Corporate Finance: Capital, Markets, and Global Trends

Posted on Dec 20, 2024 in Economy

CH12: Determinants of Cost-of-Capital (COC) Differences

  • Legal System: Stronger laws lead to a lower COC.
  • Transparency: Better disclosure leads to lower equity costs.
  • IFRS (International Financial Reporting Standards) Adoption: Standardized reporting leads to global comparability.
  • Market Imperfections: Barriers increase cost; international ownership decreases cost.
  • Investor Base: A larger base leads to lower financing costs.

Trends in Correlations Across Time

  • Increasing Correlation: Globalization and common shocks (e.g., crises).
  • Regional Variation: Higher in developed markets, lower in emerging markets.
  • Non-Financial Assets: Real estate, art lead to lower correlations.
  • Diversification Challenges: Rising correlations make it harder to reduce risk.

Cross-Listing Benefits

  • Expanded Investor Base: Attracts international investors.
  • Valuation Premium: Higher demand leads to better valuation.
  • Liquidity Boost: Increases trading activity.
  • Reputation & Transparency: Signals governance quality.
  • Capital Access: Easier to raise funds globally.

ADRs

  • Salient Features: U.S.-traded, dollar-denominated, representing foreign shares.
  • Advantages: Broader access, increased liquidity, low correlation with U.S. assets.
  • Disadvantages: Higher costs, limited voting rights, currency risk.

Trends in Alternative Assets

  • Real Estate: Low correlation, inflation hedge.
  • Art & Collectibles: Diversification, long-term gains.
  • Private Equity: High returns, illiquid.
  • Cryptocurrency: High growth but volatile.
  • Commodities: Inflation hedge, global demand.

CH11: Optimal Number of Securities in a Portfolio

20-30 securities reduce unsystematic risk effectively. Benefits diminish beyond 30 stocks due to higher costs. The goal is to balance diversification and cost-efficiency.

Major Trends in Equity Markets

Emerging vs. Developed: Emerging = higher returns & risk; Developed = stable, liquid, and diversified. Home Bias: Preference for domestic equities reduces diversification benefits.

US Market Trends

Decline in listed firms, rise in average firm size. Private equity growth delays IPOs. High M&A activity consolidates firms.

IPO Trends: US vs. China

US: Fewer IPOs, driven by SOX regulations, private equity, and M&A activity. China: More IPOs due to government support and rapid economic growth.

Emerging vs. Developed Markets

  • Liquidity: Emerging = lower; Developed = higher.
  • Concentration: Emerging = dominated by few firms.
  • Trading Costs: Higher in emerging markets.
  • Legal & Political Risks: Higher in emerging markets.
  • ForEx Risk: Significant in emerging markets.
  • Avg. Returns: Emerging = higher; Developed = stable.
  • Diversification: Emerging markets offer greater diversification benefits.

Home Bias

Definition: Overallocation to domestic equities despite benefits of international diversification. Causes: Familiarity, costs, ForEx risk, regulations, and behavioral biases. Impact: Limits diversification, increases risk exposure.

US Listing Gap

Decline in US-listed companies. Reasons: High regulatory cost (e.g., SOX), rise of private equity, increased M&A activity, companies staying private longer (unicorns).

Unicorns

Definition: Private companies valued at $1 billion. Impact: Delay IPOs, contributing to the US Listing Gap.

Cross-Border Market Correlations

Increasing correlations due to globalization. Higher during crises: Reduces diversification benefits. Emerging vs. Developed: Developed: Higher correlations. Emerging: Lower correlations, better diversification.

Performance of Emerging Economies (MSCI Index)

Volatility: Higher compared to developed markets. Returns: Higher potential but inconsistent performance. Currency Effects: ForEx fluctuations affect USD-based returns. Key Trends: Recovery post-COVID, sector dominance in tech/commodities, and China’s influence.

CH10: Variance Decomposition (Risk)

Formula: Var(RiUSD) = Var(Ri) + Var(ei) + 2Cov(Ri, ei) Meaning: Total risk is influenced by local market risk (Var(Ri)), currency risk (Var(ei)), and the relationship between both (Cov(Ri, ei)). Important for foreign bond investors who face both market and currency risks.

