IBUS Chapter 12 - The Global Capital Market

Economist Martin Feldstein

- "Hot money" refers to short-term capital - "Patient money" supports long-term cross-border capital flows - Investors need better information about foreign assets to make the global capital market work more efficiency - Economic crisis in Mexico in the mid-1990s was the result of too much hot money flowing in and out of the country

Lack of information

- About the quality of foreign markets may encourage speculative flows - Causes investors to react to dramatic events in foreign nations and move their money too quickly - Different accounting methods make it difficult to compare - In the 2000s, there has been rapid movement toward harmonization of different national accounting standards - Problems created by differences in the quantity and quality of information, so investors have yet to venture into the world of cross-border investing, and those who do are prone to reverse their decision due to limited (and perhaps inaccurate) information

Information technology

- Advances have created instantaneous communication - Allows market makers to absorb and process large volumes of information from around the world - 24 hour a day trading: shocks spread quickly - Though shocks in national financial markets do seem to spill over into other markets, on average the correlation between movements among national equity markets remains relatively low, suggesting that such shocks may have a relatively moderate long-term impact outside their home market

Attractions of the Eurobond Market

- An absence of regulatory interference - Falls outside of the regulatory domain of any single nation - Less stringent disclosure requirements than in most domestic bond markets - A favorable tax status - US laws revised in 1984 to exempt any withholding tax for holders of bonds issued by US corporations - Caused other governments to liberalize their tax laws to avoid outflows of capital - National equity markets historically separated by regulatory barriers - Difficult to take capital out of a country and invest it elsewhere - Corporations frequently lacked the ability to list their shares on stock markets outside their home nations - Difficult to attract equity capital from foreign investors

The main players in the generic capital market

- Capital markets bring together those who want to invest money and those who want to borrow money - Investors include companies, individuals and institutions - Market makers include commercial bankers and investment bankers - Borrowers include individuals, companies and governments

Growth of the Global Capital Market

- Created opportunities for international businesses that wish to borrow and/or invest money - Firms can borrow funds at a lower cost than is possible in a purely domestic capital market - The global market lacks government regulation - Foreign exchange risk is greater - Firms, institutions, and individuals can diversify their investments to limit risk - By holding a diverse portfolio of stocks and bonds in different nations, an investor can reduce total risk to a lower level than can be achieved by a purely domestic setting. - Foreign exchange risk is a complicating factor

Genesis and growth of the market

- Eastern European holders of dollars were afraid to deposit their money in the US - Many deposited these dollar holdings in London - British government prohibited British banks from lending British pounds to finance non-British trade in 1957 - US government enacted regulations that discouraged US banks from lending to non-US residents in the 1960s - Oil price increases engineered by OPEC created huge amounts of dollars that were deposited in banks in London - Political events contributed to the growth of the Eurocurrency market, but they alone were not responsible for it

International Bonds

- Foreign bonds are sold outside the borrower's country and are denominated in the currency of country where they are issued - Eurobonds are routinely issued by multinational corporations, large domestic corporations, sovereign governments, and international institutions - Most common: fixed-rate bond, receives a fixed set of cash payoffs

Drawbacks of the Eurocurrency market

- In a regulated system, the chance of bank failure is lower - Borrowing funds internationally can expose a company to foreign exchange risk - Many companies borrow funds in their domestic currency to avoid foreign exchange risk, even though the Eurocurrency markets may offer more attractive interest rates

Global capital market risks

- Individual nations may be more vulnerable to speculative capital flows - Could destabilize national economies

Consequences of international equity investment

- Internationalization of corporate ownership - Companies historically rooted in one nation are listing stock in equity markets of other nations - Although firms based in developing nations were the first to start listing their stock on foreign exchanges, increasingly firms from developing countries that find their own growth limited by illiquid domestic capital markets are exploiting this opportunity

Attractions of the Eurocurrency Market

- Lack of government regulation - Allows banks to offer higher interest rates on Eurocurrency deposits than on deposits made in the home country, and charge borrowers a lower interest rate - Banks have more freedom in their dealings in foreign currency - Companies receive a higher interest rate on deposits and pay less for loans - Strong financial motivations for companies to use the Eurocurrency market - Receive a higher interest rate on deposits and pay less for loans - Surprising that the Euromarkets haven't grown faster

The borrower's perspective of the global capital market

- Level of resources in the global capital market affect the cost of capital and the amount the company could borrow - The greater pool of resources in the global capital market, the greater liquidity, both lowers the cost of capital and increases the amount can borrow - Thus, the advantage of the global capital market to borrowers is that it lowers the cost of capital

Deregulation

- Response to development of Eurocurrency market - Increasing acceptance of the free market ideology - Many countries started to dismantle capital controls in the 1970s - Financial crisis of 2008-2009 caused experts to question if deregulation had gone too - Need for new regulations to govern sectors of financial services industry, including hedge funds (private investment funds that position themselves to make "long bets" on assets that they think will increase in value and "short bets" on assets that they think will decline in value)

The investor's perspective of the global capital market

- Wider range of investment opportunities - Investors can diversify their portfolios internationally, reducing risk - Systematic risk: movement in a stock's portfolio's value that is attributable to macroeconomic forces affecting all firms in an economy. The level of non-diversifiable risk in an economy. - Data from a classic study by Solnik suggested that a fully diversified US portfolio is only about 27% as risky as a typical individual stock - Relatively low correlation between movement of stock markets in different countries - Growing perception that integration of global economy and emergence of global capital market has increased correlation between different stock markets - Risk-reducing effects of international portfolio diversification would be greater except for the volatile exchange rates associated with the floating exchange rate regime - The uncertainty endangered by volatile exchange rates may be acting as a brake on the otherwise rapid growth of the international capital market

Foreign Exchange Risk and the Cost of Capital Manager's Dilemma

-Floating exchange rate regime complicates foreign exchange risk -Adverse movements in foreign exchange rates can substantially increase the cost of foreign currency loans -Unpredictable movements in exchange rates can inject risk into foreign currency borrowing -When a firm borrows funds from the global capital market, it must weigh the benefits of a lower interest rate against the risks of an increase in the real cost of capital due to adverse exchange rate movements

Eurocurrency

Any currency banked outside its country of origin. In addition to Eurodollars, other important Eurocurrencies include the Euro-yen, the Euro-pound, and the Euro-euro. - Eurodollars account for two-thirds of all Eurocurrencies - Can be created anywhere in the world - Important and relatively low-cost source of funds for international businesses

Equity Loans

Made when a corporation sells stock to investors

Debt Loans

Requires corporations to repay a predetermined portion of the loan amount at regular intervals regardless of how much profit it is making.

Difference in domestic and eurocurrency rate spreads

Spread between the deposit and lending rate is less than the spread between domestic deposit and lending rates

Market Makers

The financial service companies that connect investors and borrowers, either directly or indirectly - Commercial banks perform an indirect connection function - Investment banks perform a direct connection function