|SHOPPING THE CAPITAL MARKETS
Not even the wealthiest venture capital firms can provide as much capital as the capital markets, where anonymous investors buy stocks and bonds. A company can often raise significant amounts of money by selling stock through an initial public offering (IPO). And a company with a solid financial record can often borrow more cheaply by selling bonds than it can by taking a bank loan.
The decision to turn to the capital markets for financing opens up a massive source of cash—but it also affects how the business operates. Companies that issue stock must grant shareholders certain rights. And companies that issue debt securities, such as bonds, enter into legally binding contracts to repay.
TAKING IT TO THE BANK
Some of the biggest players in the capital markets are large, multinational firms known as investment banks, which specialize in corporate financing. That means providing services and advice to companies that want to raise capital or are involved in mergers and acquisitions. Investment banks help companies determine the best way to secure financing: through debt or equity, using private placement or public offering. Then they help companies navigate the requirements and paperwork involved in registering and offering securities for sale, including underwriting the offering—finding buyers and setting prices. Investment banks can also create new investment vehicles out of existing securities, cutting them up or combining them to offer specialized products for certain investors.
GOING TO THE BANK
Businesses may also be able to raise a limited amount of capital by applying for bank loans, though borrowing may have certain drawbacks. First, since repayment begins as soon as the loan is secured, monthly cash flow is affected. Second, the bank is likely to demand collateral, or security, for the loan. But a major advantage of raising capital with a loan is that once it’s paid off, the company hasn’t given away any equity. If the company succeeds, the original owners derive all the benefit of the increased value.
Rules and referees help keep the investment markets fair.
In a perfect world, every player in the capital markets would always deal honestly and fairly with every other player. The field would be perfectly level, giving everyone the same access to information and opportunities.
But in the absence of perfection, there is regulation. The system that has developed in the United States to regulate the capital markets is designed to keep them fair and efficient by setting and enforcing standards and rules, settling disputes among market participants, mandating changes, and initiating improvements.
The ultimate goal of regulation is often described as maintaining investor confidence. But why is that so important? The reason is that investor dollars are the fuel on which the economy runs. If the public distrusts the markets, investors keep their money out of investments—and out of US businesses. But when people trust the markets, they’re willing to put money into investments like stocks and bonds, giving companies money to innovate and expand.
In fact, one common explanation for the wealth of the US capital markets is that the US regulatory system is the strictest in the world, thereby earning investor confidence.
Given the scope and complexity of the job, no single regulator can supervise all aspects of the capital markets or the securities industry. Instead, regulation is carried out by a number of organizations with different and sometimes overlapping jurisdictions.
There are two major groups of market regulators: government regulators, at both the federal and state levels, and self-regulatory organizations (SROs), through which industry players govern themselves.
Regulation is a dynamic, evolving system of guidelines and controls, adapting to changes in the market environment and to events—such as scandals and failures—that reveal vulnerabilities in the current setup.
When things go wrong, however, not everyone believes that more regulation is necessarily the best solution. Although few people argue for zero government oversight, what’s often debated is exactly how much oversight is the right amount.
Opponents of regulation argue that the markets work best when government lets them alone—what is sometimes referred to as laissez faire. From this perspective, government interference increases the cost or difficulty of doing business, stifles innovation, and prevents ordinary market forces of supply and demand from determining prices and products. Regulation opponents also point out that industries already regulate themselves, and suggest that government dollars can be better spent elsewhere.
But proponents of government regulation point to the industry’s failure to prevent past problems as the reason to appoint and strengthen a third-party watchdog, especially since the securities markets are so central to the health of the US economy. They argue that outside policing is necessary to protect investors, whose interests may conflict with industry interests. When investor confidence is shaken, they maintain, government intervention is needed to calm public concerns, especially in cases where the public doesn’t believe the industry can resolve its own problems.