Exchange Rate Impact on Investment

Equity Investments: Currency fluctuations can amplify returns and losses. Investors typically tolerate this risk. Bond Investments: Currency changes can erode returns, especially since bond returns are usually lower than equities. Hedging is more common for bond investors to avoid loss from currency movements.

Why Bond Investors Hedge Currency Risk More

Stability: Bonds aim for consistent, low-risk returns. Risk of Loss: Small currency depreciation can wipe out bond returns. Hedging Justification: Due to predictable returns, the cost of hedging currency risk is worth it for bond investors.

Bearer vs. Registered Bonds

Bearer Bonds: Ownership: Whoever holds the bond owns it (anonymous). Risk: High (can be lost or stolen). Transfer: Simple (no registration required). Registered Bonds: Ownership: Registered with issuer. Risk: Low (can be replaced if lost). Transfer: Requires updates to issuer’s records.

Bonds vs. Syndicated Loans

Bonds: Public, traded in markets, higher liquidity, fewer covenants, lower monitoring requirements. Syndicated Loans: Private, higher monitoring and stricter covenants. Less liquid, harder to transfer.

Types of International Bonds

Foreign Bonds: Issued by foreign entities in the local currency (e.g., Yankee, Samurai, Bulldog bonds). Eurobonds: Issued in a foreign currency, traded globally (e.g., Eurodollar, Euroyen). Global Bonds: Bonds issued simultaneously in multiple markets, offering higher liquidity.

Foreign Bond Examples

Yankee Bonds: Dollar bonds issued by foreign entities in the U.S. Samurai Bonds: Yen bonds issued by foreign entities in Japan. Bulldog Bonds: Pound sterling bonds issued by foreign entities in the UK. Rembrandt Bonds: Euro-denominated bonds issued by foreign entities in the Netherlands.

Dim-Sum vs. Panda Bonds

Dim-Sum Bonds: RMB bonds issued offshore (mostly in Hong Kong). Panda Bonds: RMB bonds issued within mainland China by foreign entities. Trend: Panda bonds are rising as China opens its domestic markets, while Dim-Sum issuances are declining.

Sukuk Bonds

Definition: Islamic bonds that comply with Shari’ah (no interest, asset-backed). Return is based on profits or rental income from underlying assets, not interest. Purpose: Ethical investing for those seeking Shari’ah-compliant financial instruments.

CH9: Determinants of Wealth of Nations

Natural Resources: Abundance can boost wealth (e.g., oil in the Middle East). Peace and Stability: Stable governance promotes investment (e.g., Germany). Climate: Favorable conditions support agriculture but can be overcome by governance (e.g., Sweden). Institutions: Strong legal systems and property rights encourage growth. Human Capital: Educated, skilled populations drive productivity (e.g., Singapore). Culture: Work ethic, cooperation, and savings habits matter. Legal and Financial Systems: Robust legal frameworks foster financial development.

Legal Origin and Its Importance

Types: Common Law: Based on case law; stronger investor protections (e.g., USA, UK). Civil Law: Codified statutes; weaker protections (e.g., France, Italy). Why It Matters: Investor Protection: Stronger in common law (e.g., one-share-one-vote). Capital Market Development: Common law fosters larger markets. Economic Growth: Legal origins influence institutions and efficiency.

Protection of Property Rights

Company Ownership: Weak rights = concentrated ownership; strong rights = dispersed ownership. Capital Markets: Strong rights = trust in financial systems, robust markets. Economic Growth: Secure rights promote savings, investment, and innovation.

Pyramidal Ownership

Definition: Hierarchical control of companies through cascading ownership. Exploitation: Minority shareholder losses via profit diversion. Transfer pricing abuses. Empire-building by controlling shareholders. Example: Italy’s concentrated corporate ownership.

