Lesson 2: Global Financial Markets & Institutions PDF

Lesson 2: Global Financial Markets and Institutions Overview During its international business activities, an MNC may need financing from an internationally active bank, use economic information provided by an international organization, operate within a regulatory framework s...

Lesson 2: Global Financial Markets and Institutions Overview During its international business activities, an MNC may need financing from an internationally active bank, use economic information provided by an international organization, operate within a regulatory framework set by local governments or international institutions, and deal with investor relations in several countries. We briefly survey these other important players in international finance. A variety of agencies have been established to facilitate international trade and financial transactions. These agencies often represent a group of nations. Module Objectives: Recognize the role of banks in global finance and their contribution to financial risk management, credit risk, and global financial stability. Describe how financial markets function as well as the proper development of their structure. Critically analyze the role of global financial markets and institutions in globalization. Course Materials: International Banks Major banks operate internationally to service their MNC clients. The globalization of business is well expressed in the banking sector. For example, Citibank, part of the Citigroup financial services company, operates in virtually every country in the world, and it has a long tradition of foreign activity, having established offices in Europe and Asia in 1902. Cross-border mergers have also created a few top global asset management firms. In 2009, U.S.-based Blackrock became the world’s largest asset manager with over $3 trillion under management by buying Barclays Global Investors (BGI) from Barclays, a major British bank. BGI was created in 1995 when Barclays bought Wells Fargo Nikko Advisors, which combined the asset management activities of Wells Fargo, a California bank, and Nikko Securities, a leading Japanese broker. The emergence of more consolidated financial institutions at the global level is a recent phenomenon. One reason is that banks were often protected from foreign takeovers, either through explicit regulation or through political maneuvering, because they are important and strategic components of the economy. It was the Uruguay Round that paved the way for the deregulation of the financial services sector. International Institutions International Monetary Fund  The United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire, in July 1944 was called to develop a structured international monetary system. As a result of this conference, the International Monetary Fund (IMF) was formed. The major objectives of the IMF, as set by its charter, are to (1) promote cooperation among countries on international monetary issues, (2) promote stability in exchange rates, (3) provide temporary funds to member countries attempting to correct imbalances of international payments, (4) promote free mobility of capital funds across countries, and (5) promote free trade. It is clear from these objectives that the IMF’s goals encourage the increased internationalization of business. The IMF has played a major role in resolving international financial crises, including the Asian crisis in the late 1990s, the U.S. financial crisis of 2008–2010, and the European financial crisis of 2011–2012. In recent years it has provided considerable funding to countries such as Greece and Portugal, which have experienced large government deficits, because they are unable to obtain low-cost funding from other sources. In providing funds to these countries the IMF seeks to stabilize their economies so that their respective governments can ultimately repay the loans received from banks (and other creditors) based in various countries. In this way, the IMF aims to prevent the financial problems in these countries from spreading to other countries. The IMF is overseen by a board of governors that is composed of finance officers (such as the head of the central bank) from each of the 188 member countries; it also has an executive board consisting of 24 executive directors. This executive board is based in Washington, DC, and meets at least three times a week to discuss ongoing issues. The IMF uses a surveillance system that closely monitors national, regional, and global financial conditions. It attempts to anticipate financial problems in member countries and offers advice to these countries on how they can reduce their exposure to potential crises. The IMF also provides technical assistance to countries to help them implement effective tax policies, exchange rate policies, banking systems, and legal systems. Each member country of the IMF is assigned a quota that is based on a variety of factors reflecting its economic status. Members are required to pay this assigned quota. The amount of funds that each member can borrow from the IMF depends on their quota. The financing by the IMF is measured in special drawing rights (SDRs), which are a unit of account allocated to member countries to supplement currency reserves. The SDRs’ value fluctuates in accordance with the value of major currencies. One of the key duties of the IMF is its compensatory financing facility (CFF), which aims to reduce the impact of export instability on the economies of member countries. Although this facility is available to all IMF members, it is used mainly by developing countries. A country experiencing financial problems resulting from reduced export earnings must demonstrate that the reduction is temporary and beyond its control. In addition, it must be willing to work with the IMF in resolving the problem. Funding Dilemma of the IMF The IMF typically specifies economic reforms that a country must satisfy to receive IMF funding, which is meant to ensure that the country uses the funds properly. However, some countries want funding without adhering to the economic reforms required by the IMF. For example, the IMF may require that a government reduce its budget deficit as a condition for receiving funding. Some governments have failed to implement these required reforms. For example, Greece received substantial funding from the IMF and was expected to reduce its massive government spending to reduce its budget deficit. But its government continued its spending and its large budget deficit, and in July 2015, it stopped making interest payments on the funds borrowed from the IMF. World Bank The International Bank for Reconstruction