The financial markets and commodity markets serve as a medium to facilitate capital (resource) allocation. Accordingly, this characteristic is the primary, utilized in international trade and has implications on the economic performance of the countries which are participants in these markets. Additionally, it offers investors various means of implementing risk management. Likewise, firms utilize the international financial markets to raise capital on favourable terms. Therefore, it is clear that the international financial and commodity markets play a significant role in investments and macroeconomic performance. The international markets explored in this paper are comprised of the following: the foreign exchange markets, equity markets, debt markets, commodity markets and derivative markets.
FOREIGN EXCHANGE (FX) MARKET
The FX market's existence is a result of, international financial transactions which inevitably necessitate the substitution or exchange of one currency for the other. The foreign exchange market is subdivided into the Interbank Market and the Retail Market, in each of these markets currency prices are quoted as spot rates or forward rates.
Structurally, the interbank market's foundation is reliant on Eurocurrency market. Clark (2002) describes the interbank market as an informal, over-the-counter and continuously open market, with participants that include major commercial banks and specialized brokers. Participants stay connected via telephone, telex, and the utilization of SWIFT [1] .Traders and brokers are the participants within the interbank market. Traders provide liquidity in the interbank market, because they act as market makers.
Whilst traders are willing to buy (sell) currencies at a particular price, they may not be able to swiftly, or efficiently locate counterparties who want to sell (buy) currencies in order to facilitate a transaction. The brokers provide a bridge, bringing traders together in order to execute transactions. Clark (2002) highlights the importance of brokers as contributors to market efficiency, as they connect buyers and sellers, they do not prejudice the position a trader by providing anonymity and brokers provide information amongst brokers about market sentiments thus, providing traders adequate information to competitively price currencies.
The retail market is where banks and their customers carryout relatively similar foreign exchange transaction [2] . However, unlike the interbank market, the retail market spreads presented in the spot and forward rates differ. Bollerslev and Melvin (1994) provided evidence of a positive relationship between currency volatility and currency spread based on their empirical analysis of the Deutschemark/Dollar quotes during the spring of 1989. This spread is a reflection of the inherent price risk of a particular currency, unlike the interbank spread, retail spreads include an additional commission which is passed on to its clients.
The forward rates market offers opportunity to hedge against unfavourable movements in exchange rates. Investors will utilize the forward markets to lock in returns in domestic currencies. Alternatively, Clark (2002) highlights that asset value preservation in domestic is another motivate, for the utilization of the forward markets to hedge against exchange rate risk. Aabo (2006) shows that foreign currency derivatives are used as tools for hedging, this is no different from buying currencies on the forward market however, Aabo's findings indicate that use of forward currency markets are targeted on hedging ERR on a short-term basis. Clark and Judge (2005) highlight that ERR hedging utilizing facilities offered in forward markets is predominantly done by high leveraged firms, which are exposed to greater bankruptcy risk and higher probabilities of financial distress.
Investors can attempt to implement trading strategies to profit from mispriced currencies, these strategies include: covered-interest arbitrage and one-way covered arbitrage. Clark (2002) highlights that the interbank FX market and the Eurocurrency markets, due to the limited regulations and controls placed on the market's trading activities coupled with minimal transaction costs results in the interest rate parity hypothesis being the closest between the interbank market and the Eurocurrency market. Therefore, any deviation from this parity may present opportunities to arbitrageurs, subject to the cost of arbitrage.
EQUITY MARKETS
Various stock exchanges have their unique trading characteristics and legal framework, but generally exchanges will fall into one of the following organizational categories: public exchanges, private exchanges and banker exchanges.
Public exchanges are essentially government institutions which appoint brokers who have a monopoly over all transactions. Private exchanges, tend to have less government intervention, instead government agencies supervise the activities of the exchanges, leaving private exchanges to mostly self-regulate. Private exchanges differ from public exchanges as it is groups of individuals or private institutions which create them with the intention to facilitate the trading of securities. Finally, banker's exchanges are typically restricted to the banking community; these exchanges are subject to government regulation.
Price quotation on equity markets can be divided in to the following categories: auction markets, and dealer markets. In auction market prices and liquidity is determined by the amount of market orders or limit orders. In contrast, dealer-driven markets ensure liquidity as dealers act as market makers.
Clark (2002) highlights that international equity markets provide alternatives to firms seeking fresh sources of financing, he examines the advantages of the international equity market based on firm advantages and investor advantages, these are listed below:
Firm advantages:
Issuing internationally makes it possible to issue in large amounts.
