CHAPTER 13 INTERNATIONAL EQUITY MARKETS ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Exhibit 13.11 presents a listing of major national stock market indexes as displayed daily in the print edition of the Financial Times. At www.ft.com you can find an online tracking of these national stock market indexes that shows performance over the past day, month, and year. Go to this website and compare the performance for several stock market indexes from various regions of the world. How does the performance compare? What do you think accounts for differences? Answer: This question is designed to provide an intuitive understanding of the benefits from international diversification of equity portfolios. Over different time periods, different market forces will affect each national market in unique ways. Some markets will have yielded a positive return and others a negative return. Consequently, since all markets will not have moved in unison, i.e., are not perfectly correlated, international diversification provides volatility reduction to the portfolio investor. 2. As an investor, what factors would you consider before investing in the emerging stock market of a developing country? Answer: An investor in emerging market stocks needs to be concerned with the depth of the market and the market’s liquidity. Depth of the market refers to the opportunities to invest in the country. One measure of the depth of the market is the concentration ratio of a country’s stock market. The concentration ratio frequently is calculated to show the market value of the ten largest stocks traded as a fraction of the total market capitalization of all equities traded. The higher the concentration ratio, the less deep is the market. That is, most value is concentrated in only a few companies. While this does not necessarily imply that the largest stocks in the emerging market are not good investments, it does, however, suggest that there are few opportunities for investment in that country and that proper diversification within the country may be difficult. In terms of liquidity, an investor would be wise to examine the market turnover ratio of the country’s stock market. High market turnover suggests that the market is liquid, or that there are opportunities for purchasing or selling the stock quickly at close to the current market price. This is important because liquidity means you can get in or out of a stock position quickly without spending more than you intended on purchase or receiving less than you expected on sale. 3. Compare and contrast the various types of secondary market trading structures. Answer: There are two basic types of secondary market trading structures: dealer and agency. In a dealer market, the dealer serves as market maker for the security, holding an inventory of the security. The dealer buys at his bid price and sells at his asked price from this inventory. All public trades go through the dealer. In an agency market, public trades go through the agent who matches it with another public trade. Both dealer and agency markets can be continuous trade markets, but non-continuous markets tend to be only agency markets. Over-the-counter trading, specialist markets, and automated markets are types of continuous market trading systems. Call markets and crowd trading are each types of non-continuous trading market systems. Continuous trading systems are desirable for actively traded issues, whereas call markets and crowd trading offer advantages for smaller markets with many thinly traded issues because they mitigate the possibility of sparse order flow over short time periods. 4. Discuss any benefits you can think of for a company to (a) cross-list its equity shares on more than one national exchange, and (b) to source new equity capital from foreign investors as well as domestic investors. Answer: A MNC that has a product market presence or manufacturing facilities in several countries may cross-list its shares on the exchanges of these same countries because there is typically investor demand for the shares of companies that are known within a country. Additionally, a company may cross-list its shares on foreign exchanges to broaden its investor base and therefore to increase the demand for its stock. An increase in demand will generally increase the stock price and improve its market liquidity. A broader investor base may also mitigate the possibility of a hostile takeover. Additional, cross-listing a company’s shares establishes name recognition and thus facilitates sourcing new equity capital in these foreign capital markets. 5. Why might it be easier for an investor desiring to diversify his portfolio internationally to buy depository receipts rather than the actual shares of the company? Answer: A depository receipt can be purchased on the investor’s domestic exchange. It represents a package of the underlying foreign security that is priced in the investor’s local currency and in a trading range that is typical for the investor’s marketplace. The investor can purchase a depository receipt directly from his domestic broker, rather than having to deal with an overseas broker and the necessity of obtaining foreign funds to make the foreign stock purchase. Additionally, dividends are received in the local currency rather than in foreign funds that would need to be converted into the local currency. 