International Business: Competing in the Global Marketplace Fifth Edition

Chapter 11

The Global Capital Market

11

Learning objectives

Describe the functions and form of the international capital market, looking carefull at some of the facilitating and inhibiting factors in the de!elopment of the market" #ro!ide a histor , as $ell as the attractions and dra$backs of the Eurocurrenc market" Discuss the international bond and e%uit markets &uggest the implications for business, pa ing particular attention to differences in the cost of capital and risk, of raising mone on the international capital market

'he last t$o decades ha!e seen a dramatic increase in gro$th of the international capital market" 'his is a direct result of the increase in technolog , deregulation b go!ernments and inno!ations in financial instruments" 'his represents a sharp break from the practice common during much of the ()th centur " In the past, substantial regulator barriers separated national capital markets from each other" 'he international capital market has three main components" 'he global bond market $hich consists of all bonds sold outside their o$n respecti!e home countries b issuing companies, go!ernments, and or other organi*ations" 'he global e%uit market $hich consists of all stocks bought and sold outside the issuer+s home countr " 'he Eurocurrenc market $hich consists of all the $orlds+ currencies banked outside their countries of origin" 'he international capital market offers tremendous ad!antages o!er the domestic capital market because it allo$s 1, in!estors to di!ersif their risk b pro!iding a $ider range of in!estment opportunities and (, increases the suppl of funds a!ailable to borro$ers and lo$ers the cost of capital" 'he opening case describes ho$ China Mobile o!ercame the financing constraints imposed b a relati!el small and illi%uid -ong .ong capital market and raised /0"(1 billion b simultaneousl selling e%uit and bonds through se!eral different e2changes, including -ong .ong and 3e$ 4ork, to a broad range of international in!estors"

156

7eb &ource
http:88sg"bi*" ahoo"com http:88$$$"imf"org8e2ternal8pubs8ft8icm896icm8icmcon"htm http:88$$$"imf"org8e2ternal8pubs8ft8icm8icm908pdf8file)("pdf http:88pages"stern"n u"edu8:spatel8EMFinance8())(8EMF021202.ppt

;<'=I3E ;F C->#'E? 11: '-E G=;B>= C>#I'>= M>?.E' ;pening Case: China Mobile Benefits of the Global Capital Market Functions of a Generic Capital Market >ttractions of the Global Capital Market Gro$th of the Global Capital Market Information 'echnolog 8 Deregulation Global Capital Market ?isks 'he Eurocurrenc Market Genesis and Gro$th of the Market >ttractions of the Eurocurrenc Market8 Dra$backs of the Eurocurrenc Market 'he Global Bond Market >ttractions of the Eurobond Market 'he Global E%uit Market Foreign E2change ?isk and the Cost of Capital Implications for Business Critical Discussion @uestions Closing Case: 'he &urging &amurai Bond Market

=EC'<?E ;<'=I3E F;? C->#'E?

Slide 11-2 Opening Case China Mobile 'he opening case describes the e2pansion of China Mobile and ho$ it raised financing to complete the deal of borro$ing in e2cess of /A( million in the $orld market" ;ne ma $onder $h China Mobile sought funds for its transaction on the global market rather than more con!entional approaches like issuing stock or going into debtB For one thing, the -ong .ong market, a logical source of financing, could not support a financing of this si*e $ithout se!erel damaging the e2isting markets and making China Mobile incur e2tensi!e interest charges" 'he $orld market offered a greater source of funding from a !ariet of potential clients around the $orld" 'he si*e of the Chinese market, China Mobile $as able to sell its >D?s so effecti!el on the $orld market" In!estors reali*ed that the return on their in!estment could be substantial" >lso, a belief in the potential of the China mobile telephone market and its need for telecommunications ma ha!e led in!estors to snap up the offering" >n immediate effect of o!ersubscribing on the offering resulted in a decrease on the interest rate on the bonds as there $ere more bu ers than anticipated" Slide 11-3 Functions of a generic capital market 'oda b using international capital markets, firms can lo$er the costs and increase their access to funds" In!estors are also di!ersif ing their portfolios and reducing their s stematic risk b in!esting internationall , although ne$ risks are created in the process" 'he generic capital market brings together those $ho $ant to in!est such as corporations, indi!iduals, non bank financial institution as $ell as those $ho $ant to borro$ such as indi!iduals, companies, go!ernments" Market makers are the commercial and in!estment banks that connect in!estors $ith borro$ers to make it all possible" Capital market loans to corporations are either e%uit loans or debt loans" >n e%uit loan is made $hen a corporation sells stock to in!estors" 'he mone the corporation recei!es in return for its stock can be used to purchase plants and e%uipment, fund ?CD proDects, pa $ages, and so on" > share of stock gi!es its holder a claim to a firm+s profit stream" 'he corporation honors this claim b pa ing di!idends to the stockholders" 'he amount of the di!idends is based on ho$ much profit the corporation is making" > debt loan re%uires the corporation to repa a predetermined portion of the loan amount Ethe sum of the principal plus the specified interest, at regular inter!als regardless of ho$ much profit it is making" Debt loans include cash loans from banks and funds raised from the sale of corporate bonds to in!estors" 7hen an in!estor purchases a corporate bond, he purchases the right to recei!e a specified fi2ed stream of income from the corporation for a specified number of ears Ei"e", until the bond maturit date," Slide 11'he main pla ers in a generic capital market

