INTERNATIONAL

UNIT 5 SECTION 4 THE INTERNATIONAL CAPITAL MARKET

BUSINESS Unit 5, section 4: The international capital market

Welcome to the fourth Section of unit 5. Section three addressed issues

related to the functions of the foreign exchanges including the terminologies
used in such transactions. This Section will look at the nature of
international capital market, the distinction between debt and equity, and the
main components of the international market.

By the end of this Section, you should be able to;

 explain the nature of the international capital market
 differentiate between debt and equity financing
 explain any two of the main components of the international capital
market

Read on

Nature of the International Capital Market

A capital market brings together those who want to invest money and those
who want to borrow money. Its main purpose is to provide a mechanism
through which those who wish to borrow or invest money can do so
efficiently. Individuals, firms with surplus cash, and non-banking financial
institutions (e.g. pension funds, insurance companies) could be investors.
Those who want to borrow money are individuals, companies, and
governments. In between these two groups are the market makers. Market
makers are the financial service companies such as commercial banks that
connect investors and borrowers, either directly or indirectly.

Companies can obtain financing in the global money market, the collective
financial markets where firms and governments raise short-term financing.
Alternatively, companies may obtain financing from the global capital
market, the collective financial markets where firms and governments raise
intermediate and long-term financing. Since funding for most projects
comes from instruments whose maturity period is over one year, we refer to
all such funding as capital. The benefit for corporations is the ability to
access funds from a large pool of sources at a competitive cost. Access to
capital is one of the main criteria businesses consider when deciding to
expand abroad.

Commercial banks take deposits from firms and individuals and pay them a
rate of interest in turn. They then loan that money to borrowers at a higher
rate of interest, making a profit from the difference in interest rates.
Investment banks perform a direct connection function as they bring
investors and borrowers together and charge commissions for doing so.

The Distinction between Debt and Equity

Companies obtain capital in two basic ways: by borrowing it or by selling
shares of ownership in the firm. Capital market loans to firms are either equity
loans or debt loans. An equity loan is made when a firms sells stock to

172 UEW/IEDE
 INTERNATIONAL
Unit 5, section 4: The international capital market BUSINESS

investors. The money the firm receives in return for its stock can be used to
purchase plants and equipment, fund research and development projects,
pay wages, and so on. A share of stock gives its holder a claim to a firm's
profit stream. The firm honours this claim by paying out dividends to the
stockholders. The amount of the dividends is not fixed in advance; rather,
management based on how much profit the firm is making determines it.
The main advantage of equity financing is that the firm obtains capital
without debt. However, whenever new equity is sold, the firm’s ownership
is diluted. Management also risks losing control in the event that one or
more shareholders acquire a controlling interest.

A debt loan requires the firms 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. Unlike equity loans,
management has no discretion as to the amount it will pay investors. In debt
financing, a firm borrows money from a creditor (or sells bonds) in
exchange for repayment of the principal and an agreed-upon interest amount
in the future. The main advantage is that the firm does not sacrifice any
ownership to obtain needed capital. The firm may borrow from banks in its
home market or foreign markets. However, borrowing internationally is
complicated by differences in national banking regulations, inadequate
banking infrastructure, shortage of loanable funds, macroeconomic
difficulties, and fluctuating currency values. 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/she purchases the right to
receive a specified fixed stream of income from the firm for a specified
number of years (i.e. until the bound maturity date).

Main Components of the International Capital Market

The main components include the international bond, international equity
and Euro currency market.

 International Bond Market

This market is available to both domestic and foreign investors. This market
consists of both foreign bonds and Eurobonds. Issuing bonds internationally
is an increasingly popular way to obtain needed funding. A foreign bond is a
bond sold outside the borrower’s country but denominated in the currency of
the country where it was issued. A Eurobond is a financial instrument that is
typically underwritten by a syndicate of banks from different countries and is
sold in countries other than the one in which its currency is denominated. For
example, a Eurobond to raise $50 million for a Swiss company might be
underwritten by a syndicate from five different countries, floated in French
francs and sold in Luxembourg, the Netherlands, Spain and Italy. Eurobonds
are popular because governments of the countries they are sold in do not
regulate them. This substantially reduces the cost of issuing a bond but
increases its risk level. The traditional markets for Eurobonds are Europe and
North America.

UEW/IEDE 173
INTERNATIONAL
BUSINESS Unit 5, section 4: The international capital market

Foreign bonds account for approximately 22 percent of all international

bonds and follow the same rules and regulations as the domestic bonds of
the country in which they are raised. UK bonds are called Bulldog bonds;
US bonds called Yankee bonds; and Asia bonds called Dragon Bonds. Low
interest rates (cost of borrowing) fuel the growth of international bond market.
Low interest rates mean investors can earn little interest on bonds. Investors
seeking higher returns and borrowers seeking to pay lower interest rates
interplay through international bond markets;
 issuing bonds that borrowers from newly or developing countries can
borrow at lower interest rates and
 encouraging investors in developed countries to buy bonds in newly
industrialised and developing countries in order to obtain higher returns
on their investments (irrespective of the higher risks).
Despite these benefits, many emerging markets are developing their own
national markets due to the volatility in global currency market.

 International Equity Market

The globalisation of equity markets has been facilitated by the globalisation of
the financial services industry. Equity markets are now more global. This
market consists of all stocks bought and sold outside the issuer's home country.
This has led to the development of country fund – a mutual fund that
specialises in investing in a given country’s firms. Governments and
companies sell shares in this market. Frankfurt, London and New York are
the greatest stock exchange’s listing many numbers of companies from
outside their own borders. Some international companies list their stocks on
both national and international markets simultaneously. Factors that have led
to the growth of international equity markets include the spread of
privatisation, economic growth in emerging markets, activity of investment
banks and automation of stock exchanges.

 Eurocurrency Market
This market consists of the entire world's currency banked outside their
countries of origin and are traded on the Eurocurrency market. It is a
wholesale market in which transactions are conducted by governments with
excess funds generated by a prolonged trade surplus, banks with large
deposits of excess currency, extremely wealthy individuals and major
corporations. Deposits are primarily short term and consist of savings and
time deposits rather than demand deposits. Loans are typically pegged to a
certain percentage above the London interbank offered rate (LIBOR), which
is the interest rate banks charge one another on Eurocurrency loans. British
pounds deposited in New York are called Europounds; US dollars deposited
in Tokyo are called Eurodollars; Japanese Yen deposited in Frankfurt are
called Euroyen.etc. The Eurocurrency originated from Europe hence the
'Euro' prefix. This market is valued at around $6 trillion, with London
accounting for about 21 percent of all deposits.

174 UEW/IEDE
 INTERNATIONAL
Unit 5, section 4: The international capital market BUSINESS

The international capital market is growing in sophistication as a result of

technological advances in telecommunication and computers. This has led
to the companies increasing engaged in overseas operations. We have
studied the international capital market and have looked at the distinction
between debt and equity as well appreciating the main components of the
international capital market.

Now assess your understanding of this Section by answering the following

self-assessment questions. Good luck!

Activity 5.4
 Explain the differences between equity financing and debt financing,
and discuss the ways international firms obtain equity financing or debt
financing.

Did you score all? That’s great! Keep it up.

UEW/IEDE 175