6. Why do you think the empirical studies about factors affecting equity returns basically showed that domestic factors were more important than international factors, and, secondly, that industrial membership of a firm was of little importance in forecasting the international correlation structure of a set of international stocks? Answer: While national security markets have become more integrated in recent years, there is still a tremendous amount of segmentation that brings about the benefit to be derived from international diversification of financial assets. Monetary and fiscal policies differ among countries because of different economic circumstances. The economic policies of a country directly affect the securities traded in the country, and they will behave differently than securities traded in another country with other economic policies being implemented. Hence, it is not surprising that domestic factors are found to be more important than international factors in affecting security returns. Similarly, industrial activity within a country is also affected by the economic policies of the country; thus firms in the same industry group, but from different countries, will not necessarily behave the same in all countries, nor should we expect the securities issued by these firms to behave alike. PROBLEMS 1. On the Tokyo Stock Exchange, Honda Motor Company stock closed at ¥3,945 per share on Thursday, April 11, 2013. Honda trades as and ADR on the NYSE. One underlying Honda share equals one ADR. On April 11, 2013, the ¥/$ spot exchange rate was ¥99.8270/$1.00. a. At this exchange rate, what is the no-arbitrage U.S. dollar price of one ADR? b. By comparison, Honda ADRs traded at $39.97. Do you think an arbitrage opportunity exists? Solution: a. The no-arbitrage ADR U.S. dollar price is: ¥3,945 ÷ 99.8270 = $39.52. b. It is unlikely that an arbitrage opportunity exists after transaction costs. Additionally the slight difference in prices is likely accounted for by a difference in information contained in prices since the Tokyo Stock Exchange closes several hours before the NYSE. The days trading range for Honda ADR on the NYSE was $39.45—$40.15; the no-arbitrage price was inside this range. 2. If Honda ADRs were trading at $44 when the underlying shares were trading in Tokyo at ¥3,945, what could you do to earn a trading profit? Use the information in problem 1, above, to help you and assume that transaction costs are negligible. Solution: As the solution to problem 1 shows, the no-arbitrage ADR U.S. dollar price is $39.52. If Honda ADRs were trading at $44, a wise investor might sell short the relatively overvalued ADRs. Since the ADRs are a derivative security, one would expect the ADRs to decrease in price from $44 to $39.52. Assuming this happens, the position could be liquidated for a profit of $44 - $39.52 = $4.48 per ADR. MINI CASE: SAN PICO’S NEW STOCK EXCHANGE San Pico is a rapidly growing Latin American developing country. The country is blessed with miles of scenic beaches that have attracted tourists by the thousands in recent years to new resort hotels financed by joint ventures of San Pico businessmen and moneymen from the Middle East, Japan, and the United States. Additionally, San Pico has good natural harbors that are conducive for receiving imported merchandise from abroad and exporting merchandise produced in San Pico and other surrounding countries that lack access to the sea. Because of these advantages, many new businesses are being started in San Pico. Presently, stock is traded in a cramped building in La Cobijio, the nation’s capital. Admittedly, the San Pico Stock Exchange system is rather archaic. Twice a day an official of the exchange will call out the name of each of the 43 companies whose stock trades on the exchange. Brokers wanting to buy or sell shares for their clients then attempt to make a trade with one another. This crowd trading system has worked well for over one hundred years, but the government desires to replace it with a new modern system that will allow greater and more frequent opportunities for trading in each company, and will allow for trading the shares of the many new start-up companies that are expected to trade in the secondary market. Additionally, the government administration is rapidly privatizing many state-owned businesses in an attempt to foster their efficiency, obtain foreign exchange from the sale, and convert the country to a more capitalist economy. The government believes that it could conduct this privatization faster and perhaps at more attractive prices if it had a modern stock exchange facility where the shares of the newly privatized companies will eventually trade. You are an expert in the operation of secondary stock markets and have been retained as a consultant to the San Pico Stock Exchange to offer your expertise in modernizing the stock market. What would you advise? Suggested Solution to San Pico’s New Stock Exchange Most new and renovated stock exchanges are being established these days as either a partially or fully automated trading system. A fully automated system is especially beneficial for a small to medium size country in which there is only moderate trading in most issues. Such a system that deserves special note is the continuous National Integrated Market system of New Zealand. This system is fully computerized and does not require a physical structure. Essentially, all buyers and sellers of a stock enter through their broker into the computer system the number of shares they desire to buy or sell and their