Benefits of the Global Capital MarketAlthough this section is about the global capital market, we open it by discussing the functions of a generic capital market. Then we will look at the limitations of domestic capital markets and discuss the benefits of using global capital markets.The Functions of a Generic Capital MarketWhy do we have capital markets? What is their function? A capital market brings together those who want to invest money and those who want to borrow money (see Figure 11.1). Those who want to invest money include corporations with surplus cash, individuals, and nonbank financial institutions (e.g., pension funds, insurance companies). Those who want to borrow money include individuals, companies, and governments. Between these two groups are the market makers. Market makers are the financial service companies that connect investors and borrowers, either directly or indirectly. They include commercial banks (e.g., Citibank, U.S. Bank) and investment banks (e.g., Merrill Lynch, Goldman Sachs).Commercial banks perform an indirect connection function. They take cash deposits from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a higher rate of interest, making a profit from the difference in interest rates (commonly referred to as theinterest rate spread). Investment banks perform a direct connection function. They bring investors and

Figure 11.1The Main Players in a Generic Capital Marketborrowers together and charge commissions for doing so. For example, Merrill Lynch may act as a stockbroker for an individual who wants to invest some money. Its personnel will advise her as to the most attractive purchases and buy stock on her behalf, charging a fee for the service.Capital market loans to corporations are either equity loans or debt loans. An equity loan is made when a corporation sells stock to investors. The money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay wages, and so on. A share of stock gives its holder a claim to a firm's profit stream. The corporation honors this claim by paying dividends to the stockholders. The amount of the dividends is not fixed in advance. Rather, it is determined by management based on how much profit the corporation is making. Investors purchase stock both for their dividend yield and in anticipation of gains in the price of the stock. Stock prices increase when a corporation is projected to have greater earnings in the future, which increases the probability that it will raise future dividend payments.A debt loan requires the corporation to repay a predetermined portion of the loan amount (the sum of the principal plus the specified interest) at regular intervals regardless of how much profit it is making. Management has no discretion as to the amount it will pay investors. Debt loans include cash loans from banks and funds raised from the sale of corporate bonds to investors. When an investor purchases a corporate bond, he purchases the right to receive a specified fixed stream of income from the corporation for a specified number of years (i.e., until the bond maturity date).Attractions of the Global Capital MarketWhy do we need a global capital market? Why are domestic capital markets not sufficient? A global capital market benefits both borrowers and investors. It benefits borrowers by increasing the supply of funds available for borrowing and by lowering the cost of capital. It benefits investors by providing a wider range of investment opportunities, thereby allowing them to build portfolios of international investments that diversify their risks.The Borrower's Perspective: A Lower Cost of CapitalIn a purely domestic capital market, the pool of investors is limited to residents of the country. This places an upper limit on the supply of funds available to borrowers. In other words, the liquidity of the market is limited. (Deutsche Telekom faced this problem in the opening case.) A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on.Perhaps the most important drawback of the limited liquidity of a purely domestic capital market is that the cost of capital tends to be higher than it is in an international market. The cost of capital is the rate of return that borrowers must pay investors (the price of borrowing money). This is the interest rate on debt loans and the dividend yield and expected capital gains on equity loans. In a purely domestic market, the limited pool of investors implies that borrowers must pay more to persuade investors to lend them their money. The larger pool of investors in an international market implies that borrowers will be able to pay less.