Issuing internationally allows for greater diversification and an increase the shareholder base; this may serve as a barrier for takeover bids.
Firms listing internationally will be subject to greater public awareness and exposure.
Listing procedures are less stringent and often less constraining than those required for domestic issues.
There is significant activity and liquidity in the international equity market.
Investor advantages:
Portfolio diversification is the single most advantageous factor for investors.
The possibility of favourable tax treatment may also motivate investors.
Whilst firms may seek to take advantage of the numerous advantages of issuing equity internationally, it should not be forgotten that such ventures are quite expensive. Namely, the cost of the syndicated participants involve in issuing equity is quite expensive. Investors will still be exposed to ERR, and other risks associated with macroeconomic factors based on the country in which the equity is issued. Clark and Kassimatis (2004) highlight this exposure based on empirical studies of six Latin American countries show that a country's default risk premium is negatively related to its stock market performance. Hence, macro-economic factors which affect a country's default risk premium will be reflected in the country's equity market performance.
Debt Markets
Bonds are generally categorized as domestic bonds, foreign bonds or Eurobonds. Greater integration between capital markets across the world has created a competitive environment which has enabled borrowers to diversify their sources of debt financing, whilst benefitting investors in the form of portfolio diversification.
The wide array of debt instruments, make technical knowledge about the debt markets difficult for effective technical analysis, this problem is compounded as various markets have different quotation and trading practices concerning the various debt instruments. Additionally, when markets employ over the counter trading it is difficult to estimate costs which may be hidden in the bid-ask spread. Commissions charged may be negotiated between investors and brokers, costs associated with taxation again vary among markets. Calculation of the yield to maturity also varies from country to county. Therefore, these differences in debt and debt trading characteristics make it difficult for investors and borrowers, to weigh the benefits and costs of international debt.
The Eurobond market is the primary source of international debt. Eurobonds are issued in Eurocurrencies by an international syndicate of banks in several international financial markets. The globalized placement of Eurobonds means that they are subject to limited rules and regulations common to most domestic bond markets. However, the driving force behind the development of the Eurobonds market is the absence of withholding tax. Clark (2002) explains that it is the issuer who bears the responsibility of paying withholding tax, if such a tax is imposed. Another unique structure of Eurobonds is that typically, they have relatively shorter maturities than bonds found in domestic markets, with maturities spanning less than or equal to five years.
Eurobonds are registered with a stock exchange during issuing procedure. Trading of Eurobonds is predominantly over-the-counter. Structurally, Eurobond markets operate on two levels: the market making level comprised of dealers and the retail level involving traders and brokers.
Another source for international debt is the syndicated Eurocredit markets. This market is significantly integrated with the interbank Eurocurrency market. Clark (2002) highlights the Eurocredit market as a source of international liquidity which is a prominent debt facility employed by various countries to finance balance of payment disequilibrium. Additionally, Clark highlights the prominence of the syndicated Eurocurrency loans as vehicles to finance balance of payments deficits, in developing countries and a subset of the major industrialized nations during the period of 1974-1982.
Many firms or institutions which may be characterized as: small, unknown, too risky, may not be appealing in the international bond market. Considering it is institutional investors who dominate the international debt markets and most being bound by charter to acquire only investment grade securities will not hold bonds associated with small risky firms. Clark (2002) argues that banks in their capacity as intermediaries believe that they have better tools to assess and manage risks and maturities that are otherwise unattractive to the majority of the market participants. The Eurocredit market, offers accessibility to these small, unknown firms seeking financing which otherwise would have been difficult to obtain on the Eurobond market. Additionally, the Eurocredit facility is mobilized quickly and easily unlike the issuing of a Eurobond which may take various weeks as the designated syndicate group tries to organise the characteristics and distribution of the debt. Furthermore, the Eurocredit facility is more tailored towards the borrowers needs, unlike in the Eurobond market where lead manager, tailors debt more towards the lender. However, unlike Eurobonds, Eurocurrency loans do not offer the same level of publicity. Likewise, Eurobonds are more targeted to institutional investors therefore they tend to be of lower risk. Clark and Judge (2005) provide evidence of foreign currency debt as a hedging tool against long-term exposure to ERR. Further evidence of foreign debt utilization as a hedging mechanism is provided by Bancel and Mittoo (2002) and Aabo (2006).