required transaction price. The system is updated constantly as new purchase or sale orders are entered into the system. The computer constantly searches for a match between buyer and seller, and when one is found a transaction takes place. This type of system would likely serve San Pico’s needs very well. There is existing technology to implement, the bugs have been worked out in other countries, and it would satisfy all the demands of the San Pico government and easily accommodate growth in market activity. International Equity Markets Chapter Thirteen Chapter Outline • A Statistical Perspective – Market Capitalization of Developed Countries – Market Capitalization of Developing Countries – Measures of Liquidity – Measures of Market Concentration • Market Structure, Trading Practices, and Costs • Trading in International Equities – Magnitude of International Equity Trading – Cross-Listing of Shares – Yankee Stock Offerings – The European Stock Market – American Depository Receipts – Empirical Findings on Cross-Listing and ADRs Chapter Outline Continued • International Equity Market Benchmarks • iShares MSCI • Factors Affecting International Equity Returns – Macroeconomic Factors – Exchange Rates – Industrial Structure A Statistical Perspective • Market capitalization of developed countries • Market capitalization of developing countries • Measures of liquidity • Measures of market concentration Market Capitalization of Developed Countries • At year-end 2012, total market capitalization of the world’s equity markets stood at $53,164 billion. • Of this amount, 75 percent is accounted for by market capitalization of major equity markets from 31 developed countries. Market Capitalization of Developing Countries • The other 25 percent is accounted for by market capitalization of developing countries in emerging markets: – Latin America – Asia – Eastern Europe – Mideast/Africa Emerging Markets • Standard & Poor’s Emerging Markets Database classifies a stock market as “emerging” if it meets at least one of two general criteria: – It is located in a low- or middle-income economy as defined by the World Bank. – Its investable market capitalization is low relative to its most recent GNI figures. Measures of Liquidity • The equity markets of the developed world tend to be much more liquid than emerging markets. – Liquidity refers to how quickly an asset can be sold without a major price concession. • So, while investments in emerging markets may be profitable, the investor’s focus should be on the long term. Measures of Liquidity • One measure of liquidity for a stock market is the turnover ratio: ▪ The higher the ratio, the more liquid the market. ▪ In 2012, the turnover ratio varied from a low of 2 (for Bahrain) to a high of 164 (for China). ▪ For the majority of emerging markets, there is poor liquidity. Measures of Market Concentration • Emerging markets tend to be much more concentrated than our markets. – Concentrated in relatively few companies. • That is, a few issues account for a much larger percentage of the overall market capitalization in emerging markets than in the equity markets of the developed world. • The number of equity investment opportunities in emerging stock markets in developing countries has not been improving in recent years. Market Structure, Trading Practices, and Costs • Primary markets – Shares offered for sale directly from the issuing company. • Secondary markets – Provide market participants with marketability and share valuation. Market Structure, Trading Practices, and Costs • Market order – An order to your broker to buy or sell share immediately at the market price. • Limit order – An order to your broker to buy or sell at a price you want, when and if he can. • If immediate execution is more important than the price, use a market order. Market Structure, Trading Practices, and Costs • Dealer market – The stock is sold by dealers, who stand ready to buy and sell the security for their own account. – In the U.S., the OTC market is a dealer market. • Auction market – Organized exchanges have specialists who match buy and sell orders. Buy and sell orders may get matched without the specialist buying and selling as a dealer. • Automated exchanges – Computers match buy and sell orders. Market Consolidations And Mergers • There are approximately 80 major national stock markets. – Western and Eastern Europe once had more than 20 national stock exchanges where at least 15 different languages were spoken. – It appears that over time a European stock exchange will eventually develop. However, a lack of common securities regulations, even among the countries of the European Union, is hindering this development. • Today, stock markets around the world are under pressure from clients to combine or buy stakes in one another to trade shares of companies anywhere, at a faster pace. Trading in International Equities • Magnitude of international equity trading • Cross-listing of shares • Yankee stock offerings • The European stock market • American Depository Receipts (ADRs) Magnitude of International Equity Trading • During the 1980s world capital markets began a trend toward greater global integration. • This trend was caused by diversification, reduced regulation, improvements in computer and communications technology, and an increased demand from MNCs for global issuance. Cross-Listing of Shares • Cross-listing refers to a firm having its equity shares listed on one or more foreign