Figure 11.2Market Liquidity and the Cost of Capital

The argument is illustrated in Figure 11.2, using the Deutsche Telekom example. The vertical axis in the figure is the cost of capital (the price of borrowing money) and the horizontal axis, the amount of money available at varying interest rates. DD is the Deutsche Telekom demand curve for borrowings. Note that the Deutsche Telekom demand for funds varies with the cost of capital; the lower the cost of capital, the more money Deutsche Telekom will borrow. (Money is just like anything else; the lower its price, the more of it people can afford.) SSBis the supply curve of funds available in the German capital market, and SSIrepresents the funds available in the global capital market. Note that Deutsche Telekom can borrow more funds more cheaply on the global capital market. As Figure 11.2 illustrates, the greater pool of resources in the global capital market both lowers the cost of capital and increases the amount Deutsche Telekom can borrow. Thus, the advantage of a global capital market to borrowers is that it lowers the cost of capital.Problems of limited liquidity are not restricted to less developed nations, which naturally tend to have smaller domestic capital markets. As illustrated in the opening case and discussed in the introduction, in recent years even very large enterprises based in some of the world's most advanced industrialized nations have tapped the international capital markets in their search for greater liquidity and a lower cost of capital.4Another example of a company that tapped the global capital market to lower its cost of capital is profiled in the accompanying Management Focus.The Investor's Perspective: Portfolio DiversificationBy using the global capital market, investors have a much wider range of investment opportunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to below what could be achieved in a purely domestic capital market. We will consider how this works in the case of stock holdings, although the same argument could be made for bond holdings.Consider an investor who buys stock in a biotech firm that has not yet produced a new product. Imagine the price of the stock is very volatile--investors are buying and selling the stock in large numbers in response to information about the firm's prospects. Such stocks are risky investments; investors may win big if the firmproduces a marketable product, but investors may also lose all their money if the firm fails to come up with a product that sells. Investors can guard against the risk associated with holding this stock by buying other firms' stocks, particularly those weakly or negatively correlated with the biotech stock. By holding a variety of stocks in a diversified portfolio, the losses incurred when some stocks fail to live up to their promises are offset by the gains enjoyed when other stocks exceed their promise.As an investor increases the number of stocks in her portfolio, the portfolio's risk declines. At first this decline is rapid. Soon, however, the rate of decline falls off and asymptotically approaches the systematic risk of the market.Systematic riskrefers to movements in a stock portfolio's value that are attributable to macroeconomic forces affecting all firms in an economy, rather than factors specific to an individual firm. The systematic risk is the level of nondiversifiable risk in an economy. Figure 11.3a illustrates this relationship for the United States. It suggests that a fully diversified US portfolio is only about 27 percent as risky as a typical individual stock.By diversifying a portfolio internationally, an investor can reduce the level of risk even further because the movements of stock market prices across countries are not perfectly correlated. For example, one recent study looked at the correlation between three stock market indexes. The Standard & Poor's 500 (S&P 500) summarized the movement of large US stocks. The Morgan Stanley Capital International Europe, Australia, and Far East Index (EAFE) summarized stock market movements in other developed nations. The third index, the International Finance Corporation Global Emerging Markets Index (IFC) summarized stock market movements in less developed "emerging economies." From 1981 to 1994, the correlation between the S&P 500 and EAFE indexes was 0.45, suggesting they moved together only about 20 percent of the time (i.e., 0.45*0.45 = 0.2025). The correlation between the S&P 500 and IFC indexes was even lower at 0.32, suggesting they moved together only a little over 10 percent of the time.5The relatively low correlation between the movement of stock markets in different countries reflects two basic factors. First, countries pursue different macroeconomic policies and face different economic conditions, so their stock markets respond to different forces and can move in different ways. For example, in 1997, the stock markets of several Asian countries, including South Korea, Malaysia, Indonesia, and Thailand, lost over 50 percent of their value in response to the Asian financial crisis, while at the same time the S&P 500 increased in value by over 20 percent. Second, different stock markets are still somewhatsegmentedfrom each other bycapital controls--that is, by restrictions on cross-border capital flows (although such restrictions are declining rapidly). The most common restrictions include limits on the amount of a firm's stock that a foreigner can own and limits on the ability of a country's citizens to invest their money outside that country. For example, until recently it was difficult for foreigners to own more than 30 