The Sarbanes-Oxley Act of 2002 mandated reforms to enhance corporate responsibility and financial disclosures and to combat corporate and accounting fraud. It also created the Public Company Accounting Oversight Board (PCAOB) to oversee the auditing profession.
UNTYING THE KNOTS
Deregulation occurs when strict regulation of an industry is ended or relaxed. Lawmakers who support deregulation believe that fewer government controls will mean greater benefits for the public—such as lower costs and more choices—when new companies are allowed to enter a previously limited market or are given greater freedom to set prices and offer new products and services.
Global Capital Markets
The quest for capital—and for places to invest it—extends beyond national borders.
When companies open business operations abroad, or form joint partnerships with companies based in other countries, they become players in an international capital marketplace. The same is true when individual or institutional investors put their capital to work outside their national borders.
UPS AND DOWNS
One benefit of cross-border investing is that strong economic growth in one part of the world can stimulate growth in other regions. That can be good for the investors and good for the economies where the markets operate. One potentially negative consequence of globalization, however, is that problems in the economy of one nation or region may have a ripple effect on the economies of many others—even though the major factor in any nation’s financial health is what’s happening at home.
DEVELOPED AND EMERGING
Broadly speaking, world markets fall into two categories: developed and emerging.
Developed markets, including those in Europe, North America, Australia, New Zealand, and Japan tend to be highly regulated and have an efficient system for matching seekers with providers of capital and foster an active secondary market.
Emerging markets are usually significantly smaller and newer than developed markets and have fewer active participants, resulting in less liquidity and greater volatility. The trading mechanisms are often less efficient as well. These markets may also be more vulnerable to political instability, particularly if the country has a short history of democracy or if ethnic and religious controversies threaten to disrupt economic development.
Being labeled as developed or emerging is not always a clear indication of how a market operates. For example, some emerging markets are more mature and stable than others, and tend to attract more investor attention because they offer opportunities for long-term gain. This is especially true where large populations are becoming more affluent and the economies have shown sustained growth. At the same time, some developed markets may suffer through long periods of stagnation or other economic problems that deter international investors.
Some markets are open to all investors, while others limit the participation of nonresidents. That’s because some nations face a dilemma in seeking international capital: On the one hand, this capital can provide welcome growth. But at the same time, it has the potential to undermine domestic control and stability.
When they do seek to attract international investment, though, securities markets in emerging economies have strengthened their regulatory practices, improved transparency, and streamlined their clearance and settlement systems for handling the exchange of securities and cash payments.
WHAT’S GOOD FOR THE GOOSE
US investors seeking greater diversification may look abroad when they have capital to invest. At the same time, companies based abroad may want to tap the wealth of the US markets. If they do, they may offer shares of their stock on the US market through a US bank, which is known as a depositary. In this arrangement, the depositary bank holds the issuing company’s shares, known as American depositary shares (ADSs). The bank offers investors the chance to buy a certificate known as an American depositary receipt (ADR), which represents ownership of a bundle of the depositary shares. To have their ADRs listed on an exchange, companies must provide English-language versions of their annual reports, adhere to accepted US accounting practices, and grant certain shareholder rights. In addition, they must meet listing requirements imposed by the exchange or market where they wish to be traded.
In reality, many ADRs aren’t listed on an exchange, often because they are too small to meet listing requirements. Instead, they’re traded over the counter (OTC). The OTC markets are generally less liquid than the major exchanges, which can make OTC ADRs more difficult to sell at the time and price you want.
When a company makes depositary arrangements to sell its stock in two or more countries, the shares are called global depositary shares and they are sold as global depositary receipts (GDRs). In all other ways, they work the same way as ADRs.
THE WORLD BANK
The World Bank, or more formally, the International Bank for Reconstruction and Development (IBRD), is an investment bank that raises money by issuing bonds to individuals, institutions, and governments in more than 100 countries. The bonds are guaranteed by the governments of the 178 countries who own the bank.