and Development (IBRD), also referred to as the World Bank, was established in 1944. Its primary objective is to make loans to countries to reduce poverty and enhance economic development. The World Bank has been successful at reducing extreme poverty levels, increasing education, preventing the spread of deadly diseases, and improving environmental conditions. Its main source of funds is the sale of bonds and other debt instruments to private investors and governments. The World Bank has a profit-oriented philosophy. Therefore, its loans are not subsidized but instead are extended at market rates to governments (and their agencies) that are deemed likely to repay them. A key aspect of the World Bank’s mission is the Structural Adjustment Loan (SAL), established in 1980. SALs are intended to enhance a country’s long-term economic growth. Because the World Bank provides only a small portion of the financing needed by developing countries, it attempts to spread its funds by entering co-financing agreements. Cofinancing is performed in the following ways. Official aid agencies. Development agencies may join the World Bank in financing development projects in low-income countries. Export credit agencies. The World Bank co-finances some capital-intensive projects that are also financed through export credit agencies. Commercial banks. The World Bank has joined with commercial banks to provide financing for private-sector development. The World Bank recently established the Multilateral Investment Guarantee Agency (MIGA), which offers various forms of political risk insurance. This is an additional means (along with its SALs) by which the World Bank can encourage the development of international trade and investment.  The World Bank is one of the largest borrowers in the world. Its loans are well diversified among numerous currencies and countries, and it has received the highest credit rating (AAA) possible. Multilateral Development Banks (MDBs) These institutions provide financial support and professional advice for economic and social development activities in developing countries. The term typically refers to the World Bank Group and four regional development banks: the African Development Bank, the Asian Development Bank, the European Bank for Reconstruction and Development, and the InterAmerican Development Bank. These banks have a broad membership that includes both developing countries (borrowers) and developed countries (donors), and their membership is not limited to countries from the region of the regional development bank. While each bank has its own independent legal and operational status, their similar mandates and a considerable number of joint owners lead to a high level of cooperation among MDBs. The MDBs provide financing for development in three ways. First, they provide long-term loans at market interest rates. To fund these loans, the MDBs borrow on the international capital markets and re-lent to borrowing governments in developing countries. Second, the MDBs offer long-term loans (often termed credits) with interest rates set well below market rates. These credits are funded through direct contributions of governments in donor countries. Finally, grants are sometimes offered mostly for technical assistance, advisory services, or project preparation. World Trade Organization The World Trade Organization (WTO) was created because of the Uruguay round of trade negotiations that led to the GATT accord in 1993. This organization was established to provide a forum for multilateral trade negotiations and to settle trade disputes related to the GATT. The WTO began operations in 1995 with 81 member countries, and more countries have joined since then. Member countries are given voting rights that are used to render verdicts on trade disputes and other issues. World trade agreements have been signed among countries, and these agreements provide the legal foundation for facilitating international trade. Such agreements articulate how international trade must be executed so as not to violate specific social and environmental standards. Although the agreements thus contain rules, they help to promote international trade because the rules are communicated to exporters and importers alike. In other words, MNCs are more willing to pursue international trade when the rules are more transparent. International Finance Corporation In 1956 the International Finance Corporation (IFC) was established to promote private enterprise within countries. Composed of several member nations, the IFC works to promote economic development through the private rather than the government sector. It not only provides loans to corporations but also purchases stock, thereby becoming part owner in some cases in addition to a creditor. The IFC typically provides 10 to 15 percent of the necessary funds to the private enterprise projects in which it invests, and the rest of the project must be financed through other sources. Thus, the IFC serves as a catalyst, rather than a primary supporter, for privateenterprise development projects. It traditionally has obtained financing from the World Bank but can also borrow in the international financial markets. International Development Association The International Development Association (IDA) was created in 1960 with country development objectives like those of the World Bank. However, its loan policy is more appropriate for less prosperous nations. The IDA extends loans at low interest rates to poor nations that cannot qualify for loans from the World Bank. Bank of International Settlements The Bank for International Settlements (BIS) attempts to facilitate cooperation among countries regarding international transactions. It serves central banks of countries in their pursuit of financial stability. The BIS is sometimes referred to as the “central banks’ central bank” or the “lender of last resort.” It played an important role in supporting some of the less developed countries during international debt crises. It commonly provides financing for central banks in Latin American and Eastern European countries. OECD The Organization for Economic Co-operation and Development (OECD) facilitates governance in governments and corporations of countries with market economics. It has 34 member countries as well as relationships with numerous other countries. The OECD promotes international country relationships that lead to globalization. Regional Development Agencies There are several other agencies whose objectives relating to economic development are more regional than global. These include, for example, the Inter-American Development Bank (focusing on the needs of Latin America), the