Chapter Thirteen

International Equity
Markets

1
 Chapter Outline
• The World’s Equity Markets: A Statistical
Perspective
• Market Structure, Trading Practices, and
Costs
• Trading in International Equities
• International Equity Market Benchmarks
• iShares MSCI
• Factors Affecting International Equity
Returns

2
 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 $74,667b
– Five largest stock exchanges at end of 2018:
• New York Stock Exchange (NYSE)
• NASDAQ
• Japan Exchange Group
• Shanghai Stock Exchange
• Hong Kong Exchanges and Clearing
• Stock market capitalization-to-GDP ratio
3
 Top Stock Exchanges
Rank Name Market Capitalization (B$)
1 New York Stock Exchange 19,223
2 NASDAQ 6,831
3 London Stock Exchange Group 6,187
4 Japan Exchange Group – Tokyo 4,485
5 Shanghai Stock Exchange 3,986
6 Hong Kong Stock Exchange 3,325
7 Euronext 3,321
8 Shenzhen Stock Exchange 2,285
9 TMX Group 1,939

Data as on 31 January 2015

4
 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 5
 Market Concentration
• A common measure of stock market concentration is
the ratio of the market capitalization of the largest
ten companies divided by the total market
capitalization
• In 2018, the largest ten 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%
• Investors would have difficulty diversifying their
investments in concentrated markets, those
dominated by a few large firms
• Concentrated financial markets also represent poor 6
 Market Structure, Trading Practices,
and Costs
• Primary market: the market for new issues of
securities.
– New issue
– Key factor: issuer receives the proceeds from the
sale
• Secondary: the market where existing
securities are traded among investors.
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds and is not
directly involved

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Primary Market Structure

Relationship between a firm issuing securities, the underwriters, and the public

8
 Market Structure, Trading Practices,
and Costs
• Secondary equity markets of the world serve
two major purposes:
– Provide marketability
– Provide share valuation

9
Market Structure, Trading Practices,
and Costs (Continued)
• When conducting a trade in the
secondary market, public buyers and
sellers are represented by an agent,
known as a broker
• Order submitted to broker may be a
market or limit order

10
 Types of Orders
• Market orders: an order to buy or sell at
the best price when the order reaches the
trading floor.
• Price contingent orders
– Limit buy: Buy at or below a stipulated price
– Limit Sell: Sell at or above a specific limit
– Stop loss: sell if price falls below a stipulated
level (to limit losses)
– Stop buy: buy when price rises above a given
limit (to buy shares as prices are rising)
• Time expiry
– Day orders, open or good-till-cancelled orders
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 Market Structure, Trading Practices,
and Costs (Concluded)
• Secondary markets may have different
designs that allow for the efficient trading of
shares
– Generally, a secondary market is structured as a
dealer or agency market
• In a dealer market, the broker takes the trade
through the dealer, who participates in trades as a
principal by buying and selling the security for his
own account
• In an agency market, the broker takes the client’s
order through the agent, who matches it with
another public order 12
EXHIBIT 13.3
Characteristics of Major Equity Trading Systems

13
 Margin Trading
• Margin: the part of the total value of a security
transaction that a customer must pay to
initiate the transaction.
• Provide your own money (equity) as only a
portion of an investment
• Borrow the remaining via the broker
• Securities purchased on margin are kept at the
brokerage firm as collateral for the loan.

14
 Stock Margin Trading
• Initial margin (e.g., 50%)
• Minimum margin
– Minimum level the equity margin can be
– Set by the securities commissions
• Margin call: Call from the broker for more
equity funds
– It occurs when the market value of the
margined securities is less than the debt
balance of the margin account.

15
Margin Trading - Initial Conditions

X Corp $70/share
1,000 Shares Purchased
50% Initial Margin
30% Minimum Margin
Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000

16
Margin Trading - Minimum Margin
Stock price falls to $60 per share
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000

Margin% = $25,000/$60,000 =
41.67%

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 Margin Trading - Margin Call
• How far can the stock price fall before a
margin call?

1,000 P  $ 35,000
 30 %
1,000 P

Therefore, P = $50
Note: 1,000xP – Amount Borrowed = Equity

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 Leveraging Effect of Margin Purchases
• You buy 200 shares of XYZ at $100,
expecting a 30% appreciation of the
stock in one year:
– Initial margin: 50%
– Financed by a 9% loan for one year
– Expected net return: 51% (let’s check!)
• A 30% drop in the price, though, brings
a negative rate of return of -69% (let’s
check!).

