International Equity

Financing
FINA3020 International Finance
CUHK Business School

Topic 7
Lesson Outline
• Overview of global equity markets
• Sourcing equity globally
• Cross-listings: motivations, benefits, costs
• International equity benchmarks
• Factors affecting international equity returns

1
Global Market Capitalization
• At year-end 2018, total market capitalization of the 80 organized stock exchanges
tracked by the World Federation of Exchanges (WFE) stood at $74,667 billion.
• Five largest stock exchanges at end of 2018:
• New York Stock Exchange (NYSE).
• NASDAQ.
• Japan Exchange Group.
• Shanghai Stock Exchange.
• Hong Kong Exchanges and Clearing.

2
Global Market Liquidity
• A liquid stock market is one in which investors can buy and sell stocks quickly at
close to the current quoted prices
• A measure of liquidity for a stock market is the turnover ratio, calculated as the ratio of stock
market transactions over a period of time divided by the size, or market capitalization, of the
stock market.
• Generally, the higher the turnover ratio, the more liquid the secondary stock market, indicating
ease in trading.
• In 2018, many national stock exchanges had relatively high turnover ratios, with close to 40%
of the exchanges in excess of 30% turnover on average.

3
 Market microstelure
Market Concentration tick sive

• Investors would have difficulty diversifying their investments in concentrated

markets, those dominated by a few large firms
• Concentrated financial markets also represent poor access of firms to the stock
market.
• A common measure of stock market concentration is the ratio of the market
capitalization of the largest 10 companies divided by the total market
capitalization.
• In 2018, the largest 10 companies on the Budapest Stock Exchange accounted for a
whopping 95.46% of the total market capitalization of the stock exchange.
• Alternatively, also in 2018, the London Stock Exchange had a much lower concentration
ratio of 29.38%.

4
Market Consolidations and Mergers
• Approximately 80 major national stock markets
• Western and Eastern Europe once had more than 20 national stock exchanges where at least 15
different languages were spoken.
• Possibly, over time a European stock exchange will eventually develop; however, a lack of
common securities regulations, even among the countries of the European Union, hinders this
development.
• Today, stock markets around the world are under pressure from clients to combine
or buy stakes in one another to trade shares of companies anywhere, at a faster
pace.

5
 Trading in International Equities
• During the 1980s, world capital markets began a trend toward greater global
integration due to the following factors:
① 1. Investors began to realize the benefits of international portfolio diversification.
② 2. Major capital markets became more liberalized.
③ 3. New computer and communications technology facilitated efficient and fair
securities trading.
④ 4. MNCs realized the benefits of sourcing new capital internationally.

6
Sourcing Equity Globally
• Three key critical elements to understanding the issues that any firm must confront
when seeking to raise equity capital.
① • Public or private equity placement
② • Where to list the offering
③ • Type of issuance

7
Equity Avenues, Activities, and Attributes

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 ①
Sourcing Equity Globally—IPO
• Initial Public Offering (IPO) – the first public issue of a firm’s equity shares.
• First a prospectus is published
• The IPO typically represents 15% to 25% of ownership
• Later issues by the firm are considered “seasoned offerings” SEOs
• With public issuance of shares comes greater public disclosure
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 ②
Sourcing Equity Globally—Euroequity Issue
• A euroequity or euroequity issue is an initial public offering on multiple exchanges
in multiple countries at the same time.
• The “Euro” market (a generic term for international securities issues originating
and being sold anywhere in the world), was created by the same financial
institutions that had previously created an infrastructure for the Euronote and
Eurobond markets.

10
 ③
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• A directed public share issue is defined as one that is targeted at investors in a
single country and underwritten in whole or in part by investment institutions from
that country. ②

• The issue might or might not be denominated in the currency of the target market.
• The shares might or might not be cross-listed on a stock exchange in the target
market.

