International Financing and International Financial Markets

FIU –

International Finance

Session 12

Use of International Financial Markets

Foreign cash flow movements of a typical MNC:

• Foreign trade. Exports generate foreign cash inflows, while imports require cash outflows.

• Direct foreign investment. Cash outflows to acquire foreign assets generate future inflows.

• Short-term investment or financing in foreign securities, usually in the Eurocurrency market.

• Longer-term financing in the Eurocredit, Eurobond, or international stock markets.

Implications for business

• Firms can borrow funds at a lower cost than they could domestically

• Minimum regulation in international capital markets helps lower the cost of capital, but also increases risk in both currencies and security

• International capital market provides opportunities for portfolio diversification and the lowering of systematic risk

Functions of a Generic Capital Market

• Brings together:– Those who want to invest:

• corporations, individuals, nonbank financial institutions.

– Those who want to borrow:• individuals, companies, governments.

• Market makers:– Commercial and investment banks that connect

investors with borrowers.

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The Main Players in a Generic Capital Market

Investors: Companies Individuals Institutions

Market makers:“Intermediaries “ Commercial bankers Investment bankers

Borrowers: Individuals Companies Governments

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Financial Intermediaries

• Middle people

• Being pushed out

• Disintermediation

• Who will preserve order if they are pushed out?

Attraction of the Global Capital Market?

• Increases the supply of funds available for borrowing.

• Borrower’s perspective– Lowers the cost of capital.

• Investor’s perspective– Provides a wider range of investment

opportunities

Financing Alternatives

• Internally generated cash - earnings

• Short and long term external funds:– Debt– Equity– Loans

• Traditional bank loans

• Private bonds from pension funds, insurance companies

What are the differences?

• Equity – stock – giving ownership to investors – giving up control?

• Debt – bonds – no ownership is relinquished

• Loans

Debt

The preferred method of financing….

• WHY?

BASIC FEATURES OF A BOND• Long-Term

• Fixed Income

• Interest Payments

• Principal, Par Value, Face Value ($1,000)

• Maturity– Short-Term (Money Market)– Intermediate (Notes)– Long-Term (Bonds)

Bond featuresCouponTerm to MaturityPrincipal (Par Value)Market Value (Price)Ownership

• Bearer Bonds• Registered Bonds

• Consider two bonds that are identical, except one is callable while the other is not. Which bond will sell at a higher price?

Straight Bond vs Callable Bond

Value ofstraight bond

25 50 75 100 125 150

25

50

75

100

bondValue of

Straight bond

Bond callableat 100

High-Yield Bonds

•Speculative Grade Bonds or Junk Bonds•Carry a Rating of BB (Ba) or Lower •Michael Milken - Firms Involved in Leveraged Buyouts• “Fallen Angels”

•Small Growth Firms

INTERPRETING BOND QUOTES

Corporate Bond Quotes

CurrentBonds Yield Volume Close Net Change

IBM 7 1/4 02 6.9 33 104 3/8 +3/8

Types of bonds

• Domestic Bonds –issued locally by a domestic borrower and denominated in the local currency.

• Foreign Bonds – issues by foreign borrower in the local currency and regulated by local regulators

• Yankee Bonds –Bonds issues by a non-US firm denominated in US $ and issued in the US.

• Samurai Bonds –Bonds issues in Japan by non-Japanese companies denominated in Yen

Eurobonds

• Bonds underwritten by a multi-national syndicate (group), placed mainly in countries other than the currency’s country.

• Not traded on a specific market.• Unregulated and untaxed! Because they are

untaxed, buyers will accept a lower rate of interest and issuers pay less to borrow. They are also in bearer from.

Euro vs Foreign Bonds(Billions of Dollars)

0 50 100 150 200

Euro

Foreign

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Types of Foreign Bonds

• Fixed rate issues –• Floating rate issues- Coupon rate is tied to the

market interest rate – So still leaves some risk to the bondholders

• Equity related issues-

Advantages and Disadvantages of Debt

• Advantages– Tax deductibility of interest– Financial leverage can increase EPS– Ownership is not diluted

• Disadvantages– Increased financial risk– Indenture provisions restrict firm’s

flexibility

The International Bond Market• Bonds tend to be fixed rate.• Foreign bonds

– Sold outside the borrower’s country and in currency of country where issued.

