International Finance and Institutions 8-‹#› Bekaert_cornerart International Debt and Equity Financing Oleg Deev Department of Finance, Masaryk University International Finance and Institutions 8-‹#› Bekaert_cornerart Sources of Funds for International Firms •Internal – retained earnings •External – debt/equity/hybrids •External - loans •All 3 can be raised domestically or internationally •MNC foreign affiliates can also raise money from within the MNC • International Finance and Institutions 8-‹#› Bekaert_cornerart Sources of Long-Term Capital for a Multinational Corporation ex11_01 International Finance and Institutions 8-‹#› Bekaert_cornerart International Debt Markets & Instruments ex13_09.gif International Finance and Institutions 8-‹#› Bekaert_cornerart The Characteristics of Debt Instruments •Characteristics •Currency of denomination – can affect how much they have to repay; can match their revenue base though •Maturity •Nature of their interest payments •Tradability •International character – domestic vs. international •Centralized versus decentralized debt denomination •Centralized debt denomination – borrow in $’s (headquarter’s currency) •Decentralized debt denomination – borrow in different currencies of subsidiaries •Balance-sheet hedge – balance foreign assets/liabilities • International Finance and Institutions 8-‹#› Bekaert_cornerart Centralized Debt Denomination ex11_02a International Finance and Institutions 8-‹#› Bekaert_cornerart Decentralized Debt Denomination ex11_02b International Finance and Institutions 8-‹#› Bekaert_cornerart Borrowing in Low Interest Rate Environment •Is issuing debt in low-interest countries a good idea? –If UIRP holds, the cost should be the same as domestic loan •Assuming that you believe this then no because for the same cost you now assume forex risk –If UIRP does not hold, loan is cheaper! Forex risk can actually help – if currency that loan is denominated in depreciates you pay less of the principal back! –Credit spreads •Risk premium paid above the risk-free rate •Can differ across countries offering savings •Tax differentials can offer incentives to take on debt in different markets • International Finance and Institutions 8-‹#› Bekaert_cornerart Tradability of debt •Intermediated and direct debt •Financial disintermediation – corporate borrowing takes the form of a tradable security issued in the public market rather than a non-tradable loan provided by a financial institution •Private placements •Regulated by Securities Act of 1933 (in U.S.) •Must be sold to a limited number of large and sophisticated investors •Investors must have access to substantial financial information regarding the company •Investors must purchase the securities for their own investment portfolios (not for resale) and must be capable of sustaining any losses • International Finance and Institutions 8-‹#› Bekaert_cornerart The International Character of Debt •Domestic bonds – bonds that are issued and traded in domestic market (country is country of currency denomination) •International bonds – bonds traded outside the country of the issuer –Foreign Bonds – issued in domestic market by a foreign borrower (Ex. U.S. company issuing ¥ bond in Japan) •Denominated in domestic currency •Marketed to domestic residents •Regulated by domestic authorities –Eurobond – mature in less than 10 years (usually 5) •Denominated in one or more currencies •Traded in external markets outside the borders of the countries issuing the currencies • International Finance and Institutions 8-‹#› Bekaert_cornerart Size and Structure of the World Bond Market –Government bond market – most important in most countries –Domestic bond markets •Regulated by domestic governments –Required filing for issuances > $1.5 million (U.S.) –New public issues must be approved by MOF (Japan) •Most are issued in bearer form (not registered to owner) – owners can avoid paying taxes because they are anonymous •Usually annual coupons –International bond markets •Generally regulated by issuer’s government, not borrower’s •Eurobonds – issued simultaneously in capital markets of several nations –Need not comply with regulatory restrictions that apply to domestic issuers • International Finance and Institutions 8-‹#› Bekaert_cornerart The Size and Structure of the World Bond Market (in billions of U.S. dollars) ex11_03b International Finance and Institutions 8-‹#› Bekaert_cornerart The Internationalization of the World Bond Market ex11_04 International Finance and Institutions 8-‹#› Bekaert_cornerart Borrowers in the International Bond Market (amounts outstanding, Sept 2010, in billions of USD) ex11_05 International Finance and Institutions 8-‹#› Bekaert_cornerart Types of International Bonds •Straight fixed-rate issues – coupon fixed –Zero coupon bonds or coupon •Floating-rate notes – coupon based on base rate such