INTERNATIONAL FINANCIAL
CAPITAL MARKETS
Objectives
By the end of this, you should be able to:
i.
Define and explain the
participants and importance of International Capital Markets
ii.
Describe how international
Investors in capital markets make decisions, specifically the Bond Market
iii.
Illustrate the Bond Issue Drill
– Bench Mark Drill
iv.
Describe the Instruments In New
York And Tokyo Markets
Introduction
Till recently, commercial bank loans were by far the most important
source of external finance for developing countries. In 1981, approximately 46 percent of the $157
billion capital flow (gross) to the developing world, was in the form of bank
loans. A decade later, the share of bank
loans in the gross capital flow to developing countries had come down to 18
percent. This gap caused by a reduction
in bank loans was filled in, by funds raised in the world’s capital
markets. Starting with the 1980’s
there has been a tremendous increase in the activity of international capital
markets and there has also been an addition to the instruments dealt with, in
these markets. A sound understanding of
the various issues related to the international capital markets and the various
instruments dealt with in these markets is a prerequisite for any student of
International Finance and the following chapter attempts to explain these
issues in a very comprehensive manner.
The importance of capital markets for the efficient transfer of
funds between borrowers and lenders cannot be overstated. Individuals who have insufficient wealth to
take advantage of all their investment opportunities that yield rates of return
higher than the market rate are able to borrow funds and invest more than they
would without capital markets. Funds can
be efficiently allocated from individuals with few productive opportunities and
great wealth to individuals with many opportunities and insufficient wealth
through the medium of capital markets.
As a result, all (borrowers and lenders) are better off than they would
have been without capital markets.
We know that countries need to borrow externally due to:-
a)
gap between the current
external receipts and payments
b)
gap between domestic savings
and investments.
These external funds come in the form of grants, loans and equity
investments. Commercial markets are an important source of external finance and
they cater to approximately 52% of outstanding third would external
financing. These commercial markets can
be further classified under two broad heads:-
a)
domestic markets of different
countries, and
b)
euro or, off-shore markets.
The domestic markets and euro markets could be further divided
into:-
a)
Money Markets, and
b)
Capital markets.
Diagram of Flow of Funds
in Financial Markets
Financial
Intermediaries
Banks
Insurance Companies
Pension funds
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 |
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Savers
Investors
Business
Government
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Security Markets
Debt
Stock
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As we can see from the above diagram, there are two different routes
by which the funds from the savers could reach the investors. While one way in which funds reach investors
is through the banking and their allied sectors, the other route is through the
security or capital markets.
INTERNATIONAL CAPITAL
MARKETS
The role played by commercial bank loans as a source of external
finance for developing countries has come down since the 1980’s and this could
be attributed to:
a)
The losses sustained by the
international banks on third world debt in the 1980’s.
b)
The imposition of capital
adequacy norms which has made it difficult, and costly, for the banks to take
on additional assets.
Because of the reduction in the role played by commercial bank loans
as a source of external finance, the capital markets have become more important
to the developing world. In 1991, the
developing countries raised a gross amount of $46 billion from the capital
market compared to less than $40 billion of syndicated loans. In 1993,
international institutions invested as much as $40 billion in emerging markets
equities and $30 billion in Eurobond issues of borrowers from countries in
Asia, Latin America and East Europe.
Even African country bond
issues and those from borrowers in countries like Mexico are attracting
investor interest because of the attractive yields that these bonds offer. Issues from Latin American named countries
have increased from $9.88 billion in 1992 to $19.2 billion in 1993. Overall, it seems clear that the third world
will have to rely more and more on capital markets in the 1990’s.
International capital markets have grown in size and volume at a
very rapid pace. The funds raised in
these markets totalled $435 billion in 1990.
This increased to more than $609 billion in 1992, and in the first eight
months of 1993 it was $526 billion. The
multilateral agencies such as the World Bank too raise bulk of their resources
in the world capital markets and this in a way has added to the growing
importance of the international, capital markets.
