An Introduction to International Capital Markets

Products, Strategies, Participants

Andrew M. Chisholm

• Publisher: Wiley
• Year: 2009
• ISBN:
  9780470684580
• Edition: 2
• Topic: Business
• Subtopic: Finance
• Index: Business

Fully revised and updated from the hugely popular first edition, this book is an accessible and convenient one-volume introduction to international capital markets, ideal for those entering or planning to enter investment banking or asset management. As well as serving as an invaluable reference tool for professionals already working in the industry looking to extend their knowledge base it will also benefit all those working in trading, sales and support roles.

Describing how the key products and markets work, who the principle participants are and their overall goals and objectives, Andrew Chisholm provides a thorough overview of the global capital markets. The book covers a wide range of equity, debt, foreign exchange and credit instruments as well as the principal derivative products. In a step-by-step fashion, making extensive use of real world cases and examples, it explains money markets, foreign exchange, bond markets, cash equity markets, equity valuation techniques, swaps, forwards, futures, credit derivatives, options, option risk management and convertible bonds. An extensive glossary also explains concisely many of the 'jargon' expressions used in the financial markets.

Boasting an international focus, examples are drawn from major international markets around the world. It makes extensive use of numerical examples and case studies to help explain a wide range of cash and derivative products used in the capital markets business. It covers both debt and equity products and includes new material on credit products such as collateralized debt obligations and credit derivative structures; equity fundamental analysis, portfolio theory and convertible bonds. Market data has been fully updated from the first edition and recent events such as the 'credit crisis' are discussed.

1

Introduction: The Market Context

1.1 CAPITAL AND THE CAPITAL MARKETS

Financial capital can be defined as accumulated wealth that is available to create further wealth. The capital markets are places where those who require additional funds seek out others who wish to invest their excess. They are also places where participants can manage and spread their risks. Originally, capital markets were physical spaces such as coffee houses and then purpose-built exchanges. In our day, capital markets participants may be located in different continents and conduct deals using advanced information technology.

Who are the users of capital? In a broad sense we all are, at least part of the time. We borrow money to buy a house or a car so that we can live our lives, do our jobs, and make our own small contribution to the growing wealth of nations. We save to pay school and university tuition fees, investing in the ‘human capital’ that will sustain the economic health of the country. More narrowly, though, financial capital is used by corporations, governments, state and municipal authorities, and international agencies to make investments in productive resources. When a company builds a new factory it is engaged in capital expenditure - using funds provided by shareholders or lenders or set aside from past profits to purchase assets used to generate future revenues. Governments use tax revenues to invest in infrastructure projects such as roads. Agencies such as the World Bank inject funds into developing countries to create a basis for economic growth and future prosperity.

Who are the suppliers of capital? Again, the answer is that we all are. Sometimes we do this directly by buying shares issued by corporations and debt securities issued by governments and their agencies. Sometimes we employ brokers to invest funds on our behalf. We deposit cash in bank accounts, invest in mutual funds, and set aside money in pension plans for our retirement. We pay taxes to the government and local authorities. We pay premiums to insurance companies who invest the proceeds against their future liabilities. Companies too become sources of capital when they reinvest their profits rather than paying cash dividends to shareholders.

This book is about the operation of the capital markets, the market participants, the roles of the main financial intermediaries, and the products and techniques used to bring together the suppliers and users of financial capital in the modern world. It is also to a large extent about the management of risk. Risk takes many forms in the capital markets, and financial institutions play a critical role in assessing, managing, and distributing risk. For example, a bank that lends money assumes a credit risk - the risk that the borrower may default on its payments. Bankers try to analyse and mitigate such exposures to minimize losses. As the global ‘credit crisis’ which started in 2007 revealed, when they fail it has major repercussions not only for bank shareholders and depositors but also for taxpayers and for individuals working in the ‘real economy’ outside the banking system.

In recent years banks have increasingly used their position as financial intermediaries to originate loans and then ‘package’ them up and sell them off in the form of bond issues. This process is called securitization. The bond investors assume the credit risk on the loan book in return for a rate of interest greater than they could earn on safe government securities. The banks recycle the capital they were originally provided with by their shareholders and depositors, so that they have funds available to create new loans. They analyse risk, manage risk, and then distribute risk through the public bond markets.

This so-called ‘originate and distribute’ business model received a setback in the credit crisis starting in 2007, when bonds backed by US mortgage loans suffered major losses and became difficult to trade. It seems highly likely that securitization will remain a standard technique in the capital markets for the foreseeable future. However it also seems likely that the practice will be subject to closer supervision by the regulatory authorities.