Asian Development Bank (established to enhance social and economic development in Asia), and the African Development Bank (focusing on development in African countries). In 1990, the European Bank for Reconstruction and Development was created to help Eastern European countries adjust from communism to capitalism. International Bond Market The international bond market facilitates the flow of funds between borrowers who need long-term funds and investors who are willing to supply long-term funds. Major investors in the international bond market include institutional investors such as commercial banks, mutual funds, insurance companies, and pension funds from many countries. Institutional investors may prefer to invest in international bond markets, rather than in their respective local markets, when they can earn a higher return on bonds denominated in foreign currencies. Borrowers in the international bond market include both national governments and MNCs. Multinational corporations can obtain long-term debt by issuing bonds in their local markets, and they can also access long-term funds in foreign markets. They may choose to issue bonds in the international bond markets for three reasons. First, MNCs may be able to attract a stronger demand by issuing their bonds in a particular foreign country rather than in their home country. Some countries have a limited investor base, so MNCs in those countries naturally seek financing elsewhere. Second, MNCs may prefer to finance a specific foreign project in a particular currency and thus may seek funds where that currency is widely used. Third, an MNC might attempt to finance projects in a foreign currency with a lower interest rate to reduce its cost of financing, although doing so would increase its exposure to exchange rate risk. An international bond issued by a borrower foreign to the country where the bond is placed is known as a foreign bond. For example, a U.S. corporation may issue a bond denominated in Japanese yen that is sold to investors in Japan. In some cases, a firm may issue a variety of bonds in various countries. The currency denominating each type of bond is determined by the country where it is sold. The foreign bonds in these cases are sometimes referred to as parallel bonds. Eurobond Market Eurobonds are bonds that are sold in countries other than the country whose currency is used to denominate the bonds. They have become popular as a means of attracting funds because they circumvent registration requirements and avoid some disclosure requirements. Thus, these bonds can be issued quickly and at a low cost. Eurobonds are underwritten by a multinational syndicate of investment banks and are simultaneously placed in many countries, providing a wide spectrum of fund sources to tap. U.S.-based MNCs such as McDonald’s and Walt Disney commonly issue Eurobonds, and non-U.S. firms (e.g., Guinness, Nestlé, Volkswagen) also use the Eurobond market as a source of funds. Those MNCs without a strong credit record may have difficulty obtaining funds in the Eurobond market because the limited disclosure requirements may discourage investors from trusting unknown issuers. In recent years, governments, and corporations from emerging markets such as Croatia, Hungary, Romania, and Ukraine have frequently utilized the Eurobond market. New corporations that have been established in emerging markets rely on this market to finance their growth. However, they typically pay a risk premium of at least 3 percentage points annually above the U.S. Treasury bond rate on dollar-denominated Eurobonds. Features of Eurobonds  Eurobonds have several distinctive features. They are usually issued in bearer form, which means that no records are kept regarding ownership. Coupon payments are made yearly. Some Eurobonds carry a convertibility clause that allows them to be converted into a specified number of shares of common stock. An advantage to the issuer is that Eurobonds typically have few, if any, protective covenants. Furthermore, even short-maturity Eurobonds include call provisions. Some Eurobonds, called floating rate notes (FRNs), have a variable rate provision that adjusts the coupon rate over time according to prevailing market rates. Denominations Eurobonds are denominated in several currencies. The U.S. dollar is used most often, accounting for 70 to 75 percent of Eurobonds., However, in 2015, some U.S.-based MNCs including Coca-Cola, BlackRock, AT&T, and Kinder Morgan, issued Eurobonds denominated in euros to take advantage of the low interest rates in the eurozone. Similarly, some firms have issued debt denominated in Japanese yen to take advantage of Japan’s extremely low interest rates. Because credit conditions and the interest rates for each currency change constantly, the popularity of currencies in the Eurobond market changes over time. Secondary Market Eurobonds have a secondary market. The market makers are in many cases the same underwriters who sell the primary issues. Euroclear, a Belgium based financial services company, operates a settlement system that helps to inform all traders about outstanding issues for sale, thus allowing a more active secondary market. Development of Other Bond Markets Bond markets have developed in Asia and South America. Government agencies and MNCs in these regions use international bond markets to issue bonds when they believe they can reduce their financing costs. Investors in some countries use international bond markets because they expect their local currency to weaken in the future and prefer to invest in bonds denominated in a strong foreign currency. The South American bond market has experienced limited growth because the interest rates in some countries there are usually high. MNCs and government agencies in those countries are unwilling to issue bonds when interest rates are so high, so they rely heavily on short-term financing. Risk of International Bonds Interest Rate Risk. The interest rate risk of international bonds has the potential for their value to decline in response to rising long-term interest rates. When long-term interest rates rise, the required rate of return by investors rises. Therefore, the valuations of bonds decline. Interest rate risk is more pronounced for fixed rate than for floating rate  bonds because the coupon rate remains fixed on fixed-rate bonds even when interest rates rise. Exchange Rate Risk. Exchange rate risk is the potential for a bond’s value to decline (from the investor’s perspective) because the currency denominating the bond depreciates against the investor’s home currency. As a result, the future expected coupon, or principal payments to be received from