about risk reduced the access by governments of these other European countries to the debt market, since some financial institutions were no longer willing to loan them funds.
In addition, those governments had to pay a higher risk premium to compensate for their credit risk, which increased their cost of borrowing funds.
3-5b Issuance of Foreign Stock in the United States
Non-U.S. corporations that need large amounts of funds sometimes issue stock in the United States (these are calledYankee stock offerings) because the U.S. new-issues market is so liquid.
In other words, a foreign corporation is most likely to sell an entire issue of stock in the U.S.
market; in other, smaller markets, it will be more difficult to sell the entire issue.
When a non-U.S. firm issues stock in its own country, its shareholder base is quite limited. A few large institutional investors may own most of the shares. By issuing stock in the United States, non-U.S. firms may diversify their shareholder base; this can lessen the share price volatility induced by large investors selling shares.
Investment banks and other financial institutions in the United States often serve as underwriters of stock targeted for the U.S. market, and they receive underwriting fees of about 7 percent of the issued stock’s value. Because many financial institutions in the United States purchase non-U.S. stocks as investments, non-U.S. firms may be able to place an entire stock offering within the United States.
Many of the recent stock offerings in the United States by non-U.S. firms have resulted from privatization programs in Latin America and Europe. That is, businesses that were previously government owned are being sold to U.S. shareholders. Given the large size of some of these businesses, their local stock markets are not large enough to digest the stock offerings. Consequently, U.S. investors are financing many privatized businesses based in foreign countries.
Firms that issue stock in the United States are normally required to satisfy stringent disclosure rules regarding their financial condition. However, they are exempt from some of these rules when they qualify for a Securities and Exchange Commission guideline (called Rule 144a) through a direct placement of stock to institutional investors.
American Depository Receipts Non-U.S. firms also obtain equity financing by issuingAmerican depository receipts (ADRs), which are certificates representing bun- dles of the firm’s stock. The use of ADRs circumvents some disclosure requirements imposed on stock offerings in the United States while enabling non-U.S. firms to tap the U.S. market for funds. The ADR market grew when national businesses were being pri- vatized in the early 1990s, since some of these businesses issued ADRs to obtain financ- ing. Examples include Cemex (ticker symbol CX, based in Mexico), China Telecom Corp. (CHA, China), Nokia (NOK, Finland), Heinekin (HINKY, Netherlands), and Credit Suisse Group (CS, Switzerland).
Because ADR shares can be traded just like shares of a stock, the price of an ADR changes each day in response to demand and supply conditions. Over time, however, the value of an ADR should move in tandem with the value of the corresponding stock that is listed on the foreign stock exchange (after exchange rate effects are taken into account). The formula for calculating the price of an ADR is
PADR ¼PFSS
HerePADRdenotes the price of the ADR,PFSis the price of the foreign stock measured in for- eign currency, andSis the spot rate of the foreign currency. Holding the price of the foreign stock constant, the ADR price should move proportionately (against the dollar) with move- ment in the currency denominating the foreign stock. American depository receipts are espe- cially attractive to U.S. investors who anticipate that the foreign stock will perform well and that the currency in which it is denominated will appreciate against the dollar.
EXAMPLE A share of the ADR of the French firm Pari represents one share of this firm’s stock that is traded on a French stock exchange. The share price of Pari was 20 euros when the French market closed.
As the U.S. stock market opens, the euro is worth $1.05, so the ADR price can be calculated as
PADR¼PFSS
¼20$1:05
¼$21 l
If there is a difference between the ADR price and the price of the foreign stock (after adjusting for the exchange rate), then investors can use arbitrage to capitalize on this discrepancy. Over time, arbitrage will realign the prices.
EXAMPLE Continuing with the previous example, assume that there are no transaction costs. IfPADR<(PFSS) then ADR shares will flow back to France; they will be converted to shares of the French stock and then traded in the French market. Investors can engage in arbitrage by buying the ADR shares in the United States, converting them to shares of the French stock, and then selling those shares on the French stock exchange where the stock is listed.
The arbitrage will (1) reduce the supply of ADRs traded in the U.S. market, putting upward pressure on the ADR price, and (2) increase the supply of the French shares traded in the French market, putting downward pressure on the stock price in France. The arbitrage will continue until the discrepancy in prices disappears.l
The preceding example assumed a conversion rate of one ADR share per share of stock. Some ADRs are convertible into more than one share of the corresponding stock. Under these conditions, arbitrage will occur only if:
PADR¼ConvPFSS
where Conv denotes the number of shares of foreign stock that can be obtained for the ADR.
EXAMPLE If the Pari ADR described previously is convertible into two shares of stock, the ADR price should be:
PADR¼220$1:05
¼$42
In this case, the ADR shares will be converted into shares of stock only if the ADR price is less than $42.l
In reality, there are some transaction costs associated with converting ADRs to for- eign shares. This means that arbitrage will occur only if the potential arbitrage profit exceeds the transaction costs. One can find ADR price quotations on various websites, such as www.adr.com. Many of the sites that provide stock prices for ADRs are seg- mented by country.