The boundaries between different types of financial institutions have been becoming increasingly blurred in the modern financial markets. Earlier in the previous century the demarcation lines seemed more rigid. In the US the 1933 Glass-Steagall Act created a firm distinction between what became known as commercial banking and investment banking. Commercial banks took in deposits and made loans to businesses. They assumed credit or default risk and contained this risk by evaluating the creditworthiness of borrowers and by managing a diversified portfolio of loans. Investment banks underwrote new issues of securities and dealt in shares and bonds. They took underwriting risk. This arises when a bank or a syndicate buys an issue of securities from the issuer at a fixed price and assumes responsibility for selling or ‘placing’ the stock into the capital markets.

At the time of Glass-Steagall, the US Congress believed that a financial institution faced a conflict of interest if it operated as both an investment and a commercial bank. As a consequence, the great banking house of Morgan split into two separate organizations. The commercial banking business later became part of JP Morgan Chase. The investment banking business was formed into Morgan Stanley.

In the UK similar divisions of responsibility used to apply until the barriers were progressively removed. After the Second World War and until the 1980s the new issue business in London was largely the province of so-called merchant banks. Retail and corporate banking was dominated by the major clearing or ‘money centre’ banks such as Barclays and National Westminster Bank (now part of the Royal Bank of Scotland group). Trading and broking in UK and European shares and in UK government bonds in London was conducted by a number of small partnership-businesses with evocative names such as James Capel and Wedd Durlacher. The insurance companies were separate from the banks, and the world insurance market was dominated by Lloyds of London. These segregations have all since been swept away. Nowadays large UK financial institutions offer a very wide range of banking and investment products and services to corporate, institutional, and retail clients.

In the US the constraints of Glass-Steagall were gradually lifted towards the end of the twentieth century. US commercial banks started to move back into the new issuance business both inside the US and through their overseas operations. One factor that spurred this development is called disintermediation. In the last decades of the twentieth century more and more corporate borrowers chose to raise funds directly from investors by issuing bonds (tradable debt securities) rather than by borrowing from commercial banks. The development was particularly marked amongst top-quality US borrowers with excellent credit ratings. In part the incentive was to cut out the margin charged by the commercial banks for their role as intermediaries between the ultimate suppliers of financial capital (depositors) and the ultimate users. In part it reflected the overall decline in the credit quality of the commercial banks themselves. Prime quality borrowers discovered that they could issue debt securities and fund their capital requirements at keener rates than many commercial banks.

Disintermediation (cutting out the intermediation of the lending banks) developed apace in the US and then spread to other financial markets. Later even lower credit quality borrowers found that in favourable circumstances they could raise funds through the public bond markets.

The advent of the new single European currency, the euro, encouraged the same sort of process in continental Europe. Before the single currency was created, Europe developed as a collection of small and fragmented financial markets with many regional and local banks. Banks and corporations had strong mutual relationships, cemented by cross-shareholdings. In Germany the major banks and insurance companies owned large slices of the top industrial companies. Most corporate borrowing was conducted with the relationship bank. Shares and bonds were issued and traded primarily in domestic markets and in a range of different currencies. There were restrictions on the extent to which institutional investors such as pension funds could hold foreign currency assets. There was a general lack of understanding amongst investors of other European markets.

All this has been changing in recent decades, and at great speed. For example, Deutsche Bank has grown to be a major international presence in the global capital markets, with substantial operations in centres such as New York and London as well as in Frankfurt. Although cross-border mergers are still complicated by the actions of governments and regulators, banks across Europe have been consolidating. For example, in 2005 the Uncredit group of Italy merged with the Munich-based HVB group, which was itself formed from the merger of two Bavarian banks. In 2007 the Dutch bank ABN-Amro was taken over by a consortium led by the Royal Bank of Scotland. On their side, European borrowers are increasingly looking to the new issue markets to raise funds. Investors in Europe can now buy shares and bonds and other securities denominated in a single currency that are freely and actively traded across an entire continent. Stock and derivative exchanges that originated in national markets have been merging and re-inventing themselves as cross-border trading platforms.

One of the most dynamic influences on the international capital markets in recent years has been the growth of hedge funds. Essentially, hedge funds are investment vehicles aimed at wealthier investors and run by professional managers. Traditionally they were largely unregulated, but this is now set to change in the aftermath of the global credit crisis. Often hedge funds use leverage (borrowing) in an attempt to magnify the returns to the investors. Unlike a traditional mutual fund, which buys and holds stocks for a period of time and therefore tends to profit when markets rise and lose when they fall, hedge funds aim to achieve an absolute return - that is to say, to make money in all market conditions. This comes at a price however. Typically a hedge fund manager takes ‘2 and 20’: a 2 % annual management fee plus 20 % of the profits. Investors also tend to be ‘locked in’ for agreed time periods and so cannot quickly redeem their investments.

Hedge funds can pursue a wide range of different strategies, some of which are highly risky, though others are actually designed to contain risk. One classic approach is the long-short fund. As well as buying (‘going long’) shares, it can also take short positions. This involves betting that the price of a security (or an entire market index) will fall over a given period of time. Sometimes a hedge fund constructs a ‘spread’ trade, which involves betting that the price difference between two stocks or markets will increase or reduce over a given period.