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• MNCs that are listed on their domestic exchanges can also choose to list some of
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• E.g. the Rio Tinto Group is listed on the NYSE, LSE, and ASX.
①
• Cross-listings allows firms to gain access to foreign capital markets, and also raise
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• An increased firm visibility could reduce information asymmetries between frsraandrsy

insiders (managers) and outsiders (investors) leading to a reduced cost of capital.
• Various financial instruments have been created to facilitate cross-listings. On
April 29, 1927, JP Morgan created the first American Depository Receipt (ADR)
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 Mechanisms for Cross-Listings
• Cross-listings can be executed in two ways:
β 1. A firm can create a depository receipt (DR) program through a foreign depository bank, which
Ensrerwny will have custody of some of the firm’s shares and allow the DRs to be traded in the bank’s
market
2. A firm can also list its shares directly on a foreign stock exchange provided that it satisfies all
the listing requirements and adhere to the regulations of the foreign exchange
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American Depository Receipts (ADRs)

• ADRs allow US investors to trade shares of non-US firms without administrative
hassle, such as opening a foreign brokerage account overseas or converting
currencies, either on US exchanges (e.g. NYSE, NASDAQ, AMEX) or over-the-
counter (OTC).
• The depository bank (e.g. JP Morgan, BNY Mellon) acquires the shares of non-US
firms and then issues certificates (the ADRs) for delivery to US investors.
• ADRs usually includes a “bundling” ratio to align the trading price in the US to
the price levels of the underlying shares in the home market of the foreign firm.
• For instance, a 1:10 “bundling” ratio means 1 ADR represents ownership of 10 shares (either
common or preferred) of the foreign firm.

14
 ADRs Mechanics
• ADRs can be exchanged for the underlying foreign shares, or vice versa, so
θ arbitrage keeps foreign and US prices of any given share the same after adjusting
for transfer costs.
θ • ADRs also convey certain technical advantages to US shareholders.
• While ADRs are quoted only in US dollars and traded only in the US, Global
Registered Shares (GRSs) can be traded on equity exchanges around the globe in a
variety of currencies.

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15
Investment0
Advantages of ADRs
• ADRs are denominated in dollars, trade on a US exchange, and can be purchased
through the investor’s regular broker.
• Dividends received on the underlying shares are collected and converted to dollars
by the custodian.
• ADR trades clear in three business days, as do US equities.
• ADR price quotes are in US dollars.
• ADRs (except Rule 144A issues) are registered securities that provide for the
protection of ownership rights, whereas most underlying stocks are bearer
securities.
• An ADR investment can be sold by trading the depository receipt to another
investor in the US stock market, or the underlying shares can be sold in the local
stock market.

16
Investment0
Advantages of ADRs
• ADRs frequently represent a multiple of the underlying shares, rather than a one-
for-one correspondence, to allow the ADR to trade in a price range customary for
US investors.
• ADR holders give instructions to the depository bank as to how to vote the rights
associated with the underlying shares.

17
Types of ADRs camptaeey
• Sponsored ADRs are created by a bank at the request of the foreign company that
issued the underlying security.
• Only type that can be listed on the US stock markets.
• Unsponsored ADRs were usually created at the request of a US investment
banking firm without direct involvement by the foreign issuing firm.
• Consequently, the foreign company may not provide investment information or financial
reports to the depository on a regular basis or in a timely manner.

18
Types of ADRs

19
 Global Registered Shares (GRS)
• A global registered share is a share of equity that is traded across borders and
markets without conversion, where one share on the home exchange equals one
share on the foreign exchange. : 1
• Different from a global depositary receipt in that the DR is bundled or split so that
the price represents a typically traded value for that market.⑨A GSR has the same
value everywhere and is not bundled (or split) for purposes of trading.
θ • Main advantages of GRSs over ADRs appear to be that all shareholders have
equal status and direct voting rights, while main disadvantage of GRSs appears to
be the greater expense in establishing the global registrar and clearing facility.
θ

20
Empirical Findings on Cross-Listings
• Several empirical studies document important findings on cross-listing in general
and on ADRs in particular
• Listed below are a few examples:
• Ammer et al. (2012) found that the single most important determinant of the
① amount of US investment a foreign firm receives is whether the firm cross-lists
on a US exchange.
• Sarkissian and Schill (2016) established that cross-listing occurs in waves at
② the host market, home market, and industry levels.

21
 Empirical Findings on Cross-Listings
• Jayaraman, Shastri, and Tandon (1993) interpreted their results as evidence that an
③ A D R listing provides the issuing firm with another market from which to source
new equity capital
• Results of Berkman and Nguyen (2010) indicate that cross-listed firms from
④ countries with poor corporate governance and/or weak accounting standards gain
from improvements in domestic liquidity in the first two years after cross-listing
but tend to diminish later

22
0
Benefits of Cross-Listings
• Empirical evidence shows that cross-listed firms are perceived to be less risky and
therefore benefit from a lower cost of capital.
• There are 4 hypotheses explaining this phenomenon:
①• Market segmentation - Markets that are highly-segmented face higher barriers to capital
flows due to higher transaction costs or foreign ownership restrictions. Therefore, firms that
are able to overcome market segmentation through cross-listings benefit from a wider pool of
investors. Consequently, the risk associated with equity ownership is spread, and since
individual investors face lower risk the cost of equity should be lower.
② • Liquidity - Cross-listings can enhance the liquidity of share trading because of (i) an increase
in the investor base, (ii) a reduction of informational asymmetries resulting from the increased
disclosure requirements (e.g. when firms opt for Level III ADRs), and (iii) longer total trading
hours especially for cross-continental listings thereby increasing trading volume.

