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Texts belong to their owners and are placed on a site for acquaintance. |
Benefits of the Global Capital Market Although this section is about the global capital market, we open it by discussing the functions of a generic capital market. Then we will look at the limitations of domestic capital markets and discuss the benefits of using global capital markets. The Functions of a Generic Capital Market Why do we have capital markets? What is their function? A capital market brings together those who want to invest money and those who want to borrow money (see Figure 11.1). Those who want to invest money include corporations with surplus cash, individuals, and nonbank financial institutions (e.g., pension funds, insurance companies). Those who want to borrow money include individuals, companies, and governments. Between these two groups are the market makers. Market makers are the financial service companies that connect investors and borrowers, either directly or indirectly. They include commercial banks (e.g., Citibank, U.S. Bank) and investment banks (e.g., Merrill Lynch, Goldman Sachs). Commercial banks perform an indirect connection function. They take cash deposits from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a higher rate of interest, making a profit from the difference in interest rates (commonly referred to as the interest rate spread). Investment banks perform a direct connection function. They bring investors and
Figure 11.1 The Main Players in a Generic Capital Market borrowers together and charge commissions for doing so. For example, Merrill Lynch may act as a stockbroker for an individual who wants to invest some money. Its personnel will advise her as to the most attractive purchases and buy stock on her behalf, charging a fee for the service. Capital market loans to corporations are either equity loans or debt loans. An equity loan is made when a corporation sells stock to investors. The money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay wages, and so on. A share of stock gives its holder a claim to a firm's profit stream. The corporation honors this claim by paying dividends to the stockholders. The amount of the dividends is not fixed in advance. Rather, it is determined by management based on how much profit the corporation is making. Investors purchase stock both for their dividend yield and in anticipation of gains in the price of the stock. Stock prices increase when a corporation is projected to have greater earnings in the future, which increases the probability that it will raise future dividend payments. A debt loan requires the corporation to repay a predetermined portion of the loan amount (the sum of the principal plus the specified interest) at regular intervals regardless of how much profit it is making. Management has no discretion as to the amount it will pay investors. Debt loans include cash loans from banks and funds raised from the sale of corporate bonds to investors. When an investor purchases a corporate bond, he purchases the right to receive a specified fixed stream of income from the corporation for a specified number of years (i.e., until the bond maturity date). Attractions of the Global Capital Market Why do we need a global capital market? Why are domestic capital markets not sufficient? A global capital market benefits both borrowers and investors. It benefits borrowers by increasing the supply of funds available for borrowing and by lowering the cost of capital. It benefits investors by providing a wider range of investment opportunities, thereby allowing them to build portfolios of international investments that diversify their risks. The Borrower's Perspective: A Lower Cost of Capital In a purely domestic capital market, the pool of investors is limited to residents of the country. This places an upper limit on the supply of funds available to borrowers. In other words, the liquidity of the market is limited. (Deutsche Telekom faced this problem in the opening case.) A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on. Perhaps the most important drawback of the limited liquidity
of a purely domestic capital market is that the cost of capital tends
to be higher than it is in an international market. The cost of capital
is the rate of return that borrowers must pay investors (the price of
borrowing money). This is the interest rate on debt loans and the dividend
yield and expected capital gains on equity loans. In a purely domestic
market, the limited pool of investors implies that borrowers must pay
more to persuade investors to lend them their money. The larger pool of
investors in an international market implies that borrowers will be able
to pay less. Market Liquidity and the Cost of Capital
The argument is illustrated in Figure 11.2, using the Deutsche Telekom example. The vertical axis in the figure is the cost of capital (the price of borrowing money) and the horizontal axis, the amount of money available at varying interest rates. DD is the Deutsche Telekom demand curve for borrowings. Note that the Deutsche Telekom demand for funds varies with the cost of capital; the lower the cost of capital, the more money Deutsche Telekom will borrow. (Money is just like anything else; the lower its price, the more of it people can afford.) SSB is the supply curve of funds available in the German capital market, and SSI represents the funds available in the global capital market. Note that Deutsche Telekom can borrow more funds more cheaply on the global capital market. As Figure 11.2 illustrates, the greater pool of resources in the global capital market both lowers the cost of capital and increases the amount Deutsche Telekom can borrow. Thus, the advantage of a global capital market to borrowers is that it lowers the cost of capital. Problems of limited liquidity are not restricted to less developed nations, which naturally tend to have smaller domestic capital markets. As illustrated in the opening case and discussed in the introduction, in recent years even very large enterprises based in some of the world's most advanced industrialized nations have tapped the international capital markets in their search for greater liquidity and a lower cost of capital.4 Another example of a company that tapped the global capital market to lower its cost of capital is profiled in the accompanying Management Focus. The Investor's Perspective: Portfolio Diversification By using the global capital market, investors have a much wider range of investment opportunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to