C H A P T E R 13

INTERNATIONAL EQUITY MARKETS

 Introduction

• This chapter focuses on equity markets, or how ownership in publicly owned

corporations is traded throughout the world.

• It discusses both the primary sale of new common stock by corporations to initial
investors and how previously issued common stock is traded between investors in
the secondary markets.
 A Statistical Perspective

Market Capitalization of Developed Countries

• At year-end 2012, total market capitalization of the world’s equity markets stood at
$53,164 billion. Of this amount, 75 percent is accounted for by the market
capitalization of the major equity markets from 31 developed countries.

• In 31 developed countries for 2008 through 2012, total market capitalization

increased nearly 51 percent over the five-year period, from $26,534 billion to
$40,016 billion.
 A Statistical Perspective

Market Capitalization of Developing Countries

• The majority of emerging markets have grown significantly from 2008 through
2012.

• There are several tiny national equity markets in Latin America, Europe, the Middle
East, and Africa.

• Many of the national equity markets in Latin America (Brazil and Mexico) and in
Asia (China, India, and Taiwan) have market capitalizations far in excess of the size
of some of the smaller equity markets in the developed countries.
 A Statistical Perspective

Measure of Liquidity
• A measure of liquidity for a stock market is the turnover ratio; that is, the ratio of
stock market transactions over a period of time divided by the size, or market
capitalization, of the stock market.

• Generally, the higher the turnover ratio, the more liquid the secondary stock
market, indicating ease in trading.

• In 29 equity markets of developed countries for the five years beginning with 2008
had very high turnover ratios, with the great majority in excess of 50 percent
turnover per year.

• For the majority of 35 emerging countries, the turnover ratio was less in 2012 than
it was in 2008, indicating poor liquidity in most emerging equity markets.
 A Statistical Perspective

Measure of Market Concentration

• The more concentrated a national equity market is in a few stock issues, the less
opportunity a global investor has to include shares from that country in an
internationally diversified portfolio.

• The number of equity investment opportunities in emerging stock markets in

developing countries has not been improving in recent years.
 Market Structure, Trading Practices, and Costs

• The secondary equity markets of the world serve two major purposes.
1. Marketability. Firms would have a difficult time attracting buyers in the primary
market without the marketability provided through the secondary market.

2. Share valuation. Competitive trading between buyers and sellers in the secondary
market establishes fair market prices for existing issues.
 Market Structure, Trading Practices, and Costs

• In conducting a trade in a secondary market, public buyers and sellers are

represented by an agent, known as broker.
1. A market order is executed at the best price available in the market when the
order is received, that is, the market price.

2. A limit order is an order away from the market price that is held in a limit order
book until it can be executed at the desired price.
 Market Structure, Trading Practices, and Costs

• Generally, a secondary market is structured as:

1. Dealer market. The broker takes the trade through the dealer, who participates in
trades as a principal by buying and selling the security for his own account. The
over-the-counter (OTC) market is a dealer market.
2. Agency market. The broker takes the client’s order through the agent, who
matches it with another public order. The exchange markets in the United States
are agency/auction markets.

• Both the OTC and the exchange markets in the United States are continuous
markets where market and limit orders can be executed at any time during
business hours.

• In recent years, most national stock markets have become automated for at least
some of the issues traded on them.
Market Structure, Trading Practices, and Costs

Market Characteristics
Equity Trading Public Orders Order Flow Example
System
Dealer Trade with dealer Continuous NASDAQ OTC
Agency Agent assists with Continuous or NYSE
matching of public periodic specialist
orders system
(continuous)
Old Paris
Bourse (non-
continuous)
Fully Electronic matching Continuous Toronto Stock
automated of public orders Exchange