23
0
Benefits of Cross-Listings
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• Hypotheses continued:
③ • Investor recognition - According to Robert Merton’s “investor recognition hypothesis” (see A
Simple Model of Capital Market Equilibrium with Incomplete Information (1987) Journal of
Finance) as firms gain greater recognition as a result of cross-listings, expected returns will
decrease and firm value will increase.
④ • Shareholder protection - Firms from domestic markets with weak shareholder protection can
demonstrate their commitment to better shareholder rights by listing in markets with stronger
shareholder protection. This can lead to lower agency costs, which translates to lower cost of
capital.

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Benefits of Cross-Listings

25
 Repercussions of Cross-Listings
① • Flow back - Some DR programs may not be successful at achieving critical
trading volume to sustain liquidity, which deters investors from trading those
shares locally and instead opt to trade in the firms’ home markets. This negates the
benefits of cross-listings.
• Market externalities from trading migration - When large MNCs cross-list on
② foreign exchanges, investors in the home markets may also migrate to the foreign
markets. Thus, reducing local liquidity, which could be severe especially when
shares of the MNCs form the bulk of trading activity in the home markets.

26
Private Placement
• One type of directed issue with a long history as a source of both equity and debt
is the private placement market.
• A private placement is the sale of a security to a small set of qualified institutional
buyers under SEC Rule 144A.
• Since the securities are not registered for sale to the public, investors have
typically followed a “buy and hold” policy.
• Private placement markets now exist in most countries.

27
International Equity Market Benchmarks
• As a benchmark of activity or performance of a given national equity market, an
index of the stocks traded on the secondary exchange (or exchanges) of a country
is used
• Indexes constructed and published by MSCI are an excellent source of national stock market
performance.
• MSCI presents return and price level data for 23 national stock market indexes from developed
countries, 27 emerging market countries, and 34 frontier markets that cover investment
opportunities beyond traditional developed and emerging markets.
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International Equity Market Benchmarks
• MSCI also publishes a market-value-weighted World Index representing large and
mid-cap stocks across 23 developed markets
• Includes approximately 2,600 stock issues of major corporations in the world.
• MSCI publishes several regional indexes
• The European, Australasia, Far East (EAFE) Index, the North American Index, the Far East
Index, several Europe Indexes, the Nordic Countries Index, the Pacific Index, and the
Emerging Markets Index.

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 iShares MSCI CPassive investmenl
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ETFs

• BlackRock Inc., an international investment management firm, operates iShares

MSCI as vehicles to facilitate investment in country, regional, and world funds
• iShares MSCI are baskets of stocks designed to replicate various MSCI stock indexes.
• Currently dozens of iShares MSCI.
• Exchange-traded funds, with most trading on NYSEAMEX.
• Low-cost, convenient way for investors to hold diversified investments in several different
countries.
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30
Factors Affecting International Equity
Returns
• Which factors influence equity returns?
① • Macroeconomic factors.
• Exchange rates.
㉚ • Industrial structure.

31
Macroeconomic Factors
• Two studies have tested the influence of various macroeconomic variables on
stock returns:
1. Solnik (1984) found that international monetary variables had only weak
influence on equity returns in comparison to domestic variables.
2. Asprem (1989) found that changes in industrial production, employment, and
imports, the level of interest rates, and an inflation measure explained only a
small portion of the variability of equity returns for 10 European countries, but
that substantially more of the variation was explained by an international market
index.

32
Exchange Rates
• Adler and Simon (1986)
• Found changes in exchange rates generally explained a larger portion of the variability of
foreign bond indexes than foreign equity indexes.

• Eun and Resnick (1988)

• Found that the cross-correlations among major stock markets and exchange markets are
relatively low, but positive.

• Gupta and Finnerty (1992)

• Concluded that exchange risk is generally not priced.

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• Studies examining the influence of industrial structure on foreign equity returns

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