percent of the equity of South Korean enterprises. Tight restrictions on capital flows make it very hard for Chinese citizens to take money out of their country and invest it in foreign assets. Such barriers to cross-border capital flows limit the ability of capital to roam the world freely in search of the highest risk-adjusted return. Consequently, at any one time, there may be too much capital invested in some markets and too little in others. This will tend to produce differences in rates of return across stock markets.6The implication is that by diversifying a portfolio to include foreign stocks, an investor can reduce the level of risk below that incurred by holding just domestic stocks.Figure 11.3b illustrates the relationship between international diversification and risk found by a now classic study.7According to the figure, a fully diversified portfolio that contains stocks from many countries is less than half as risky as a fully diversified portfolio that contains only US stocks. A fully diversified portfolio of international stocks is only about 12 percent as risky as a typical individual stock, whereas a fullyFigure 11.3seeRisk Reduction through Portfolio DiversificationSource: B. Solnik, "Why Not Diversify Internationally Rather than Domestically?" Adapted with permission fromFinancial Analysts Journal,July/August 1974, p. 17, Copyright 1974, Financial Analysts Federation. Charlottesville, VA. All rights reserved.diversified portfolio of US stocks is about 27 percent as risky as a typical individual stock. More recent studies have tended to confirm the relationship summarized in Figure 11.3b. A 1994 study of portfolio diversification in Europe found that a diversified portfolio of stocks held within a single country was on average about 38 percent as risky as a typical individual stock, whereas a portfolio of stocks that was diversified across 12 European countries was only 18 percent as risky as a typical individual stock.8Such data suggest a strong case for investing internationally as a means of diversifying risk.The risk-reducing effects of international portfolio diversification would be greater were it not for the volatile exchange rates associated with the current floating exchange rate regime. Floating exchange rates introduce an additional element of risk into investing in foreign assets. As we have said repeatedly, adverse exchange rate movements can transform otherwise profitable investments into unprofitable investments. The uncertainty engendered by volatile exchange rates may be acting as a brake on the otherwise rapid growth of the international capital market.Figure 11.4Net International Bank Lending ($ billions)

Growth of the Global Capital MarketIn the introduction, we noted that there has been rapid growth in the size of the global capital market in recent years. The following figures add some substance to this claim.9Figure 11.4 shows the growth in international bank lending from 1983 to the end of 1997. As can be seen, international bank lending increased rapidly over this period, hitting a record $5.3 trillion by the end of 1997. Figure 11.5 shows the quarter-by-quarter increase in international bond issuance, from 1994 through 1997. By 1997, international bond issues were running at over $250 billion per quarter, up from $110 to $150 billion a quarter in 1994. Figure 11.5 also gives details of the currency in which most international bonds were issued. The US dollar has been the favored currency for issuing international bonds. Figure 11.6 shows the volume of international equity offerings between 1985 and 1997. Again, there has been a steep increase, with international equity issues closing in on $100 billion in 1997, up from about $4 billion in 1985. Figure 11.6 also shows details of the Morgan Stanley Capital Market International World Stock Market Index. As can be seen, the value of world stock markets has also increased substantially. It is easier to raise capital from new stock issue in a climate where stock markets are rising than in one where stock markets are declining in value. A decline in the value of world stock markets, such as occurred toward the end of 1987, makes it more difficult for companies to raise additional funds from international equity issues.The data contained in Figures 11.4 to 11.6 clearly illustrate the rapid growth in the size of the global capital market in recent years. What factors allowed the international capital market to bloom in the 1980s and 1990s? There seem to be two answers--advances in information technology and deregulation by governments.Information TechnologyFinancial services is an information-intensive industry. It draws on large volumes of information about markets, risks, exchange rates, interest rates, creditworthiness, and so on. It uses this information to make decisions about what to invest where, how much to charge borrowers, how much interest to pay to depositors, and the value and riskiness of a range of financial assets including corporate bonds, stocks, government securities, and currencies.Because of this information intensity, the financial services industry has been revolutionized more than any other industry by advances in information technology since the 1970s. The growth of international communications technology has facilitated instantaneous communication between any two points on the globe. At the same time, rapid advances in data processing capabilities have allowed market makers to

Figure 11.5International Bond Issues and the US Dollar Exchange Rate.Source: Bank for International Settlements database; Euromoney data; Bank of England data.

