business global question
Relative Merits of Fixed vs Floating Exchange Rates
Arguments for fixed exchange rates
Prevents governments from expanding money supply at inflationary levels.
Reduces currency volatility and speculation.
Arguments for floating exchange rates
Gives governments monetary autonomy.
Provides an automatic adjustment mechanism for trade imbalances.
Conclusion (solution not clear)
A fixed rate system ala Bretton Woods will not work.
Maybe a better system can be developed in the future to support trade and investment.
Chapter 12
The Global Capital Market
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Learning Objectives
LO 12-1 Describe the benefits of the global capital market.
LO 12-2 Identify why the global capital market has grown so rapidly.
LO 12-3 Understand the risks associated with the globalization of capital markets.
LO 12-4 Compare and contrast the benefits and risks associated with the Eurocurrency market, the global bond market, and the global equity market.
LO 12-5 Understand how foreign exchange risks affect the cost of capital.
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Benefits of the Global Capital Market 1 of 6
Functions of a Generic Capital Market
Market makers - the financial service companies that connect investors and borrowers, either directly or indirectly
Commercial banks
Investment banks
Investors
Market Makers
Borrowers
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Figure 12.1 The main players in the generic capital market
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Benefits of the Global Capital Market 2 of 6
Functions of a Generic Capital Market continued
Capital market loans
Equity loans - made when a corporation sells stock to investors
Debt loans - requires corporation to repay a predetermined portion of the loan amount at regular intervals regardless of how much profit it is making
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Benefits of the Global Capital Market 3 of 6
Attractions of the Global Capital Market
The borrower’s perspective: lower cost of capital
Domestic capital market – higher cost of capital
Global capital market – lower cost of capital
Lowers the Cost of Capital…Why?
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Figure 12.2 Market liquidity and the cost of capital.
1. Increased supply lowers the cost
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Benefits of the Global Capital Market 4 of 6
Attractions of the Global Capital Market continued
The investor’s perspective: portfolio diversification
More investment opportunities
Investors can diversify their portfolios internationally, reducing risk
Systematic risk
Impacted by volatile exchange rates associated with the current floating exchange rate regime
2. Diversification lowers risk for investors….HOWEVER
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Benefits of the Global Capital Market 5 of 6
Growth of the Global Capital Market
Information technology
Instantaneous communication
Allows market makers to absorb and process large volumes of information from around the world
24-hour a day trading
“Shocks” spread quickly
Deregulation
Response to the Eurocurrency market
Increasing acceptance of the free market ideology
Hedge funds
Major Growth…Driven by IT & Deregulation
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Hedge funds are private investment funds that position themselves to make “long bets” on assets that they think will increase in value and “short bets” on assets that they think will decline in value.
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Benefits of the Global Capital Market 6 of 6
Global Capital Market Risks
Individual nations may be more vulnerable to speculative capital flows
Could destabilize national economies
Martin Feldstein: “Hot money” vs. “patient money”
Lack of information about the quality of foreign investments may encourage speculative flows
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The Eurocurrency Market 1 of 4
Eurocurrency
Eurodollars account for two-thirds of all Eurocurrencies
Can be created anywhere in the world
Important and relatively low-cost source of funds for international businesses
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Eurocurrency Any currency banked outside its country of origin
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The Eurocurrency Market 2 of 4
Genesis and Growth of the Market
Eastern European holders of dollars did not want to deposit their money in the U.S.
Instead deposited them in London banks
British government prohibited British banks from lending British pounds to finance non-British trade
U.S. government enacted regulations that discouraged U.S. banks from lending to non-U.S. residents
Oil price increases engineered by OPEC created huge amounts of dollars that were deposited in banks in London
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The Eurocurrency Market 3 of 4
Attractions of the Eurocurrency Market
Lack of government regulation
Allows banks to offer higher interest rates on Eurocurrency deposits than on deposits made in the home currency, and charge borrowers a lower interest rate
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Figure 12.3 Interest rate spreads in domestic and Eurocurrency markets
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The Eurocurrency Market 4 of 4
Drawbacks of the Eurocurrency Market
In a regulated system, the chance of bank failure is lower.
Borrowing funds internationally can expose a company to foreign exchange risk.
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The Global Bond Market 1 of 2
Bonds are an important means of financing.
Most common is fixed-rate bond – receives a fixed set of cash payoffs
International bonds
Foreign bonds
Eurobonds
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Foreign bonds Sold outside the borrower’s country and are denominated in the currency of the country in which they are issued.
Eurobonds Bonds placed in countries other than the one in whose currency the bonds are denominated.
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The Global Bond Market 2 of 2
Attractions of the Eurobond Market
An absence of regulatory interference.
Less stringent disclosure requirements than in most domestic bond markets
A favorable tax status.
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The Global Equity Market 1 of 2
National Equity Markets
Difficult to take capital out of a country and invest it elsewhere
Corporations frequently lacked the ability to list their shares on stock markets outside their home nations
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The Global Equity Market 2 of 2
Global Equity Market
Enabled firms to attract capital from international investors, to list their stock on multiple exchanges, and to raise funds by issuing equity or debt around the world.
Internationalization of corporate ownership
Companies with historic roots in one nation are broadening their stock ownership by listing their stock in the equity markets of other nations.
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Foreign Exchange Risk and the Cost of Capital
Floating Exchange Rate Regime
Adverse movements in foreign exchange rates can substantially increase the cost of foreign currency loans.
Unpredictable movements in exchange rates can inject risk into foreign currency borrowing
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Focus on Managerial Implications
Growth of the Global Capital Market
Has created opportunities for international businesses that wish to borrow and/or invest money.
Firms can often borrow funds at a lower cost than is possible in a purely domestic capital market.
The global market is not regulated.
Foreign exchange risk is greater.
Firms, institutions, and individuals can diversify their investments to limit risk.
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Team Discussion Question (q2) The Great Recession and Globalization of Capital Markets
“In 2008-2009, the world economy retrenched in the wake of a global financial crisis. (The Great Recession) 1. Did the globalization of capital markets contribute to this crisis?
2. If so, what can be done to stop global financial contagion in the future?... NO Easy answers…check out what the G20 is up to.
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