International Financing and International Financial Markets FIU – International Finance Session 12

Use of International Financial Markets Foreign cash flow movements of a typical MNC: Foreign trade. Exports generate foreign cash inflows, while imports require cash outflows. Direct foreign investment. Cash outflows to acquire foreign assets generate future inflows. Short-term investment or financing in foreign securities, usually in the Eurocurrency market. Longer-term financing in the Eurocredit, Eurobond, or international stock markets.

Implications for business Firms can borrow funds at a lower cost than they could domestically Minimum regulation in international capital markets helps lower the cost of capital, but also increases risk in both currencies and security International capital market provides opportunities for portfolio diversification and the lowering of systematic risk

Functions of a Generic Capital Market Brings together: –Those who want to invest: corporations, individuals, nonbank financial institutions. –Those who want to borrow: individuals, companies, governments. Market makers: –Commercial and investment banks that connect investors with borrowers. 11-1

The Main Players in a Generic Capital Market Investors: Companies Individuals Institutions Market makers: “Intermediaries “ Commercial bankers Investment bankers Borrowers: Individuals Companies Governments 11-2

Financial Intermediaries Middle people Being pushed out Disintermediation Who will preserve order if they are pushed out?

Attraction of the Global Capital Market? Increases the supply of funds available for borrowing. Borrower’s perspective –Lowers the cost of capital. Investor’s perspective –Provides a wider range of investment opportunities

Financing Alternatives Internally generated cash - earnings Short and long term external funds: –Debt –Equity –Loans Traditional bank loans Private bonds from pension funds, insurance companies

What are the differences? Equity – stock – giving ownership to investors – giving up control? Debt – bonds – no ownership is relinquished Loans

Debt The preferred method of financing…. WHY?

BASIC FEATURES OF A BOND Long-Term Fixed Income Interest Payments Principal, Par Value, Face Value ($1,000) Maturity –Short-Term (Money Market) –Intermediate (Notes) –Long-Term (Bonds)

Bond features Coupon Term to Maturity Principal (Par Value) Market Value (Price) Ownership Bearer Bonds Registered Bonds Consider two bonds that are identical, except one is callable while the other is not. Which bond will sell at a higher price?

Straight Bond vs Callable Bond Value of straight bond bond Value of Straight bond Bond callable at 100

High-Yield Bonds Speculative Grade Bonds or Junk Bonds Carry a Rating of BB (Ba) or Lower Michael Milken - Firms Involved in Leveraged Buyouts “Fallen Angels” Small Growth Firms

INTERPRETING BOND QUOTES Corporate Bond Quotes Current Bonds Yield Volume Close Net Change IBM 7 1/ /8+3/8

Types of bonds Domestic Bonds – issued locally by a domestic borrower and denominated in the local currency. Foreign Bonds – issues by foreign borrower in the local currency and regulated by local regulators Yankee Bonds – Bonds issues by a non-US firm denominated in US $ and issued in the US. Samurai Bonds – Bonds issues in Japan by non- Japanese companies denominated in Yen

Eurobonds Bonds underwritten by a multi-national syndicate (group), placed mainly in countries other than the currency’s country. Not traded on a specific market. Unregulated and untaxed! Because they are untaxed, buyers will accept a lower rate of interest and issuers pay less to borrow. They are also in bearer from.

Euro vs Foreign Bonds (Billions of Dollars) 11-17

Types of Foreign Bonds Fixed rate issues – Floating rate issues- Coupon rate is tied to the market interest rate –So still leaves some risk to the bondholders Equity related issues-

Advantages and Disadvantages of Debt Advantages –Tax deductibility of interest –Financial leverage can increase EPS –Ownership is not diluted Disadvantages –Increased financial risk –Indenture provisions restrict firm’s flexibility

The International Bond Market Bonds tend to be fixed rate. Foreign bonds –Sold outside the borrower’s country and in currency of country where issued. Eurobonds –underwritten by an international syndicate. –issued by large corporations, international institutions and governments. –placed in country other than country of currency and its residents.

Eurocurrency Market Consists of banks, called “Eurobanks” that accept deposits and make loans in foreign currencies. Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside its country of origin.

Eurocurrency It’s not the Euro! It is any currency banked outside its country of origin. 1950s. Eastern Europeans afraid US would seize deposits to reimburse claims for business losses as a result of Communist takeover of Eastern Europe.

The Eurocurrency Market Characterized by a lack of regulation compared to domestic financial markets. This means that you don’t have to pay for the cost of regulation. Hence, cheap (or cheaper) money. Downside: – Banks could be more likely to fail (not probable) –Because you are getting foreign money, you have currency exchange risks.

Eurocurrency Market U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars and are not subject to U.S. regulations. In the 1960s and 70s, the Eurodollar market, or what is now called the Eurocurrency market, grew to accommodate increasing international business. The market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies. $

Eurocurrency Market U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars and are not subject to U.S. regulations. In the 1960s and 70s, the Eurodollar market, or what is now called the Eurocurrency market, grew to accommodate increasing international business. The market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies. $

Although the market focuses on large-volume transactions, at times no single bank is willing to lend the needed amount. A syndicate of Eurobanks may then be composed. Two regulatory events allow for a more competitive global playing field: – The Single European Act opens up the European banking industry and calls for similar regulations. – The Basel Accord includes standardized guidelines on the classification of capital. Eurocurrency Market $

Securitization Popular because of deregulation Banks must make their offering more attractive The matching of borrowers and lenders The process of aggregating similar instruments, such as loans or mortgages, into a negotiable security – like GNMA and FNMA.

Benefits of globalization to obtaining capital Freer markets More information

Exchange Rate Risk of Foreign Bonds Some foreign currencies exhibit more risk than others. The exchange rate risk from financing with bonds in foreign currencies can be hedged with 1 offsetting cash inflows in that currency, 2 forward contracts, or 3 currency swaps.

Bonds sold outside the country whose currency they are denominated in. Eurobonds are underwritten by a multi-national syndicate of investment banks and simultaneously placed in many countries. They are usually issued in bearer form. Bonds have become popular in the last 20 years as Swaps have become more popular Eurobond Market BONDS

Eurobonds increased rapidly in volume when in 1984, the withholding tax was abolished in the U.S. and corporations were allowed to issue bonds directly to non-U.S. investors. Interest rates for each currency and credit conditions change constantly, causing the market’s popularity to vary among currencies. In recent years, governments and corporations from emerging markets have frequently utilized the Eurobond market. Eurobond Market BONDS

Interest rate swaps can be used to hedge interest rate risk. They enable a firm to exchange fixed rate payments for variable rate payments, or vice versa. Financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee. Using Swaps to Hedge Financing Costs

International Stock Markets MNCs can obtain funds by issuing stock in international markets, in addition to the local market. By having access to various markets, the stocks may be more easily digested, the image of the MNC may be enhanced, and the shareholder base may be diversified. The proportion of individual versus institutional ownership of shares varies across stock markets. The regulations are different too.

The locations of the MNC’s operations may affect the decision about where to place stock, in view of the cash flows needed to cover dividend payments in the future. Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock offerings. Non-U.S. firms can also issue American depository receipts (ADRs), which are certificates representing bundles of stock. The use of ADRs circumvents some disclosure requirements. International Stock Markets

Trading in Non-US Stocks US Billions

Global Equity Markets Where investors can buy/sell stocks. Made up of many stock exchanges around the world.

Who Uses These Markets? Investors seeking to diversify their portfolios. Companies seeking to –issue stock in the country –use stock and options as a form of employee incentives –satisfy local ownership requirements –create funding for future acquisitions –increase the visibility of the company.