FNCE 3020 Financial Markets and Institutions

1
FNCE 3020Financial Markets and Institutions

• Lecture 11
• Capital Markets
• An Overview of the Equity Markets

2
Common Stock

• Defining Common Stock These are securities
  representing
• equity ownership in a corporation,
• providing voting rights, and
• entitling the holder to a share of the company's
  success through dividends and/or capital
  appreciation.
• One of three major ways in which business obtain
  funds
• (1) Equity Offerings (IPOs)
• (2) Issuing Bonds
• (3) Borrowing Short term in Money Markets

3
World Stock Market Capitalization, 1980 -2007,
Trillions of U.S. Dollars
4
Global Stock Markets Trillions of U.S. Dollars
and of Total, 2006 (2002)

• World 50.8 100.0
• Developed Markets 39.1 77.0 (91.8)
• U.S. 19.6 38.6 (50.1)
• Japan 4.8 9.5 ( 9.4)
• UK 3.8 7.5 ( 8.2)
• EU 13.1 25.8 (25.0)
• Euro area 8.4 16.5 (15.7)
• Germany 1.6 3.2
• Emerging Markets 11.7
  23.0 ( 8.2)
• Emerging Asia 6.9 13.5 ( 5.7)
• Emerging Latin America 1.5
  3.0
• Emerging Europe 1.8
  3.5
• Note Dollar amount of global equity markets in
  2002 22.1 Trillion

5
Global Stock Markets Summary

• From 2002 to 2006, the combined stock markets of
  the world has grown 130.
• Developed markets have grown 93
• Emerging markets have grown 550
• U.S. market has grown 77
• From 2002 to 2006
• Developed markets share has declined from 92 to
  77
• Emerging markets share has increased from 8 to
  23
• U.S. share has declined from 50 to 39

6
Country Preferences for Raising Capital, Debt to
Equity Ratios Average 1980-91
7
Trends in Debt to Equity Ratios, 1977 - 1992
8
Recent Trend in U.S. , 1996 - 2006
9
What Influences a Firms Financing Preferences?

• Equity Risk Cultures (Investors and Owners)
• U.S and U.K. well developed and acceptance of
  risk.
• Europe and Asia not as well developed less
  tolerance for equity risk taking.
• Chinese versus Americans.
• Tax Treatment of Sources of Funds
• Level of Development of Financial Markets
• Especially equity markets How large, how liquid,
  how open?
• Level of Development of Financial Institutions
• Commercial banks, investment banks, brokerage
  firms

10
The Value of Financial Claims on Firms, 2003 as a
of GDP (A Measure of Equity Risk Culture
11
Comparison of Household Financial Asset
Allocation (Risk Cultures)
12
Global Equity Market Recent Trends

• (1) Equity markets (stock exchanges) going public
• Historically stock markets were private
  organizations.
• However, in February of 2001 Germanys stock
  exchange, the Deutsche Börse went public
• In July 2001, the London Stock Exchange and
  Euronext went public
• In 2006, the NYSE followed.
• (2) Consolidations (mergers) between stock
  exchanges.
• Facilitated by publically traded exchanges.
• NYSE and Paris based Euronext merged on April 4,
  2007 (formed NYSE Euronext, NYX).
• Visit their web site at http//www.nyse.com/
• Why are exchanges merging to provides liquidity
  and global outreach benefits to investors,
  capital raising benefits to corporations and cost
  reductions to the exchanges themselves

13
Stock Exchange Consolidations

• October 22, 2000 Euronext, based in Paris,
  becomes the first pan-European stock exchange
  with the merger of Amsterdam, Brussels and Paris
  exchanges. Acquired the Portugal stock exchange
  and LIFFE (London International Financial Futures
  Exchange) in 2002.
• March 7, 2006 The NYSE Group is formed with the
  acquisition of Archipelago Holdings (an
  electronic trading platform for stocks) and the
  Pacific Stock Exchange.
• April 4, 2007 NYSE Group and Euronext merge to
  form NYSE Euronext. This creates the worlds
  largest stock exchange (combined capitalization
  of 27 billion at that time).

14
Stock Exchange Consolidations

• 2006 NASDAQ fails in its second attempt to
  takeover (through a hostile takeover) of the
  London Stock Exchange.
• January 31, 2007 NYSE Euronext enters into a
  strategic alliance with the Tokyo Stock Exchange
  to work on share trading information and
  strategies (will this lead to an eventual merger
  of the two?)
• June 2007 London Stock Exchange acquires Borsa
  Italiana.

15
Issues with Consolidations

• Major issues today in stock market consolidations
  involve
• Cultural differences
• Trading platform differences
• Regulation differences
• Regulation Concern Will one countrys
  regulation become the standard for both
  exchanges?
• Specifically for the U.S. and a foreign exchange
  Will the Sarbanes Oxley Act of 2002 become the
  regulatory standard for U.S. exchange mergers
  overseas?
• NYSE and Euronext merger overcame this by each
  countrys regulatory body agreeing that each
  exchange (and thus the securities listed on each
  exchange) would continue to be regulated by the
  country in which they operate.

