Fourth Edition

InternationalBusiness

CHAPTER 11

The Global Capital Market

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11-3

Chapter Focus

The benefits of the global capital market.Growth of the international capital market.

Macroeconomic risks associated with the growth.

Important segments of the market:Eurocurrency market.International bond market.International equity market.

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11-4

Functions of a Generic Capital Market

Brings together those who want to invest with who want to borrow.Invest:

Firms with surplus cash.Individuals.Nonbank financial institutions.

Borrow:Individuals.Companies.Governments.

Market makers:Financial service companies that connect investors and borrowers, either directly or indirectly.

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11-5

The Main Players in a Generic Capital Market

Investors: Companies Individuals Institutions

Market makers: Commercial bankers Investment bankers

Borrowers: Individuals Companies Governments

Figure 11.1

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11-6

Attractions of the Global Capital Market

Benefits both borrowers and investors.Borrowers:

Increases the money supply.Lowers the cost of capital.

Investors:Provides a wide range of investment opportunity.Diversifies investor risk.

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11-7

Market Liquidity and the Cost of Capital

l

B

D

21

SSD

SS

D DDollars

0

9

10%

Cost

of

Cap

ital

Figure 11.2

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11-8

Risk Reduction Through Portfolio Diversification

(a) Risk reduction through domestic diversification

0.27

1.0

1 10 20 30 40 50

U.S. Stocks

TotalRisk

SystematicRisk

Number of Stocks

Variance of portfolio return

Variance of return on

typical stock

Figure 11.3a

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11-9

Risk Reduction Through Portfolio Diversification

(b) Risk reduction through domestic and international diversification

0.27

1.0

1 10 20 30 40 50

U.S. Stocks

International Stocks

Number of Stocks

Variance of portfolio return

Variance of return on

typical stock0.12

Figure 11.3b

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11-10

International Portfolio Risk Reduction

Movements of stock prices across across countries are not perfectly correlated.

Reflects two factors:Countries pursue different macroeconomic policies and face different economic conditions.Different stock markets are segmented by capital controls.

Perception that markets are integrating, but not as rapidly as thought.

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11-11

Growth of Global Capital Markets

Information Technology:Diminishing costs of sharing information.

Internet.Computer power.

Shocks in one market affect other markets

Deregulation:Response to:

Eurocurrency market.Financial services firms.Increasing acceptance a ‘free market’ concept.

Dismantling of national capital controls.

Less restrictions on inward/outward capital flows.

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11-12

Global Capital Market Risks

Nations more vulnerable to speculative capital flows.

Potential destabilization of economies.Capital pursuing short term gains.

Hot money.Patient money.

Lack of quality information.Investors react to quickly to news events.Differing accounting conventions.

Martin Feldstein

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11-13

Index of Capital Controls in Emerging Markets

0.52

0.54

0.56

0.58

0.6

0.62

0.64

0.66

0.68

86 87 88 89 90 91 92 93 94 95 96

0 = No Capital controls

1 = Tight Capital Controls

Figure 11.4

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11-14

The Euro Currency Market.A eurocurrency is any currency banked outside its country of origin.

It’s not the euro!

Eurodollars are dollars banked outside the United States.!950s. Eastern Europeans, fearing U.S. seizure of their dollars to reimburse U.S. citizens for property expropriated by their governments, deposited them in foreign banks (mostly in London).

Other events:

Britain – 1957.U.S. – 1960s.Failure of Bretton Woods.Oil crisis – 1970s.

Gave opportunity to those who wanted to deposit or borrow dollars (later,other currencies, as well).

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11-15

Interest Rate Spreads in Domestic and Eurocurrency Markets

Rate of interest

Domestic lendingrate

Domesticdeposit rate

Eurocurrencylending rate

Eurocurrencydeposit rate

0%Figure 11.5

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The Eurocurrency Market

AttractionLack of government regulation.

Pay higher interest rates.Charge lower rates.Reserve restrictions are less costly.

Drawbacks:Probability of bank failure (low).Foreign exchange risk.

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Global Bond MarketFixed rate.Two types:

Foreign:Sold outside borrower’s country and denominated by the currency of the country where issued.Desire to lower cost of capital.

Eurobonds:Underwritten by a bank syndicate and placed in countries other than the one in whose currency the bond is denominated.Issued by multinational corporations,large domestic corporations, and international institutions.Not offered in capital market, or to residents, of the country whose currency they are denominated.

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11-18

Attractions of the Eurobond Market

Attraction:An absence of regulatory interference.Less stringent disclosure requirements than domestic bond markets.Favorable tax status.

                                                                                                                                          

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Global Equity MarketNo equity market in the sense of the international currency and bond markets.

Countries have their own markets to trade corporate stocks.

Many open to foreign investors.

Two trends:Internationalization of corporate ownership.Companies broadening stock ownership by listing stock on foreign exchanges.

Tap into larger pool of funds for investment.Lowering capital costs.Facilitate future acquisitions.Stock and stock options for local employees, suppliers and bankers.

Increasing, firms from developing countries are taking advantage of the opportunity to access these funds.

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11-20

Foreign Exchange Risk and the Cost of Capital

Unpredictable movements in

rates.

Increases costof currency Forward

exchangemarket provides

some hedge.

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11-21

Implications for Business

Global capital marketsProvide opportunities for

For firms wishingTo borrow or

Invest money.

Lower costs

FX risk

Diversifyinvestments

Perhaps the emergenceof a unified

capital marketin the EU?