The principal instruments dealt in the international capital markets
are, as in the domestic market, bond and equity issues. Euro bonds, foreign bonds, Euro-convertible
bonds, floating rate notes, global depository receipts, American depository
receipts, Asian dragon bonds etc., are the various instruments dealt with in
the international capital markets. The
major centres which deal in these instruments are the New York stock exchange,
the Tokyo stock exchange, the capital markets in London, Luxembourg etc.
INTERNATIONAL INVESTOR
International investors can be broadly classified under two
categories viz., the institutional investor and the individual investor.The
first category would include big mutual and pension funds which are keen to
diversify investments all over the world and willing to invest a part, albeit
small of their portfolios in third world companies and stock markets.
From the purely financial point of view, investors, whether they be
firms or individuals, ought to consider the possibility of expanding their
investments beyond the geographical limits of their own countries, if only
because of the diversity of investment possibilities available. If the universe of assets available for
investment is larger than just the assets in one country, even a country as
large as the USA, the investors may be able to reduce the risk of their
investment portfolio by diversifying across countries.
A study was conducted by Solnik to estimate the risk of an internationally
diversified portfolio compared with a diversified portfolio that is purely
domestic. Using weekly data on stocks in
8 major European countries and the USA, Solnik found that an internationally
diversified portfolio would be one-tenth as risky as a typical security and
half as risky as a well diversified portfolio of U.S. stocks alone. He also found that inter industry
diversification was inferior to inter country diversification. This finding clearly points out the
importance of diversifying one’s portfolio internationally.
With growing awareness of the benefits of diversification, funds in
industrial countries are increasingly looking at the emerging markets for
investment in equities. For instance in
1992 alone, U.S. outlaws into bonds and equities exceeded$ 50 billion.
Apart from diversification in different markets and currencies, the
large institutional investors in industrial countries, faced with stagnant
domestic economies, are also attracted by the faster growing developing countries
and the higher yields that they offer.
The large institutional investors have global choices and perspectives,
posses a long term outlook and make research-based investments.
In contrast, the individual
investor, once the mainstay of the international bond market, makes his/her
decisions more by perception than by analysis.
And, as for the third world, his perceptions are derived more from what
flashes on his TV screen or his newspaper headlines. Therefore as of now, it is difficult to
persuade him to invest in third world countries’ bond and equity issues. As a result, the developing countries’ access
to investors through capital markets is likely to be limited to the large,
professionally managed institutional investor.
When we talk of equity investments, the foreign investments
worldwide total nearly $2 trillion. This
foreign equity investment is basically of two types:
a)
Foreign Direct Investment (FDI)
b)
Portfolio Investment.
FDI is equity investment accompanied by technology and management from
the foreign investors and is the largest element of equity funds for most
countries. FDI’s totalled $226 billion
in 1990. The total net resource flows
from OECD countries to developing countries in the form of FDI’s has steadily
gone up from about $11.3 billion in 1985 to around #29 billion in 1992. The higher returns on investments in poor
countries is estimated to increase the FDI flow from $40 billion a year in 1992
to around $80 billion a year by the end of the century.
Portfolio investments, on the other hand are aimed at capital
appreciation and portfolio investors have little say in management of the
investors company. The portfolio
investors also don't bring in any technology.
Portfolio investments are of four types:
a)
Close – ended country funds floated abroad
They operate in the
same way as domestic mutual funds.
b)
Open-ended country funds
These too are mutual funds but with no specific maturity
date. Also the fund manager is obliged
to quote the bid and offered prices, depending on the net asset value.
c)
Foreign institutional investors (FIL’S)
They invest directly in the stock market.
d)
Equity (or convertible bond) issues in foreign markets.
Portfolio investments to developing countries have more
than doubled between 1989 and 1991, from $3.4 billing to $7.3 billion according
to the World Bank Research Observer (January 1993).
BOND MARKET
A bond is a promise under seal to pay money. The term is generally used to designate the
promise made by a corporation, either public on private, to pay money to the
bearer. The public issue of bonds can be
divided between those issued by governments or their agencies and those issued
by private institutions.
In every country bond issues represent 75% or more of total issues
of securities. Equity shares account for
the remaining 25%. The issue of
international bonds to finance cross border capital flows has a history of more
than 150 years. As early as the 19th
century, foreign issuers of bonds, mainly governments and Railway
companies, used the London market to raise funds.
