Fourth Edition International Business

CHAPTER 11 The Global Capital Market

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Functions of a Generic Capital Market Brings together those who want to invest with who want to borrow.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Functions of a Generic Capital Market Brings together those who want to invest with who want to borrow. Invest: Firms with surplus cash.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Functions of a Generic Capital Market Brings together those who want to invest with who want to borrow. Invest: Firms with surplus cash. Individuals.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Functions of a Generic Capital Market Market makers: Financial service companies that connect investors and borrowers, either directly or indirectly.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Attractions of the Global Capital Market Benefits both borrowers and investors. Borrowers: Increases the money supply.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Attractions of the Global Capital Market Benefits both borrowers and investors. Borrowers: Increases the money supply. Lowers the cost of capital.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Market Liquidity and the Cost of Capital l B D 21 SS D DD Dollars % Cost of Capital Figure 11.2

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved International Portfolio Risk Reduction Movements of stock prices (and bonds) across countries are not perfectly correlated.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved International Portfolio Risk Reduction Movements of stock prices (and bonds) across countries are not perfectly correlated. This Reflects two factors:

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved International Portfolio Risk Reduction Movements of stock prices (and bonds) across countries are not perfectly correlated. This Reflects two factors: Countries pursue different macroeconomic policies and face different economic conditions.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved International Portfolio Risk Reduction Movements of stock prices (and bonds) across countries are not perfectly correlated. This Reflects two factors: Countries pursue different macroeconomic policies and face different economic conditions. Different stock markets are segmented by capital controls.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Growth of Global Capital Markets Information Technology

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Growth of Global Capital Markets Information Technology Deregulation

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Growth of Global Capital Markets Information Technology: Diminishing costs of sharing information. Internet. Computer power.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Growth of Global Capital Markets Information Technology: Diminishing costs of sharing information. Internet. Computer power. Shocks in one market affect other markets

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Growth of Global Capital Markets Deregulation: Response to: Eurocurrency market. Financial services firms. Increasing acceptance a ‘free market’ concept.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Growth of Global Capital Markets Deregulation: Response to: Eurocurrency market. Financial services firms. Increasing acceptance a ‘free market’ concept. Dismantling of national capital controls.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Growth of Global Capital 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Capital Market Risks Nations more vulnerable to speculative capital flows.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Capital Market Risks Nations more vulnerable to speculative capital flows. Potential destabilization of economies. Capital pursuing short term gains. Hot money. Patient money. Martin Feldstein

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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 too quickly to news events. Differing accounting conventions. Martin Feldstein

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Euro Currency Market. Eurocurrency (It’s not the euro!) Eurocurrency is any currency banked outside its country of origin.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Euro Currency Market. Eurodollars are dollars banked outside the United States.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Euro Currency Market. History !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).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Euro Currency Market. History !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 prohibited banks from financing non- British trade.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Euro Currency Market. History !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 prohibited banks from financing non-British trade. U.S. – 1960s discouraged banks from lending to non- US residents.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Euro Currency Market. History !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 prohibited banks from financing non-British trade. U.S. – 1960s discouraged banks from lending to non-US residents. Oil crisis – 1970s led to huge amount of dollars amassed by OPEC countries. They did not want them to be in the US because they were afraid that they would be confiscated by the US government.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Euro Currency Market. History !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 prohibited banks from financing non-British trade. U.S. – 1960s discouraged banks from lending to non-US residents. Oil crisis – 1970s led to huge amount of dollars amassed by OPEC countries. They did not want them to be in the US because they were afraid that they would be confiscated by the US government. Gave opportunity to those who wanted to deposit or borrow dollars (later,other currencies, as well).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Interest Rate Spreads in Domestic and Eurocurrency Markets Rate of interest Domestic lending rate Domestic deposit rate Eurocurrency lending rate Eurocurrency deposit rate 0% Figure 11.5

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Eurocurrency Market Attraction Lack of government regulation. Pay higher interest rates.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Eurocurrency Market Attraction Lack of government regulation. Pay higher interest rates. Charge lower rates.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Eurocurrency Market Attraction Lack of government regulation. Pay higher interest rates. Charge lower rates. Reserve restrictions are less costly.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Eurocurrency Market Drawbacks: Probability of bank failure (low).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved The Eurocurrency Market Drawbacks: Probability of bank failure (low). Foreign exchange risk.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Bond Market Fixed rate or variable rates. Two types: Foreign Bonds: Sold outside borrower’s country and denominated by the currency of the country where issued. They each have a nickname:

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Bond Market Fixed rate or variable rates. Two types: Foreign Bonds: Sold outside borrower’s country and denominated by the currency of the country where issued. They each have a nickname: Yankee Bonds: Foreign bonds sold in the US (Honda issuing a bond in NY denominated in the US $)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Bond Market Fixed rate or variable rates. Two types: Foreign Bonds: Sold outside borrower’s country and denominated by the currency of the country where issued. They each have a nickname: Yankee Bonds: Foreign bonds sold in the US (Honda issuing a bond in NY denominated in the US $) Samurai Bonds: Foreign bonds sold in the Japan (IBM issuing a bond in Japan denominated in Japanese Yen).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Bond Market Fixed rate or variable rates. Two types: Foreign Bonds: Sold outside borrower’s country and denominated by the currency of the country where issued. They each have a nickname: Yankee Bonds: Foreign bonds sold in the US (Honda issuing a bond in NY denominated in the US $) Samurai Bonds: Foreign bonds sold in the Japan (IBM issuing a bond in Japan denominated in Japanese Yen). Bulldog Bonds: Foreign bonds sold in Britain (Ford issuing a bond denominated in £ sold in London).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Bond Market Fixed rate or variable rates. Two types: Foreign Bonds: Sold outside borrower’s country and denominated by the currency of the country where issued. Yankee Bonds: Foreign bonds sold in the US (Honda issuing a bond in NY denominated in the US $) Samurai Bonds: Foreign bonds sold in the Japan (IBM issuing a bond in Japan denominated in Japanese Yen). Bulldog Bonds: Foreign bonds sold in Britain (Ford issuing a bond denominated in £ sold in London). Eurobonds: Underwritten by a bank syndicate and placed in countries other than the one in whose currency the bond is denominated (e.g., a Japanese corporation issuing a dollar denominated bond sold in Europe by Rothschild bank of France and Deutsche bank of Germany).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Bond Market Fixed rate or variable rates. Two types: Foreign Bonds: Sold outside borrower’s country and denominated by the currency of the country where issued. Yankee Bonds: Foreign bonds sold in the US (Honda issuing a bond in NY denominated in the US $) Samurai Bonds: Foreign bonds sold in the Japan (IBM issuing a bond in Japan denominated in Japanese Yen). Bulldog Bonds: Foreign bonds sold in Britain (Ford issuing a bond denominated in £ sold in London). 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Bond Market Fixed rate or variable rates. Two types: Foreign Bonds: Sold outside borrower’s country and denominated by the currency of the country where issued. Yankee Bonds: Foreign bonds sold in the US (Honda issuing a bond in NY denominated in the US $) Samurai Bonds: Foreign bonds sold in the Japan (IBM issuing a bond in Japan denominated in Japanese Yen). Bulldog Bonds: Foreign bonds sold in Britain (Ford issuing a bond denominated in £ sold in London). 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Attractions of the Eurobond Market Attraction: An absence of regulatory interference. There is less requirements for securities denominated in other currencies and securities that are sold in other countries compared to these that are denominated in local currencies and sold domestically. Therefore, cost of borrowing is less when it is done outside the country.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Attractions of the Eurobond Market Attraction: An absence of regulatory interference. Less stringent information disclosure requirements about the company (e.g., executive salaries, stock trades by executives, etc.) and its financial position (profits and losses according to the US standards) relative to domestic bond markets.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Attractions of the Eurobond Market Attraction: An absence of regulatory interference. Less stringent disclosure requirements than domestic bond markets. Favorable tax status. Before 1984, US corporation were required to withhold taxes on interest payment to their bond holders. This was reversed in Other countries followed suit and increased demand for Eurobonds.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market No international equity market in the sense of the international currency and bond markets. Countries have their own markets to trade corporate stocks. Many of these markets (New York Stock Exchange) are open to foreign investors.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market Two trends: Internationalization of corporate ownership.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market Two trends: Internationalization of corporate ownership. Companies broadening stock ownership by listing stock on foreign exchanges (BMW selling its stocks on NYSE).

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market Two trends: Internationalization of corporate ownership. Companies broadening stock ownership by listing stock on foreign exchanges (BMW selling its stocks on NYSE). This allows them to: Tap into larger pool of funds for investment.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market Two trends: Internationalization of corporate ownership. Companies broadening stock ownership by listing stock on foreign exchanges (BMW selling its stocks on NYSE). This allows them to: Tap into larger pool of funds for investment. Lowering capital costs.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market Two trends: Internationalization of corporate ownership. Companies broadening stock ownership by listing stock on foreign exchanges (BMW selling its stocks on NYSE). This allows them to: Tap into larger pool of funds for investment. Lowering capital costs. Facilitate future acquisitions.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market Two trends: Internationalization of corporate ownership. Companies broadening stock ownership by listing stock on foreign exchanges (BMW selling its stocks on NYSE). This allows them to: Tap into larger pool of funds for investment. Lowering capital costs. Facilitate future acquisitions. Stock and stock options for local employees, suppliers and bankers.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Global Equity Market Two trends: Internationalization of corporate ownership. Companies broadening stock ownership by listing stock on foreign exchanges (BMW selling its stocks on NYSE). This allows them to: 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Foreign Exchange Risk and the Cost of Capital Unpredictable movements in rates.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Foreign Exchange Risk and the Cost of Capital Unpredictable movements in rates. Honda Borrows 1 billion Yens In the US at 10% $1 = 100 yen Borrows 1 billion Must pay 1.1 billions

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Foreign Exchange Risk and the Cost of Capital Unpredictable movements in rates. Honda Borrows 1 billion Yens In the US at 10% $1 = 100 yen Borrows 1 billion Must pay 1.1 billions After one year yen devalues $1 = 110 yes Borrowed $10 millions Must pay 1.21 billions (110*$11)

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Foreign Exchange Risk and the Cost of Capital: this could be safeguarded through forward market

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Implications for Business Global capital markets Provide opportunities for For firms wishing To borrow or Invest money. Lower costs FX risk Diversify investments Perhaps the emergence of a unified capital market in the EU?