Brian Levin

Harvard Summer School

Chapter 11: The Global Capital Market

Functions of a Capital Market The capital market matches those who wish to

invest excess cash with those who wish to borrow

Intermediaries put the two parties together (‘Market Makers’)– Commercial Banks: pay depositors a rate of return

and make loans at a higher rate of return– Investment Banks: broker a direct transaction

between an investor and borrower

Advantage of a Global Capital Market For a borrower, it lowers the cost of capital

See Figure 11.2 in the textbook; global capital market acts like a supply shift in a supply/demand graph

For an investor, it allows for international portfolio diversification which theoretically decreases the risk of a portfolio (more on this later…)

Overall, the global capital market achieves a lower cost of capital which allows firms to take on more long term projects because the hurdle rate for the investment is lower (which leads to more economic growth, etc.)

Does the global capital market really achieve risk reduction for investors?

Research such as Solnik (1974) postulates that global markets are weakly correlated

According to portfolio theory, weak correlation leads to diversification and less systematic risk of the portfolio

While during ‘normal’ times this may be true, crisis are a different story!

Weak correlation? Japan Market

Weak Correlation? U.S. Market

Weak Correlation? U.K. Market

Strong Correlation! Benefit of a global market for investors may be

overstated because of a hidden risk - correlation risk– Very difficult to hedge!

Studies by Solnik and followers overlook the endogenous relationship of the development of global capital markets and correlation; the more investors shift money abroad, the more correlated all markets become the LESS diversified a portfolio becomes

Why? A crisis in one country leads investors to liquidate holdings across portfolio to make up for shortfall cascading fall in global markets!

Why do companies seek global equity? Improved liquidity Possible higher share price Increase the firm’s visibility with bankers,

suppliers, government, etc. “Acquisition currency” Compensate foreign management

Eurocurrency Markets Eurocurrency – any currency banked outside of its

country of origin. Eurodollars – dollars banked outside of the U.S.

– Euroyen, europound, euro-euro

1950 Eurocurrency Market is born as Eastern Europeans were afraid to deposit $ in the U.S. fearing that they would be seized to finance lost business from the Communist takeover of Europe. Continued expansion by OPEC nations during Oil spike in 1970’s.

– London was happy to take the money and paid higher interest rates (see the next slide).

Exhibit 11.4 Comparative Spreads Between Lending and Deposit Rates in the Eurodollar Market

3.000 %

7.000 %DomesticLoan Rate

DomesticDeposit Rate

Domestic Spreadof 4.000%

Eurodollar Loan Rate

Eurodollar Deposit Rate

Eurodollar Spread of 0.500%

Interest Rate

4.625 %

4.125 %

Why doesn’t everyone bank in eurodollars? Eurocurrency market is not regulated; no FDIC

insurance in the case of U.S. In the case of a bank failure, depositors don’t have the

recourse that they do in domestic banking Therefore, the higher rate of interest paid on deposits is

simply a risk/reward calculation During September/October 2008, eurocurrency deposit

rates and lending rates (LIBOR, etc.) sky rocketed because of this risk

Global Bond Markets Foreign bonds are bonds issued in one country by a

foreign issuer. – “Yankee Bonds” are bonds issued by a non-U.S. entity that are

traded in the U.S. – “Samurai Bonds” are bonds traded in Japan issued by a non-

Japanese entity. – “Bulldog bonds” are traded in the U.K. but issued by a non-U.K.

entity, – “Rembrandt Bonds” are bonds traded in the Netherlands by a

non-Dutch entity,– “Matador Bonds” are bonds traded in Spain issued by a non-

Spanish entity.

Eurobonds Eurobonds have the following characteristics:

– Underwritten by an international syndicate– Issued to investors in more than one country– Generally, not issued in the country that issues the currency in

which they are denominated.– Usually unregistered.

Note: Eurobonds are named in accordance with the currency in which they are denominated, not according to where they are issued.

– Eurodollar bonds are denominated in U.S. dollars but not issued in the U.S., Euroyen bonds are denominated in yen, but not issued in Japan.

