BENEFITS OF THE INTERNATIONAL CAPITAL MARKET

INTERNATIONAL
UNIT 5 SECTION
BUSINESS
5
Unit 5, section 5: Benefit of the international capital market

Borrowers and investors involved international capital market transactions

are in to make some gains irrespective the risks involved. The main players
in the generic Capital Markets are individual or group investors, companies,
institutions, market makers, commercial bankers, investment bankers,
borrowers and governments. It is important to look at the benefits derived
from the players in this form of market.

By the end of this Section, you should be able to;

 explain the benefits of international capital market from the borrower’s
perspective
 explain the benefits of international capital market from the investor’s
perspective
 describe methods used to transfer funds within a multinational enterprise

Read on

Benefits of the International Capital Market

An international capital market benefits both borrowers and investors. It
helps increases the supply of funds available to borrowers and investors, and
lowers the cost of capital. It benefits investors by providing a wider range of
investment opportunities thereby allowing them to build portfolios of
international investments that diversify their risks.

The Borrowers' Perspective: A Lower Cost of Capital

In a purely domestic capital market, the pool of investors is limited to
residents of the country, thereby placing an upper limit on the supply of
funds available to borrowers, leading to limited liquidity in the market. An
international capital market provides a larger supply of funds for borrowers
to draw on; however, the cost of capital tends to be higher than it is in an
international market. The cost of capital is the rate of return that borrowers
must pay investor (the price of borrowing money). The limited pool of
investors implies that borrowers must pay more to persuade investors to
loan them their money. The larger pool of investors in an international
market implies that borrowers will be able to pay less.

The Investor Perspective: Portfolio Divaricating

From the perspective of an investor, in a purely domestic capital market the
set of investment opportunities is limited. In contract, by utilizing the
international capital market, the investor has such wider ranges of
investment opportunities enabling them to diversify their portfolio of
holdings internationally, thereby reducing their risk(s). The investment
strategy is to acquire a diversified portfolio of stock holdings, and by
holding a variety of stocks, the losses incurred when some stocks fail to live
up to their promises are offset by the gains enjoyed when their stocks
exceed their promise.

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Implications for Business

The growth of the international capital market has created opportunities of
international business that wish to borrow and or invest money.
On the borrowing side, firms can often borrow funds (equity, bonds, or
loans) at a lower cost than is possible in a purely domestic capital market.
This reflects their greater liquidity and the general absence of government
regulation as government regulation tends to raise the cost of capital in most
domestic capital markets. The international market escapes regulation but
associated with foreign exchange risk.

On the investment side, this international market provides opportunities for

firms, institutions, and individuals to better diversify their investments in
financial assets to limit risks. By holding a diverse portfolio of stocks and
bonds in different nations, an investor can reduce total risks to a lower level.
The forces that are expanding the global capital market include information
technology, deregulation of national capital markets, and innovative
financial instruments as well technical expertise.

Methods Used To Transfer Funds within a Multinational

Enterprise (MNE)
The methods used to transfer funds within an MNE include the following
Through trade credit, a subsidiary can defer payment for goods and services
received from the parent company. Credit terms tend to be longer in foreign
markets (90 days) compared to the United States (30 days).

Dividend remittances are a common method for transferring funds from

foreign subsidiaries to the parent, but vary for each subsidiary depending on
factors such as tax levels and currency risks. For instance, some host
governments levy high taxes on dividend payments and limit how much
MNEs can remit.
 Transfer pricing refers to prices that subsidiaries and affiliates charge
one another as they transfer goods and services within the same MNE.
Firms can use transfer pricing to shift profits out of high-tax countries
into low-tax countries; minimize foreign exchange risks, and optimize
the management of internal cash flows.
 Royalty payments are remuneration paid to the owners of intellectual
property. Assuming the subsidiary has licensed technology, trademarks,
or other assets from the parent or other subsidiaries, royalties can be an
efficient way to transfer funds. Also, because they may be viewed as an
expense, royalties are tax-deductible in many countries. The parent
MNE can collect royalties from its own subsidiaries as a way of
generating funds.
 A fronting loan is a loan between the parent and its subsidiary,
channelled through a large bank or other financial intermediary.
Fronting allows the parent to circumvent restrictions that foreign
governments impose on direct intracorporate loans. While some

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countries restrict international funds transfers in order to keep money

within their borders, such restrictions usually do not apply to the
repayment of bank loans.
 Multilateral netting is another method for funds transfer within the
MNE. It amounts to strategic reduction of cash transfers within the
MNE family through the elimination of offsetting cash flows.