The distinctive characteristic of the international bond market is
that these bonds are always sold outside the country of the borrower. Therefore, funds in the international bond
market are generally raised in currencies other than the one of the
borrower. One can go further and
subdivide the international bond market into:
Euro-bond market, and Foreign bond market.
This classification is based on the currency in which the lender
buys the bonds and the borrower repays the debt.
Euro bonds
When the bonds are sold principally in countries other than the
country of the currency in which the issue is denominated, it is called a
Euro-bond issue. For example, a dollar
bond issued in Europe is a Euro (dollar) bond.
In the Euro-bond market the rates of one-currency bond are directly
related to the long term rate level in the home country of the currency, the
euro rate for short maturities of that currency, the rates in other currencies,
and currency regulations and restriction.
For example, the Euro-dollar bond rate depends on the U.S. long term
rates, the Euro-dollar rates (and therefore on U.S. short term rates), and the
long-term rates in other countries.
Foreign bonds
When the bonds are sold primarily in the country of the currency of
the issue it is called a foreign bond. A
foreign bond is an international bond sold by a foreign borrower but
denominated in the currency of the country in which it is placed. It is underwritten and sold by a national
underwriting syndicate in the lending country.
For example, an Indian company might float a bond issue in the U.S.
capital market, underwritten by a U.S.
syndicate and denominated in U.S. dollars.
The bond issue is sold to investors in the U.S. capital market,
where it will be quoted and traded. As
controls over movement of capital got relaxed, many foreign bonds were issued
in the domestic markets of the United States, U.K. Germany, Japan, Netherland,
Switzerland etc. These foreign bonds are
referred to as Yankee bonds (i.e. those issued in the U.S. domestic market)
Bull dog bonds (UK), Samurai bonds (Japan), etc.
The interest rates on
foreign bonds are directly correlated with the rates prevailing in the given
country adjusted by whatever regulation affects foreign bonds in particular in
comparison with the Euro-bond market.
U.S. companies- though playing a significant role (about 20%) – have
not dominated the foreign bond market.
Instead, for the period as a whole, international organization such as
the World Bank have been the major participants in this market by accounting
for approximately half of the foreign bonds.
In recent times, foreign governments have come to be the major borrowers
in the foreign bond market.
Both Euro-bonds and foreign bonds may include options as to the
currency in which the final payment may be made. In addition, the Euro-bond market offers
several alternatives in the currency composition of the unit of account of the
issue.
The regulatory requirements are less stringent when foreign bond
issues are made on private placement basis rather than through an invitation to
the general public to subscribe. In the
United States, for example, there is a list of investors with whom private
placements may be made under Rule 144A of the SEC: These investors are established professional
institutional investors capable of making the risk assessment on their own and
therefore do not need protection of stringent regulatory safeguards on the same
scale as the general public.
Euro-bonds have also proven to be versatile instruments. Not only have maturities been tailored to the
needs of the borrowers but Euro-bonds have also appeared with a variety of
features designed to make the instrument more desirable to the investor and
practical to the borrower. The
innovations in the euro-bonds have brought into existence various types of euro
bonds viz.
(a)
Straight Euro-bonds: These are pure debt
issues. These euro bonds are denominated
in a given currency and there are no major regulations with which to
contend. These straight euro bonds are
fixed interest bonds with no right to convert into the common shares of the
issuer.
(b)
Euro-bonds involving more
than one currency: The multiple currency bond, in one of the most widely used forms,
entitles the creditor to request payment of the interest and the principal of
the bond in any pre-determined currency as well as in the currency of the loan
in accordance with a previously established unchangeable parity. These alternate arrangements as to currencies
have responded to two primary needs.
First, they are an incentive to the lender. Second, they are a way to average the
uncertainty involved in the foreign exchange risk of a single currency.
(c)
European Monetary Unit
(EMU) bonds:
The EMU (also called the European currency Unit) bond is a multiple
currency bond which is based on six major reference currencies of the EEC.