Fig 11 is an illustration of the main pla ers in the capital market" In the case of international capital markets, there are simpl more of all of these pla ers and a greater di!ersit in the pla ers and the possible combinations" Slide 11-! >ttractions of the global capital market 'here are t$o main reasons $h an international capital market offers an impro!ement o!er a purel domestic capital market: 1, from a borro$erFs perspecti!e, it increases the suppl of funds a!ailable for borro$ing and lo$ers the cost of capitalG and (, from an in!estorFs perspecti!e, it pro!ides a $ider range of in!estment opportunities, thereb allo$ing in!estors to build a portfolio of international in!estments that di!ersifies risk" Slide 11-" Graph If there is limited li%uidit in a purel domestic capital market, the cost of capital is higher relati!e to $hat $ould be found in an international market" China Mobile demand for funds !aries $ith the cost of capitalG the lo$er the cost of capital, the more mone China Mobile $ill borro$" Mone is Dust like an thing elseG the lo$er its price, the more of it people can afford" >lso, the greater the pool of resources in the global capital marketHthe greater li%uidit Hboth lo$ers the cost of capital and increases the amount China Mobile can borro$" Figure 11"( sho$s this graphicall for the China Mobile case" Slide 11-# Graph 7ith an increase in the choices a!ailable to an in!estor, the in!estor is able to di!ersif holdings internationall , thereb reducing s stematic risk belo$ $hat could be achie!ed in a purel domestic market" Figure 11"A sho$s this graphicall " 7hile the s stematic risks are reduced $ith international portfolio in!estments, the effects of e2change rate risks still e2ist" Slide 11-$ International portfolio risk reduction Mo!ements of stock prices across countries are not perfectl correlated mainl because: Countries pursue different macroeconomic policies and face different economic conditions" Different stock markets are segmented b capital controls such as restrictions on crossI border capital flo$s Slide 11-% Gro$th of the global capital market DeIregulation and impro!ements in technolog ha!e facilitated the gro$th of the international capital market" Due to ad!ances in communications and data processing capabilities, the international capital markets are al$a s acti!e around the globe" International trading is an information intensi!e acti!it that $ould not ha!e been possible onl a fe$ decades ago $hen computing and telecommunication capabilities $ere much less de!eloped"

