CHAPTER 13 - INTERNATIONAL EQUITY MARKETS STATISTICAL PERSPECTIVE ON INTL. EQUITY Update: 2007 Total Stock Mkt.

. Capitalization is about $60T 2003 - Total Mkt. Capitalization of world equity markets was more than $32T. 89% of this ($28.29T) was from 31 developed countries, see Exhibit 13.1 on p. 314. 15% decrease from 1999-2003 for Developed Countries. U.S. -14% (-3.8% per year), Europe -13% (-3.4% per year), and Japan -33% (-9.6% per year). Exhibit 13.2, p 315 - Emerging secondary markets in Developing Countries, Per capita income either low (< $900), or lower-middle to middle income range ($900-$15,000). Some of these countries have larger equity markets than smaller developed countries, e.g., Russia, China, Brazil, S. Africa, Korea, and Taiwan are larger than New Zealand, Austria, Ireland, Luxembourg, Finland, etc. High growth markets have been in the emerging markets, like China (50% per year), Russia (90% per year), and they have attracted increasing amounts of capital. 1990s: Trend started for investment in emerging equity markets, and some investment advisors suggest 50% of an ideal portfolio by 2005 should be in emerging markets like Asia, Latin America and Eastern Europe (Russia). Prediction: "In 20 years China, Russia and India will be the biggest stock markets in the world, bigger than the U.S. and Japan." In 2000, there were 170 emerging market equity mutual funds and 27 emerging market fixed income mutual funds. LIQUIDITY - One measure of stock market liquidity is the Turnover Ratio = Total Value of All Market Transactions / Total Stock Market Value. Example: Total stock market value is $5m, and there is $100m of market transactions during the year, the turnover is $100m/$5m or 20x. The average stock has turned over 20 times during the year, or about every 2.5 weeks. In general, the higher the Turnover Ratio, the greater the liquidity of the secondary equity market. See Exhibit 13.3, p. 316, Turnover Ratios for developed countries. For U.S., the turnover was 123x in 2003, meaning that there was about $1,753 trillion in annual stock market transactions and $14.26 trillion of total market value ($1753 T / $14.26 T = 123x). U.S. was one of the world's most liquid market, along with Sweden, Spain, Italy, etc. Most of the developed markets had turnover ratios of 50 or higher (50-150). See Exhibit 13.4, p. 317 for emerging markets. Some of the emerging markets have very low turnover ratios (Colombia, Philippines, Nigeria, etc.), especially the smaller markets. The larger markets have higher turnover (Taiwan, India, Korea, China, Turkey, Brazil, etc.) Also, liquidity is improving for many emerging markets (India, Russia, Egypt, etc) over time; 13/33 countries had higher turnover in 2003 compared to 1999. Market Concentration - Measures how concentrated a stock market's value is for the ten largest companies. For example, if the market concentration ratio is 50%, that means that the ten largest companies represent 50% of the total market value of the stock market. The more concentrated the stock market is, the less desirable the stock market is for global diversification.
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See Exhibit 13.5 on p. 318. Some countries have become less concentrated from 1999-2003, like Turkey, China, Korea, and Zimbabwe. Other countries have become more concentrated, e.g., India, Indonesia, Mexico, and Venezuela. Trade off: Higher the concentration ratio, the less selection of stocks available. However, why might a higher concentration ratio be a good thing, or a sign of improvement, e.g., in China or Russia? What is your guess of the concentration ratio in the U.S. market?

INTERNATIONAL EQUITY INDEXES Benchmarks/indexes of international stock market performance (representing stocks traded on the secondary market) are important. Why? To whom? Several intl. stock market indexes are available: 1. Standard and Poors (S&P) publishes comparative stock market statistics (emerging and developed markets) in its annual report "Emerging Stock Markets Factbook." Data in this chapter are from S&P. 2. MSCI - Morgan Stanley Capital International issues a monthly publication of stock market data/indexes for 24 developed countries, along with a world index. MSCI is also reported daily in the WSJ - country indexes and a world index of 2,600 stocks from 23 countries. Indexes represent at least 60% of market capitalization in each country, and are market-value weighted (Example: 100 companies in index, if one company represents 3.2% of the market value, it gets 3.2% weight and not 1%). MSCI also releases: 1) Regional indexes: a) EAFE = Europe, Australia, and Far East (World - N. America), b) North America (U.S. and Canada), 2) Industry Indexes (dozens), 3) 27 Emerging Market country indexes, and 4) Regional Emerging Markets indexes. 3. Dow Jones Global Indexes - published daily in the WSJ (Dow Jones). See Exhibits 13.8 and 13.9, p. 323-324, and handout. In addition to its own indexes, the WSJ also reports other major market stock indexes, see Exhibit 13.9. See Exhibit 13.9 on p. 324 for some of the major stock market indexes. iShares MSCI (ETFs) Exchange-traded country funds, country-specific baskets of stocks that replicate the MSCI country indexes of 21 countries and 4 regions. Advantage: low cost, convenient way to own diversified portfolios of foreign stocks. See p. 323.