Classification of Political Risk

Contract Enforcement Risk: Weak legal systems, delayed payments. Transfer Risk: Currency restrictions, profit repatriation limits. Operational Risk: Changes in labor laws, regulations. Control Risk: Expropriation, excessive taxation. Political Instability Risk: Civil unrest, coups. Policy Risk: Tariffs, regulatory shifts. Sovereign Risk: Government debt defaults. Geopolitical Risk: Trade sanctions, cross-border conflicts.

Measuring Political Risk

World Bank Governance Indicators: Rule of law, corruption control. Transparency International (CPI): Public sector corruption perception. ICRG Ratings: Political, economic, and financial risk ratings. Ease of Doing Business: Regulatory environment analysis. Geopolitical Risk Index: Global tension tracking. Freedom House: Political and civil liberties ranking.

Hedging Political Risk

Geographic Diversification: Spread operations across regions. Political Risk Insurance: Coverage for expropriation, violence, etc. Joint Ventures: Partner with local firms for shared risks. Local Financing: Use local banks to reduce exposure. Currency Hedging: Financial instruments for currency risks. Contract Clauses: Force majeure, compensation clauses. Monitoring: Use data sources like ICRG or EIU.

Hofstede’s Cultural Dimensions

Power Distance: High = hierarchy accepted (e.g., Malaysia). Low = equality valued (e.g., Denmark). Individualism vs. Collectivism: Individualism (e.g., USA) vs. group focus (e.g., China). Masculinity vs. Femininity: Competition (e.g., Japan) vs. quality of life (e.g., Sweden). Uncertainty Avoidance: High = structured rules (e.g., Greece). Low = flexibility (e.g., Singapore). Long-Term vs. Short-Term Orientation: Future-focused (e.g., China) vs. tradition-focused (e.g., USA). Indulgence vs. Restraint: Fun-loving (e.g., Mexico) vs. restrained (e.g., Russia).

Rice vs. Wheat Farming Analogy

Rice Farming: Labor-intensive, cooperative. Collective governance, centralized systems (e.g., China). Wheat Farming: Individualistic, less cooperation needed. Decentralized, market-driven governance (e.g., USA). Implications: Agriculture shapes societal values and governance structures.

Governance Reform Trends

Transparency: Open data, whistleblower laws, RTI acts. Anti-Corruption: Independent agencies, public procurement reforms. Decentralization: Empowering local governments. Digital Governance: E-governance platforms, blockchain. Citizen Participation: Public consultations, participatory budgeting. Civil Service Reform: Merit-based recruitment, performance management. Environmental Governance: SDGs, climate policies.

CH8: Types of Exposure

Transaction Exposure: Sensitivity of a firm’s contractual cash flows to exchange rate changes (e.g., payments or receipts in foreign currency). Economic Exposure: Impact of exchange rate changes on a firm’s market value and competitive position. Translation Exposure: Effect of exchange rate changes on consolidated financial statements when converting subsidiaries’ accounts.

Managing Transaction Exposure

Forward Market Hedge: Lock in exchange rates with forward contracts. Money Market Hedge: Use borrowing/lending in domestic and foreign currencies. Options Hedge: Buy options for flexibility (protect against unfavorable movements while benefiting from favorable ones). Exposure Netting: Offset receivables and payables across the firm.

Forward Market Hedge Explained

Lock in a future exchange rate using a forward contract. Example: U.S. company owes €500,000 in 6 months; forward rate = $1.20/€. Cost: €500,000 × 1.20 = $600,000 (fixed). Protects against adverse exchange rate changes.

Money Market Hedge Explained

For Payables: Borrow the present value of foreign currency owed. Convert to domestic currency and invest. Use investment proceeds to repay. For Receivables: Borrow in foreign currency equal to PV of receivables. Convert and invest domestically. Repay loan with foreign currency receivables.

Options vs. Forwards

Options: Right but not obligation; pay a premium. Best for uncertain exposures or when upside potential is needed. Forwards: Obligation to transact; no upfront cost. Best for certain exposures and lower cost.