Exhibit 13.1 Characteristics of Major Equity Trading Systems

 Market Structure, Trading Practices, and Costs

Market Consolidations and Mergers

• Euronext was formed on September 22, 2000, as a result of a merger of the
Amsterdam Exchanges, Brussels Exchanges, and the Paris Bourse.
• In June 2001, the Lisbon stock exchange merged with Euronext.
• The April 4 2007, merger of Euronext with the New York Stock Exchange, to form
NYSE Euronext.
• On October 1, 2008, NYSE Euronext acquired the American Stock Exchange to form
NYSE AMEX.
• On November 13, 2013, Intercontinental Exchange (ICE), the 12-year-old energy
and commodity futures exchange, acquired NYSE Euronext for $11 billion.
• On May 25, 2007, NASDAQ acquired OMC to form NASDAQ OMX, and on July 24,
2008, NASDAQ OMX acquired the Philadelphia Stock Exchange.
 Trading in International Equities

Cross-Listing of Shares
• Cross-listing refers to a firm having its equity shares listed on one or more foreign
exchanges, in addition to the home country stock exchange.

• A firm may decide to cross-list its shares form many reasons:

1. Cross-listing provides a means for expanding the investor base for a firm’s stock,
thus potentially increasing its demand.

2. Cross-listing establishes name recognition of the company in a new capital

market, thus paving the way for the firm to source new equity or debt capital from
local investors as demands dictate.
 Trading in International Equities

Cross-Listing of Shares
3. Cross-listing brings the firm’s name before more investor and consumer groups.
Local consumer (investors) may more likely become investors in (consumers of)
the company’s stock (products) if the company’s stock is (products are) available.

4. Cross-listing into developed capital markets with strict securities regulations and
information disclosure requirements may be seen as a signal to investors that
improved corporate governance is forthcoming.

5. Cross-listing may mitigate the possibility of a hostile takeover of the firm through
the broader investor base created for the firm’s shares.

• Cross-listing of a firm’s stock obligates the firm to adhere to the securities

regulations of its home country as well as the regulations of the countries in which
it is cross-listed.
 Trading in International Equities

Yankee Stock Offerings

• Yankee stock offerings is the direct sale of new equity capital to U.S. public
investors.

• Three factors appear to be fueling the sale of Yankee stocks:

1. The push for privatization by many Latin American and Eastern European
government-owned companies.
2. The rapid growth in the economies of the developing countries.
3. The large demand for new capital by Mexican companies following approval of the
North American Free Trade Agreement.
 Trading in International Equities

American Depository Receipts

• An American Depository Receipt (ADR) is a receipt representing a number of
foreign shares that remain on deposit with the U.S. depository’s custodian in the
issuer’s home market.

• Advantages of ADRs include:

1. ADRs are denominated in dollars, trade on U.S. stock exchange, and can be
purchased through the investor’s regular broker.
2. Dividends received on the underlying shares are collected and converted to
dollars by the custodian and paid to the ADR investor, whereas investment in the
underlying shares requires the investor to collect the foreign dividends and make
a currency conversion.
3. ADR trades clear in three business days as do U.S. equities, whereas settlement
practices for the underlying stock vary in foreign countries.
 Trading in International Equities

American Depository Receipts

4. ADR price quotes are in U.S. dollars.
5. ADRs (except Rule 144A issues) are registered securities that provide for the
protection of ownership rights, whereas most underlying stock are bearer
securities.
6. An ADR investment can be sold by trading the depository receipt to another
investor in the U.S. stock market, or the underlying shares can be sold in the local
stock market.
7. ADRs frequently represent a multiple of the underlying shares, rather than a one-
for-one correspondence, to allow the ADR to trade in a price range customary for
U.S. investors.
8. ADR holders give instructions to the depository bank as to how to vote the rights
associated with the underlying shares.
 Trading in International Equities

American Depository Receipts

• There are two types of ADRs:
1. Sponsored ADRs are created by a bank at the request of the foreign company that
issued the underlying security.
2. Unsponsored ADRs-some dating back prior to 1980 still exist-were usually created
at the request of a U.S. investment banking firm without direct involvement by the
foreign issuing firm.

• In general, only sponsored ADRs trade on NASDAQ or the major stock exchanges.
 Trading in International Equities

Global Registered Shares (GRSs)

• GRSs are shares that are traded globally, unlike ADRs, which are receipts for bank
deposits of home-market shares and traded on foreign markets.