Figure 11.6International Equity Offerings and Equity Price DevelopmentsSource: Bank for International Settlements database; Euromoney data.absorb and process large volumes of information from around the world. According to one study, because of these technological developments, the real cost of recording, transmitting, and processing information has fallen by 95 percent since 1964.10Such developments have facilitated the emergence of an integrated international capital market. It is now technologically possible for financial services companies to engage in 24-hour-a-day trading, whether it is in stocks, bonds, foreign exchange, or any other financial asset. Due to advances in communications anddata processing technology, the international capital market never sleeps. San Francisco closes one hour before Tokyo opens, but during this period trading continues in New Zealand.The integration facilitated by technology has a dark side.11"Shocks" that occur in one financial center now spread around the globe very quickly. The collapse of US stock prices on the notorious Black Monday of October 19, 1987, immediately triggered similar collapses in all the world's major stock markets, wiping billions of dollars off the value of corporate stocks worldwide. However, most market participants would argue that the benefits of an integrated global capital market far outweigh any potential costs.DeregulationIn country after country, financial services have been the most tightly regulated of all industries. Governments around the world have traditionally kept other countries' financial service firms from entering their capital markets. In some cases, they have also restricted the overseas expansion of their domestic financial services firms. In many countries, the law has also segmented the domestic financial services industry. In the United States, for example, commercial banks are prohibited from performing the functions of investment banks, and vice versa. Historically, many countries have limited the ability of foreign investors to purchase significant equity positions in domestic companies. They have also limited the amount of foreign investment that their citizens could undertake. In the 1970s, for example, capital controls made it very difficult for a British investor to purchase American stocks and bonds.Many of these restrictions have been crumbling since the late 1970s. In part, this has been a response to the development of the Eurocurrency market, which from the beginning was outside of national control. (This is explained later in the chapter.) It has also been a response to pressure from financial services companies, which have long wanted to operate in a less regulated environment. Increasing acceptance of the free market ideology associated with an individualistic political philosophy also has a lot to do with the global trend toward the deregulation of financial markets (see Chapter 2). Whatever the reason, deregulation in a number of key countries has undoubtedly facilitated the growth of the international capital market.The trend began in the United States in the late 1970s and early 80s with a series of changes that allowed foreign banks to enter the US capital market and domestic banks to expand their operations overseas. In Great Britain, the so-called Big Bang of October 1986 removed barriers that had existed between banks and stockbrokers and allowed foreign financial service companies to enter the British stock market. Restrictions on the entry of foreign securities houses have been relaxed in Japan, and Japanese banks are now allowed to open international banking facilities. In France, the "Little Bang" of 1987 is gradually opening the French stock market to outsiders and to foreign and domestic banks. In Germany, foreign banks are now allowed to lend and manage foreign deutsche mark issues, subject to reciprocity agreements.12All of this has enabled financial services companies to transform themselves from primarily domestic companies into global operations with major offices around the world--a prerequisite for the development of a truly international capital market. As we saw in Chapter 5, in late 1997, the World Trade Organization brokered a deal that removed many of the restrictions on cross-border trade in financial services. This deal should encourage further growth in the size of the global capital market.In addition to the deregulation of the financial services industry, many countries beginning in the 1970s started to dismantle capital controls, loosening both restrictions on inward investment by foreigners and outward investment by their own citizens and corporations. By the 1980s, this trend spread from developed nations to the emerging economies of the world as countries across Latin America, Asia, and Eastern Europe started to dismantle decades-old restrictions on capital flows. Figure 11.7 illustrates the consequences. Since 1985, an index of capital controls in emerging markets that is comFigure 11.7Index of Capital Controls in Emerging MarketsNote: Index ranges from 0 to 1. 0 = No capital controls, 1 = Tight capital controls.