as LIBOR or Euribor •Equity-related bonds –Convertible bond – convertible into a number of shares of equity –Warrant – grants the bondholder the right to purchase a certain amount of common stock at a specified price • International Finance and Institutions 8-‹#› Bekaert_cornerart Types of International Bonds Issued in the Marketplace (in billions of US dollars) ex11_06 International Finance and Institutions 8-‹#› Bekaert_cornerart International Banking •Banks as MNCs •Merchant banks – banks that perform both traditional commercial banking and investment banking functions •Universal/Full-service banks – banks that provide a wide array of services, including securities activities •Consolidation via M&A •With formation of EU, it was thought banks would consolidate across borders since they only needed a single license; didn’t happen though, mostly within country (except central Europe) International Finance and Institutions 8-‹#› Bekaert_cornerart International Banking •Globalization had fundamentally changed banking around the world from localized to one of the most global sectors in the world –Banking sector has become a larger part of many economies – perhaps too large (2007-2010 crisis has taught us this) –Enables spillover of stress across borders International Finance and Institutions 8-‹#› Bekaert_cornerart –Correspondent banks – a bank that allows a commercial bank which doesn’t have an operation in a major financial center to conduct trade financing, foreign exchange services, and other activities –Representative offices – a small service facility that is staffed by parent bank personnel and designed to assist the clients of parent bank in their dealings with the bank’s correspondents or with information about local business practices and credit evaluation of foreign customers –Foreign branches – legally a part of the parent bank but operates like a local bank •Much more expensive than setting up a correspondent •Subject to regulations of BOTH countries Types of International Banking offices (1) International Finance and Institutions 8-‹#› Bekaert_cornerart –Subsidiary and affiliate banks – wholly or partly owned by a parent bank, but is incorporated in the foreign country where it is located •Affiliate is only partly owned but not controlled by a foreign parent bank –Offshore banking centers •Bulk of financial activity (borrowing and lending) is offshore •Transactions are typically initiated outside of financial ctr •Majority of the financial institutions involved are controlled by nonresidents doing business with nonresidents •Centers typically offer low or zero taxation •Found in Aruba, Bahamas, Bahrain, Barbados, Bermuda, Cayman Islands, Hong Kong, Lebanon, Liberia, the Netherlands Antilles, Panama, Singapore, Vanuata, the West Indies, and others •Used for tax avoidance and crime so BIS, OECD and EU have joined forces to supervise activities –Edge Act banks – federally chartered subsidiaries of U.S. banks allowed to engage in full range of international banking activities –International banking facilities (IBF) – a separate set of asset/liability accounts segregated on parent bank books but not separate physically • Types of International Banking offices (2) International Finance and Institutions 8-‹#› Bekaert_cornerart Organization Structure of International Banking ex11_10 International Finance and Institutions 8-‹#› Bekaert_cornerart •Differences across countries, international regulations could give one country an advantage •International capital adequacy: The 1988 Basel Accord –Banks must hold capital equal to at least 8% of a basket of assets measured in different ways according to their riskiness –Create ways to measure risk of off-balance-sheet activities –Attempts to address both credit AND market risk •A new capital-adequacy framework on Basel II –Banks can follow Basel Accord framework for measuring risk or use own models subject to strict requirements and disclosure •Asset securitization – packaging of assets or obligations into securities for sale to third parties •Value at risk – model developed by JPMorgan to measure market risk; dollar loss that a given position can experience with 5% probability over time –Supervisory review –Disclosure requirements International Banking Regulation International Finance and Institutions 8-‹#› Bekaert_cornerart •Crisis laid bare many deficiencies in the Basel II –Old framework underestimated risk because most models overestimate the power of diversification to reduce risk, especially in times of crisis –BIS and central banks/supervisory authorities have new framework •Core capital is defined as retained earnings and common shares •Reserves increased from 2% to 4.5% •Capital conservation buffer – 2.5% of banks risk-weighted assets •Local authorities require a countercyclical capital buffer, which decreases (increases) in good (bad) times •Tracing/monitoring of liquidity funding •Introduction of a maximum leverage ratio Basel III and the Crisis International Finance and Institutions 8-‹#› Bekaert_cornerart International Bank Loans (1) •Eurocredits – longer term loans in Eurobank market –Types of Eurocredits •Term loan – loan with a fixed maturity for a fixed amount •Credit line – allows borrower to withdraw as a loan any amount of money up to a fixed limit –Syndicates – group of banks that share risk •Lead bank negotiates with borrower over terms •Participating banks – banks that provide funding •Paying agent – the bank that receives the service payments from the borrower and distributes them to participating banks –Fees and Borrowing Costs •Periodic costs – interest –Interest rate (e.g., LIBOR + 1.5%) –Commitment fee (0.25% - 0.75%) on unused portion of credit –Agent fee •Upfront cost – 1% - 2.5% of total; deducted from principal –History and Size of Eurocredits –The Secondary Market • International Finance and Institutions 8-‹#› Bekaert_cornerart •The Euronote Market –Euro-commercial paper and other short-term paper –Medium-term notes – maturities from 9 months – 10 years •Notes can be offered continuously •Can be issued in small denominations •Lower costs than a Eurobond issue •Not underwritten •Amounts/timing of sales are not disclosed – allows for discretion –NIF/SNIF/RUF – syndicates of banks committed to distribute or purchase a borrower’s Euronotes with maturities of 1,3,6, or 12 months. •The Major Debt Arrangers –The top 15 global banks arrange 60% of all global debt • International Bank Loans (2) International Finance and Institutions 8-‹#› Bekaert_cornerart Comparing the Costs of Debt •Compare apples to apples –Similar amounts –Maturity –Cash flow patterns (same currency too!) •Annual yield = (1-Semiannual yield)2 - 1 –Interest rate structure •The All-in-Cost Principle (AIC) –The discount rate or internal rate of return that equates the PV of all future interest rate and principal payments to the net proceeds –Solve for “i” in Proceeds = Σn=1N Coupon/(1+i)n + Principal/(1+i)N –Cost of loan = Risk-free rate + Credit spread + transaction cost –Credit rating – based on current information of risk of default •Moody’s and Standard & Poor’s; European Rating Agency (Eurorating) and Japan Credit Rating Agency (JCR) •Ratings differ across agencies • International Finance and Institutions 8-‹#› Bekaert_cornerart Minimizing the cost of debt internationally •Why source debt internationally? –Evidence suggests credit spreads differ across countries •Differing perceptions of credit risk •Diversify funding sources •Cyclical differences – credit spreads tend to be countercyclical (widens in recessions) •Can borrow in countries low interest rates and invest in countries with high interest rates while hedging currency risk –CIRP doesn’t always hold because transaction costs keep arbitrage from being profitable and there’s always default risk –Tax loopholes • International Finance and Institutions 8-‹#› Bekaert_cornerart Credit Ratings for Bond Issuers ex11_13 International Finance and Institutions 8-‹#› Bekaert_cornerart International Stock Markets •The size of stock markets –U.S. stock market was about 31% of the world’s stock market capitalization at the end of 2010 –Relative market capitalization of most exchanges around the world change though –Cross-holding – on firm owning shares in another firm – can cause an overstating of market cap •Especially common in Japan and many European countries •Trends –Consolidation of exchanges across countries –The exchanges of some developing nations have become among the largest in the world International Finance and Institutions 8-‹#› Bekaert_cornerart Globalization of Exchanges •Cross-listing – listing on foreign exchanges –Exchanges have extended hours –Exchanges have merged/created alliances to automate cross-listing •In 2000, stock exchanges of Amsterdam, Brussels, and Paris merged to form Euronext (and subsequently absorbed Lisbon and LIFFE) •German and Swiss exchanged combined to form Eurex •In March, 2007, NYSE and Euronext formed a new company called NYSE Euronext, Inc. •Demutualization – the process of converting exchanges from nonprofit, member-owned organizations to for-profit investor-owned, and typically publicly-traded companies –Examples – Australian SE (98), Toronto SE (00), Euronext (00), NASDAQ (00) and NYSE (05) International Finance and Institutions 8-‹#› Bekaert_cornerart Trading Practices (1) –Directly affects price discovery – how information is revealed –Should lead to fair and correct pricing that cannot be manipulated for the gain of an individual –Price-driven trading systems •Market makers stand ready to buy at their bid prices and sell at their ask prices •Examples – forex market; NASDAQ; SEAQ –Order-driven trading systems •Orders are batched together and