Commodity Markets
Commodity markets provide a bridge between countries with excess raw materials to those with a shortage of raw materials. Additionally, commodity markets reflect the inherent supply and demand for particular raw materials thus, serving as pricing mechanism. Furthermore, commodity markets are subject to risk from various sources: political interference, natural catastrophes and variations in climate to name a few. Globally, the commodity markets can be categorized as markets for energy, metals and minerals, agricultural products and other miscellaneous commodities.
Commodity markets are either structured as organized exchange markets or over-the-counter (OTC) markets. On the exchange markets only commodities which are of standardized grades are bought and sold, based on a standardized contract. OTC markets utilize reference prices to facilitate trade. In the market, commodities are traded at spot prices or via some derivative instrument.
Trading of commodities takes place based on a physical commodity contracts. Trading includes various primary participants these include: producers which supply commodities, industrial end-consumers which demand the commodities and trading companies which is an intermediary linking producers and end-consumers. Other participants such as insurers, financial institutions, certifying companies and distributers, brokerage companies complement the transaction process.
Clark (2002) mentions that commodity transactions are subject to the following major risks: price risk, exchange rate risk, purchaser and supplier default risk, quality risk and supply distribution.
Since the prices in contracts are usually fixed, if the delivery of goods and payment of these goods take place at a future date, both parties to the contract will be subject to volatility inherent in commodity prices. Purchasers lose, if the spot price on the date of the transaction is less than that of the contract price whilst, Producers lose if the contract price is less than spot price available in the market. To mitigate the effects of these risks both participants can enter into positions on derivative instruments such as futures and options to lock in future prices to hedge against unfavourable price movements. Exchange rate risk has the same effect on prices if both parties involved use different currencies. Similarly, futures and options are utilized to mitigate the exposure to this risk.
Bid bonds and performance bonds are issued by the producer's bank. These are guarantees from the producer's bank, they will pay the purchaser the value of the bond should the producer not fulfil his obligations. Therefore, bid bonds and performance bonds are tools to mitigate the risk of the supplier (producer) defaulting on the provision of the stipulated commodity.
Letters of Credit (LOC) are guarantees from the purchaser's bank of payment with respect to the amount contractually agreed. The LOC mitigates the purchaser's risk of default. However, the Letter of credit only assures the producer payment, given that the producer has met all his contractual obligations.
Quality risk; is the risk that the supplier does not supply the quality of commodity specified contractually. This risk is usually minimized by performance bonds. Documents like the LOC will only be issued to the producer's bank when the buyer is in possession of the quality certificate and performance bond. Therefore, this minimizes the buyer's risk exposure of acquiring sub-standard goods.
Finally, physical risks associated with the transaction process such as pilferage and natural disasters during transportation and the delivery of commodities can be minimized by the utilization of conventional insurance contracts.
DERIVATIVE MARKET
The derivative markets are mainly categorized as the futures markets and options markets.
Futures Market
Futures trading mainly, takes place on organised exchanges, OTC trading does exist as well. The functioning of futures market is dependent on a competitive spot market, product homogeneity and price volatility.
Clark (2002) and Copeland, Weston and Shastri (2005) highlight that there are four marquee features integrated into the futures market organization namely;
Standardized contracts.
Trading is centralized in one physical location.
Contracts are settled between the exchange's clearing houses.
Contracts are marked to market each day, hence contracts are re-valued daily.
Futures trading is only permitted to commission houses registered as member firms on the exchange. All other individuals seeking access to the futures market must do so through the commission houses by opening trading accounts with them.
A key participant in the futures market is the clearing house. The clearing house has three key functions in the market; recording of existing contracts, it manages the settlement of day-to-day operations and it guarantees the delivery of the underlying asset at contract maturity. Finally, the clearing house effectively eliminates counterparty risk, as clients will ultimately have the clearing house for a counter party.
The clearing house maintains an impregnable financial position; hence its exposure to solvency risk is significantly minimal. As such, futures traders do not worry that the clearing house will default on its responsibility as counterparty this fosters trading confidence and liquidity. However, the clearing house is subject to the counterparty risk of its business. This risk is minimized as it demands a clearing margin from all members of the futures exchange.
Commission houses will enter into positions on futures based on the request of its clients, therefore to minimize the amount of guarantee they have to place with the clearing house in the form of the clearing margin, they to require a similar guarantee from its clients. The margins held by commission houses are usually higher than the clearing margin.
Options Markets
The underlying structure of options market is very similar to the futures market. There are OTC markets, where options are written by financial institutions and terms negotiated with the option buyer. There also exists an organized exchange market which features as mentioned, are very similar to that of Futures exchanges.