Global Equity Markets

Source: www.world-exchanges.org

Market Capitalization May 2009 (USD Billions)

Americas 15, 257

Asia Pacific 11, 602

Europe, Middle East, Africa 10, 515

TOTAL 37, 374

China’s Equity Markets Shanghai Stock

Exchange (SHSE)

Shenzhen Stock Exchange (SZSE)

Exchange Shanghai SE Shenzhen SE Hong Kong NYSE

End 1990 299 1,774End 1991 357 1,989End 1992 413 1,750End 1993 477 1,945End 1994 529 2,128End 1995 542 2,242End 1996 583 2,476End 1997 658 2,626End 1998 680 2,670End 1999 708 3,025End 2000 790 2,468End 2001 646 508 867 2,400End 2002 715 508 978 2,366End 2003 780 505 1,037 2,308End 2004 837 536 1,096 2,293End 2005 833 544 1,135 2,270

Number of Listed Companies

Source: world-exchanges.org

Exchange Shanghai SE Shenzhen SE Hong Kong NYSE

End 1990 NA NA 83,385.9 2,692,123.0End 1991 NA NA 121,880.9 3,484,340.3End 1992 NA NA 171,983.5 3,798,238.1End 1993 NA NA 385,042.7 4,212,956.0End 1994 NA NA 269,507.8 4,147,936.7End 1995 NA NA 303,705.3 5,654,815.4End 1996 NA NA 449,218.8 6,841,987.6End 1997 NA NA 413,322.6 8,879,630.6End 1998 NA NA 343,566.5 10,277,899.8End 1999 NA NA 609,090.4 11,437,597.3End 2000 NA NA 623,397.7 11,534,612.9End 2001 NA NA 506,072.9 11,026,586.5End 2002 306,443.6 156,647.6 463,054.9 9,015,270.5End 2003 360,106.3 152,872.4 714,597.4 11,328,953.1End 2004 314,315.7 133,404.6 861,462.9 12,707,578.3End 2005 286,190.3 115,661.9 1,054,999.3 13,310,591.6

Market Capitalization (in US millions)

Source: world-exchanges.org

HK less than 1/3 the size of NYSE NYSE had 18x the Market Cap

Sourcing Equity Globally Designing a Strategy to Source Equity Globally

American depository receipts (ADRs) are certificates traded in the United States and denominated in US dollars.

– ADRs are sold, registered, and transferred in the US in the same manner as any share of stock with each ADR representing some multiple of the underlying foreign share (allowing for ADR pricing to resemble conventional US share pricing between $20 and $50 per share).

ADRs Levels Level I

– OTC only

Level II– Listed on a U.S. stock exchange.

New York Stock Exchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX).

Level III– Firm can also raise money

Popular ADRs

Bank of New York: www.adrbny.comJP Morgan: www.adr.com

Novartis – Biotech SwedenHSBC – Banking UKNestle – SwitzerlandLan.com – Airline ChileEricsson – Telecom Switzerland Vodafone – Telecom UKWipro – IT IndiaNokia – Telecom FinlandElan – Biotech Ireland

Islamic Finance Muslims represent 1/4th of the world’s population. Under Islam, the following beliefs affect business and

finance:– Making money from money is not permissible– Earning interest is prohibited– Profit and loss should be shared– Speculation is prohibited– Investments should only support activities that are legal under

Islamic law

Islamic Finance An Islamic bank cannot pay interest to depositors who

are Muslim.– So depositors are considered shareholders and the returns they

receive are a function of the bank’s investments.– Returns are not guaranteed, because profit and loss must be

shared. To buy a home under Islamic law:

– The buyer selects a property which is purchased by the bank.– The bank then resells the property to the buyer at a higher price

and the buyer is allowed to pay off the bank over a period of time.

– One problem: in the U.S. and the U.K. the difference is not a tax deductible expense for the homeowner.

Implications for Managers Global Market Opportunities Currency Management

– Forecasting & Hedging Activities– Strategic Flexibility

Dispersed Production Outsourcing