the bond may convert to a smaller amount of the investor’s home currency. Liquidity Risk. Liquidity risk of bonds represents the potential for their prices to be lower at the time they are sold by investors because no consistently active market exists for them. Thus, investors who wish to sell the bonds may have to lower their price to attract potential buyers. Credit Risk. The credit risk of international bonds is the potential for default: interest and/or principal payments to investors to be suspended either temporarily or permanently. This risk is especially relevant in countries where creditor rights are limited because creditors may be unable to require that debtor firms take the actions necessary to enable debt repayment. As the credit risk of the issuing firm increases, the risk premium required by investors also increases. Any investors who want to sell their holdings of the bonds under these conditions must sell the bonds for a lower price to compensate potential buyers for the credit risk. Impact of Greek Crisis In spring of 2010, Greece experienced weak economic conditions and a large increase in the government budget deficit. Investors were concerned that the government of Greece would not be able to repay its debt. Furthermore, investors learned that the government’s reported budget deficits in the previous eight years were understated. A debt crisis erupted in Greece, as its government was desperate for new financing. As of March 2010, bonds issued by the government of Greece offered a 6.5 percent yield, which reflected a 4 percent annualized premium above bonds issued by other European governments (such as Germany) that also used the euro as their currency. This implies that the borrowing of the equivalent of $10 billion dollars from a bond offering would require that Greece pay an additional $400 million in interest payments every year because of its higher degree of default risk. These high interest payments caused even more concern that Greece would not be able to repay its debt. In 2010, governments and banks in the other eurozone countries provided Greece with a bailout loan of 110 billion euros and required that Greece meet so-called austerity conditions (such as reducing its public-sector salaries and pensions) that could reduce the future budget deficit. However, Greece’s budget deficit increased, and it needed another bailout of about 130 billion euros from several European governments in 2012. Over the next few years, Greece’s budget deficit continued to grow and by 2015, the government had debt of more than 300 billion euros. It needed another bailout, its third in five years. In July 2015, several European governments agreed to provide a third bailout loan of about 85 billion euros to Greece. Contagion Effects Because European governments served as major creditors for Greece, they were subject to credit contagion. A default by Greece on its debt could have had devastating financial effects on the European governments that provided loans, which could have prevented some of them from repaying their own debt. The contagion concerns created by the Greece debt crisis also affected MNCs. If Greece defaulted on its debt, its government might be unable to pay some MNCs that sell products or services to Greece. In addition, the austerity measures that were imposed on Greece were intended to result in lower government pension payments to retirees, which could result in a lower demand for products or services provided by some MNCs to retirees. The Greece crisis also forced creditors to recognize that government debt is not always risk free. Hence creditors began to assess more carefully the credit risk of other countries that had large budget deficits, such as Portugal, Spain, and Italy. Such concerns about risk reduced the access by governments of these other European countries to the debt market, as some financial institutions were no longer willing to loan them funds. In addition, those governments had to pay a higher risk premium to compensate for their credit risk, which increased their cost of borrowing funds. International Stock Markets Just as some MNCs issue stock outside their home country, many investors purchase stocks outside their home country. There are several reasons for such a strategy. First, these investors may expect favorable economic conditions in a particular country and therefore invest in stocks of the firms in that country. Second, investors may wish to acquire stocks denominated in currencies that they expect to strengthen over time, because that would enhance the return on their investment. Third, some investors invest in stocks of other countries as a means of diversifying their portfolio. Thus, their investment is less sensitive to possible adverse stock market conditions in their home country. Issuance of Stock in Foreign Markets MNCs may issue stock in foreign markets for various reasons. MNCs may more readily attract funds from foreign investors by issuing stock in international markets. They have their stock listed on an exchange in any country where they issue shares, because investors in a foreign country are only willing to purchase stock if they can later easily sell their holdings locally on the secondary market. The stock is denominated in the currency of the country where it is placed. An MNC’s stock offering may be more easily digested when it is issued in several markets. The stocks of some U.S.-based MNCs are widely traded on numerous stock exchanges around the world, which gives non-U.S. investors easy access to those stocks and gives the MNCs global name recognition. Many MNCs issue stock in a country where they will generate enough future cash flows to cover dividend payments. Example: Dow Chemical Co., a large U.S.-b Example: Dow Chemical Co., a large U.S.