund managers.

Bibliography:

Sebastian Auguste, Cross-Border Trading as a Mechanism for Capital Flight: ADRs and the Argentine Crisis (National Bureau of Economic Research, 2002);
Alex Chambers and Jethro Wookey, “Crunch Wakes US to CDS E-trading,” Euromoney (February 2008);
Dennis Davitt, “Handicapping Bank Payouts,” Barron’s (December 2007);
Steven Dellaportas, Barry J. Cooper, and Peter Braica, “Leadership, Culture and Employee Deceit: The Case of the National Australia Bank,” Corporate Governance: An International Review (v.15/6, 2007);
Danielle Goldfarb, Is Just-in-Case Replacing Just-in-Time? How Cross-Border Trading Behaviour Has Changed Since 9/11 (Conference Board of Canada, 2007);
Lina Saigol, “Keep Them on Their Toes,” Financial Times (December 4, 2007);
Steven Sears, “Traders Tiptoe Back to Banks,” Barron’s (October 2007);
“Traders Glimpse Daylight as Fed Rescue of Bear Sinks In,” Euroweek (March, 2008).

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