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 Short Sales
• The sale of a stock not owned by the
investor but borrowed from a third party.
• Purpose: to profit from a decline in the
price of a stock or security
• Mechanics:
– Borrow stock through a dealer
– Sell it and deposit proceeds and margin in an
account with the broker
– Close out the position: buy the stock and
return it to the party who lent it to dealer
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 Short Sale - Initial Conditions
Z Corp 100 Shares
$100 Initial Price
50% Initial Margin
30% Minimum Margin

Sale Proceeds $10,000

Margin & Equity $ 5,000
Market value of assets $15,000

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 Short Sale - Minimum Margin
When Stock Price Rises to $110

Market value of assets

$15,000
Stock Owed $11,000
Net Equity $ 4,000
Margin ratio = Equity/Stock owed
= 4,000/11,000 = 36%

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Short Sale - Margin Call
• What is the stock price that will
trigger a margin call?

Note: your equity must be at least 30% of the

value of your short position.

$ 15,000 $15,000  100 P

130 % 30%
100 P 100 P
So, P = $115.38

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 Short Sale - Margin Call
• What will happen if the price of the
shares, which were sold immediately,
increases to $120?
– Market value of assets: 15000
– Stock owed: $12000
– Net equity: 15000 – 12000 = 3000
– Minimum margin requirement =
12000*30%=3600, so required
deposit=3600 -3000 = 600

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 Trading in International Equities
• During the 1980s, world capital markets
began a trend toward greater global
integration due to the following factors:
1. Investors began to realize the benefits of
international portfolio diversification
2. Major capital markets became more
liberalized
3. New computer and communications
technology facilitated efficient and fair
securities trading
4. MNCs realized the benefits of sourcing new
capital internationally
25
 Cross-Listing of Shares
• Cross-listing refers to a firm having its
equity shares listed on one or more foreign
exchanges, in addition to the home
country stock exchange
– Not a new concept, but amount of cross-listing
has exploded in recent years due to increased
globalization
– MNCs often cross-list their shares, but non-
MNCs may choose to cross-list, as well

26
 Cross-Listing of Shares (Continued)
• A firm may cross-list shares for many reasons:
1. Provides a means for expanding the investor base
for a firm’s stock, thus potentially increasing its
demand
2. Establishes name recognition of the company in a
new capital market
3. Brings the firm’s name before more investor and
consumer groups
4. May be a signal to investors that improved
corporate governance is forthcoming (if cross-
listing into developed capital markets with strict
securities regulations and information disclosure
requirements)
27
 Yankee Stock Offerings
• Yankee stock offerings are sold directly to U.S.
investors by foreign companies
– Since the beginning of the 1990s, many foreign
companies, Latin America in particular, have listed
their stocks on U.S. exchanges to prime the U.S.
equity market for future Yankee stock offerings
– Three factors appear to be fueling the sale of Yankee
stocks
1. Push for privatization by many Latin American and
Eastern European government-owned companies
2. Rapid growth in economies of developing countries
3. Large demand for new capital by Mexican companies
following approval of NAFTA 28
 American Depository Receipts
• An American Depository Receipt (ADR)
is a receipt representing a number of foreign
shares that remain on deposit with the U.S.
depository’s custodian in the issuer’s home
market
– First ADRs began trading in 1927
• Foreign stocks can be traded directly on a
national stock market, but frequently they
are traded in the form of a depository
receipt
– Depository receipts (DR) market has grown
significantly over the years 29
 Advantages of ADRs
• Investment advantages of ADRs include the
following:
– ADRs are denominated in dollars, trade on a U.S.
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 3 business days, as do U.S.
equities
– ADR price quotes are in U.S. dollars
– ADRs (except Rule 144A issues) are registered
securities that provide for the protection of 30
 Advantages of ADRs (Continued)
• Investment advantages of ADRs include the
following:
– An ADR investment can be sold by trading the
depository receipt to another investor in the U.S.
stock market, or the underlying shares can be
sold in the local stock market
– 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 U.S. investors
– ADR holders give instructions to the depository
bank as to how to vote the rights associated with
the underlying shares
31
American Depository Receipts (Continued)

