Global Capital Market

Chapter 12: The Global Capital Market

Learning Objectives

12-1: Describe the benefits of the global capital market.
12-2: Identify why the global capital market has grown so rapidly.
12-3: Understand the risks associated with the globalization of capital markets.
12-4: Compare and contrast the benefits and risks associated with the Eurocurrency market, the global bond market, and the global equity market.
12-5: Understand how foreign exchange risks affect the cost of capital.

Introduction

Over the last 30 years, national capital markets have been segmented from each other due to regulatory barriers.
For instance, Kenya has historically run a budget deficit which has been financed by issuing bonds.
Investors demand higher interest rates to offset higher risks associated with investments in certain regions.
These points highlight the benefits that arise from the globalization of capital markets.

Benefits of the Global Capital Market

1. The Functions of a Generic Capital Market

Market Makers: Financial service companies that connect investors with borrowers. - Commercial Banks: Perform indirect connection functions between investors and borrowers. - Investment Banks: Fulfill direct connection functions, facilitating transactions between capital seekers and providers.

2. Types of Capital Market Loans

Equity Loans: Provided when a corporation sells stock to investors, essentially representing ownership.
Debt Loans: Require corporations to repay a specific portion of the loan at regular intervals, irrespective of profit levels.

3. Attractions of the Global Capital Market – Borrower’s Perspective

Lower Cost of Capital: Borrowers in a global capital market often face lower borrowing costs compared to domestic markets. - Cost of Capital: This term refers to the price of borrowing money and varies significantly between domestic and global markets.

4. Attractions of the Global Capital Market – Investor’s Perspective

Portfolio Diversification: - Investors benefit from a wider range of investment opportunities across international markets. - International diversification can effectively reduce risk by spreading investments across various economic environments. - Systematic Risk: Refers to risks affecting the overall market or economy, impacting a stock portfolio’s value.

5. Market Correlation and Diversification Risks

Despite potential for lower risk, increasing integration of global economies and markets has resulted in growing correlation among various stock markets.
Volatile exchange rates may diminish the risk-reducing benefits of international portfolio diversification.

6. Growth of the Global Capital Market – Information Technology

Technological advancements allow instantaneous communication, enhancing the efficiency of market makers.
Global trade operates continuously, allowing for 24-hour trading.
Information 'shocks' can circulate and affect market dynamics rapidly, influencing investor behavior.

7. Growth of the Global Capital Market – Deregulation

Deregulation stems from the development of the Eurocurrency market and the global embrace of free market ideologies.
Many nations began dismantling capital controls through the 1970s, continuing into the 2000s.
The 2008-2009 financial crisis raised concerns about the adequacy of deregulation and prompted discussions on the need for regulations in various financial sectors, including hedge funds.

8. Global Capital Market Risks

National economies can become susceptible to speculative capital flows, which may destabilize them.
"Hot Money": This term describes short-term capital, while "Patient Money" refers to supportive long-term capital flows.
Investors require better information to navigate foreign asset investments efficiently.

9. Information Deficits and Speculative Flows

A lack of information about foreign investments can lead investors to react impulsively to events in foreign markets, potentially resulting in rapid capital flight.
The challenge of differing accounting standards complicates investment comparisons, though the 2000s saw progress toward harmonizing these standards.

The Eurocurrency Market

1. Introduction to Eurocurrency

Eurodollars: Make up two-thirds of all Eurocurrencies and can be created globally.
They provide an essential, low-cost source of funds for international businesses.

2. Genesis and Growth of the Market

Many Eastern European holders of dollars opted to deposit their funds in London due to concerns about U.S. regulatory frameworks.
The British and U.S. governments established regulations that discouraged banks from lending, which led to the accumulation of dollar deposits in London.
The oil price shocks caused by OPEC further contributed to the deposit proliferation in London.

3. Attractions of the Eurocurrency Market

Lack of Government Regulation: - Eurocurrency deposits fetch higher interest rates than local currency deposits, benefiting banks and depositors alike. - Banks have greater flexibility in foreign currency dealings compared to domestic regulations.

4. Drawbacks of the Eurocurrency Market

In a regulated system, the chances of bank failure are typically lower, thus potentially increasing stability for lenders.
Companies borrowing internationally face foreign exchange risks; for example, if the British pound appreciates against the dollar, it may raise the dollar cost of repaying a Euro-pound loan, increasing the company's cost of capital.

The Global Bond Market

1. Importance of Bond Financing

Bonds serve as a primary means of financing, with fixed-rate bonds being the most common, promising a fixed series of cash payoffs. - Foreign Bonds: Issued outside the borrower's home country and denominated in the local currency. - Eurobonds: Frequently issued by multinational corporations and other large entities across borders.

2. Attractions of the Eurobond Market

Regulatory Absence: Eurobonds fall outside the regulatory reach of any single nation, providing advantages over regulated domestic markets.
Disclosure and Tax Benefits: There are less stringent disclosure requirements and favorable tax treatments, like the U.S. exemptions on withholding taxes for Eurobond holders, prompting other governments to adjust their tax laws accordingly.

The Global Equity Market

1. Historical Separation of National Equity Markets

Historically, national equity markets were constrained by regulatory barriers, complicating capital investment movements across borders.
Challenges arose for corporations attempting to list shares internationally or attract capital investments from foreign investors.

2. Consequences of International Equity Investment

Encouraging Internationalization of Corporate Ownership: An increasing trend where corporations historically tied to one nation list shares globally.
Companies are increasingly extending their reach into foreign equity markets, diversifying ownership and investment.

Foreign Exchange Risks and the Cost of Capital

The floating exchange rate regime introduces complexities regarding foreign exchange risk: - Adverse exchanges can spike the costs of foreign currency loans, adding unpredictability and risk to international borrowing activities.

360° View: Focus on Managerial Implications

The growth of global capital markets presents new prospects for international businesses seeking to borrow or invest.
Firms can benefit from lower borrowing costs compared to domestic markets; however, the absence of regulation raises foreign exchange risks.
There are avenues for diverse investments which organizations can leverage to mitigate risks associated with market fluctuations.

Figures and Illustrations

Figure 12.1: Overview of the main players in the capital market, illustrating the connections between investors, market makers, and borrowers.
Figure 12.2: Graph depicting market liquidity's relationship with the cost of capital, detailing shifts in demand and supply in domestic vs global markets.
Figure 12.3: Visualization of interest rate spreads in domestic and Eurocurrency markets, analyzing trends and disparities in lending and deposit rates.