(d)
Unit of Account Bond: The European Unit of Account
(EUA) was utilized for the issue of international bonds since 1961. The value of EUA is that of the unit of
account of the European payments Union (EPU), i.e. 0.88867088 gram of fine
gold. This value could be changed only under
very strict conditions as to the fluctuations in the seventeen “reference
currencies” to which it was limited.
(e)
Parallel Bond: A parallel bond is a
multinational issue (usually a large issue) composed of several loans floated
simultaneously among various countries, with each participating country raising
one loan in its own currency. The
parallel bond is similar to the foreign bond discussed earlier, only more
complex. It is a combination of a group
of foreign bonds among several countries, with synchronization of timing and
issue terms.
(f)
Floating Rate Notes (FRN’s): One major innovation in the
Euro-bond market has been the issue of bonds carrying floating rates of
interest, linked to the LIBOR. The
floating rate mechanism allows the interest rate risk to be passed from the
investor to the issuer of the bonds.
Such bonds are called floating rate notes (FRNs). FRN sector is fashionable again. The floating rate note market has recovered
since 1992 onwards. Volume of Euro
dollar FRN new issues has risen to$43 billion up to November 1993 compared with
$25.4 billion in 1992. It was only $4
billion in 1991.
(g)
Euro-Convertible
bonds: These
are bonds which allow the holder to convert the bonds into the equity of the
issuing, or occasionally its parent, company’s equity, at a pre-determined
price. The euro convertible bond issues
have had a rapid growth in the 1980’s with more than 600 outstanding issues,
amounting to more than $50 billion. Most
issues are listed either in the London or Luxembourg stock market, although
actual trading is on an over the counter basis.
The Euro-convertible bonds are also bearer securities. The typical size of an Euro-convertible bond
issue is $30-50 million.
Bond Issue Drill
The steps to be taken before bonds can be issued depend to a very
large extent on whether the issue is a foreign bond or a Euro bond, and whether
it is to be privately placed or to be sold to the general public. Depending on this, the various steps involved
in a bond issue would include the following:-
(a)
Appointment of a group of
managers/lead managers to the issue: In a new securities issue, the managing bank
responsible for initiating the transaction with the borrower and for
organising, underwriting and placing the issue in the primary market is the lead
manager. The lead managers play a vital role in the management of public
issues. They are responsible for all
issue management activities from drafting of prospectus/letter of offer to
allotment of securities and despatch of securities. The lead managers also advice the
company/borrower on underwriting to the issue and syndicate the underwriting
arrangements.
(b)
Appointment of
underwriters: A bank engaged in the business of underwriting security issues is an
underwriter. Underwriting is an
arrangement between the issuing company/borrower and a financial institution,
bank merchant banker, broker or other person, providing for their taking up the
shares or debentures to the extent specified in the agreement between them, if
the public do not subscribe for them.
For the euro bonds, the underwriting syndicate typically comprise
investment bankers from a number of countries whereas the foreign bonds are
underwritten in the country of the currency of the bond denomination. The underwriting cost for Eurobonds issue is
ordinarily 2.5%, consisting of a 1.5% selling commission, 0.5% management fees
and a 0.5% underwriting fee.
(c)
Completion of regulatory
requirements, as may be necessary for the kind of issue proposed: The regulatory requirements while floating an issue include
registration of an issue, disclosure of interest, credit rating etc. The euro bond flotation is not governed by
national regulations.The legal advisers to the issue scrutinise the draft
prospectus/letter of offer on the basis of the documents and information
furnished by the company/borrower and confirm that the draft prospectus/letter
of offer has been drawn up in accordance with the provisions of the various
regulatory guidelines applicable to the issue.
(d)
Pricing of the issue: The pricing of the issue is
the most important part in the issuing of a bond. The price depends on the credit worthiness of
the borrower as also of the market appetite for the issue and also the
prevailing rates of comparative instruments in the market.
(e)
The actual issue: After all the
formalities have been completed, the bonds are released into the market and
sold, at authorised outlets by authorised agents (usually the bankers to the
issue.
(f)
A tombstone, i.e. An advertisement recording the issue of the bonds.