The World Bank lends the money from its investors to the governments of developing countries at affordable interest rates to help finance internal projects and economic policy reforms. In fact, long-term loans to the poorest nations through the bank’s International Development Association (IDA) are interest free. The Bank’s International Finance Corporation (IFC) provides funds for private enterprise in emerging nations and helps stimulate additional financing from other investors. Its affi liate, the Multilateral Investment Guarantee Agency, promotes private investment by providing guarantees that protect investors from political risks, such as the possibility of nationalization. Without this safety net, investors might otherwise be reluctant to participate.
The World of Money
Currencies are floated against each other to measure their worth in the global marketplace.
A currency’s value in the world market-place reflects whether individuals and governments are interested in using it to make purchases or investments, or in holding it as a source of long-term security. If demand is high, its value increases in relation to the value of other currencies. If it’s low, the reverse occurs.
Some currencies are relatively stable, reflecting an underlying financial and political stability. Other currencies experience wild or rapid changes in value, the sign of economies in turmoil as the result of runaway inflation, deflation, defaults on loan agreements, serious balance-of-trade deficits, or economic policies that seem unlikely to resolve the problems.
Similarly, certain currencies are used widely in international trade while others are not. That’s the result of the relative stability of the currencies and the volume of goods and services a country or economic union produces.
NOTHING IS FIXED
Currency values of even the most stable economies change over time as traders are willing to pay more—or less—for dollars or pounds or euros or yen. For example, great demand for a nation’s products means great demand for the currency needed to pay for those products.
If there’s a big demand for the stocks or bonds of a particular country, its currency’s value is likely to rise as over-seas investors buy it to make investments. Similarly, a low inflation rate can boost a currency’s value, since investors believe that the value of long-term purchases in that country won’t erode over time.
HOW CURRENCY VALUES ARE SET
Between 1944 and 1971, major trading nations had a fixed, official rate of exchange tied to the US dollar, which could be redeemed for gold at $35 an ounce. Since 1971, when the gold standard was abandoned, currencies have floated against each other, influenced by supply and demand and by various governments’ efforts to manage their currency. Some countries, for example, have sought stability by pegging, or linking, their currency to the value of the US dollar. In Europe, the European Union established the euro as a common currency for participating member nations. By 2002, euro bank notes and coins had replaced many individual currencies for all transactions.
Governments generally try to keep their currencies stable, maintaining constant relative worth with the currencies of their major trading partners. One way to control the value of currency is by adjusting the money supply according to demand, depending on how much business is being transacted in that currency. Another way to control currency values is by adjusting interest rates. When rates are high, international investors are more likely to buy investments in that currency. When rates are low, demand for the investments in that currency falls, along with its exchange value.
Sometimes governments deliberately devalue their currency, bringing the exchange rate lower relative to other countries. One reason is that this makes the country’s exports relatively cheap, giving it a trade advantage.
Large-scale currency trading in the global foreign exchange market, or forex, is handled on telecommunications networks controlled by banks or other financial institutions. In spot trading, the deal is settled, or finalized, within two days at current rates. Forward transactions involve setting an exchange rate that will apply when the currency is traded on a set date in the future. Currency swaps involve exchanging one cash flow for another, such as a stream of income in one currency in exchange for a stream of income in another currency at a preset exchange rate.
In the new economy, investors looking for ways to diversify their portfolios have a world of opportunity.
If you want to balance some of the risks of investing in only US securities, you can diversify your portfolio by also investing in equities and debt available on overseas markets. Although the economic situation in one country or region may have an impact on securities markets around the world, domestic factors tend to play the most important role in determining investment return in any particular market. This means by investing globally, you’re in a position to benefit from strong performances in multiple markets. And if returns in other markets are strong in a period when US markets are flat or falling, those gains may offset potential losses.