below what could be achieved in a purely domestic capital market. We will consider how this works in the case of stock holdings, although the same argument could be made for bond holdings. Consider an investor who buys stock in a biotech firm that has not yet produced a new product. Imagine the price of the stock is very volatile--investors are buying and selling the stock in large numbers in response to information about the firm's prospects. Such stocks are risky investments; investors may win big if the firm produces a marketable product, but investors may also lose all their money if the firm fails to come up with a product that sells. Investors can guard against the risk associated with holding this stock by buying other firms' stocks, particularly those weakly or negatively correlated with the biotech stock. By holding a variety of stocks in a diversified portfolio, the losses incurred when some stocks fail to live up to their promises are offset by the gains enjoyed when other stocks exceed their promise. As an investor increases the number of stocks in her portfolio, the portfolio's risk declines. At first this decline is rapid. Soon, however, the rate of decline falls off and asymptotically approaches the systematic risk of the market. Systematic risk refers to movements in a stock portfolio's value that are attributable to macroeconomic forces affecting all firms in an economy, rather than factors specific to an individual firm. The systematic risk is the level of nondiversifiable risk in an economy. Figure 11.3a illustrates this relationship for the United States. It suggests that a fully diversified US portfolio is only about 27 percent as risky as a typical individual stock. By diversifying a portfolio internationally, an investor can reduce the level of risk even further because the movements of stock market prices across countries are not perfectly correlated. For example, one recent study looked at the correlation between three stock market indexes. The Standard & Poor's 500 (S&P 500) summarized the movement of large US stocks. The Morgan Stanley Capital International Europe, Australia, and Far East Index (EAFE) summarized stock market movements in other developed nations. The third index, the International Finance Corporation Global Emerging Markets Index (IFC) summarized stock market movements in less developed "emerging economies." From 1981 to 1994, the correlation between the S&P 500 and EAFE indexes was 0.45, suggesting they moved together only about 20 percent of the time (i.e., 0.45 * 0.45 = 0.2025). The correlation between the S&P 500 and IFC indexes was even lower at 0.32, suggesting they moved together only a little over 10 percent of the time.5 The relatively low correlation between the movement of stock markets in different countries reflects two basic factors. First, countries pursue different macroeconomic policies and face different economic conditions, so their stock markets respond to different forces and can move in different ways. For example, in 1997, the stock markets of several Asian countries, including South Korea, Malaysia, Indonesia, and Thailand, lost over 50 percent of their value in response to the Asian financial crisis, while at the same time the S&P 500 increased in value by over 20 percent. Second, different stock markets are still somewhat segmented from each other by capital controls--that is, by restrictions on cross-border capital flows (although such restrictions are declining rapidly). The most common restrictions include limits on the amount of a firm's stock that a foreigner can own and limits on the ability of a country's citizens to invest their money outside that country. For example, until recently it was difficult for foreigners to own more than 30 percent of the equity of South Korean enterprises. Tight restrictions on capital flows make it very hard for Chinese citizens to take money out of their country and invest it in foreign assets. Such barriers to cross-border capital flows limit the ability of capital to roam the world freely in search of the highest risk-adjusted return. Consequently, at any one time, there may be too much capital invested in some markets and too little in others. This will tend to produce differences in rates of return across stock markets.6 The implication is that by diversifying a portfolio to include foreign stocks, an investor can reduce the level of risk below that incurred by holding just domestic stocks. Figure 11.3b illustrates the relationship between international diversification and risk found by a now classic study.7 According to the figure, a fully diversified portfolio that contains stocks from many countries is less than half as risky as a fully diversified portfolio that contains only US stocks. A fully diversified portfolio of international stocks is only about 12 percent as risky as a typical individual stock, whereas a fully Figure 11.3 see Risk Reduction through Portfolio Diversification Source: B. Solnik, "Why Not Diversify Internationally Rather than Domestically?" Adapted with permission from Financial Analysts Journal, July/August 1974, p. 17, Copyright 1974, Financial Analysts Federation. Charlottesville, VA. All rights reserved. diversified portfolio of US stocks is about 27 percent as risky as a typical individual stock. More recent studies have tended to confirm the relationship summarized in Figure 11.3b. A 1994 study of portfolio diversification in Europe found that a diversified portfolio of stocks held within a single country was on average about 38 percent as risky as a typical individual stock, whereas a portfolio of stocks that was diversified across 12 European countries was only 18 percent as risky as a typical individual stock.8 Such data suggest a strong case for investing internationally as a means of diversifying risk. The risk-reducing effects of international portfolio diversification would be greater were it not for the volatile exchange rates associated with the current floating exchange rate regime. Floating exchange rates introduce an additional element of risk into investing in foreign assets. As we have said repeatedly, adverse exchange rate movements can transform otherwise profitable investments into unprofitable investments. The uncertainty engendered by volatile exchange rates may be acting as a brake on the otherwise rapid growth of the international capital market. Figure 11.4 Net International Bank Lending ($ billions)
Source: Bank for International Settlements database. |
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