16
Global Equity Market Recent Trends

• (3) Increasing number of stock markets
• John Thain, 2006, CEO, the NYSE Most countries
  have an army, a flag, an airline, and a stock
  exchange.
• Approximately 300 stock exchanges around the
  world.
• Today, many emerging countries have their own
  stock markets.
• Part of their privatization process.
• (4) Declining share of U.S. equity market in the
  overall global equity picture.
• Down to 38.6 in 2006 compared to 50 in 2002.

17
Global Equity Market Recent Trends

• (5) Companies listing their common stock on
  foreign stock markets as well as their home stock
  market
• Done through a process called cross listing.
• Viewed as a means of raising capital globally
  (IPOs) and facilitating global trading in company
  shares (taking on an international investor
  base).
• (6) Foreign companies engaging in IPOs in foreign
  equity markets, with the U.S. historically being
  dominant, but
• Perhaps recently slipping in importance because
  of the June 2002 Sarbanes-Oxley Act and its
  requirements (see next slide).
• London is becoming a major foreign company IPO
  market.

18
Percent of Foreign IPOs in the U.S.
19
Is the U.S. Equity Markets Competitive Position
Declining?

• Those that say yes, point to data which show a
  decline in U.S. equity market involvement in
• IPO distribution
• In 1999, the American markets accounted for 57
  of world wide IPOs. In 2006, Americas share had
  fallen to 18 and to about 7 in 2007.
• Foreign stocks listed in the U.S.
• U.S. equity markets have seen a decline in the
  number of foreign companies listings.
• Since peaking in 2002, NYSE foreign listings have
  fallen 4 to 451 and NSADAQ has fallen 34 to 321
  (since 2000).
• In 2007, 68 foreign companies delisted from the
  NYSE (including British Airways, Fiat, and
  Bayer), representing about 15 of all foreign
  listings.
• The explanation for this decline is that
  increasing regulation is putting U.S. markets at
  a competitive disadvantage.
• It is estimated that Sarbanes Oxley added 2 to
  3 million in average annual compliance costs for
  companies.

20
Is Americas Competitive Position Really
Declining?

• Some argue no and suggest that the data simply
  suggests that foreign markets have become larger,
  thus encouraging companies to seek IPOs in their
  home markets.
• In addition, trading across borders has become
  easier, thus reducing the usefulness of a
  non-home country listing.
• In essence, the changing U.S. position simply
  represents the changing nature of global
  financial markets.
• For a full development of this side of the
  argument, please see web site reading A Global
  Twist.

21
Equity Markets and Global Diversification

• Recall that stock markets are opening up all over
  the world.
• This has resulted in expanding opportunities for
  global investors and global companies in
• Asia
• Latin America
• Eastern Europe
• Africa/Middle East
• Question Do returns vary cross country?
• Question Are there diversification possibilities
  for global investors?

22
Equity Returns Vary Considerably
23
Why Invest in Foreign Equities?

• Brainard and Tobin (1992) demonstrated that
  international diversification can be an effective
  hedging tool against domestic economic shocks
  since an investor can create a better risk/return
  trade-off by investing in more than one market.
• Parillo and Zumwalt (1996) revealed that risk
  reduction and higher returns are attainable via
  international diversification because of low
  correlations between stock price movements on the
  various national exchanges.

24
International Diversification

• Empirical evidence suggests that international
  diversification can potentially enhance the
  reward-to-volatility ratio of an investors
  portfolio.
• Why? Even though correlations between the U.S.
  market and other major industrialized economies
  are typically positive, they are often are
  significantly lower than correlations between
  stocks in a well-diversified domestic portfolio.
• One issue What is happening to these cross
  country positive correlations (especially to the
  U.S. market)?

25
The Efficient Frontier

• The efficient frontier graphs into a C-shaped
  curve the potential impact of including foreign
  securities in a portfolio.
• The Efficient Frontier is a general depiction of
  potential long-run diversification gains, given
  the long-term historical record of foreign and
  U.S. equity markets.