Bench Mark Drill
The various steps to be taken before a rate of interest can be
arrived at while issuing a bond are:
(a)
Choosing a bench market rate of
interest viz., prime rate, Treasury bill rate, certificate of deposit rate.
(b)
Quoting a spread over this
bench mark rate so as to include the costs involved in floating the issue viz.,
brokerage costs, commissions etc.
The bench mark rate of interest for all fixed rate debt, including
bonds, is the yield on government securities of corresponding maturities. Thus, the bench mark for fixed interest
dollar debt is the yield on U.S. Government dollar bonds of corresponding
maturity.
On the subject of “corresponding maturity” one point needs to be
taken note of. In general, government
bonds have a bullet repayment of the principal, while most corporate loans (not
bonds) carry instalment repayments. In
such cases, the weighted average maturity of the loan is calculated and the
bench mark is the yield on government bonds with a maturity equal to the
weighted average maturity (also referred to as the duration) of the loan.
While the bench mark is the yield on government bonds, the fixed
rate borrower pays a premium on this.
The premium depends on the borrower’s credit standing and market demand
for his bonds.
For floating rate notes (FRN’s) the most popular bench mark is the
London Interbank Offered Rate, LIBOR, or the rate at which banks in London are
willing to offer funds to other banks in the market. The actual rate is expressed as a spread over
the bench mark, and the applicable rate changes every 3/6 months, depending on
how LIBOR has moved.
INSTRUMENTS IN NEWYORK AND
TOKYO MARKET
New York Stock Exchange
(NYSE)
The U.S. capital market is the largest and most diverse in the
world. There are no foreign exchange
restrictions and every encouragement is given to foreign investors. U.S. dollar bonds and shares have come to
form a major portion of most international investor portfolio. Although New York is the most important
financial centre, Chicago is becoming a significant rival.
Through the National Association of Securities Dealers Automatic
Quote System (NASDAQ), the U.S. also has the largest OTC (over the Counter)
market in the world. Electronics have
played a large role in creating rapid training systems for use across the
countries and the massive trading volumes generated make the U.S. market
extremely liquid.
The market value of the NYSE at the end of 1986 was U.S.$ 2199.2
billion, of which domestic stocks accounted for 96.78% and foreign stocks for
3.22%. The number of listed companies
increased from 1541 to 1575. A recent
survey revealed that private individuals account for approximately 30% of
turnover by volume on the NYSE, with institutions accounting for 46% and member
firms (when they dealt as principals) for 24%.
The types of shares that are dealt with in the NYSE could be
classified as;
(a)
Common stock: Shares carrying
the right both to vote and to participate in a distribution of the net assets
of the corporation on dissolution are referred to as “common stock”, of which
there can be more than one class.
(b)
Preferred stock: The articles
of incorporation of a company may authorise one or more classes of share, which
can have different limitations and preferential rights relating to voting;
convertibility, redeemability, dividends and liquidation.
(c)
American Depository
Receipts: These are negotiable certificates in registered form, issued in the
U.S. by a U.S. bank, certifying that a specific number of foreign shares have
been deposited with an overseas branch of the bank(or another financial
institution), which acts as a custodian in the country of origin.
(d)
Trust Certificates of
beneficial interest: A trust certificate of beneficial interest
represents an equity interest in the underlying assets of a trust which holds
debt security or other interest. The
certificates represent a prorate ownership of the underlying assets. The holders of the certificates are entitled
to receive dividends based on their pro rata ownership but voting power may be
limited to the election of trustees.
(e)
Warrants: Warrants are certificates giving the holder the right to purchase
shares at a stipulated price within a determined period or, in some cases,
without time limit.
Tokyo Stock Exchange (TSE)
Japan has the world’s second largest stock market. At the end of 1986 the TSE’s total market
capitalisation and trading turnover were exceeded only by that of the NYSE.
Japanese companies have traditionally been highly geared, with less
than a fifth of their capital represented by equity. The bulk of capital is represented by bank
loans, predominantly short-term borrowing from commercial banks.
In recent years, Japanese
companies have begun reducing debt through a combination of share and
convertible bond issues.