-based MNC, does much business in Japan. It has supported its operations in Japan by issuing stock to investors there, which is denominated in Japanese yen. Thus, Dow can use the yen proceeds to finance its expansion in Japan and does not need to convert dollars to yen. To ensure that Japanese investors can easily sell the stock that they purchase, Dow Chemical Co. lists its stock on the Tokyo exchange. Because the stock listed on the Tokyo exchange is denominated in Japanese yen, Japanese investors who are buying or selling this stock need not convert to or from dollars. If Dow plans to expand its business in Japan, it may consider a secondary offering of stock in Japan. Because its stock is already listed there, it may be easy for Dow to place additional shares in that market and hereby raise equity funding for its expansion. Non-U.S. corporations that need large amounts of funds sometimes issue stock in the United States (these are called Yankee stock offerings) because the U.S. new-issues market is so liquid. Because many financial institutions in the United States purchase non-U.S. stocks as investments, non-U.S. firms may be able to place an entire stock offering in the United States. By issuing stock in the United States, non-U.S. firms may diversify their shareholder base; this can lessen the share price volatility induced by large investors selling shares. Investment banks and other financial institutions in the United States often serve as underwriters of stock targeted for the U.S. market, and they receive underwriting fees of about 7 percent of the issued stock’s value. Many of the recent stock offerings in the United States by non-U.S. firms have resulted from privatization programs in Latin America and Europe. That is, businesses that were previously government owned are being sold to U.S. shareholders. Given the large size of some of these businesses, their local stock markets are not large enough to digest the stock offerings. Consequently, U.S. investors are financing many privatized businesses based in foreign countries. Non-U.S. firms that issue stock in the United States have their shares listed on a U.S. stock exchange, so that the shares placed in the United States can be easily traded in the secondary market. Firms that issue stock in the United States are normally required to satisfy stringent disclosure rules regarding their financial condition. However, they are exempt from some of these rules when they qualify for a Securities and Exchange Commission guideline (called Rule 144a) through a direct placement of stock to institutional investors. Effect of Sarbanes-Oxley Act on Foreign Stock Listings In 2002 the U.S. Congress passed the Sarbanes-Oxley Act, which required firms whose stock is listed on U.S. stock exchanges to provide more complete financial disclosure. However, the high cost of compliance caused many non-U.S. firms to place new issues of their stock in the United Kingdom, rather than the United States. Furthermore, some non-U.S. firms listed on U.S. stock exchanges before the Sarbanes-Oxley Act de-registered after its passage; such withdrawals may be attributed to the high cost of compliance. American Depository Receipts Non-U.S. firms also obtain equity financing by issuing American depository receipts (ADRs), which are certificates representing bundles of the firm’s stock. The use of ADRs circumvents some disclosure requirements imposed on stock offerings in the United States while enabling non-U.S. firms to tap the U.S. market for funds. Examples include Cemex (ticker symbol CX, based in Mexico), China Telecom Corp. (CHA, China), Nokia (NOK, Finland), Heineken (HINKF, Netherlands), Alibaba (BABA, China), and Credit Suisse Group (CS, Switzerland). Because ADR shares can be traded just like shares of a stock, the price of an ADR changes each day in response to demand and supply conditions. Over time, however, the value of an ADR should move in tandem with the value of the corresponding stock that is listed on the foreign stock exchange (after exchange rate effects are considered). The formula for calculating the price of an ADR is PADR = PFS x S. Here PADR denotes the price of the ADR, PFS is the price of the foreign stock measured in foreign currency, and S is the spot rate of the foreign currency. Holding the price of the foreign stock constant, the ADR price should move proportionately (against the dollar) with movement in the currency denominating the foreign stock. American depository receipts are especially attractive to U.S. investors who anticipate that the foreign stock will perform well and that the currency in which it is denominated will appreciate against the dollar. Example: A share of the ADR of the French firm Pari represents one share of this firm’s stock that is traded on a French stock exchange. The share price of Pari was 20 euros when the French market closed. As the U.S. stock market opens, the euro is worth $1.05, so the ADR price can be calculated as PADR = PFS x S = 20 x $1.05 = $21 If there is a difference between the ADR price and the price of the foreign stock (after adjusting for the exchange rate), then investors can use arbitrage to capitalize on this discrepancy. Over time, arbitrage will realign the prices. Example: Continuing with the previous example, assume that there are no transaction costs. If PADR < (PFS x S), then ADR shares will flow back to France; they will be converted to shares of the French stock and then traded in the French market. Investors can engage in arbitrage by buying the ADR shares in the United States, converting them to shares of the French stock, and then selling those shares on the French stock exchange where the stock is listed. The arbitrage will (1) reduce the supply of ADRs traded in the U.S. market, putting upward pressure on the ADR price, and (2) increase the supply of the French shares traded in the French market, putting downward pressure on the stock price in France. The arbitrage will continue until the discrepancy in prices disappears. There are some transaction costs associated with converting ADRs to foreign shares. This means that arbitrage will occur only if the potential arbitrage profit exceeds the transaction costs. ADR price quotations are provided by various websites, such as www.adr.com. Comparing the Size among Stock Markets Exhibit 2.1 provides a summary of the major stock markets, although there are numerous other exchanges. Some foreign stock markets are much smaller than the U.S. markets because their firms have traditionally relied more on debt financing than on equity financing. However, recent trends indicate that firms outside the United States now issue stock more frequently, which has led to the growth of non-U.S. stock markets. The percentage of individual versus institutional ownership of shares varies across stock markets. Outside the United States, financial institutions (and other firms) own a large proportion of the shares, whereas individual investors own a relatively small proportion. In 2000, the stock exchanges of Amsterdam, Brussels, and Paris merged to create the Euronext market; since then, the Lisbon stock exchange has also joined. In 2007, the NYSE joined Euronext to create NYSE Euronext, which represented a major step toward creating a global stock exchange. In 2012, Intercontinental Exchange (ICE) acquired NYSE Euronext. Both the NYSE and Euronext now operate as divisions of ICE. Most of the largest firms based in Europe have listed their stock on the Euronext market. In recent years, many new stock markets have been developed. Such emerging markets allow foreign firms to raise large amounts of capital by issuing stock. These markets should enable U.S. firms doing business in developing countries to raise funds by issuing stock there and listing their stock on the local stock exchanges. How Governance Varies among Stock Markets In general, stock market participation and trading activity are higher in countries where there is strong governance. Exhibit 2.2 identifies some factors that enable stronger governance and thus may increase the trading activity in a stock market.  