The exchanges, trades only standardized option contracts. Additionally, option exchanges utilize a clearing house in the similar capacity as it serves in futures markets. Therefore, it serves as counterparty to individuals with different positions on an option, it records all transactions concluded by exchange members.
It should be noted that the derivative markets, are not limited to futures or options. There exist a vast number of derivative that have been engineered, to meet the various needs of investors. Such derivatives are usually in the form of exotic options and because of their non-standardized nature are predominately traded on OTC markets.
Derivatives are utilized by investors for the purpose of hedging or speculating, based on the volatility present in the underlying assets price or its' cash flows.
Futures offer the possibility of implementing fixed hedge strategies; this enables investors to avoid losses inherent with volatility in spot price movements which may prove unfavourable for him. Fixed hedges prevent the possibility of taking advantage of gains should spot prices move in a favourable direction. As such, investors with strong expectation of unfavourable movement will employ this hedging strategy. Alternatively, options offer a different hedging strategy insofar as not to limit the investor's potential gain from favourable movements in spot prices. Therefore, investors with less conviction about the probable direction of movements in the spot market of the underlying asset will more likely employ options in his hedging strategy. Elton et al (2007) explains that options provide investors the ability modify the return patterns on portfolios to facilitate risk minimization, or return maximization.
Speculation is another motive for acquiring derivative instruments. Clark (2002) highlights the volatility in the basis of futures, investors with long (short) positions in futures with profits when the underlying asset spot price appreciates (depreciates). Likewise, long positions in call options provide the capacity for limitless profits, whilst minimizing loss.
INTERNATIONAL FINANCIAL AND COMMODITY MARKETS AND ECONOMIC PERFORMANCE
The international financial and commodity markets and an economy's external position reflected in its Balance of Payment (BOP) accounts are closely linked. Considering that the effects of external disequilibrium will mean an economy's currency will face the possibility of a revaluation, should monetary authorities not intervene in financial. Since the BOP also serves as window to macroeconomic performance, any external disequilibrium will have effects on domestic financial assets, investment, consumption and income whether intervention takes place or not.
Clark (2002) explains that economies with BOP deficits will result in a reduction in cash balances of investors, they will seek to replenish these balances by selling domestic and foreign financial assets. The fall in demand for domestic assets, lowers their prices and increases interest rates. Higher interest rates mean a decrease in investment, a decrease in income and a decrease in consumption. However, higher interest rates make domestic assets more attractive than their foreign counterparts. Interestingly, should monetary authorities intervene by selling foreign exchange, gold and other financial assets to implement external equilibrium, this has the effect of decreasing the money base. As such credit to the economy will decrease, leading to higher interest rates and a similar outcome on domestic assets, investment, consumption and income if intervention had not taken place.
Should the external position of an economy be a BOP surplus, investors may find themselves with excess cash balances. These excesses will be used to acquire further domestic and foreign assets. The greater demand for domestic assets lowers interest rates, which in turn stimulates investment, increased income and increased consumption, with the magnitude of the stimulation subject to the investment income multiplier. Lower interest rates make domestic assets less attractive, relative to their foreign counterparts. However, as Clark (2002) explains intervention by monetary assets will not change the economic adjustment process associated with a BOP surplus, as intervention would increase the monetary base and effectively increase credit to the economy.
An economy's external position will therefore, affect financial asset returns on the international financial markets. As such, capital flows will be affected by the position of an economy's external disequilibrium. Additionally, international trade will also be affected, subject to the price elasticises of exports and imports. Clark (2002) illustrates based on the elasticises approach to devaluation that if export and import demand is elastic, whilst supply of export and imports have infinite elasticises, then a devaluation will result in an increase in the export of domestic commodities and decrease in importable commodities. The converse if true for trade in the event of an appreciation should the same elasticises hold.
CONCLUSION
In conclusion the international commodity and financial markets provide an important role in resource allocation. Their utilization has a significant impact and reflection upon macroeconomic performance of countries which participate in the markets. Furthermore, the markets provide investors with the ability minimize various risk exposures whilst, simultaneous presenting opportunities for speculative investment, from an array of assets present in commodity, debt, equity, derivative and foreign exchange markets. Structurally, the markets are designed to encourage efficiency, liquidity and facilitate trade. Therefore, the international commodity and financial markets have significant roles in economic performance, investment opportunities, risk management, production and consumption.