The types of shares that are dealt in TSE are; Ordinary shares,
preferred shares, deferred shares, shares to be retired with profits, shares
without voting rights, convertible shares, convertible debentures, debentures
with rights of pre-emption in respect of new shares and separable warrant
debenture bond.
Preferred and deferred shares take a preferred or deferred position
in respect to distribution of profits or surplus assets on liquidation. Shares to be retired with profits are
intended to be issued by a company which is scheduled to be dissolved at a
given future date. Shares without voting
rights usually take the form of shares with preferred profit sharing rights.
Convertible debentures are
becoming increasingly popular, with conversion frequently at the market price
of the shares immediately prior to the date of issue of the convertible. The separable warrant debenture bonds allow
transactions in two ways, as one unit or in separated segments of warrant and
bonds.
SUMMARY
The 1980’s witnessed a boom in the activity of international capital
markets as sources of raising external funds.
Apart from the efficient transfer of funds between the borrowers and
lenders, the capital markets have gained the reputation of being truly
international in character by helping developing countries raise external
finance and also by their ability to reduce risks to the investors (lenders) by
providing for diversification of their portfolios. The stagnant domestic economies of industrial
countries in a way fuelled the investments to flow into the faster growing
developing countries.
The foreign equity investments are in the form of FDIs or portfolio
investments. These investments could be
in instruments such as bonds, which are of the Eurobond or the foreign
type. The emergence of a large euro
dollar market and the controls on FDI imposed by U.S. companies gave impetus to
the growth of the international bond market.
Various innovations in the structure and composition of bonds have been
made, in order to facilitate and cater to the requirements of the players in
the bond market.
Further, when we talk of bonds there are various procedures involved
in their issuance. The bond issue drill
and the bench mark drill are some of the steps involved in the process of the
issue of bonds.
When we talk of markets in bonds, the NYSE and TSE are the two major
exchanges which deal in a lot many instruments which are available in the bond
market.
Euro-Commercial Paper
Unsecured corporate debt with a short maturity and structured to
appeal to large financial institutions active in the Euro currency market.
Federal Funds Rate
This is the overnight rate of interest at which US Federal funds are
traded among financial institutions; regarded as a key indicator of all US
domestic interest rates.
Floating rate CDs
Certificates of deposit which pay on a floating rate basis tied to
certain short term interest rates. Also
referred to as FRCDs.
Foreign bond
A bond issue for a foreign borrower, offered in the domestic capital
market of a particular country and denominated in the currency of that country.
Grilts
British government securities
Junk Bonds
These are high interest rate bonds issued by companies whose
credit-rating from rating agencies such as Standard and Poor or Moody is below
the “investment grade” (i.e. BB or lower).
These have often been used to finance the takeover of a company in a
leveraged buy-out where typically, the company will have a positive cahs flow
which is used to service the high yielding bond.
Lead Manager
In a new securities issue, the managing bank responsible for
initiating the transaction with the borrower and for organising, underwriting
and placing the issue in the primary market.
Market Maker
Any bank, investment bank or securities trading firm making prices
in an issue and prepared to deal at that price.
Odd lot
Any block of securities bid for or offered which is smaller than the
standard lot size for the type of security.
As defined by the AIBD an odd lot bond is a bond with a principal value
of less than US$ 25,000
Over the counter
Purchases and sales of securities executed otherwise than on a stock
exchange. The Eurobond secondary market
is predominantly an over-the-counter market.
Private placement
European: Any offer of securities made to a limited number of investors or a
single investor, generally not listed.
American: a debt issue offered to a limited number of sophisticated
investors and not subject to the registration requirements of the US securities
ACT of 1933.
Prospectus: A document giving
a description of the terms of a securities issue, and full financial and other
information relating to the borrower. It
is also called an offering circular.
Rating: A letter grade signifying a
security’s investment quality. In the
United States, the chief rating agencies are Moody’s and Standard & Poor’s.
Samurai bond: Foreign bonds
offered in the Japanese bond market.
Secondary Market: The market for
bond issues which have already been offered (i.e. their initial distribution
has ended).
Straight Bonds: Fixed interest
bonds with no right to convert into the common shares of the issuer.
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