then auctioned off at an equilibrium market price •Example – Tokyo Stock Exchange –Price priority – highest bid and lowest ask have priority –Time priority – orders at same price 1st come/1st serve –Order priority – market orders have priority over limit orders –NYSE is a combination of price- and order-driven • International Finance and Institutions 8-‹#› Bekaert_cornerart Trading Practices (2) –Automation and electronic trading •Trend toward automation; investors get best prices this way •1st was Paris Bourse –Private electronic communication networks (ECNs) have rapidly developed •Lists the prices of securities trading on other exchanges and either lets its subscribers trade directly or uses some form of order-crossing network •Off-exchange trading venues –Europe – MiFID –U.S. – Alternative Trading Systems •Facilitate anonymous trading of large blocks of shares – “dark pools” •Also promotes the growth of high-frequency trades • International Finance and Institutions 8-‹#› Bekaert_cornerart Turnover and Transaction Costs –Turnover – total volume of trade done on an exchange during the year divided by the exchange’s total market cap at the end of the year •Emerging markets have lower turnover but vary widely •Often thought of as a proxy for liquidity •Inversely related to trading costs –Trading costs – costs of trading; includes brokerage commissions and other fees, bid/ask prices, and market impact costs •Market impact – impact on price of a large trade in an illiquid market •Commission costs are easiest to estimate – decrease with trade size • International Finance and Institutions 8-‹#› Bekaert_cornerart Trading Costs ex12_04 International Finance and Institutions 8-‹#› Bekaert_cornerart International Cross-Listing •London is the biggest cross-listing market – 42% of trading pertains to foreign companies •Other important markets for foreign trading: Switzerland, South Africa, Argentina •How Do Firms Cross-list? –First: Comply with the standards set for listing –Second: Adhere to the security regulations •Depositary Receipt (DR) –Represents a number of original shares held in custody by a financial institution in the country of the stock exchange –American Depositary Receipts (ADR) •Held by Bank of New York (over 50%), JPMorgan Chase, Citibank, and Deutsche Bank – – • International Finance and Institutions 8-‹#› Bekaert_cornerart Types of ADRs ex12_07 International Finance and Institutions 8-‹#› Bekaert_cornerart The Structural Execution of ADRs ex13_06.gif International Finance and Institutions 8-‹#› Bekaert_cornerart Equity Capital Raised Through Depositary Receipts ex13_08.gif International Finance and Institutions 8-‹#› Bekaert_cornerart Why firms choose to cross-list –Increased liquidity – an increase in total trading volume and a significant decrease in home market bid-ask spreads –Wider shareholder base –Market integration – securities of similar risk have the same expected returns when trading in two markets –Corporate governance signal – “bonding” –Capital needs and growth opportunities –Other benefits of cross-listing •Visibility/brand awareness •Cross-border acquisitions •The flexibility to set up stock option plans for foreign employees • International Finance and Institutions 8-‹#› Bekaert_cornerart •The Costs and Benefits of Cross-listing • ex12_08 International Finance and Institutions 8-‹#› Bekaert_cornerart The Advantages and Disadvantages of Cross-Listing (1) •Why firms decide against cross-listing –Costs •One-time listing and registration fees •Ongoing costs of additional reporting and disclosure –Relative costs – U.S. exchanges are considered prohibitively expensive by some •Sarbanes-Oxley Act increased the costs of corporate governance regulations •3 out of 4 new DR listings in 2006 were on non-U.S. exchanges • International Finance and Institutions 8-‹#› Bekaert_cornerart The Advantages and Disadvantages of Cross-Listing (1) •Global Registered Shares (GRS) –Pros •Does not require the intervention of a depository bank •$5 settlement cost paid to the Depository Trust Company (DTC) covers a per-share fee for conversion •Ownership is more direct giving investors the same voting privileges, rights to receive dividends, etc. –Cons •No depository bank to oversee coordination of the transfer, clearing, and settlement procedures •No flexibility of bundling a number of home-market shares into a receipt to ensure fair pricing • International Finance and Institutions 8-‹#› Bekaert_cornerart Strategic Alliances •Strategic alliance – an agreement between legally distinct entities to share the costs and benefits of what is hoped to be a beneficial activity –Joint venture: two or more independent firms form and jointly control a different entity, created to pursue a specific objective –Why are these formed instead of doing this internally? •Some think it is to pursue risky projects •