• GRSs are fully fungible-a GRS purchased on one exchange can be sold on another.

• Daimler AG, Deutsche Bank and UBS trade as GRSs.

 Trading in International Equities

Empirical Findings on Cross-Listing and ADRs

• Park (1990) found that a substantial portion of the variability in ADR returns is
accounted for by variation in the share price of the underlying security in the home
market. however, information observed in the U.S. market is also an important
factor in the ADR return generating process.

• Kao, Wenchi, Wei, and Vu (1991) found that an internationally diversified portfolio
of ADRs outperforms both a U.S. stock market and a world stock market
benchmark on a risk-adjusted basis.

• Jayaraman, Shastri, and Tando (1993) found positive abnormal performance of the
underlying security on the initial listing date. Additionally, they found an increase in
the volatility of returns of the underlying stock.
 Trading in International Equities

Empirical Findings on Cross-Listing and ADRs

• Gagnon and Karolyi (2004) discovered that cross-listed shares trading in the U.S.
are relatively more (less) correlated with the U.S. market index than with the home
market when there is proportionately more (less) trading in the U.S. market.

• Berkman and Nguyen (2010) found little evidence that cross-listing results in
significant improvement in domestic liquidity.

• Abdallah and Ioannidis (2010) results do not support the bonding theory’s
prediction that cross-listing signals the firm’s commitment to protect minority
shareholders’ interests and thus increase the value of the firm by reducing the
required rate of return.

• Doidge, Karolyi, and Stulz (2010) concluded that firms that delist and leave U.S.
markets do so because they do not foresee the need to raise new external funds.
International Equity Market Benchmarks

• As a benchmark of activity or performance of a given national equity market, an

index of the stocks traded on the secondary exchange (or exchanges) of a country is
used.

• Each year S&P publishes its Global Stock Markets Factbook, which provides a
variety of statistical data on both emerging and developed country stock markets.

• The indexes constructed an published by MSCI are an excellent source of national

stock market performance.

• The Financial Times reports values in local currency of the major stock market
indexes of the national exchanges or markets from various countries in the world

• Standard & Poor’s publishes the S&P ADR Index.

 iShares MSCI

• iShares MSCI are baskets of stocks designed to replicate various MSCI stock
indexes.

• Some funds may not perfectly replicate their respective MSCI index. Nevertheless,
iShares are a low-cost, convenient way for investors to hold diversified investments
in several different countries.
Factors Affecting International Equity Returns

Macroeconomic Factors
• Solnik (1984) found that international monetary variables had only weak influence
on equity returns in comparison to domestic variables.

• Asprem (1989) found that changes in industrial production, employment, and

imports, the level of interest rates and an inflation measure explained only a small
portion of the variability of equity returns for 10 European countries, but that
substantially more of the variation was explained by an international market index.
Factors Affecting International Equity Returns

Exchange Rates
• Adler and Simon (1986) found that changes in exchange rates generally explained a
larger portion of the variability of foreign bond indexes than foreign equity indexes,
but that some foreign equity markets were more exposed to exchange rate changes
than were the respective foreign bond markets.

• Eun and Resnick (1988) found that the cross-correlations among major stock
markets and exchange markets are relatively low, but positive.

• Gupta and Finnerty (1992) concluded that exchange risk is generally not priced.
Factors Affecting International Equity Returns

Industrial Structure
• Roll (1992) concluded that the industrial structure of a country was important in
explaining a significant part of the correlation structure of international equity
index returns. He also found that industry factors explained a larger portion of
stock market variability than did exchange rate changes.

• Eun and Resnick (1984) found that the pairwise correlation structure of
international security returns could be better estimated from models that
recognized country factors rather than industry factors.

• Heston and Rouwenhorst (1994) concluded “that industrial structure explains very
little of the cross-sectional difference in country return volatility, and that the low
correlation between country indexes is almost completely due to country specific
sources of variation.