• Eurobonds– underwritten by an international syndicate.– issued by large corporations, international institutions

and governments.– placed in country other than country of currency and

its residents.

Eurocurrency Market

• Consists of banks, called “Eurobanks” that accept deposits and make loans in foreign currencies.

• Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside its country of origin.

Eurocurrency

• It’s not the Euro!• It is any currency banked outside its country

of origin. • 1950s. Eastern Europeans afraid US would

seize deposits to reimburse claims for business losses as a result of Communist takeover of Eastern Europe.

The Eurocurrency Market• Characterized by a lack of regulation compared

to domestic financial markets.

• This means that you don’t have to pay for the cost of regulation.

• Hence, cheap (or cheaper) money.

• Downside:– Banks could be more likely to fail (not probable)– Because you are getting foreign money, you have

currency exchange risks.

Eurocurrency Market

• U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars and are not subject to U.S. regulations.

• In the 1960s and 70s, the Eurodollar market, or what is now called the Eurocurrency market, grew to accommodate increasing international business.

• The market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies.

$$

Eurocurrency Market

• U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars and are not subject to U.S. regulations.

• In the 1960s and 70s, the Eurodollar market, or what is now called the Eurocurrency market, grew to accommodate increasing international business.

• The market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies.

$$

• Although the market focuses on large-volume transactions, at times no single bank is willing to lend the needed amount. A syndicate of Eurobanks may then be composed.

• Two regulatory events allow for a more competitive global playing field:– The Single European Act opens up the European banking

industry and calls for similar regulations.– The Basel Accord includes standardized guidelines on the

classification of capital.

Eurocurrency Market $$

Securitization

• Popular because of deregulation

• Banks must make their offering more attractive

• The matching of borrowers and lenders• The process of aggregating similar

instruments, such as loans or mortgages, into a negotiable security – like GNMA and FNMA.

Benefits of globalization to obtaining capital

• Freer markets

• More information

Exchange RateRisk of Foreign Bonds

• Some foreign currencies exhibit more risk than others.

• The exchange rate risk from financing with bonds in foreign currencies can be hedged with1 offsetting cash inflows in that currency,2 forward contracts, or3 currency swaps.

• Bonds sold outside the country whose currency they are denominated in.

• Eurobonds are underwritten by a multi-national syndicate of investment banks and simultaneously placed in many countries. They are usually issued in bearer form.

• Bonds have become popular in the last 20 years as Swaps have become more popular

Eurobond Market BONDSBONDS

• Eurobonds increased rapidly in volume when in 1984, the withholding tax was abolished in the U.S. and corporations were allowed to issue bonds directly to non-U.S. investors.

• Interest rates for each currency and credit conditions change constantly, causing the market’s popularity to vary among currencies.

• In recent years, governments and corporations from emerging markets have frequently utilized the Eurobond market.

Eurobond Market BONDSBONDS

• Interest rate swaps can be used to hedge interest rate risk. They enable a firm to exchange fixed rate payments for variable rate payments, or vice versa.

• Financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee.

Using Swapsto Hedge Financing Costs

International Stock Markets• MNCs can obtain funds by issuing stock in international

markets, in addition to the local market.

• By having access to various markets, the stocks may be more easily digested, the image of the MNC may be enhanced, and the shareholder base may be diversified.

• The proportion of individual versus institutional ownership of shares varies across stock markets. The regulations are different too.

• The locations of the MNC’s operations may affect the decision about where to place stock, in view of the cash flows needed to cover dividend payments in the future.

• Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock offerings.

• Non-U.S. firms can also issue American depository receipts (ADRs), which are certificates representing bundles of stock. The use of ADRs circumvents some disclosure requirements.

International Stock Markets

Trading in Non-US Stocks

0

100

200

300

400

500

NASDAQ NYSE

1994199519961997

US Billions

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Global Equity Markets

• Where investors can buy/sell stocks.

• Made up of many stock exchanges around the world.

Who Uses These Markets?

• Investors seeking to diversify their portfolios.

• Companies seeking to– issue stock in the country– use stock and options as a form of employee incentives– satisfy local ownership requirements– create funding for future acquisitions– increase the visibility of the company.