Source: IMF database.puted by the IMF has declined from a high of 0.66 to around 0.56 (the index would be 1.0 if all emerging economies had tight capital controls, and 0.0 if they had no controls). According to the World Bank, capital flows into the emerging economies of the world went from less than $50 billion in 1990 to over $336 billion in 1997.13As of 1998, the trends toward deregulation of financial services and removal of capital controls were still firmly in place. Given the benefits associated with the globalization of capital, the growth of the global capital market mapped out in Figures 11.4 to 11.6 can be expected to continue for the foreseeable future. While most commentators see this as a positive development, there are those who believe that there are serious risks inherent in the globalization of capital.Global Capital Market RisksSome analysts are concerned that due to deregulation and reduced controls on cross-border capital flows, individual nations are becoming more vulnerable to speculative capital flows. They see this as having a destabilizing effect on national economies.14Harvard economist Martin Feldstein, for example, has argued that most of the capital that moves internationally is pursuing temporary gains, and it shifts in and out of countries as quickly as conditions change.15He distinguishes between this short-term capital, or "hot money," and "patient money" that would support long-term cross-border capital flows. To Feldstein, patient money is still relatively rare, primarily because although capital is free to move internationally, its owners and managers still prefer to keep most of it at home. Feldstein supports his arguments with statistics that demonstrate that although $1.2 trillion flows through the foreign exchange markets every day, "when the dust settles, most of the savings done in each country stays in that country."16Feldstein argues that the lack of patient money is due to the relative paucity of information that investors have about foreign investments. In his view, if investors had better information about foreign assets, the global capital market would work more efficiently and be less subject to short-term speculative capital flows. Feldstein claims that Mexico's economic problems in the mid-1990s were the result of too much hot money flowing in and out of the country and too little patient money. This example is reviewed in detail in the accompanying Country Focus.A lack of information about the fundamentalqualityof foreign investments may encourage speculative flows in the global capital market. Faced with a lack of quality information, investors may react to dramatic news events in foreign nations and pull their money out too quickly. Despite advances in information technology, it is still difficult for an investor to get access to the same quantity and quality of information about foreign investment opportunities that he can get about domestic investment opportunities. This information gap is exacerbated by different accounting conventions in different countries, which makes the direct comparison of cross-border investment opportunities difficult for all but the most sophisticated investor (see Chapter 19 for details). For example, German accounting principles are very different from those found in the United States and can present quite a different picture of the health of a company. Thus, when the Germany company Daimler-Benz translated its German financial accounts into US-style accounts in 1993, as it had to do to be listed on the New York Stock Exchange, it found that while it had made a profit of $97 million under German rules, under US rules it had lost $548 million!17Given the problems created by differences in the quantity and quality of information, many investors have yet to venture into the world of cross-border investing, and those that do are prone to reverse their decision on the basis of limited (and perhaps inaccurate) information. However, if the international capital market continues to grow, financial intermediaries likely will increasingly provide quality information about foreign investment opportunities. Better information should increase the sophistication of investment decisions and reduce the frequency and size of speculative capital flows. Although concerns about the volume of "hot money" sloshing around in the global capital market have recently increased as a result of the Asian financial crisis, IMF research suggests there has not been an increase in the volatility of financial markets over the past 25 years.18The Eurocurrency MarketAeurocurrencyis any currency banked outside of its country of origin.Eurodollars, which account for about two-thirds of all eurocurrencies, are dollars banked outside of the United States. Other important eurocurrencies include the euro-yen, the euro-deutsche mark, the euro-franc, and the euro-pound. The termeurocurrencyis actually a misnomer because a eurocurrency can be created anywhere in the world; the persistent euro- prefix reflects the European origin of the market. As we shall see, the eurocurrency market is an important, relatively low-cost source of funds for international businesses.Genesis and Growth of the MarketThe eurocurrency market was born in the mid-1950s when Eastern European holders of dollars, including the former Soviet Union, were afraid to deposit their holdings of dollars in the United States lest they be seized by the US government to settle US residents' claims against business losses resulting from the Communist takeover of Eastern Europe. These countries deposited many of their dollar holdings in Europe, particularly in London. Additional dollar deposits came from various Western European central banks and from companies that earned dollars by exporting to the United States. These two groups deposited their dollars in London banks, rather than US banks, because they were able to earn a higher rate of interest (which will be explained).The eurocurrency market received a major push in 1957 when the British government prohibited British banks from lending British pounds to finance non-British trade, a business that had been very profitable for British banks. British banks began financing the same trade by attracting dollar deposits and lending dollars to companies engaged in international trade and investment. Because of this historical event, London became, and has remained, the leading center of eurocurrency trading.The eurocurrency market received another push in the 1960s when the US government enacted regulations that discouraged US banks from lending to non-US residents. Would-be dollar borrowers outside the United States found it increasingly difficult to borrow dollars in the United States to finance international trade, so they turned to the eurodollar market to obtain the necessary dollar funds.The US government changed its policies after the 