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FNCE 3020 Financial Markets and Institutions


World Stock Market Capitalization, 1980 -2007, Trillions of U.S. Dollars ... Historical Review of Security Return (Stock Market) Correlations ... – PowerPoint PPT presentation

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Title: FNCE 3020 Financial Markets and Institutions

FNCE 3020Financial Markets and Institutions
  • Lecture 11
  • Capital Markets
  • An Overview of the Equity Markets

Common Stock
  • Defining Common Stock These are securities
  • 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
  • One of three major ways in which business obtain
  • (1) Equity Offerings (IPOs)
  • (2) Issuing Bonds
  • (3) Borrowing Short term in Money Markets

World Stock Market Capitalization, 1980 -2007,
Trillions of U.S. Dollars
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
  • Emerging Europe 1.8
  • Note Dollar amount of global equity markets in
    2002 22.1 Trillion

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
  • Emerging markets share has increased from 8 to
  • U.S. share has declined from 50 to 39

Country Preferences for Raising Capital, Debt to
Equity Ratios Average 1980-91
Trends in Debt to Equity Ratios, 1977 - 1992
Recent Trend in U.S. , 1996 - 2006
What Influences a Firms Financing Preferences?
  • Equity Risk Cultures (Investors and Owners)
  • U.S and U.K. well developed and acceptance of
  • 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

The Value of Financial Claims on Firms, 2003 as a
of GDP (A Measure of Equity Risk Culture
Comparison of Household Financial Asset
Allocation (Risk Cultures)
Global Equity Market Recent Trends
  • (1) Equity markets (stock exchanges) going public
  • Historically stock markets were private
  • 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
  • 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

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).

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

Issues with Consolidations
  • Major issues today in stock market consolidations
  • Cultural differences
  • Trading platform differences
  • Regulation differences
  • Regulation Concern Will one countrys
    regulation become the standard for both
  • 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
  • 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.

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
  • Approximately 300 stock exchanges around the
  • 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.

Global Equity Market Recent Trends
  • (5) Companies listing their common stock on
    foreign stock markets as well as their home stock
  • 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
  • (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

Percent of Foreign IPOs in the U.S.
Is the U.S. Equity Markets Competitive Position
  • 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
  • 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

Is Americas Competitive Position Really
  • 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

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?

Equity Returns Vary Considerably
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.

International Diversification
  • Empirical evidence suggests that international
    diversification can potentially enhance the
    reward-to-volatility ratio of an investors
  • 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)?

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.

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

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
  • 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)

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.

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.

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
  • During negative U.S. months the correlation was
  • During the 20 year period 1984 2004
  • During positive U.S. months the correlation was
  • During negative U.S. months the correlation was
  • Correlations higher during U.S. market downturns.

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?

Exchange Rates Impact in 2005
Exchange Rates Impact in 2006
Exchange Rates Impact in 2007
Examples of Exchange Rate Impacts in 2007
Appendix 1 Overview of the Worlds Major Stock
  • This section includes a discussion of the Tokyo
    Stock Exchange, the London Stock Exchange and

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

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
  • The first section is for the largest, most
    successful companies - often referred to as 'blue
  • 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.

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
  • 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.

  • Euronext (Paris based holding company) formed in
    September 2000 by the merger of
  • the Amsterdam, Brussels Exchanges and Paris
  • 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
  • Official web site http//www.euronext.com/
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