THERE ARE REWARDS
Investing abroad can produce rich returns. In the best of all possible worlds, investors win three ways, in what investment pros call the triple whammy:
• The investment rises in price, providing capital gains
• The investment pays dividends
• The country’s currency rises against the dollar, so that when investors sell they get more dollars
BUT ALSO RISKS
Investing abroad is no less risky than buying at home. Prices do fall and dividends get cut. Plus, there may be hidden traps that can catch unwary investors. Here are some of the common ones:
• Tax treatments of gains or losses differ from one country to another
• Accounting and trading rules may be different
• Converting dividends into dollars may add extra expense to the transaction
• Some markets are only loosely regulated
• It can be hard to find information
• Giving buy and sell orders can be complicated by distance and language barriers
• Unexpected changes in overseas interest rates or currency values can cause major upheavals
• Political instability in a country or region can affect the value of investments there
Overseas investors make money in US stocks when the dollar is strong against their currency and stock prices are climbing. If the dollar weakens, though, the value of their investment drops as well.
Investors are often more comfortable investing in bonds issued in their own currency by an overseas entity than buying bonds in another currency. International bonds, known generically as Eurobonds, are usually issued by a borrower in a country other than its own, in a currency other than its own—often in the currency of the intended purchasers. There are also dual-currency bonds, where interest is paid in one currency but the bonds are redeemed in another.
The Banking System
Banks are an integral part of the capital markets and keep things fluid.
Investors help keep the capital markets healthy by investing in securities, often for the long term. But what about capital that they may need for more immediate use?
While there are a number of short-term investment alternatives, people may prefer to deposit their extra cash in a bank. It’s safer than keeping money in a drawer or carrying it around, and it’s easily accessible. The money that people and organizations deposit in bank accounts is the capital that banks put to work.
By lending money to businesses to meet short-term financing needs, banks help keep the economy fluid, or liquid. And by providing long-term mortgages, banks provide individuals with the capital they seek to purchase homes. In fact, banks are such an important source of community funding for both business and individuals that their lending practices have some- times been credited—or blamed—for the economic health of local areas.
WHAT’S A BANK?
Commercial banks traditionally differed from investment banks because their main business was making loans and accepting transaction deposits on which you can write checks, demand deposits, from which you can withdraw your money at any time, and time deposits, on which you receive interest for a fixed term. But banks can also underwrite corporate debt and initial public offerings of common stock, advise clients who are planning a merger or an acquisition, and handle other investment banking functions through the division of their institutions that is described as a merchant bank.
THE MONEY MARKET
The major purpose of financial markets is to transfer funds from lenders to borrowers. Financial market participants commonly distinguish between the "capital market" and the "money market," with the latter term generally referring to borrowing and lending for periods of a year or less. The United States money market is very efficient in that it enables large sums of money to be transferred quickly and at a low cost from one economic unit (business, government, bank, etc.) to another for relatively short periods of time.
The need for a money market arises because receipts of economic units do not coincide with their expenditures. These units can hold money balances—that is, transactions balances in the form of currency, demand deposits, or NOW accounts—to insure that planned expenditures can be maintained independently of cash receipts. Holding these balances, however, involves a cost in the form of foregone interest. To minimize this cost, economic units usually seek to hold the minimum money balances required for day-today transactions. They supplement these balances with holdings of money market instruments that can be converted to cash quickly and at a relatively low cost and that have low price risk due to their short maturities. Economic units can also meet their short-term cash demands by maintaining access to the money market and raising funds there when required.
Maturities range from one day to one year; the most common are three months or less. Active secondary markets for most of the instruments allow them to be sold prior to maturity.
The money market encompasses a group of short-term credit market instruments, futures market instruments, and the Federal Reserve's discount window. The major participants in the Money market are commercial banks, governments, corporations, government-sponsored enterprises, Money market mutual funds, futures market exchanges, brokers and dealers, and the Federal Reserve.