Rights. Shareholders in some countries have more rights than those in other countries. For example, shareholders have more voting power in some countries than others, and they can have influence on a wider variety of management issues in some countries. Legal Protection. Shareholders in some countries may have more power to sue publicly traded firms if their executives or directors commit financial fraud. In general, commonlaw countries such as Canada, the United Kingdom, and the United States allow for more legal protection than civil-law countries such as France and Italy. Managers are more likely to serve shareholder interests when shareholders have more legal protection. Government Enforcement. A country might have laws to protect shareholders yet not adequately enforce those laws, which means that shareholders are not protected. Some countries tend to have less corporate corruption than others. In these countries, shareholders are less susceptible to major losses due to agency problems whereby managers use shareholder money for their own benefit. Accounting Laws. Beginning in 2001, the International Accounting Standards Board issued accounting rules for public companies. Many countries now require public companies to use these rules in preparing their financial statements. As a result, there is more uniformity in accounting rules across countries, but there are still some differences that might make it difficult to directly compare financial statements of MNCs across countries. Shareholders are less susceptible to losses stemming from insufficient information when more transparency is required of public companies in their financial reporting. Impact of Governance Characteristics. In general, stock markets that allow more voting rights for shareholders, more legal protection, more enforcement of the laws, and more stringent accounting requirements attract more investors who are willing to invest in stocks. This allows for more confidence in the stock market and greater pricing efficiency, because there is a large set of investors who monitor each firm. A stock market that does not attract investors will not attract companies in search of funds; in this case, companies must rely either on stock markets in other countries or on credit markets (bonds and bank loans). Integration of International Stock Markets and Credit Markets Because the economies of countries are integrated and because stock market prices reflect the host country’s prevailing and anticipated economic conditions, stock market prices are integrated across countries. Furthermore, international credit and stock markets are integrated because they are both adversely affected when conditions cause the perceived credit risk of companies to increase. When economic conditions become unfavorable, there is more uncertainty surrounding the future cash flows of firms; hence the risk premium required by investors rises and valuations of debt securities and stocks fall. Currency Swaps A fixed-to-fixed cross-currency swap is an agreement between two parties to exchange (swap), via the intermediation of a bank, the principal and interest payments associated with a coupon bond denominated in one currency for the principal and interest payments of a similar coupon bond denominated in another currency. Specifically, a currency swap involves three sets of cash flows: (1) the initial exchange of principals at the inception of the swap, (2) a stream of interest payments made by each counterparty to the other during the life of the swap, and (3) the final re-exchange of principals at maturity of the swap. Both the initial and final (re)exchange of principals is made at the initial spot exchange rate that prevails when the currency swap is first contracted. Currency swap contracts typically include the right of offset whereby each counterparty to the swap is entitled to offset any nonpayment of interest or principal by withholding a comparable payment.  The currency swap effectively allows a company to transform an exposure in one currency into an exposure in a second currency. When combined with a debt issue, a currency swap allows a corporate borrower to convert the currency in which it initially raised funds into the currency in which the funds are ultimately needed while achieving a lower all-in cost of capital than it would have by tapping the market directly (otherwise there would be no reason to follow this roundabout strategy). Viewed somewhat differently, a currency swap is similar in nature to a series of sales/purchases of forward contracts, and it has far-ranging implications for hedging long-dated forex exposure. Cash Flow Analysis of a Currency Swap Consider the case of U.S.-based Duke Power (DUK) and France-based Electricité de France (EDF), which both need 5-year financing in the amount of €100 million (or equivalent). Duke Power is AAA-rated in U.S. capital markets but a novice in international financial markets. DUK can issue 5-year dollar-denominated straight debt at the effective rate of 5.25 percent annual coupon payments and bullet repayment at maturity. Its investment banker, however, suggests that a primary issue in euros (€) at the effective rate of 4.50 percent immediately swapped into U.S. dollars would lower its effective cost of debt to 5.10 percent. The counterparty in this operation – AAA-rated Electricité de France (EDF) – is omnipresent in the €-debt market but relatively absent from the $-bond market: It would also lower its cost of debt from 4.70 percent to 4.50 percent if it agreed to raise dollars first at the effective rate of 5.10 percent to be immediately swapped into euros. Exhibit 2.3 recapitulates DUK and EDF’s cost of debt in the respective dollar and euro bond markets before entering a currency swap. Each borrower has a cost advantage in the currency denomination in which it does not wish to borrow – DUK has a 20-basis-point advantage in the €-debt market and EDF a 15-basis-point advantage in the $-debt market. The currency swap will allow each party to transfer its cost advantage to the counterparty, thereby lowering its own cost of debt in the desired currency (dollar for DUK and euro for EDF). Here is how it would work. Initial Exchange at Inception of the Swap. DUK floats a €100 million bond issue and – assuming that the spot exchange rate is S$,€(0) = 1.25 – EDF issues a $125 million debenture. Both parties immediately swap the bond proceeds and assume their counterparty’s debt servicing obligations – DUK winds up with a 5-year dollar-denominated bond liability and EDF with a eurodenominated 5-year debenture.  