exchanges. • The number of firms doing this has exploded in recent years. Advantages of Cross-Listing • It expands the investor base for a firm. – Very important advantage for firms from emerging market countries with limited capital markets. • Establishes name recognition for the firm in new capital markets, paving the way for new issues. • May offer marketing advantages. • Cross-listing into developed markets with strict securities regulations and information discloser may signal investors that improved corporate governance is forthcoming. • May mitigate possibility of hostile takeovers. Yankee Stock Offerings • The direct sale of new equity capital to U.S. public investors by foreign firms. – Privatization in South America and Eastern Europe. – Equity sales by Mexican firms trying to “cash in” following implementation of NAFTA. American Depository Receipts • Foreign stocks often trade on U.S. exchanges as ADRs. • It is a receipt that represents the number of foreign shares that are deposited at a U.S. bank. • The bank serves as a transfer agent for the ADRs. Advantages of ADRs • There are many advantages to trading ADRs as opposed to direct investment in the company’s shares: – ADRs are denominated in U.S. dollars, trade on U.S. exchanges, and can be bought through any broker. – Dividends are paid in U.S. dollars. – Most underlying stocks are bearer securities and the ADRs are registered. – ADR trades clear in 3 business days whereas settlement practices for the underlying stock vary in foreign countries. Volvo ADR • A good example of a familiar firm that trades in the U.S. as an ADR is Volvo AB, the Swedish car maker. • Volvo trades in the U.S. on the NASDAQ under the ticker VOLVY. – The depository institution is JPMorgan ADR Group. – The custodian is a Swedish firm, S E Banken Custody. • Of course, Volvo also trades on the Stockholm Stock Exchange under the ticker VOLVB. Mechanics of Issuance & Cancellation of ADRs Types of ADRs Level I Level II Level III Rule 144A Description Unlisted program in the U.S. Listed on a U.S. exchange Shares offered and listed on a U.S. exchange Private placement to Qualified Institutional Buyers Trading OTC NASDAQ, AMEX, NYSE NASDAQ, AMEX, NYSE U.S. private placement SEC Registration Form F-6 Form F-6 Forms F-1 and F-6 None U.S. Reporting Requirements Exempt under Rule 12g52(b) Form 20-F Form 20-F Exempt under Rule 12g52(b) Global Registered Shares • The merger of Daimler Benz AG and Chrysler Corporation in November 1998 created DaimlerChrysler AG, a German firm. The merger simultaneously created a new type of equity share, called Global Registered Shares (GRSs). • GRSs are traded globally, unlike ADRs, which are traded on foreign markets. • The company was renamed Daimler AG in October 2007 when it spun off Chrysler. The primary exchanges for Daimler GRSs are the Frankfurt Stock Exchange and the NYSE; however, they are traded on a total of 20 exchanges worldwide. • The shares are fully fungible—a GRS purchased on one exchange can be sold on another. They trade in both U.S. dollars and euro. Global Registered Shares • The main advantage of GRSs over ADRs appears to be that all shareholders have equal status and direct voting rights. • The main disadvantage of GRSs appears to be the greater expense in establishing the global registrar and clearing facility. • GRSs have met with limited success; many companies that considered them opted instead for ADRs. • Deutsche Bank, UBS, and NYSE Euronext also trade as GRSs. Empirical Findings on Cross-Listings and ADRs • An internationally diversified portfolio of ADRs outperforms both a U.S. stock market and a world stock market benchmark on a riskadjusted basis. • For most stocks, the home-market price and the ADR price is within 20-85 basis points—thus limiting any arbitrage opportunities. International Equity Market Benchmarks • North America • Europe • Asia/Pacific Rim North American Equity Market Benchmarks NAME SYMBOL Dow Jones Industrial Average DJIA NASDAQ Combined Composite CCMP S&P 500 SPX TSE 300 TS300 Mexico BOLSA Index MEXBOL European Equity Market Benchmarks NAME SYMBOL FT-SE 100 UKX CAC 40 CAC Frankfurt DAX Index DAX IBEX Index IBEX Milan MIB30 MIB30 BEL20 Index BEL20 Asia/ Pacific Rim Equity Market Benchmarks NAME SYMBOL NIKKEI 225 Index NKY Hang Seng Index HSI Sing Straits Times Index STI ASX All Ordinaries Index AS300 iShares MSCI • Country-specific baskets of stocks designed to replicate the country indexes of 22 countries. • iShares are exchange-traded funds that trade on the American Stock Exchange and are subject to U.S. SEC and IRS diversification requirements. – Low cost, convenient way for investors to hold diversified investments in several different countries. Factors Affecting International Equity Returns • Macroeconomic factors • Exchange rates • Industrial structure Macroeconomic Factors Affecting International Equity Returns • The data do not support the notion that equity returns are strongly influenced by macro factors. • This is correspondent with findings for U.S. equity markets. Exchange Rates • Exchange rate movements in a given country appear to reinforce the stock market movements within that country. • One should be careful not to confuse correlation with causality. Industrial Structure • Studies examining the influence of industrial structure on foreign equity returns are inconclusive. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605
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