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 % % Domestic Loan Rate Domestic Deposit Rate Domestic Spread of 4.000% Eurodollar Loan Rate Eurodollar Deposit Rate Eurodollar Spread of 0.500% Interest Rate % %

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: Market CapitalizationMay 2009 (USD Billions) Americas15, 257 Asia Pacific11, 602 Europe, Middle East, Africa10, 515 TOTAL37, 374

China’s Equity Markets Shanghai Stock Exchange (SHSE) Shenzhen Stock Exchange (SZSE) Number of Listed Companies Source: world-exchanges.org Market Capitalization (in US millions) Source: world-exchanges.org HK less than 1/3 the size of NYSENYSE 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: JP Morgan: Novartis – Biotech Sweden HSBC – Banking UK Nestle – Switzerland Lan.com – Airline Chile Ericsson – Telecom Switzerland Vodafone – Telecom UK Wipro – IT India Nokia – Telecom Finland Elan – Biotech Ireland

Islamic Finance Muslims represent 1/4 th 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