However, the activities of hedge funds have greatly diversified in recent years. Some buy shares of companies that are potential takeover targets. Others speculate on commodity prices and currency rates, analysing macroeconomic trends in the global economy. Some use complex mathematical models to exploit pricing anomalies; while others bet on the levels of volatility in the market by using derivative products. There are also hedge funds which take direct stakes in unlisted companies, which is the traditional business of private equity houses. Some hedge funds invest in so-called ‘distressed’ securities, such as bonds issued by companies in severe financial difficulties. They can profit if the amount recovered by selling off the company’s assets exceeds the price paid for the bonds.

One of the major growth areas for investment banks in recent years is the prime brokerage business, which involves providing high-value services to hedge funds. This includes stock lending, research advice, trading and settlement services, administrative support, providing loans against collateral, and tailoring advanced structured products to help a hedge fund implement a particular investment strategy.

Outside Europe and the US, a recent key trend in the capital markets is the rise of China, India, Brazil, and other emerging countries. With its huge trade surpluses, China has amassed capital that is no longer invested only in US government bonds. For example, in 2007 it took a $ 3 billion stake in US private equity firm Blackstone in an initial public offering of shares.

The power of so-called sovereign wealth funds (SWFs) is now felt everywhere in global markets. SWFs make international investments using wealth derived from the sale of natural resources and other export activities. According to forecasts published by the Economist in May 2007, based on research from Morgan Stanley, SWFs could have assets of $ 12 trillion under management by 2015. The largest SWF as at March 2007 was run by the United Allied Emirates with assets of $ 875 billion. At that time China had around $ 300 billion under management. In 2008 US banks such as Citigroup and Merrill Lynch sought major cash injections from SWFs to re-build their balance sheets following losses in the sub-prime mortgage lending market.

1.2 THE EUROMARKETS (INTERNATIONAL CAPITAL MARKETS)

The modern capital markets have become truly global in their scale and scope. Although New York is the biggest financial centre in the world by many measures, some of the developments that led to today’s international marketplace for money originated in London. In the years immediately following the Second World War London had lost its traditional role as a place where financial capital could be raised for large-scale overseas investment projects. It shrank to a small domestic market centred around the issuance and trading of UK shares and government bonds. It rediscovered its global focus through the growth of the so-called Euromarkets starting in the 1950s and 1960s. (The prefix ‘Euro’ here is historical and does not relate to the single European currency, which was created later.)

It all started with Eurodollars. These are dollars held in international accounts outside the direct regulatory control of the US central bank, the Federal Reserve. The largest Eurodollar market is based in London, and from the 1950s banks from the US and around the world set up operations in London to capture a share of this lucrative business. These dollars were recycled as loans to corporate and sovereign borrowers, and through the creation of Eurodollar bonds sold to international investors searching for an attractive return on their surplus dollars. The first Eurobond was issued by Autostrade as far back as 1963.

The oil crisis of the early 1970s gave a tremendous boost to the Euromarkets. Huge quantities of so-called petrodollars from wealthy Arab countries found a home with London-based banks. The Eurobond market boomed in 1975, and the international market for securities has never looked back. The banks became ever more innovative in the financial instruments they created. A market developed in other Eurocurrencies - Euromarks, Euroyen, and so forth. The watchwords of the Euromarkets are innovation and self-regulation. The UK government allowed the market to develop largely unhindered, and kept its main focus on the domestic sterling markets and the UK banking system. To avoid confusion with the new single European currency, Eurobonds are now often referred to as ‘international bonds’. They can be denominated in a range of different currencies, though the US dollar is still the most popular.

Although London is the home of the Euromarkets, there are other centres such as in Asia. The London market has been compared to the Wimbledon tennis tournament - it is staged in the UK but the most successful players are foreigners. This is not entirely fair, given the presence of firms such as Barclays Capital and Royal Bank of Scotland. However it is true that the large US, German, and Swiss banks are strong competitors. The trade association for Eurobond dealers is the International Capital Market Association (ICMA). It provides the self-regulatory code of rules and practices which govern the issuance and trading of securities.

1.3 MODERN INVESTMENT BANKING

The term ‘investment banking’ tends to be used nowadays as something of an umbrella expression for a set of more-or-less related activities in the world of finance. Firms such as Goldman Sachs and Morgan Stanley were up until very recently classified as ‘pure play’ investment banks because of their focus on debt and equity (share) issuance and trading as well as on mergers and acquisitions advisory work. Other organizations such as Citigroup and JP Morgan Chase have actually developed as highly diversified ‘universal’ banks which have commercial and investment banking divisions as well as other businesses such as retail banking, credit cards, mortgage lending, and asset management.

In the wake of the credit crisis, however, it is not clear what the future holds for the concept of a ‘pure play’ investment bank, except for smaller niche businesses which focus on specific areas such as corporate finance. In March 2008, in the wake of the crisis which began over write-downs on the value of sub-prime loan...