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International Business Fourth Edition CHAPTER 11 The Global Capital Market 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. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-4 Functions of a Generic Capital Market Brings together those who want to invest with who want to borrow. Invest: Market makers: Financial service companies that connect investors and borrowers, either directly or indirectly. Firms with surplus cash. Individuals. Nonbank financial institutions. Borrow: Individuals. Companies. Governments. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-7 Market Liquidity and the Cost of Capital D SS B SS 10% 9 l D 0 McGraw-Hill/Irwin D 1 2 D Dollars Figure 11.2 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-8 Risk Reduction Through Portfolio Diversification (a) Risk reduction through domestic diversification 1.0 Variance of portfolio return Variance of return on typical stock Figure 11.3a McGraw-Hill/Irwin U.S. Stocks 0.27 Total Risk 1 Systematic Risk 10 20 30 40 50 Number of Stocks © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-9 Risk Reduction Through Portfolio Diversification (b) Risk reduction through domestic and international diversification 1.0 Variance of portfolio return Variance of return on typical stock Figure 11.3b McGraw-Hill/Irwin U.S. Stocks 0.27 International Stocks 0.12 1 10 20 30 40 Number of Stocks 50 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. Martin Feldstein Lack of quality information. Investors react to quickly to news events. Differing accounting conventions. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-13 Index of Capital Controls in Emerging Markets Figure 11.4 0.68 0.66 0.64 0.62 0.6 0.58 0 = No Capital controls 0.56 1 = Tight Capital Controls 0.54 0.52 86 McGraw-Hill/Irwin 87 88 89 90 91 92 93 94 95 96 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 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). McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-15 Interest Rate Spreads in Domestic and Eurocurrency Markets Rate of interest Domestic lending rate Eurocurrency lending rate Eurocurrency deposit rate Domestic deposit rate Figure 11.5 McGraw-Hill/Irwin 0% © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-16 The Eurocurrency Market Attraction Drawbacks: Lack of government regulation. Pay higher interest rates. Charge lower rates. Reserve restrictions are less costly. McGraw-Hill/Irwin Probability of bank failure (low). Foreign exchange risk. © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-17 Global Bond Market Fixed 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. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-18 Attractions of the Eurobond Market Attraction: An absence of regulatory interference. Less stringent disclosure requirements than domestic bond markets. Favorable tax status. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-19 Global Equity Market No 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. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-20 Foreign Exchange Risk and the Cost of Capital Unpredictable movements in rates. Increases cost of currency McGraw-Hill/Irwin Forward exchange market provides some hedge. © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 11-21 Implications for Business Lower costs Global capital markets Provide opportunities for For firms wishing To borrow or Invest money. FX risk Diversify investments McGraw-Hill/Irwin Perhaps the emergence of a unified capital market in the EU? © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.