Commercial Banks Banks play three important roles in the money market. First, they borrow in the money market to fund their loan portfolios and to acquire funds to satisfy noninterest-bearing reserve requirements at Federal Reserve Banks. Banks are the major participants in the market for federal funds, which are very short-term—chiefly overnight—loans of immediately available money; that is, funds that can be transferred between banks within a single business day. The funds market efficiently distributes reserves throughout the banking system. The borrowing and lending of reserves takes place at a competitively determined interest rate known as the federal funds rate.
Banks also borrow funds in the money market for longer periods by issuing large negotiable certificates of deposit (CDs) and by acquiring funds in the Eurodollar market. A large denomination CD is a certificate issued by a bank as evidence that a certain amount of money has been deposited for a period of time— usually ranging from one to six months—and will be redeemed with interest at maturity. Eurodollars are dollar-denominated deposit liabilities of banks located outside the United States (or of International Banking Facilities in the United States). They can be either large CDs or nonnegotiable time deposits. U.S. banks raise funds in the Eurodollar market through their overseas branches and subsidiaries.
A final way banks raise funds in the money market is through repurchase agreements (RPs). An RP is a sale of securities with a simultaneous agreement by the seller to repurchase them at a later date. (For the lender—that is, the buyer of the securities in such a transaction—the agreement is often called a reverse RP.) In effect this agreement (when properly executed) is a short-term collateralized loan. Most RPs involve U.S. government securities or securities issued by government-sponsored enterprises. Banks are active participants on the borrowing side of the RP market.
A second important role of banks in the money market is as dealers in the market for over-the-counter interest rate derivatives, which has grown rapidly in recent years. Over-the-counter interest rate derivatives set terms for the exchange of cash payments based on subsequent changes in market interest rates. For example, in an interest rate swap, the parties to the agreement exchange cash payments to one another based on movements in specified market interest rates. Banks frequently act as middleman in swap transactions by serving as a counterparty to both sides of the transaction.
A third role of banks in the money market is to provide, in exchange for fees, commitments that help insure that investors in money market securities will be paid on a timely basis. One type of commitment is a backup line of credit to issuers of money market securities, which is typically dependent on the financial condition of the issuer and can be withdrawn if that condition deteriorates. Another type of commitment is a credit enhancement—generally in the form of a letter of credit—that guarantees that the bank will redeem a security upon maturity if the issuer does not. Backup lines of credit and letters of credit are widely used by commercial paper issuers and by issuers of municipal securities.
Governments The U.S. Treasury and state and local governments raise large sums in the money market. The Treasury raises funds in the money market by selling short-term obligations of the U.S. government called Treasury bills. Bills have the largest volume outstanding and the most active secondary market of any money market instrument. Because bills are generally considered to be free of default risk, while other money market instruments have some default risk, bills typically have the lowest interest rate at a given maturity. State and local governments raise funds in the money market through the sale of both fixed- and variable-rate securities. A key feature of state and local securities is that their interest income is generally exempt from federal income taxes, which makes them particularly attractive to investors in high income tax brackets.
Corporations Nonfinancial and nonbank financial businesses raise funds in the money market primarily by issuing commercial paper, which is a short-term unsecured promissory note. In recent years an increasing number of firms have gained access to this market, and commercial paper has grown at a rapid pace. Business enterprises—generally those involved in international trade—also raise funds in the money market through bankers acceptances. A bankers acceptance is a time draft drawn on and accepted by a bank (after which the draft becomes an unconditional liability of the bank). In a typical bankers acceptance a bank accepts a time draft from an importer and then discounts it (gives the importer slightly less than the face value of the draft). The importer then uses the proceeds to pay the exporter. The bank may hold the acceptance itself or rediscount (sell) it in the secondary market.
Government-Sponsored Enterprises Government-sponsored enterprises are a group of privately owned financial intermediaries with certain unique ties to the federal government. These agencies borrow funds in the financial markets and channel these funds primarily to the farming and housing sectors of the economy. They raise a substantial part of their funds in the money market.