3-5c Non-U.S. Firms Listing on U.S. Exchanges
Non-U.S. firms that issue stock in the United States have their shares listed on the New York Stock Exchange or the Nasdaq market. By listing their stock on a U.S. stock exchange, the shares placed in the United States can be easily traded in the secondary market.
Effect of the Sarbanes-Oxley Act on Foreign Stock Listings In 2002 the U.S. Congress passed the Sarbanes-Oxley Act, which required firms whose stock is listed on U.S. stock exchanges to provide more complete financial disclosure. The legislation resulted from financial scandals involving the U.S.-based MNCs Enron and WorldCom, which had used misleading financial statements to hide their weak financial condition.
Investors therefore overestimated the value of these companies’ stocks and eventually lost most or all of their investment. Sarbanes-Oxley was intended to ensure that financial reporting was more accurate and complete, although the cost for complying was esti- mated to be more than $1 million annually for some firms. Many non-U.S. firms decided WEB
www.wall-street.com/
foreign.html
Provides links to many stock markets.
WEB
finance.yahoo.com Access to various domestic and international financial markets and financial market news; also gives links to national financial news servers.
to place new issues of their stock in the United Kingdom, rather than the United States, so they could avoid complying with the law. Some U.S. firms that went public also decided to place their stock in the United Kingdom for the same reason. Furthermore, some non-U.S. firms listed on U.S. stock exchanges before the Sarbanes-Oxley Act de- registered after its passage; such withdrawals may be attributed to the high cost of compliance.
3-5d Investing in Foreign Stock Markets
Just as some MNCs issue stock outside their home country, many investors purchase stocks outside of the home country. There are several reasons for such a strategy. First, these investors may expect favorable economic conditions in a particular country and therefore invest in stocks of the firms in that country. Second, investors may wish to acquire stocks denominated in currencies that they expect to strengthen over time, since that would enhance the return on their investment. Third, some investors invest in stocks of other countries as a means of diversifying their portfolio. Thus, their invest- ment is less sensitive to possible adverse stock market conditions in their home country.
More details about investing in international stock markets are provided in the appendix to this chapter.
Comparing the Size of Stock Markets Exhibit 3.5 gives a summary of the major stock markets, although there are numerous other exchanges. Some foreign stock mar- kets are much smaller than the U.S. markets because their firms have traditionally relied more on debt financing than on equity financing. However, recent trends indicate that firms outside the United States now issue stock more frequently, which has led to the growth of non-U.S. stock markets. The percentage of individual versus institutional WEB
www.worldbank.org/
data
Information about the market capitalization, stock trading volume, and turnover in each stock market.
Exhibit 3.5 Comparison of Stock Exchanges (2013) C O U N T R Y
M A R K E T C A P I T A L I Z A T I O N ( b i l l i o n s o f d o l l a r s )
N U M B E R O F L I S T E D C O M P A N I E S
Argentina 42 107
Australia 1,422 2,056
Brazil 1,257 364
Chile 335 245
China 3,911 2,494
Greece 49 265
Hong Kong 2,978 1,547
Hungary 22 52
Japan 3,827 3,481
Mexico 551 136
Norway 259 228
Slovenia 20 61
Spain 1,038 3,200
Switzerland 1,222 265
Taiwan 740 840
United Kingdom 3,846 2,767
United States 20,948 5,003
Source:World Federation of Exchanges.
ownership of shares varies across stock markets. Outside the United States, financial institutions (and other firms) own a large proportion of the shares whereas individual investors own a relatively small proportion. Some related generalization (that applies to stock markets *in* the United States) goes here.
Large MNCs have begun to float new stock issues simultaneously in various countries.
In this case, investment banks underwrite stocks through one or more syndicates across countries. The global distribution of stock can then reach a much larger market, so greater quantities of stock can be issued at a given price.
In 2000, the stock exchanges of Amsterdam, Brussels, and Paris merged to create the Euronext market; since then, the Lisbon stock exchange has also joined. In 2007, the NYSE joined Euronext to create NYSE Euronext, the largest global exchange. It repre- sents a major step in creating a global stock exchange and will probably lead to more consolidation of stock exchanges across countries in the future. Most of the largest firms based in Europe have listed their stock on the Euronext market. This market is likely to grow over time because other stock exchanges may well join. A single European stock market with similar guidelines for all stocks, irrespective of their home country, would make it easier for investors who prefer to do all of their trading in one market.
In recent years, many new stock markets have been developed. Suchemerging markets allow foreign firms to raise large amounts of capital by issuing stock. These markets should enable U.S. firms doing business in developing countries to raise funds by issuing stock there and listing their stock on the local stock exchanges. Market characteristics, such as the amount of trading relative to market capitalization and the applicable tax rates, can vary substantially among different emerging markets.