Stream of Annual Interest Payments. DUK services the dollar debt – initially raised by EDF – by paying a coupon of $125 million × 0.051 = $6.375 million. Similarly, EDF pays an annual coupon of €100 million × 0.045 = €4.5 million on the euro debt initially raised by DUK. The contractual exchange rates at which interest payments are exchanged is S$,€(t) = 6.375/4.50 = 1.41 with t = 1, 2, 3, 4 and 5. Exhibits 2.4A, B, and C portray graphically the exchange of cash flows at inception, during, and at maturity of the swap. Re-exchange of Principals at Maturity of Swap. Five years later – when both bonds are to be fully repaid – DUK delivers €100 million to EDF and receives $125 million from EDF. Bonds principals are de facto exchanged at the initial exchange rate of S$,€(5) = 1.25.  In sum, the currency swap enabled DUK to borrow indirectly $125 million at a lesser annual cost of 5.10 percent than if it had borrowed directly at 5.25 percent. Similarly, EDF borrowed indirectly the euros it needed at a lesser cost of 4.50 percent than if it had borrowed directly at 4.70 percent. In effect: For DUK: € debt + currency swap “pay $-interest/receive €-interest” = $ synthetic debt For EDF: $ debt + currency swap “pay €-interest/receive $-interest” = € synthetic debt Typically, a currency swap such as the one described between DUK and EDF involves a major commercial or investment bank, which brokers, structures, and guarantees the deal, presumably eliminating counterparty risk and for which it would be compensated by a small spread. Q. Referring to the above DUK/EDF currency swap, explain how a 5-basispoint transaction fee would impact the post-swap cost of debt for both counterparties assuming that it would be shared equally. A. DUK would pay a slightly higher dollar annual interest of 5.125 percent and EDF would similarly incur a slightly annual euro cost of 4.525 percent. One may wonder why the two issuers – both of which enjoy AAA ratings in their respective financial markets – face more favorable conditions in a foreign market where they are relatively unknown. If each borrower has saturated its home market through large-scale debentures, then by courting foreign investors, the borrower can capitalize on the unique benefits of portfolio diversification that it can offer those foreign investors. There are other reasons behind capital market segmentation such as differences in regulation governing investment by institutional investors and asymmetry in the tax treatment of interest income and capital gains/losses. All these factors help explain arbitrage opportunities across different currency spaces. Of course, as more and more currency swaps are structured, differences in the cost of capital will be arbitraged away progressively in much the same fashion as interest rate parity aligns domestic, short-term interest rates when correction is made for the cost of covering exchange rate risk. Valuation of Currency Swaps Bond valuation techniques can be used for deriving the net present value of the respective stream of assets (receipts) and liabilities (payments). At the inception of the currency swap, its net worth should be zero – that is, the net present value of the currency i-denominated bond Bi(0) is equal to the net present value of the currency j-denominated bond Bi(0) translated at the current spot currency i price of one unit of currency j, Si,j(0): Vswap(0) = Bi (0) − Bj (0) × Si,j (0) = 0 (2a) If the net value of the swap is not zero, a compensatory payment would have to be made to the recipient of the higher net-present-value bond. As soon as random news starts affecting the bond and currency markets, the value of each of the legs of the swap will immediately adjust to a new price. Therefore, it is possible to compute the net worth, Vswap(t), as the algebraic difference between the asset and liability side using equation (2a). This is nothing other than marking to market the value of the swap: Vswap(t) = Bi (t) − Bj (t) × Si,j (t) (2b) As an illustration, we could value the DUK/EDF currency swap at the outset of year 2 (i.e., immediately after paying the year 1 coupon) if 5-year interest rates in $ and € coupon bonds of similar credit rating have moved to 5 percent and 4 percent, respectively, and that the € has appreciated to €1 = $1.30. Expression (2b) yields: Vswap (1) = B$ (1) − B€ (1) × S (1) (2c) Where:  The above calculation results in a swap depreciation from the DUK point of view from Vswap(0) = 0 to –$6,916,188. In other words, if DUK were to liquidate its currency swap it would incur a net dollar cash-flow cost of $6,916,188. Interest Rate Swaps A variant of the currency swap is the interest rate swap, in which both legs of the swap are denominated in the same currency. The most common type of interest rate swap is a fixed to floating coupon swap, whereby fixed interest rate payments are exchanged for floating interest rate payments. Floating interest rates are generally pegged to an interest rate index such as the 6-month U.S. dollar London Interbank Offered Rate (LIBOR). Because principal amounts on the two legs of the swap are denominated in the same currency, principals need not be exchanged and instead are simply notional amounts used for calculating interest payments. Thus, only the difference between the interest payments is swapped when interest payments are due. Reducing the Cost of Borrowing with Interest Rate Swaps Consider the case of GE and assume that the company has borrowed $100 million fixedrate 3-year debt at 5 percent and wants to take advantage of a lower-cost floating rate note (FRN) because it believes that interest rates will hold steady or possibly head lower. Wells Fargo had previously issued an FRN indexed to LIBOR currently paying 3.25 percent and resets every 6 months. Because of a maturity mismatch between its assets and liabilities, Wells Fargo seeks to rebalance its assets/liabilities portfolio by increasing the relative weight of fixed-rate debt in its liabilities portfolio. Instead of repaying its fixed-rate debt and reissuing floating rate debt, GE enters on July 1, 2019, into an interest rate swap with Wells Fargo. GE would now pay the floating rate on the FRN to Wells Fargo while receiving the fixed 5 