EXCHANGE TRADED FUNDS (ETFs)

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Usually passively managed funds based on an existing stock or bond index: S&P 500, Russell 2000, Nasdaq Composite, MSCI Germany Index, MSCI Brazil Index, MSCI Europe Index, MSCI Japan Index, MSCI BRIC Index, Dow Jones US Regional Bank Index, Nasdaq Biotechnology Index, Vanguard REIT Index, etc. Note: The iShares ETFs are based on MSCI Indexes. Advantages of ETFs vs. Mutual Funds: 1. Lower costs: Average annual expense ratio for ETFs is 0.42% vs. 1.3% for traditional mutual funds vs. 0.74% for traditional index mutual funds. Example: Vanguard Total Stock Market Index ETF has annual expense ratio of 0.07%, or only $70 total expenses on a $100,000 investment. Reason: Even indexed mutual fund companies like Vanugard have to pay for offices, staff, customer service, recordkeeping for accounts, websites with online access to account information, mailings, sending tax forms at the end of the year, etc. Note: A difference between 0.42% and 1.30% annual expenses on $100,000 would be $880 per year, and $8,800 over a ten-year period. 2. Tax efficiency: a) When traditional mutual funds shifts stocks in the portfolio, there is turnover in the portfolio, and capital gains can be generated, which are passed on to all investors. ETFs are based on indexes, so there is almost no turnover. Even with indexed mutual funds, a large redemption might require a sale of stocks, which could trigger capital gains for all investors in the fund. ETFs can redeems shares for baskets of the underlying securities, which is not a taxable event.
Through a regulatory loophole, ETFs are considered to be created by trading equivalent certificates (the ETF for the many stocks that make up the basket) in what is called an in-kind trade. This exchange of essentially identical items does not trigger capital gains, according to the IRS. Traditional mutual funds must go into the open market and exchange cash for stocks and vice versa, which trigger realization of gains. It's a subtle difference, admittedly, but which results in an advantage for the ETF investor.

Youll have to pay capital gains eventually if you sell stocks/mutual funds/ETFs at a gain, but ETFs allow better control over the exact timing of the capital gains than a mutual fund.
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3. Transparency: Owning an ETF, you know daily exactly whats in the portfolio daily, compared to owning an actively-managed mutual fund, where you might not know daily what the fund manager is doing: how much cash is being held, if the manager is following the investment strategy of the fund. 4. Flexibility: ETFs are traded like stocks and are priced throughout the day like stocks, versus mutual funds, which are priced only once, at the close of the market. ETFs have greater flexibility to time purchases or sales during the day to take advantage of price fluctuations. Like stocks, you can a) buy ETFs on margin, b) sell ETFs short, and c) buy/sell ETF options.

MARKET STRUCTURE Secondary market for equity serves two purposes: 1. Marketability - Allows buyers in the primary market (IPO) to subsequently sell shares. Would be hard to sell stock in primary market if there wasn't a secondary market. 2. Share price valuation - Active trading in secondary markets establishes a true fair market value of stock (vs. privately held stock like UPS before 1999). Secondary Markets are set up as either: 1. Dealer Market - OTC, dealer network, like NASDAQ, where about 450 dealers ("market makers") specialize in buying/selling certain stocks. You are buying (selling) the stock from (to) the dealer, not from (to) another investor, who holds the stock in his/her account. Bid (dealer buys)- Ask (dealer sells) Spread is the dealer's commission, e.g., $5(bid)-$5.05(ask), 1% spread. There are about 20 active dealers/market makers for the average, actively traded stocks, close to 100 dealers for high volume stocks like Dell Computer, 75 for Ebay, 67 for Starbucks, 58 for Fifth Third Bank. Other NASDAQ stocks: Amazon, Toyota, Microsoft, Yahoo!, Cisco, Sun, MCI, Nissan, etc. Only quotations are automated, actual trades do not take place through the computer system, but require direct contact between the dealer and a broker. 2. Agency Market - like NYSE, AMEX. The broker takes a buy (sell) order from a client/investor/trader, and matches it with a sell (buy) order from another client/trader. More of an auction market. Both OTC and exchange markets are Continuous Markets, where trading takes place continually during the trading day. Most efficient, especially for actively traded issues. Non-continuous trading systems include the call market in France and the crowd trading in Spain. 3. Another system is the Fully Automated Trading system, common in Toronto, New Zealand, Australia, etc. where trading is completely automated. Similar to NASDAQ, but quotations and trading
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takes place directly by computer. Orders are filled faster, and there is very few people are needed to operate an exchange. See Exhibit 13.7 on p. 321-322. TRADING IN INTERNATIONAL EQUITIES We have seen increased global integration of world equity markets due to: 1. Investors seeking international portfolio diversification. 2. Increased capital mobility. Barriers to intl. capital flows (elimination of fixed commissions, deregulation of financial markets, etc.) have been reduced. Introduction of Euro has integrated European financial markets. 3. Advances in Information Technology have facilitated capital flows, research and intl. investing. 4. MNCs have expanded global operations, and have taken advantage of global capital markets. Cross-Listing of Shares is when a firm (MNC) lists/sells its shares on one or more foreign exchanges in addition to the domestic exchange. Example: GM might list on NYSE, and on the exchanges in London and Paris. Honda, Toyota and Yamaha list on the NYSE, in addition to Tokyo. See Exhibit 13.10 on p. 326. NYSE has 20% foreign listings (15% of new listings), NASDAQ has 10.4% foreign listings, AMEX has 9.87% (21% new). Luxembourg has 81.8% foreign listings, Switzerland 31%. Many countries are almost exclusively domestic: Italy, Argentina, Toronto, Korea, Tokyo, Australia, Norway, Thailand and Finland are all 95-100% domestic. Why Cross-List? 1. Increased liquidity, broader investor base. Increased global demand may support a higher stock price. 2. Cross-listing improves name recognition globally in new capital markets. May make it easier in future to raise additional equity or debt capital globally, get a higher price for stock, lower interest rate for debt. 3. Company may benefit as more consumers and investors become familiar with the company and it products. Consumers who like the company's products may be more likely to invest in the company, and investors in the company may be more likely to become consumers of the company's products. Nike customers may buy Nike stock, and Nike investors may buy Nike products. 4. May make it harder for an unwanted, hostile takeover due to the diversified, global stockholder base. Advantage or Disadvantage? Cross-listing requires a MNC to conform to securities laws in both countries. Foreign firms crosslisted in U.S. must meet SEC requirements for financial disclosure and financial reporting. Firms must reconcile accounting and financial statements to U.S. standards, which can be very difficult and time consuming. If foreign firms can sell shares only to large, institutional investors in U.S., less rigorous accounting and disclosure standards apply. American Depository Receipts (ADRs) - the most efficient and common method of selling foreign stocks in the U.S. market. ADRs are an example of financial engineering, the creation and marketing
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of new securities from underlying securities, e.g., stripped zero coupons, Mortgage Backed Securities (MBSs) like CMOs and pass-throughs. ADR process: 1. A number of foreign shares (stock certificates) are placed on deposit (in escrow) in the home country (Russia, China, or India) with a custodian bank or financial intermediary. 2. The ADRs are then traded in the U.S. stock market, on NYSE or NASDAQ, like stocks (Level II).