'he deregulation of capital flo$s, remo!al of limitations on the t pes of ser!ices that can be pro!ided b foreign financial ser!ices firms, and a reduction in the restrictions imposed on domestic financial ser!ices firms ha!e all contributed to the gro$th of the international capital market" Slide 11-1& Global capital market risks 7hile capital is generall free to mo!e internationall , e!idence to date suggests that most in!estors choose to make long term in!estments in their home countr and onl make short term opportunistic in!estments else$here" > lack of information about the fundamental %ualit of foreign in!estments ma encourage speculati!e flo$s in the global capital market" 'he Countr Focus on Me2ico and the global capital markets sho$s that a countr cannot count on capital inflo$s to finance its deficits, especiall $hen the mone that is being in!ested is not there for the long term" Slide 11-11 'he Eurocurrenc Market > Eurocurrenc is an currenc that is banked outside of its countr of origin" Eurodollars, $hich account for about t$oIthirds of all Eurocurrencies, are dollars banked outside of the <nited &tates" 'he Eurocurrenc got its origin as holders of dollars outside the <&, initiall communist countries but later also middle eastern countries, $anted to deposit their dollars but $ere afraid that the ma be confiscated if deposited in the <&" Slide 11-12 'he Eurocurrenc market 'he lack of go!ernment regulation makes the Eurocurrenc market attracti!e to both depositors and borro$ers" Due to the lack of regulation, the spread bet$een the Eurocurrenc deposit rate and the Eurocurrenc lending rate is less than the spread bet$een the domestic deposit rate and the domestic lending rate" 'his gi!es Euro banks a competiti!e ad!antage" 'he lack of regulation is also a dra$back of Eurocurrenc deposits, as the risk of forfeiture is greater than for domestic deposits" 'here is also a risk of currenc fluctuations that $ould not arise if funds $ere held domesticall in the domestic currenc Slide 11-13 Interest rate spreads in domestic and Eurocurrenc markets" Figure

Slide 11-1

'he Global bond market"

'he international bond market falls into t$o general classificationsG the foreign bond market and the Eurobond market" " Eurobonds account for the lionFs share of international bond issues" Foreign bonds are sold outside of the borro$erFs countr and are denominated in the currenc of the countr in $hich the are issued" > Eurobond issue is normall under$ritten b an international s ndicate of banks and placed in countries other than the one in $hose currenc the bond is denominated" 'he Eurobond market is an attracti!e $a for companies to raise funds due to the absence of regulator interference, less stringent disclosure re%uirements than in most domestic bond markets, and the fa!orable ta2 status of Eurobonds" Euro denominated bonds ha!e become increasingl common" ;ne ad!antage of these bonds is that the risks associated $ith e2change rates are lo$er, since the Euro is actuall a basket of currencies" Slide 11-1! 'he Global e%uit market 'here is no international e%uit market in the same sense that there are international currenc and bond markets" Instead there are a number of separate e%uit markets that are linked !ia specific e%uities and o!erall market fundamentals" Slide 11-1" 7ho uses these marketsB Foreign in!estors are increasingl in!esting in different national e%uit markets, primaril as a $a of di!ersif ing risk b di!ersif ing their portfolio of stock holdings across nations" 'oda , firms are listed on multiple national e2changes and ha!e their shares o$ned b large number of shareholders from different nationalities" Companies are beginning to list their stock in the e%uit markets of other nations, primaril as a prelude to issuing stock in the market to raise additional capital" ;ther reasons for foreign listings include facilitating future stock s$aps, using the compan Fs stock and stock options to compensate local management and emplo ees, satisf ing local o$nership desires, pro!iding access to funding for future ac%uisitions in a countr , and increasing the compan Fs !isibilit to local emplo ees, customers, suppliers, and bankers Slide 11-1# Foreign e2change risk and the cost of capital 7hen borro$ing funds from the international capital market, companies must $eigh the benefits of a lo$er interest rate against the risks of an increase in the real cost of capital due to ad!erse e2change rate mo!ements" <sing for$ard rates cannot t picall remo!e the risk altogether, particularl in the case of longIterm in!estments"