percent interest payment with which it meets its pre-swap fixed-rate debt obligation. Each payment is based on a notional amount of $100 million and the swap agreement specifies that interest payments are to be exchanged every 6 months. Specifically, the first exchange of interest payment would take place on January 1, 2020 – six months after the swap was entered. GE – the floating rate payer – will pay the 6-month LIBOR which prevailed six months earlier on July 1, 2019, on the swap notional principal or 0.0325/2 × 100 million = $1,625,000. Wells Fargo, the fixed-rate payer, pays the 6-month fixed interest on the same notional principal or.05/2 × 100 million = $2,500,000. The second exchange of interest payments would be due on July 1, 2020, with GE paying the 6-month LIBOR prevailing 6-months prior on January 1, 2020, and assumed to be 3.50 percent on the same notional principal of $100 million or 0.0350/2 × $100 million = $1,750,000. Wells Fargo will pay the same fixed interest payment of $2,500,000 as it did on January 1, 2020. Over the 3-year life of the swap there will be a total of six payments. The fixed interest payments made by Wells Fargo are always $2.5 million. The floating interest payments made by GE are based on the floating benchmark LIBOR as it stood 6 months prior to the payment date and – except for the first payment on January 1, 2020 – are unknown to the parties when the parties entered the swap contract and must be forecasted for valuing the swap. Exhibit 2.5 spells out the details of each payment to be made on the remaining five payments assuming that prevailing LIBOR is known on these dates. As the “floating rate payer,” GE exposes itself to interest rate risk or repricing risk; that is, when the interest rate is reset 6 months later, LIBOR may have substantially increased – possibly above the 5 percent interest rate that GE was paying before the swap. Indeed, it turned out that LIBOR did increase from 3.25 percent to 4.50 percent over the life of the swap. For all practical purposes, once the swap is in place it is as if GE had borrowed a short-term floating rate note (in lieu of its pre-swap fixed-rate liability) and Wells Fargo had issued a fixed coupon bond (in lieu of its pre-swap FRN). Why Do Firms Enter into Interest Rate Swaps? One may wonder what the other motivations for the two parties are to enter an interest rate swap beyond reducing the cost of debt. Interest rate swaps are the instrument of choice for financial institutions in managing interest rate risks in asset/liability management as well as hedging repricing risk or more generally hedging a firm’s exposure to interest rate movements. In our earlier case, GE wanted to free itself from the rigidity of fixed interest rate loans and take advantage of lower floating interest rates. The counterparty could be any financial institution that lends at a 5-year fixed rate to an AAA-rated construction company and is financed with floating rate commercial paper. It would want to eliminate its exposure to interest rate risk (it lends at a fixed rate money that it borrowed at a floating rate) by locking in its margin (the spread between the fixed interest rate at which it lends and the fixed interest rate at which it borrows) by swapping out of its floating rate debt into a 5-year fixed-rate note. It would be a natural counterparty to GE, and Wells Fargo would just play matchmaker. International Portfolio Investment The adage “Don’t put all your eggs in one basket” is the cornerstone of investing. At its simplest, it calls for diversifying any investment pool across several asset classes rather than one. The objective is to reduce the risk of the overall stock portfolio while maintaining its return or, equivalently, to increase return for a given level of risk. Presumably this is achieved by investing in several stocks across industries whose price movements are less than perfectly correlated. Portfolio risk is reduced through skillful diversification, which means adding high-return stocks that exhibit little correlation to stocks already in the portfolio. Because stock returns tend to be far less correlated across countries than within a given country, it stands to reason that international diversification (adding foreign stocks to a domestic portfolio) will deliver far greater risk reduction than simple domestic diversification. Thus, by expanding the universe of available stocks through international diversification, it is possible to reduce the level of risk for a given level of return. In a pathbreaking study, Solnik (1974) showed that a fully diversified U.S. stock portfolio is only 27 percent as risky as one representative U.S. stock and that a portfolio of only about 20 stocks will reduce the risk of an entire portfolio to the level of non-diversifiable risk (also known as systematic risk). Exhibit 2.6 portrays the reduction in portfolio risk as additional stocks are added to the portfolio. The vertical axis is the ratio of the portfolio variance to the variance of a typical stock, whereas the horizontal axis measures the number of stocks in the portfolio. As more stocks were added to the portfolio of U.S. stocks its variance declined to 27 percent of the variance of a typical U.S. stock. However, if the portfolio variance declined quickly at first, it stabilized once the portfolio had included about 20 stocks. Thus, 73 percent of a typical stock variance can be eliminated through diversification.  But wait – diversification in U.S. stocks is only half as good as diversifying the portfolio internationally. Indeed, the same portfolio’s total risk as measured by its variance can be further reduced to only 12 percent of the riskiness of a representative U.S. stock, and this can also be achieved again with as few as 20 foreign stocks (see Exhibit 2.7). The same study shows that the benefits of international diversification are even greater for investors domiciled in non-U.S. stock markets. For example, a Swiss investor can only reduce the portfolio risk of a strictly Swiss portfolio to 44 percent of the risk of a representative Swiss stock. This result should be expected since U.S. capital markets account for approximately 40 percent of world capitalization and therefore offer the largest benefits of domestic diversification to their resident investors, who can select from the largest array of investable stocks.  Risk reduction through portfolio diversification is a function of how strongly correlated the different assets in the portfolio are. International diversification yields greater benefits than domestic diversification because foreign markets exhibit a low level of correlation with the investor’s home market.