26
Historical Review of Security Return (Stock
Market) Correlations

• In the 1970s, when the investing world began to
  discover the benefits of global diversification,
  security returns showed little correlation.
• 1973-1982 Data U.S. Stock Market to
• German Market 0.170
• Japanese Market 0.137
• United Kingdom Market 0.279

27
Correlations in the Late 1980s and into the 1990s

• During this period, stock returns across markets
  started to show a greater relationship.
• Driven by the globalization process.
• First evidence October 1987 global stock market
  crash when most developed markets declined
  together.
• View http//archives.cbc.ca/on_this_day/10/19/
• 1980-2000 correlation data of US markets to
• German market 0.45 (0.170)
• Japanese market 0.31 (0.137)
• United Kingdom market 0.58 (0.279)

28
Correlation of Developed Markets to U.S. Market,
To June 30, 2007

• MSCI EAFE Index to the SP 500
• 1973 to June 30, 2007 .310
• 1988 to June 30, 2007 .381
• 1997 to June 30, 2007 .660
• The MSCI (Morgan Stanley Capital International)
  EAFE Index consists indices from 21 developed
  markets Australia, Austria, Belgium, Denmark,
  Finland, France, Germany, Greece, Hong Kong,
  Ireland, Italy, Japan, Netherlands, New Zealand,
  Norway, Portugal, Singapore, Spain, Sweden,
  Switzerland, United Kingdom. The index excludes
  those from the U.S. and Canada. Combined the MSCI
  EAFE represents over 1,100 companies. The index
  has as its base (100) December 31, 1969.

29
Correlation of Emerging Markets to U.S. Market,
To June 30, 2007

• MSCI Emerging Markets Index to the SP 500
• 1988 to June 30, 2007 .346
• 1997 to June 30, 2007 .551
• The MSCI (Morgan Stanley Capital International)
  Emerging Market Index consists of indices
  representing 26 emerging economies Argentina,
  Brazil, Chile, China, Colombia, Czech Republic,
  Egypt, Hungary, India, Indonesia, Israel, Jordan,
  Korea, Malaysia, Mexico, Morocco, Pakistan, Peru,
  Philippines, Poland, Russia, South Africa,
  Taiwan, Thailand, Turkey and Venezuela. Combined
  the MSCI represents over 700 companies. The
  index has as its base (100) December 31, 1987.

30
International Diversification

• Additional Measures of Stock Market Correlations
• What happens to these correlations during
  different market swings (i.e., when the U.S.
  market returns have been positive and when they
  have been negative)?
• During the 25 year period 1960 1984
• During positive U.S. months the correlation was
  0.28
• During negative U.S. months the correlation was
  0.48
• During the 20 year period 1984 2004
• During positive U.S. months the correlation was
  0.41
• During negative U.S. months the correlation was
  0.71
• Correlations higher during U.S. market downturns.
  

31
Risk in Global Investing

• Company Risk
• Market Risk
• Foreign Exchange Risk
• This is unique to foreign equity investing.
• Issue Do changes in foreign exchange rates have
  much affect on home currency returns?

32
Exchange Rates Impact in 2005
33
Exchange Rates Impact in 2006
34
Exchange Rates Impact in 2007
35
Examples of Exchange Rate Impacts in 2007
36
Appendix 1 Overview of the Worlds Major Stock
Exchanges

• This section includes a discussion of the Tokyo
  Stock Exchange, the London Stock Exchange and
  Euronext.

37
Worlds Major Stock Exchanges

• U.S.
• NYSE (now NYSE Euronext)
• NASDAQ
• London
• London Stock Exchange (LSE)
• Japan
• Tokyo Stock Exchange (TSE)
• Continental Europe
• Paris based Euronext (now NYSE Euronext)
• Frankfurt (Deutsche Borse)

38
Tokyo Stock Exchange

• One of the oldest stock exchanges in Asia founded
  in 1878 (the oldest is the Bombay Stock Exchange
  in India founded in 1875).
• There are two major sections on the Tokyo Stock
  Exchange
• The first section is for the largest, most
  successful companies - often referred to as 'blue
  chips'.
• The second section is for smaller companies with
  lower trading volume levels.
• Official web site http//www.tse.or.jp/
• Tokyos major stock market index is the TOPIX
  (TOkyo stock Price IndeX). This index includes
  all First Section listed shares.

39
London Stock Exchange

• Founded in 1792.
• Initially used by British Government to raise
  funds (war with France).
• Big Bang in 1986 series of reforms liberalizing
  commissions and introducing a screen based
  trading system. Paved the way for foreign
  ownership.
• Important to Western European market IPOs (80
  are done through the LSE Euronext at 5)
• Major stock index is the FTS 100 (largest 100
  U.K. firms).
• Official web site http//www.londonstockexchange.
  com

40
Euronext

• Euronext (Paris based holding company) formed in
  September 2000 by the merger of
• the Amsterdam, Brussels Exchanges and Paris
  Bourse.
• Added the Lisbon Exchange and London
  International Financial Futures Exchange (LIFFE)
  in 2002.
• As a result of the Liffe acquisition, it is the
  2nd largest derivatives exchange in the world.
• Created a 5 country cross-border, electronic
  market for European and international equities
  and bonds.
• Merged with the NYSE in April 2007.
• Euronexts major stock index is the Euronext 100
  (representing the 100 largest European
  companies).
• Official web site http//www.euronext.com/