Slide 11-1$ Managerial implications B utili*ing international capital markets, firms can often borro$ funds at a lo$er cost than the could domesticall I regardless of $hether the funds are in the form of cash loans, e%uit , or bonds" 'he minimal regulation in international capital markets helps lo$er the cost of capital, but also increases risk in both currencies and securit " For in!estors, the international capital market pro!ides opportunities for portfolio di!ersification and the lo$ering of s stematic risk" >t the same time, it creates ne$ currenc risks" >3&7E?& '; C?I'IC>= DI&C<&&I;3 @<E&'I;3& F;? C->#'E? 11 @<E&'I;3 1: 7h has the global capital market gro$n so rapidl in recent decadesB Do ou think that this gro$th $ill continue throughout the ()))sB 7h B >3&7E? 1: '$o ke trends are responsible for the rapid gro$th in the international capital market in recent decades I impro!ed communication and information processing technolog and deregulation" 7hile there certainl $as demand for the ser!ices pro!ided b the international capital market before the ad!ent of technolog , go!ernment restrictions and technological limitations made globali*ation difficult" 'he gro$th is likel to continue" 3ot onl is technolog continuing to impro!e, but there are still additional go!ernmental regulations that can be remo!ed" 7hile these continuing trends $ill facilitate further gro$th in the international capital market, increased demand from in!estors and borro$ers is likel to continue as business increasingl globali*es" @<E&'I;3 (: > firm based in Me2ico is finding its gro$th limited b the limited li%uidit of the Me2ican capital market" =ist the firm+s options for raising mone on the international capital market" Discuss the pros and cons of each option, and make a recommendation" -o$ might our recommendation be affected if the Me2ican peso depreciates significantl on the foreign e2change markets o!er the ne2t t$o earsB >3&7E? (: 'he Me2ican firm could consider foreign e%uit offerings, floating foreign or Eurobonds, or borro$ing on Eurocurrenc markets" 'he Eurocurrenc market $ill certainl make additional funds a!ailable to the firm, and at a lo$er rate than it is likel to recei!e domesticall " If the peso falls in the ne2t t$o ears, the fact that the firm $ill ha!e to pa back the loan in another currenc Eunless the firm is able to use the for$ard market, $ould decrease the attracti!eness of Eurocurrenc loans" 'he use of both foreign bonds and Eurobonds ha!e this same dra$back I the bonds $ill ha!e to be paid back in a currenc that likel has appreciated significantl against the peso" Due to the minimal regulation, disclosure re%uirements, and ta2 implications, the international bond market does ha!e some strong points that make it $orth considering if the currenc risk can be ade%uatel anal *ed and minimi*ed" 'he foreign e%uit market ma be the most attracti!e for this firm, as it is not re%uired to make pa ments to its shareholders and has

the most autonom o!er its actions" Its gro$th prospects ha!e to be strong enough, ho$e!er, to o!ercome the hesitations in!estors $ill likel ha!e" @<E&'I;3 A: -app Compan $ishes to raise /( million in <& dollars $ith debt financing" 'he funds, needed to finance $orking capital, $ill be repaid $ith interest in one ear" -app Compan Fs treasurer is considering three options: Ea,Borro$ing <& dollars from &ecurit #acific Bank at 0J Eb,Borro$ing British pounds from Midland Bank at 11J Ec,Borro$ing Kapanese en from &an$a bank at LJ If -app borro$s foreign currenc , it $ill not co!er itG that is, it $ill simpl change foreign currenc for dollars at toda Fs spot rate and bu foreign currenc back one ear later at the spot rate then in effect" -app Compan estimates that the pound $ill depreciate b LJ relati!e to the dollar and the en $ill appreciate AJ relati!e to the dollar during the ne2t ear" From $hich bank should -app Compan borro$B >3&7E? A: 'o compare the alternati!es, the amount of dollars that -app $ill ha!e to repa in one ear $ill be used as the basis of comparison" Ea,/( million M 1")0 N /("15) million Eb,/( million M E1 O EE"11M"9L, I ")L,, N /("16) million Ec,/( million M E1 O EE")LM1")A, O ")A,, N /("15A million &ince the <& bank, &ecurit #acific, has both the lo$est cost and no e2change rate risk, -app should borro$ from &ecurit #acific" Gi!en ho$ close these alternati!es are in !alue, ho$e!er, an onl slightl different e2change rate for either the 4en or the #ound could easil change the attracti!eness of these options" 'E>C-I3G &<GGE&'I;3& F;? '-E C=;&I3G C>&E ;F C->#'E? 11 'he closing case describes the &amurai bond market and the interest of foreign in!estors to offer en dominated debt" Discussion of the case can be assisted b the follo$ing %uestions: @<E&'I;3 1: 7hat are the macroIeconomic underpinnings of the recent increase in &amurai bond issues8 >3&7E? 1: Corporations from around the $orld ha!e found lo$er interest rates from issuing &amurai bonds than are a!ailable to them in their o$n countr " Foreign corporations from countries like Croatia, <rugua , and Bra*il ha!e been able to find interest rates as lo$ as ("( J, $hile in their o$n countr the ma ha!e had to pa as high as 6"5 J in borro$ing rates" 'he cost of raising debt in Kapan has been lo$er than other forms of capital that are a!ailable around the $orld" @<E&'I;3 (: -o$ might an increase in Kapan+s rate of economic gro$th affect the !italit of the &amurai bond marketB >3&7E? (: 'he gro$th in the econom might ad!ersel affect the &amurai bond market because in!estment in corporate e%uit ma become more attracti!e than &amurai bonds" 'herefore, to continue to attract in!estors, the &amurai bond rate $ould ha!e to