• There are two types of ADRs:

– 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 U.S. stock
markets
– Unsponsored ADRs were usually created at the
request of a U.S. investment banking firm
without direct involvement by the foreign issuing
firm
• Consequently, the foreign company may not
provide investment information or financial 32
EXHIBIT 13.6
Types of ADRs

33
 Global Registered Shares
• Global Registered Shares (GRSs) are
traded globally, unlike ADRs
• GRSs are fully fungible – a GRS
purchased on one exchange can be
sold on another
• 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 34
Empirical Findings on Cross-Listings and ADRs

• 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 amount of U.S.
investment a foreign firm receives is whether
the firm cross-lists on a U.S. exchange
– Sarkissian and Schill (2016) established that
cross-listing occurs in waves at the host
market, home market, and industry levels 35
 Empirical Findings on Cross-Listings and ADRs
(Continued)

• Jayaraman, Shastri, and Tandon (1993)

interpreted their results as evidence that an ADR
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 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

36
 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 Morgan
Stanley Capital International (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
37
frontier markets that cover investment
International Equity Market Benchmarks (Continued)

• 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 38
 iShares MSCI
• 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
NYSE
– Low-cost, convenient way for investors to hold
diversified investments in several different 39
 Factors Affecting International Equity Returns

• Which factors influence equity

returns?
– Macroeconomic factors
– Exchange rates
– Industrial structure

40
 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
ten European countries, but that substantially 41
 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 42
 Industrial Structure
• Studies examining the influence of
industrial structure on foreign equity
returns are inconclusive

43
 Measuring the total return from foreign portfolio
investing

• The total dollar return includes dividend/interest

income, capital gains (losses), and currency gains
(losses).
• The one-period dollar return on a foreign investment
can be calculated as
dollar return = foreign currency return × currency gain
(loss)  P (1)  P (0)  DIV / Interest 
1  R$ 1   (1  g )
 P(0) 

where P(0) and P(1) are the foreign currency security

price on dates 0 and 1, respectively. g is the
percentage change in dollar value of the foreign
currency.
44
 Total dollar return from foreign portfolio investing:
an example

• Consider a foreign currency (FC)

bond. Suppose the initial bond price
is FC 95, and coupon income is FC 8,
the end-of-period price is FC 97, and
the local currency appreciates by 3%
against the dollar during the period.
Then, the total dollar return is
R$ = [1+(97 – 95 + 8)/95](1 + 3%) –
1
45
 Measuring exchange risk on foreign securities

• Dollar return = foreign currency return ×

currency gain (loss)
1 + R$ = (1+Rfc)(1+g)
• Ignoring the cross-product term, Rfg, we
can approximate the above formula by
R$ = Rfc + g
• The standard deviation of the dollar
return, σ$ is
σ$ = [σfc2 + σg2 +2σfcσgρfcg]1/2
46
 Measuring exchange risk on foreign securities: an
example

Suppose that the STD of the return on a Japanese

firm in terms of yen is 23% and the STD of the
rate of change in the dollar/yen exchange rate
is 17%. In addition, the estimated correlation
between the yen return on the firm and the
rate of change in the exchange rate is 0.31.
Then, the STD of the dollar rate of return on
investing in the firm’s stock is
σ$ = [0.232 + 0.172
+2×0.23×0.17×0.31]1/2=0.3256.
In this case, foreign exchange risk increases risk.
47
The benefits of international equity investing

• Offers more opportunities than a

purely domestic portfolio
• Attractive investments overseas
• Impact on efficient portfolio with
diversification benefits.

48
The benefits of international equity investing

• Risk-return tradeoff may be greater than

by investing solely in domestic securities.
– The advantages of purely domestic
diversification are limited because all
companies in a country are more or less
subject to the same cyclical economic
fluctuations.
– By diversifying across nations with different
economic cycles, investors can further reduce
the variability of their returns.
– While there is systematic risk within a nation,
outside the country it may be nonsystematic
and diversifiable.
49
 International diversification
• Theoretical Conclusion:
International diversification pushes
out the efficient frontier.

50
 The New Efficient Frontier

E(r) C

A
B


51
The Benefits of Int’l Diversification

#-52
International diversification

53
Cross-market correlations

54
Barriers to International Diversification

55