A Recap of the Global Financial Crisis in 2008

In 2008, the global financial crisis emerged in the global financial and
monetary systems. It all begun in the United States when investors lost
confidence in the value of home mortgages. Commercial banks, mortgage
lenders, and insurance companies entered a period of high volatility, leading to
the crash of the stock markets around the world, and sinking many national
into a deep recession. The effect was spiky decline in consumer wealth,
economic activity, and international trade. For several years, the Federal
Reserve Bank (U.S. central bank), had pursued a policy of low interest rates,
generating surplus capital in the United States and abroad. However, a key
factor in the crisis was the widespread of money supply.

The huge investments from many emerging economies in bonds and other
securities in the US, led to the build-up of a vast global money supply
resulting to soaring price inflation in housing, oil and food. Much of the
money was used to finance the huge U.S. trade deficit, accumulated from
massive imports of consumer and industrial goods into the United States.
Many of the loans during this period were “securitized,” or bundled into
investment assets that were sold in financial markets worldwide. Investors
realised that many of the loans were high risk and unlikely to be repaid. As
the overheated U.S. mortgage market cooled, the value of homes and
securitized mortgages crashed, and the U.S. financial system fell into crisis.
The crisis spread quickly to Europe and beyond.

Capital flight is the rapid sell-off by residents or foreigners of their holdings in

a nation's currency or other assets, usually in response to a domestic crisis that
causes them to lose confidence in the country's economy. Investors exchange
their holdings in the weakening currency for a hard currency. Subsequently,
governments took corrective measures by injecting massive sums into their
national economies and launching aid packages. Other emerging governments
also obtained loans from the International Monetary Fund and the World
Bank. Some also imposed trade and investment barriers. Gradually,
governments began to cooperate in financial matters. The crisis highlights the
importance of strong regulation, transparency, and supervision of institutions
in the global financial system.

This has called for effective international financial management. International

financial management is the acquisition and use of funds for cross-border
trade, investment, R&D, manufacturing, marketing, outsourcing, and other
commercial activities. It is a complex but critical business function. Financial

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managers access funds from investors, foreign bond markets, local stock
exchanges, foreign banks, venture capital firms, and intracorporate
financing—wherever in the world capital is cheapest. Five (5) key
International Financial Management Tasks identified to enhance international
financial management include the ability to;
 raise funds for the firm: acquire equity, debt, or intracorporate financing
for funding activities and investments
 manage cash flow: manage funds passing in and out of the firm’s value-
adding activities
 perform capital budgeting: assess financial attractiveness of major
investment projects (e.g., foreign market expansion & entry)
 manage currency risk: manage the multiple-currency transactions of the
firm and its exposure to exchange-rate fluctuations
 manage accounting and tax practices: Learn to operate in a global
environment with diverse accounting practices and international tax
regimes

We have successfully explained the benefits derived from international

capital management from both borrowers’ and investors’ perspectives. We
also described the methods through MNEs transfer funds. A recap of the
global financial crisis was also made to address the need for effective
international financial management. This resulted to us appreciating the 5
key elements involved in international financial management tasks

Now assess your understanding of this Section by answering the following

self-assessment questions. Good luck!

Activity 5.5
 Describe any four methods used to transfer funds within an MNE.
 Distinguish between the benefits of international capital market from
both investors’ and borrowers’ perspectives. (refer to notes for answers)

Did you score all? That’s great! Keep it up.

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