rise, and corporations $ould ha!e to pa out more interest" 'hat $ould make it less attracti!e as a capital raising !enture for international businesses" @<E&'I;3 A: For a compan like Deutsche 'elekom, $hich issues en dominated debt to raise funds for in!estments outside of Kapan, the lo$er interest rate must be offset against higher costs" 7hat are these higher costs and $hat determines their magnitudeB >3&7E? A: 'he higher costs include the costs of e2changing en into the currenc of choice for a particular in!estment" > ke determinant $ould be the fluctuation of the en, and that is largel determined b ho$ in!estors percei!e the economic strength of Kapan @<E&'I;3 1: 7hat $ould happen to acti!it in the &amurai bond market if the en started to appreciate significantl against the dollar, but interest rate differentials bet$een the <nited &tates and Kapan sta ed constantB 7hat $ould happen if the en depreciated against the dollarB 7hat does this tell ou about the risks of issuing foreign bondsB >3&7E? 1: If the differential bet$een the t$o countries remained constant and the en started to appreciate, then the en $ould be stronger to the dollar and that $ould make the en more e2pensi!e" In turn that might discourage <& in!estors, and those countries $hose currenc is pegged to the <& dollar from using &amurai bonds" Kust the opposite $ould occur if the en depreciated against the dollar" ;b!iousl , there is great risk in issuing foreign bonds, for e!en minor fluctuations in the e2change rate can ha!e a maDor affect on the financial impact of using foreign bonds" &'<DE3' EPE?CI&E& F;? C->#'E? 11 global'(G') '*ercise +,estions >ns$ers to E2ercise @uestions E2ercise 1 'he Global Financial &tabilit ?eport is located at the IMF $ebsite, in the publications section" 'he report is accessible b searching for the term QIMFR at http:88globaledge"msu"edu8ibrd8ibrd"asp" 'his resource is named IMF: Global Financial &tabilit ?eport and is found under the globalEDGE categor QMone : FinanceR" 'he latest edition of the report is usuall listed at the top of the page, follo$ed b past issues" &earch #hrase: QIMFR ?esource 3ame: IMF Global Financial &tabilit ?eport 7ebsite: http:88$$$"imf"org8e2ternal8pubs8ft8GF&?8inde2"htm globalEDGES Categor : QMone : FinanceR E2ercise ( 'he Global Financial &tabilit ?eport is located at the IMF $ebsite, in the publications section" 'he report is accessible b searching for the term QIMFR at http:88globaledge"msu"edu8ibrd8ibrd"asp" 'his resource is named IMF: Global Financial http-..global'(G'/0s,/ed,.

&tabilit ?eport and is found under the globalEDGE categor QMone : FinanceR" 'he latest edition of the report is usuall listed at the top of the page, follo$ed b past issues" &earch #hrase: QIMFR ?esource 3ame: IMF Global Financial &tabilit ?eport 7ebsite: http:88$$$"imf"org8e2ternal8pubs8ft8GF&?8inde2"htm globalEDGES Categor : QMone : FinanceR &<GGE&'ED ?E>DI3G& F;? C->#'E? 11 'he footnotes suggest some appropriate additional readings" 'he follo$ing ma be of particular interest: D" 7aller, QDaimler in /(L)m &ingapore #lacing,R Financial Times, Ma 1), 1991 G" #latt, QChina 'elecom Issue #oorl ?ecei!ed in <"&"R, Global Finance, Kanuar ())A C" G" =uck and ?" Choudhur , QInternational E%uit Di!ersification for #ension Funds,R Journal of Investing L, no" ( E1995,, pp" 1ATLA ."."=e$is, Q'r ing to E2plain -ome Bias in E%uities and Consumption,R Journal of Economic Literature, 1999, Uol A6, pp" L61I5)0" Ian Domo$it*, Kack Glen, and >nanth Madha!an, QMarket &egmentation and &tock #rices: E!idence from an Emerging Market,R Journal of Finance A, no" A E1996,, pp" 1)L9T50"