3-5e How Market Characteristics Vary among Countries
In general, stock market participation and trading activity are higher in countries where managers of firms are encouraged to make decisions that serve shareholder interests. If investors believe that the money invested in firms will not be used to serve their interests or that the firms do not provide transparent reporting of their condition or operations, then they will probably not invest in the stocks of that country’s firms. An active stock market requires the trust of local investors, and increased trust leads to more participa- tion and trading. Exhibit 3.6 identifies some factors that enable stronger governance and thus may increase the trading activity in a stock market. These factors are discussed next.
Rights Shareholders in some countries have more rights than those in other coun- tries. For example, shareholders have more voting power in some countries than others, and they can have influence on a wider variety of management issues in some countries.
Legal Protection The legal protection of shareholders varies substantially among countries. Shareholders in some countries may have more power to sue publicly traded firms if their executives or directors commit financial fraud. In general, common-law countries (e.g., Canada, the United Kingdom, the United States) allow for more legal protection than civil-law countries (e.g., France and Italy). Managers are more likely to serve shareholder interests when shareholders have more legal protection.
Government Enforcement Government enforcement of securities laws varies among countries. A country might have laws to protect shareholders yet not adequately enforce those laws, which means that shareholders are not protected. Some countries tend to have less corporate corruption than others. In these countries, shareholders are less susceptible to major losses due to agency problems whereby managers use share- holder money for their own benefit.
Accounting Laws The amount of financial information that must be provided by public companies varies among countries. The variation may be due to accounting laws set by the government for public companies or to reporting rules enforced by local stock exchanges. Shareholders are less susceptible to losses stemming from insufficient informa- tion when more transparency is required of public companies in their financial reporting.
In general, stock markets that allow more voting rights for shareholders, more legal protection, more enforcement of the laws, less corruption, and more stringent account- ing requirements attract more investors who are willing to invest in stocks. This allows for more confidence in the stock market and greater pricing efficiency (since there is a large set of investors who monitor each firm). At the same time, the presence of many investors will attract a company to the stock market because under these conditions it can easily raise funds. A stock market that does not attract investors will not attract com- panies in search of funds; in this case, companies must rely either on stock markets in other countries or on credit markets (such as bank loans).
3-5f Integration of Stock Markets
Since the economies of countries are integrated and since conditions in the stock market reflect the host country’s prevailing and anticipated economic conditions, it follows that
Exhibit 3.6 Impact of Governance on Stock Market Participation and Trading Activity
Greater Investor Participation
and Trading Activity Managerial
Decisions Are Intended to Serve
Shareholders
Greater Transparency of Corporate Financial
Conditions Shareholder
Voting Power
Strong Shareholder
Rights
Strong Securities Laws
Low Level of Corporate Corruption
High Level of Financial Disclosure
stock market conditions are integrated. In particular, stock market conditions among European countries are highly correlated because the European economies are highly correlated. Strong stock market conditions in a few European countries have a favorable effect on other European stock markets because optimism in one market can spread throughout Europe. Likewise, adverse stock market conditions in one or more European countries can adversely affect other European stock markets because one market’s pessi- mism can spread throughout Europe.
3-5g Integration of International Stock Markets and Credit Markets
Conditions in the international credit and stock markets are integrated. The key link is the risk premium, which affects the rate of return required by financial institutions who provide credit or invest in stock. Under favorable conditions, the risk premium required by investors is low and valuations of debt securities (such as bonds) and stocks is high.
When economic conditions become unfavorable, however, there is more uncertainty sur- rounding the future cash flows of firms; hence the risk premium required by investors rises and valuations of debt securities and stocks fall. Consequently, stock prices often decline in response to any news that hints at a possible credit crisis.
EXAMPLE In the 2010–2012 period, news of government budget deficit problems in Greece caused concerns about credit risk that led to a decline in bank stock valuations. Greek banks could not increase their capital levels by issuing new stock because their stock prices were weak. Since they experi- enced serious loan losses and could not easily boost their capital levels, they were subject to pos- sible bankruptcy. Financial media reported on problems with banks in other European countries and frequently asked which European country would become “the next Greece.” Prospective investors and depositors avoided European banks for fear of suffering directly from the credit losses those banks might incur. As concerns about risk increased in countries such as Portugal, Spain, and Italy, their governments and firms were perceived as higher credit risks and forced to pay higher interest rates when seeking credit from banks. These higher rates further reduced their ability to repay the loans that they received. As the uncertainty surrounding firms increased, their stock prices declined.
As the European crisis intensified, its effects stretched beyond Europe. European banks serve as a major financial intermediary for emerging markets in Asia. The financial problems experi- enced by banks in Europe caused them to restrict their credit, which had the effect of limiting the access of some Asian companies to credit. Thus, economies of some Asian countries were restricted by the limited amount of credit that their firms could obtain. As the Asian economies weakened, their demand for products in Europe declined. These events provide another illustra- tion of contagion effects resulting from the international integration of economies. Note also that the weakness in the Asian credit markets caused more uncertainty about stock values and thus declining stock values.l