1973 collapse of the Bretton Woods system (see Chapter 10), removing an important impetus to the growth of the eurocurrency market. However, another political event, the oil price increases engineered by OPEC in the 1973 - 74 and 1979 - 80 periods, gave the market another big shove. As a result of the oil price increases, the Arab members of OPEC accumulated huge amounts of dollars. They were afraid to place their money in US banks or their European branches, lest the US government attempt to confiscate them. (Iranian assets in US banks and their European branches were frozen by President Carter in 1979 after Americans were taken hostage at the US embassy in Tehran; their fear was not unfounded.) Instead, these countries deposited their dollars with banks in London, further increasing the supply of eurodollars.Although these various political events contributed to the growth of the eurocurrency market, they alone were not responsible for it. The market grew because it offered real financial advantages--initially to those who wanted to deposit dollars or borrow dollars and later to those who wanted to deposit and borrow other currencies. We now look at the source of these financial advantages.Attractions of the Eurocurrency MarketThe main factor that makes the eurocurrency market so attractive to both depositors and borrowers is its lack of government regulation. This allows banks to offer higher interest rates on eurocurrency deposits than on deposits made in the home currency, making eurocurrency deposits attractive to those who have cash to deposit. The lack of regulation also allows banks to charge borrowers a lower interest rate for eurocurrency borrowings than for borrowings in the home currency, making eurocurrency loans attractive for those who want to borrow money. In other words, the spread between the eurocurrency deposit rate and the eurocurrency lending rate is less than the spread between the domestic deposit and lending rates (see Figure 11.8). To understand why this is so, we must examine how government regulations raise the costs of domestic banking.Domestic currency deposits are regulated in all industrializedFigure 11.8Interest Rate Spreads in Domestic and Eurocurrency Markets

branches of US banks subject to US reserve requirement regulations, provided those deposits are payable only outside the United States. This gives eurobanks a competitive advantage.For example, suppose a bank based in New York faces a 10 percent reserve requirement. According to this requirement, if the bank receives a $100 deposit, it can lend out no more than $90 of that and it must place the remaining $10 in a non-interest-bearing account at a Federal Reserve bank. Suppose the bank has annual operating costs of $1 per $100 of deposits and that it charges 10 percent interest on loans. The highest interest the New York bank can offer its depositors and still cover its costs is 8 percent per year. Thus, the bank pays the owner of the $100 deposit (0.08*$100 =) $8, earns (0.10*$90 =) $9 on the fraction of the deposit it is allowed to lend, and just covers its operating costs.In contrast, a eurobank can offer a higher interest rate on dollar deposits and still cover its costs. The eurobank, with no reserve requirements regarding dollar deposits, can lend out all of a $100 deposit. Therefore, it can earn 0.10*$100 = $10 at a loan rate of 10 percent. If the eurobank has the same operating costs as the New York bank ($1 per $100 deposit), it can pay its depositors an interest rate of 9 percent, a full percentage point higher than that paid by the New York bank, and still cover its costs. That is, it can pay out 0.09*$100 = $9 to its depositor, receive $10 from the borrower, and be left with $1 to cover operating costs. Alternatively, the eurobank might pay the depositor 8.5 percent (which is still above the rate paid by the New York bank), charge borrowers 9.5 percent (still less than the New York bank charges), and cover its operating costs even better. Thus, the eurobank has a competitive advantage vis--vis the New York bank in both its deposit rate and its loan rate.Clearly, there are very strong financial motivations for companies to use the eurocurrency market. By doing so, they receive a higher interest rate on deposits and pay less for loans. Given this, the surprising thing is not that the euromarket has grown rapidly but that it hasn't grown even faster. Why do any depositors hold deposits in their home currency when they could get better yields in the eurocurrency market?Drawbacks of the Eurocurrency MarketThe eurocurrency market has two drawbacks. First, when depositors use a regulated banking system, they know that the probability of a bank failure that would cause them to lose their deposits is very low. Regulation maintains the liquidity of the banking system. In an unregulated system such as the eurocurrency market, the probability of a bank failure that would cause depositors to lose their money is greater (althoughin absolute terms, still low). Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a system and are willing to pay the price.Second, borrowing funds internationally can expose a company to foreign exchange risk. For example, consider a US company that uses the eurocurrency market to borrow euro-pounds--perhaps because it can pay a lower interest rate on euro-pound loans than on dollar loans. Imagine, however, that the British pound subsequently appreciates against the dollar. This would increase the dollar cost of repaying the euro-pound loan and thus the company's cost of capital. This possibility can be insured against by using the forward exchange market (as we saw in Chapter 9) but the forward exchange market does not offer perfect insurance. Consequently, many companies borrow funds in their domestic currency to avoid foreign exchange risk, even though the eurocurrency markets may offer more attractive interest rates.The Global Bond MarketThe global bond market grew rapidly during the 1980s and 1990s (see Figure 11.5). Bonds are an important means of financing for many companies. The most common kind of bond is a fixed-rate bond. The investor who purchases afixed-rate bondreceives a fixed set of cash payoffs. Each year until the bond matures, the investor gets an interest payment and then at maturity he gets back the face value of the bond.International bonds are of two types: foreign bonds and eurobonds.Foreign bondsare sold outside of the borrower's country and are denominated in the currency of the country in which they are issued. Thus, when Dow Chemical issues bonds in Japanese yen and sells them in Japan, it is issuing foreign bonds. Many foreign bonds have nicknames; foreign bonds sold in the United States are called Yankee bonds, foreign bonds sold in Japan are Samurai bonds, and foreign bonds sold in Great Britain are bulldogs.Eurobondsare normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated. For example, a bond may be issued by a German corporation, denominated in US dollars, and sold to investors outside of the United States by an international syndicate of banks. Eurobonds are routinely issued by multinational corporations, large domestic corporations, sovereign governments, and international institutions. They are usually offered simultaneously in several national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency they are denominated. Eurobonds account for the lion's share of international bond issues.Attractions of the Eurobond MarketThree features of the eurobond market make it an appealing alternative to most major domestic bond markets; specifically, An absence of regulatory interference. Less stringent disclosure requirements than in most domestic bond markets. A favorable tax status.Regulatory InterferenceNational governments often impose tight controls on domestic and foreign issuers of bonds denominated in the local currency and sold within their national boundaries. These controls tend to raise the cost of issuing bonds. However, government limitations are generally less stringent for securities denominated in foreign currencies and sold to holders of those foreign currencies. Eurobonds fall outside of the regulatory domain of any single nation. As such, they can often be issued at a lower cost to the issuer.Disclosure RequirementsEurobond market disclosure requirements tend to be less stringent than those of several national governments. For example, if a firm wishes to issue dollar-denominated bonds within the United States, it must first comply with SEC disclosure requirements. The firm must disclose detailed information about its activities, the salaries and other compensation of its senior executives, stock trades by its senior executives, and the like. In addition, the issuing firm must submit financial accounts that conform to US accounting standards. For non-US firms, redoing their accounts to make them consistent with US standards can be very time consuming and expensive. Therefore, many firms have found it cheaper to issue eurobonds, including those denominated in dollars, than to issue dollar-denominated bonds within the United States.Favorable Tax StatusBefore 1984, US corporations issuing eurobonds were required to withhold for US income tax up to 30 percent of each interest payment to foreigners. This did not encourage foreigners to hold bonds issued by US corporations. Similar tax laws were operational in many countries at that time, and they limited market demand for eurobonds. US laws were revised in 1984 to exempt from any withholding tax foreign holders of bonds issued by US corporations. As a result, US corporations found it feasible for the first time to sell eurobonds directly to foreigners. Repeal of the US laws caused other governments--including those of France, Germany, and Japan--to liberalize their tax laws likewise to avoid outflows of capital from their markets. The consequence was an upsurge in demand for eurobonds from investors who wanted to take advantage of their tax benefits.The Global Equity MarketAlthough we have talked about the growth of the global equity market, strictly speaking there is no international equity market in the sense that there are international currency and bond markets. Rather, many countries have their own domestic equity markets in which corporate stock is traded. The largest of these domestic equity markets are to be found in the United States, Britain, Japan, and Germany. Although each domestic equity market is still dominated by investors who are citizens of that country and companies incorporated in that country, developments are internationalizing the world equity market. Investors are investing heavily in foreign equity markets to diversify their portfolios. By 1994, individuals and institutions had invested more than $1.3 trillion in stocks outside their home markets.19This figure continued to increase through 1997. Facilitated by deregulation and advances in information technology, this trend seems to be here to stay.An interesting consequence of the trend toward international equity investment is the internationalization of corporate ownership. Today it is still generally possible to talk about US corporations, British corporations, and Japanese corporations, primarily because the majority of stockholders (owners) of these corporations are of the respective nationality. However, this is changing. Increasingly, US citizens are buying stock in companies incorporated abroad, and foreigners are buying stock in companies incorporated in the United States. Looking into the future, Robert Reich has mused about "the coming irrelevance of corporate nationality."20A second development internationalizing the world equity market is that companies with historic roots in one nation are broadening their stock ownership by listing their stock in the equity markets of other nations. The reasons are primarily financial. Listing stock on a foreign market is often a prelude to issuing stock in that market toraise capital. The idea is