Advantages of ADRs: 1. ADRs are priced in dollars, trade on a U.S. exchange, and can be purchased through a regular broker. If foreign shares were purchased directly, it would involve a) working with a broker in Russia or China, b) foreign currency exchange, and c) arrange for shipment of stock certificates. 2. Dividends for ADRs are collected and converted to dollars by the custodian. 3. Like U.S. stocks, ADRs clear in three days. 4. ADRs are registered shares, not bearer securities like many foreign shares, offering greater protection of ownership rights. 5. ADRs can be easily traded by transferring the depository receipt to another investor in the U.S. market. 6. ADRs typically trade at a multiple of the underlying shares, to adjust the price up (or down) to a normal trading range for U.S. ($5-$50), e.g., ratios of 1:10 or 1:.25. ADR trading: OTC (Level I) - more than 1,000 ADRs are traded, Level IIs: NASDAQ (300 ADRs), NYSE (350 ADRs), and AMEX (3 ADRs). Note: One company can have several ADRs listed at once, and can also be listed on more than one exchange. Level I ADRs are sold OTC. Easiest, least expensive and least regulated way for foreign companies to market ADRs in U.S., require minimal SEC registration. Foreign companies can build a presence here and generate interest among investors. Level I ADRs cannot be used to raise new capital. Not as liquid as Level II ADRs. Level II ADRs are sold on NASDAQ, NYSE and AMEX, stricter SEC requirements, more liquid market. Level III ADRs are used to raise new equity capital in U.S. markets. Typical countries represented in ADR markets: Russia, Brazil, China, Turkey, South Africa, Mexico, India, etc. Typical industries: Banking, mining, chemicals, textiles, oil and gas, airlines, electric utilities, machinery, real estate, etc. Typical companies: Aeroflot, Wal-Mart Mexico, Volvo, Wipro,
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Yamaha, VW, Virgin Airlines, Sharp Electronics, Samsung, Rolls Royce, Mitsubishi, Adidas, etc. See web site at: http://www.adr.com . S&P now has the S&P ADR Index of 260 U.S.-listed ADRs, at levels II and III and global shares (see below). Mutual funds can be set up to buy the S&P ADR Index, just like the S&P 500 Index. Passive approach to investment. Global Registered Shares (GRS) started as new equity shares when Chrysler and Mercedes merged in 1998, to form DaimlerChrysler, headquartered in Germany. Compared to ADRs (which are receipts for bank deposits of home-market shares traded on foreign market) GRS are one class of shares that are traded globally, usually in both dollars and Euros, with exactly the same voting rights and equal status as domestic shares. Shares are fungible (interchangeable), so you can buy GRSs in U.S. and sell in Germany. Disadvantage of GRS: More expensive to establish a global registrar and clearing facility. See Example 13.1 on p. 332 about Daimler-Chrysler GRS in NY and Frankfurt. CH 15 covers international investment and international portfolios.
Updated: March 3, 2013

BUS 466/566: International Finance CH 13

Professor Mark J. Perry