MBA 5540A IB CH 12
Eurocurrency
A Eurocurrency is any currency banked outside its country of origin. It can be created anywhere in the world Eurodollars, which account for about two-thirds of all Eurocurrencies, are dollars banked outside the U.S. Other important Eurocurrencies include the Euro-yen (yen deposited outside Japan), the Euro-pound, and the Euro- euro! Eurocurrencies are important and relatively low-cost source of funds for international businesses.
The Global Equity Market
A few decades ago, national equity markets were separated, making it difficult to take capital out of a country and invest it elsewhere. Also, corporations frequently lacked the ability to list their shares on stock markets outside their home nations. The globalization of national equity markets has resulted in two developments. 1. Many owners of large corporations are not domestic investors. e.g., Amazon has British, German, Japanese, and Taiwanese shareholders. 2. Many companies list their shares outside home countries. e.g., in 2010, 39 Chinese companies issued shares in the U.S.
Factor 1: Information technology
Because of using a lot of information, the financial services industry has been revolutionized more than any other industry by advances in information technology since the 1970s. The growth of technology has facilitated instantaneous communication between any two points on the globe. Rapid advances in data processing capabilities have allowed market makers to absorb and process large volumes of information from around the world. 24-hour a day trading; "Shocks" spread quickly.
The Global Bond Market
Bonds are an important means of financing for many companies. The most common kind of bond is a fixed-rate bond. The holder of this bond receives an interest payment per year, and then at maturity she gets back the face value of the bond. Two types of international bonds are foreign bonds and Eurobonds.
Benefits of the Global Capital Market Global Capital Market Risks
Due to deregulation and reduced controls on cross-border capital flows, individual nations are becoming more vulnerable to speculative capital flows. Martin Feldstein has argued that most of the capital that moves internationally is pursuing temporary gains, and it shifts in and out of countries as quickly as conditions change. This short-term capital is "hot money," which may not be good for many nations. "Patient money" that would support long-term cross-border capital flows, according to Feldstein, is still relatively rare. A lack of information about the fundamental quality of foreign investments may encourage speculative flows in the global capital market.
Attractions of the Eurobond Market
Eurobonds fall outside the regulatory domain of any single nation. As such, they can often be issued at a lower cost. Eurobond market disclosure requirements tend to be less stringent than in most domestic bond markets. Eurobond holders have a favorable tax status. Little or no withholding tax is imposed. 12.23
Foreign bonds and Eurobonds
Foreign bonds are sold outside the borrower's country and are denominated in the currency of the country in which they are issued. When IBM of the U.S. issues bonds in Japanese yen and sells them in Japan, it is issuing foreign bonds. When BMW of Germany issues bonds in U.S. dollar and sells them in the U.S., it is issuing foreign bonds. Many foreign bonds have nicknames: foreign bonds sold in the U.S. are called Yankee bonds, foreign bonds sold in Japan are Samurai bonds, and foreign bonds sold in Great Britain are bulldogs. Eurobonds are normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated. For example, a bond may be issued by Toyota Motor of Japan, denominated in U.S. dollars, and sold to investors outside the U.S. by an international syndicate of banks. Eurobonds are routinely issued by multinational corporations, large domestic corporations, sovereign governments, and international institutions. They are usually offered simultaneously in several national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency they are denominated.
The borrower's perspective: lower cost of capital
In a purely domestic capital market, the pool of investors is limited to residents of the country, resulting in limited liquidity. A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on, resulting in high liquidity and a lower cost of capital. e.g., Deutsche Telekom in Figure 12.2.
Drawbacks of the Eurocurrency Market
In a regulated banking system (in, say, Japan), the chance of bank failure is low (deposit insurance offered). So, deposits are relatively safe. In an unregulated banking system such as the Eurocurrency market, the chance of bank failure is greater. So, deposits are not as safe. No protection! Borrowing funds internationally can expose a company to the foreign exchange (FX) risk.
Factor 2: Deregulation
In response to the development of the Eurocurrency market, which is not regulated by any country, many countries have removed regulatory barriers in their financial markets since the 1980s. Increasing acceptance of the free market ideology associated with an individualistic political philosophy also has a lot to do with the global trend toward the deregulation of financial markets (see Chapter 2).
The Eurocurrency Market Genesis and Growth of the Market
In the 1950s, Eastern European holders of U.S. dollars did not want to deposit their money in the U.S. Instead, they deposited them in London banks. The British government prohibited British banks from lending British pounds to finance non-British trade. The U.S. government enacted regulations that discouraged U.S. banks from lending to non-U.S. residents. Oil price increases in the 1970s engineered by the OPEC (Organization of the Petroleum Exporting Countries) created huge amounts of U.S. dollars that were deposited in banks in London.
Figure 12.1 The main players in the generic capital market
Investors -Companies -Individuals -Institutions Market Makers - Commercial Banks -Investment Banks Borrowers -Individuals -companies -governments
The investor's perspective: portfolio diversification
More investment opportunities. Investors can diversify their portfolios internationally, reducing systematic risk, which is the level of non- diversifiable risk in an economy. Systematic risk refers to movements in a stock portfolio's value that are attributable to macroeconomic forces affecting all firms in an economy, rather than factors specific to an individual firm. Floating exchange rates introduce an additional element of risk into investing in foreign assets.
The Eurocurrency Market: Attractions
The lack of government regulation makes the Eurocurrency market attractive. Banks can offer higher interest rates on Eurocurrency deposits than on deposits made in the home currency. The lack of regulation also allows banks to charge borrowers a lower interest rate for Eurocurrency borrowings than for borrowings in the home currency, making Eurocurrency loans attractive for those who want to borrow money.
Focus on Managerial Implications Growth of the Global Capital Market
The market growth has created opportunities for international businesses that wish to borrow and/or invest money. Firms can often borrow funds at a lower cost than is possible in a purely domestic capital market. The global market is little or not regulated. Firms, institutions, and individuals can diversify their investments to limit risk. Foreign exchange (FX) risk is greater.
Capital market loans (funds): 2 types. Type 2
When a corporation borrows money from a bank, it takes out a loan. When a corporation issues bonds to investors, it raises debt funds. In both cases, the firm raises debt capital (called debt loans in the text). In either case, the company repays a predetermined portion of the loan or bond amount (the sum of the principal plus the specified interest) at regular intervals regardless of how much profit it is making.
Capital market loans (funds): 2 types. Type 1
When a corporation sells stock to investors, it raises equity funds (called equity loans in the text). The company can use these funds to buy fixed assets. The stockholders can have two benefits: dividends (not fixed in advance) and potential price gains (could be negative).
Foreign Exchange Risk and the Cost of Capital Floating Exchange Rate Regime
While a firm can borrow funds at a lower cost in the global capital market, adverse movements in foreign exchange (FX) rates can substantially increase the cost of foreign currency loans. Unpredictablemovementsinexchangeratescan inject risk into foreign currency borrowings.
Market makers
are the financial service companies (commercial banks and investment banks) that connect investors and borrowers, either directly or indirectly.
Capital (or, financial) markets
bring together those who want to invest money and those who want to borrow money
Investors (Saver-lenders)
corporations, individuals, and nonbank financial institutions (e.g., pension funds, insurance companies).
Borrowers (borrower-spenders)
individuals, companies, and governments.
Investment banks (IBs)
perform a direct connection function. They bring investors and borrowers together and charge commissions for doing so.
Commercial banks (CBs)
perform an indirect connection function, taking deposits from corporations and individuals (pay, say, 1%) and lending to borrowers (at, say, 3%). They earn the interest rate spread (3% - 1% = 2%).