Hedging Strategies

Minor Currencies: Use cross-hedging or basket currencies. Contingent Exposure: Use options for uncertain exposures. Recurring Exposure: Use swaps or forwards for regular transactions. Invoice Currency: Shift, share, or diversify invoicing currencies. Leading/Lagging: Adjust payment timing based on expected currency movements.

Operating Exposure Management

Low-Cost Production Sites: Locate production in favorable currency regions. Flexible Sourcing: Source inputs from multiple countries. Market Diversification: Spread sales across different regions. Natural Hedging: Match revenues and costs in the same currency. R&D/Product Differentiation: Reduce price sensitivity through innovation.

Exposure Netting

Consolidate all exposures across subsidiaries. Offset receivables and payables in the same currency. Hedge only the net exposure to reduce costs and complexity.

Why Hedge?

Pros: Stabilizes cash flows. Lowers cost of capital. Avoids financial distress. Mitigates competitive disadvantages. Offers tax benefits. Cons: Involves costs (e.g., premiums, transaction fees). May limit upside potential. Complexity in managing strategies. Shareholders may prefer direct exposure.

Break-Even Analysis for Options vs. Forwards

Break-even exchange rate = Forward Rate + (Option Premium / Exposure Amount). If spot rate exceeds break-even, options are better; otherwise, forwards are preferred.

Key Formulas

Money Market Hedge (PV): PV = FutureValue / (1 + Interest Rate). Forward Hedge Cost: Cost = Amount × ForwardRate. Option Net Cost: Net Revenue = (Spot Rate − Premium) × Amount.

CH7: Options

In the Money vs. Out of the Money (ITM, OTM): Call Option: Market price > Strike price (profitable to buy) | Market price < Strike price (no profit to buy). Put Option: Market price < Strike price (profit to sell) | Market price > Strike price (no profit to sell). Payoff: Positive, exercisable for profit | Zero, no reason to exercise.

Swap Types

  • Interest Rate Swaps: Exchange of fixed and floating interest rate payments in the same currency.
  • Fixed-for-Floating Swap: One party pays fixed, the other pays floating.
  • Floating-for-Floating Swap: Both parties pay floating rates, but based on different benchmarks.
  • Currency Swaps: Exchange of fixed or floating interest rate payments in different currencies.
  • Fixed-for-Fixed: Fixed-rate payments exchanged in two different currencies.
  • Fixed-for-Floating: One fixed-rate payment in one currency, and floating in another.
  • Floating-for-Floating: Both floating-rate payments in different currencies.

Key Swap Concepts

Notional Principal: The amount on which the interest payments are based (but not exchanged). QSD (Quality Spread Differential): The difference in borrowing costs due to credit quality differences, shared between the swap parties and the dealer.

LIBOR & Market Efficiency

Definition: Benchmark interest rate at which major global banks lend to each other. Use: LIBOR is used to price loans, bonds, and derivatives. Calculation: Based on daily submissions by banks (excluding the highest and lowest rates, averaging the middle ones). Replacements: Replaced by SOFR in the U.S. and other rates in different currencies.

Swaps Quotations

Reading Swap Quotes Example: 3.82–3.85 vs. LIBOR. 3.82%: Swap bank pays fixed rate in exchange for receiving LIBOR. 3.85%: Swap bank receives fixed rate in exchange for paying LIBOR.

Calculating Swap Cash Flows

  • Interest Rate Swap Example:
  • Fixed Payment: Notional × Fixed Rate × Time Period.
  • Floating Payment: Notional × Floating Rate × Time Period.
  • Net Cash Flow: Fixed Payment – Floating Payment.
  • Currency Swap Example:
  • Convert Principal: Exchange initial principal amounts.
  • Interest Payment: Calculated based on fixed or floating rates in both currencies.
  • Re-exchange Principal: At maturity, exchange the initial principal amounts.

Market Inefficiency

Swaps exist due to market inefficiencies, such as differences in borrowing costs between firms with different credit ratings (QSD). Swaps allow firms to access better financing terms by leveraging their comparative advantages. Swap Dealers (banks) facilitate these trades and profit from the QSD (spread).