to tap into the liquidity of foreign markets, thereby increasing the funds available for investment and lowering the firm's cost of capital. (The relationship between liquidity and the cost of capital was discussed earlier in the chapter.) Firms also often list their stock on foreign equity markets to facilitate future acquisitions of foreign companies. Other reasons for listing a company's stock on a foreign equity market are that the company's stock and stock options can be used to compensate local management and employees, it satisfies the desire for local ownership, and it increases the company's visibility with local employees, customers, suppliers, and bankers.Foreign Exchange Risk and the Cost of CapitalWe have emphasized repeatedly that a firm can borrow funds at a lower cost on the global capital market than on the domestic capital market. However, we have also mentioned that under a floating exchange rate regime, foreign exchange risk complicates this picture. Adverse movements in foreign exchange rates can substantially increase the cost of foreign currency loans, which is what happened to many Asian companies during the 1997 - 98 Asian financial crisis.Consider a South Korean firm that wants to borrow 1 billion Korean won for one year to fund a capital investment project. The company can borrow this money from a Korean bank at an interest rate of 10 percent, and at the end of the year pay back the loan plus interest, for a total of W 1.10 billion. Or the firm could borrow dollars from an international bank at a 6 percent interest rate. At the prevailing exchange rate of $1=W 1,000, the firm would borrow $1 million and the total loan cost would be $1.06 million, or W1.06 billion. By borrowing dollars, the firm could reduce its cost of capital by 4 percent, or W40 million. However, this saving is predicated on the assumption that during the year of the loan, the dollar/won exchange rate stays constant. Instead, imagine that the won depreciates sharply against the US dollar during the year and ends the year at $1=W1,500. (This occurred in late 1997 when the won declined in value from $1=W1,000 to $1=W1,500 in two months.) The firm still has to pay the international bank $1.06 million at the end of the year, but now this costs the company W1.59 billion (i.e., $1.06*1,500). As a result of the depreciation in the value of the won, the cost of borrowing in US dollars has soared from 6 percent to 59 percent, a huge rise in the firm's cost of capital. Although this may seem like an extreme example, it happened to many South Korean firms in 1997 at the height of the Asian financial crisis. Not surprisingly, many of them were pushed into technical default on their loans.Unpredictable movements in exchange rates can inject risk into foreign currency borrowing, making something that initially seems less expensive ultimately much more expensive. The borrower can hedge against such a possibility by entering into a forward contract to purchase the required amount of the currency being borrowed at a predetermined exchange rate when the loan comes due (see Chapter 9 for details). Although this will raise the borrower's cost of capital, the added insurance limits the risk involved in such a transaction. Unfortunately, many Asian borrowers did not hedge their dollar-denominated short-term debt, so when their currencies collapsed against the dollar in 1997, many saw a sharp increase in their cost of capital.When a firm borrows funds from the global capital market, it must weigh the benefits of a lower interest rate against the risks of an increase in the real cost of capital due to adverse exchange rate movements. Although using forward exchange markets may lower foreign exchange risk with short-term borrowings, it cannot remove the risk. Most importantly, the forward exchange market does not provide adequate coverage for long-term borrowings.Implications for BusinessThe implications of the material discussed in this chapter for international business are quite straightforward but no less important for being obvious. The growth of the global capital market has created opportunities for international businesses that wish to borrow and/or invest money. On the borrowing side, by using the global capital market, firms can often borrow funds at a lower cost than is possible in a purely domestic capital market. This conclusion holds no matter what form of borrowing a firm uses--equity, bonds, or cash loans. The lower cost of capital on the global market reflects their greater liquidity and the general absence of government regulation. Government regulation tends to raise the cost of capital in most domestic capital markets. The global market, being transnational, escapes regulation. Balanced against this, however, is the foreign exchange risk associated with borrowing in a foreign currency.On the investment side, the growth of the global capital market is providing opportunities for firms, institutions, and individuals to diversify their investments to limit risk. By holding a diverse portfolio of stocks and bonds in different nations, an investor can reduce total risk to a lower level than can be achieved in a purely domestic setting. Once again, however, foreign exchange risk is a complicating factor.The trends noted in this chapter seem likely to continue, with the global capital market continuing to increase in both importance and degree of integration over the next decade. Perhaps the most significant development will be the emergence of a unified capital market and common currency within the EU by the end of the decade as those countries continue toward economic and monetary union. Since Europe's capital markets are currently fragmented and relatively introspective (with the major exception of Britain's capital market), such a development could pave the way for even more rapid internationalization of the capital market in the early years of the next century. If this occurs, the implications for business are likely to be positive.