International Financial Markets – the euro - Essay Example

For this assignment I have been asked to write an essay on two questions, I thought it might useful to briefly touch on a few key points about the euro first. The euro is a common currency for Europe; it has been in existence since the 1st January 1999 and became a full currency from 1st January 2002. Twelve members of the EU have adopted the euro: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain, the only other countries which are not using the euro are the UK, Denmark and Sweden.

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1.1 Foreign Exchange markets

The euro has eliminated foreign exchange risk and markets have deepened in the euro area since its introduction, before it was common for investors to invest domestically but now this perspective has changed and investors from all over the world are now more attracted to investing in euro areas than before. Both borrowers and lenders have benefited, borrowers being able to have access to a larger investor base and likewise investors being able to allocate funds in a wider range of channels and across borders. Since the euro is a floating exchange rate, the ECB has no obligations to the euro outside the EU, it does not try to fix it against other currencies it just basically lets market forces of demand and supply determine its value and so really the euro is actually worth what the market thinks it is worth.

Since the introduction of the euro in 1999 it has fallen in value against most currencies most notably the US dollar, in January of 1999 �1 was valued at $1.18, it fell to around $0.87 during July of 2001 but is currently worth around a $1, it has picked up recently but this kind of volatility is not good for investors, if investors view the euro as unstable then they are less likely to hold euros in their portfolios, at the moment because of the volatility of the euro investors are probably more likely to hold US dollars instead.

The graph in (Appendices 1 (Source: Thomson Financial) shows geographically the fall of the euro against the US dollar from its introduction to the end of 2001, obviously its not just the euro that has fallen in value so has the British pound and the Japanese yen, all of which have similar patterns, decreasing value through to June and then picking up from July onwards. With the euro falling to as low as it did you could argue that maybe this was a good thing, European exports would become more competitive in world markets because of the lower exchange rate and for some companies it was probably beneficial but generally it was not. Foreign exchange markets have seen a decline in the number of banks and other market making facilities quoting foreign exchange products, the increase in global bank mergers has hugely reduced the number of banks marketing FE services. Since the introduction of the Euro, it has increased the need for more European bank mergers to gain competitive advantages over others.

1.2 Bond markets The introduction of the euro has integrated the national bond markets of the member states creating a larger, harmonized and much more liquid euro bond market it has been the financial market segment where the influence of the single currency has been the quickest and most obvious. Even before the introduction of the euro, the European bond markets had a fairly international character anyway but now it is much more attractive to investors and borrowers alike.

The introduction of the euro has unified eleven relatively small debt securities markets into the second largest corporate bond market in the world. This has not only eliminated the foreign exchange rate risk but added to the relaxation of technical restrictions that had in the past led to the segmentation of markets, the result of this is reflected in higher issuance volumes. This unification of bond markets has been beneficial to all, investors have been able to distribute funds in a wider range of activities, across borders and the development of an active repurchase market and borrowers have benefited from having easier access to a large investor base and not just people within the EU, the EU bond market now attracts investors from all over the world. It allows non EU countries to diversify their international borrowings, the success of the Euro in bond markets has made competition between the stock exchanges even more competitive and has encouraged markets to merge in order to maximize efficiency and meet the growing demand, this has created new exchanges such as Euronext, Clearnet and Clearstream etc.

It also allows national governments to finance themselves more cheaply, some of the poorer members of the EU have benefited greatly from being able to do as they are now able to attract investors that before may not have found that country an attractive place for investment. A government for example might issue index linked bonds with a good rate of interest, in this way they are making a statement to people about what they expect to happen in the future in terms of interest and inflation rates to the country and this is likely to encourage people to invest.

For corporate bonds, the impact of the euro has had a similar but not such a dramatic impact, firms can raise capital much easier and the market has become much more diversed and more competitive, firms now are being looked at by potential investors in comparison to other similar firms in other EU countries in the same market rather than just its domestic market making it much more attractive to non European investors.

1.3 Eurocurrency markets The introduction of the European single currency has reduced the number of Eurocurrencies but not the demand for Euromarket products denominated in euros (Source: Eurocurrency markets and interest rates 2002 new ppt). The impact on the Eurocurrency markets is similar to that of the bond market but, again instead of having separate Eurocurrency markets there is just one, larger much more deeper and liquid market and by removing exchange rate risk this has encouraged demand for cross border equity investment.

This has benefited the poorer member states which had weaker currencies previously for example Portugal, before the euro the Portuguese escudo was not that popular outside its own country or a particularly strong currency but now since Portugal is part of the EU its markets are much more attractive to other EU and non EU countries. For lenders the introduction of the euro has increased transparency between markets and countries, for example interest rates offered by financial institutions will now be under closer analysis by lenders and not just within the EU but foreign investors as well, because they will be able to see these differences much easier and therefore shop around for the best deal.

For banks it has enabled them to syndicate large loans to companies very quickly. The inter-bank lending system basically makes possible one bank to raise large amounts of capital to borrow a company by contacting other banks they feel comfortable with and offering them a share of the loan in return for interest. Likewise if a large company needs to raise large sums of cash, this would not normally be possible by just one bank but they now can have access to capital within twenty four hours of a lead bank successfully syndicating the loan.