International equity markets are an important platform for global finance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper.
To understand the importance of international equity markets, market valuations and turnovers are important tools. Moreover, we must also learn how these markets are composed and the elements that govern them. Cross-listing, Yankee stocks, ADRs and GRS are important elements of equity markets.
In this chapter, we will discuss all these aspects along with the returns from international equity markets.
The secondary equity markets provide marketability and share valuation. Investors or traders who purchase shares from the issuing company in the primary market may not desire to own them forever. The secondary market permits the shareholders to reduce the ownership of unwanted shares and lets the purchasers to buy the stock.
The secondary market consists of brokers who represent the public buyers and sellers. There are two kinds of orders −
Market order − A market order is traded at the best price available in the market, which is the market price.
Limit order − A limit order is held in a limit order book until the desired price is obtained.
There are many different designs for secondary markets. A secondary market is structured as a dealer market or an agency market.
In a dealer market, the broker takes the trade through the dealer. Public traders do not directly trade with one another in a dealer market. The over-the-counter (OTC) market is a dealer market.
In an agency market, the broker gets client’s orders via an agent.
Not all stock market systems provide continuous trading. For example, the Paris Bourse was traditionally a call market where an agent gathers a batch of orders that are periodically executed throughout the trading day. The major disadvantage of a call market is that the traders do not know the bid and ask quotations prior to the call.
Crowd trading is a form of non-continuous trade. In crowd trading, in a trading ring, an agent periodically announces the issue. The traders then announce their bid and ask prices, and look for counterparts to a trade. Unlike a call market which has a common price for all trades, several trades may occur at different prices.
A greater global integration of capital markets became apparent for various reasons −
First, investors understood the good effects of international trade.
Second, the prominent capital markets got more liberalized through the elimination of fixed trading commissions.
Third, internet and information and communication technology facilitated efficient and fair trading in international stocks.
Fourth, the MNCs understood the advantages of sourcing new capital internationally.
Cross-listing refers to having the shares listed on one or more foreign exchanges. In particular, MNCs do this generally, but non-MNCs also cross-list. A firm may decide to cross-list its shares for the following reasons −
Cross-listing provides a way to expand the investor’s base, thus potentially increasing its demand in a new market.
Cross-listing offers recognition of the company in a new capital market, thus allowing the firm to source new equity or debt capital from local investors.
Cross-listing offers more investors. International portfolio diversification is possible for investors when they trade on their own stock exchange.
Cross-listing may be seen as a signal to investors that improved corporate governance is imminent.
Cross-listing diminishes the probability of a hostile takeover of the firm via the broader investor base formed for the firm’s shares.
In 1990s, many international companies, including the Latin Americans, have listed their stocks on U.S. exchanges to prime market for future Yankee stock offerings, that is, the direct sale of new equity capital to U.S. public investors. One of the reasons is the pressure for privatization of companies. Another reason is the rapid growth in the economies. The third reason is the expected large demand for new capital after the NAFTA has been approved.
An ADR is a receipt that has a number of foreign shares remaining on deposit with the U.S. depository’s custodian in the issuer’s home market. The bank is a transfer agent for the ADRs that are traded in the United States exchanges or in the OTC market.
ADRs offer various investment advantages. These advantages include −
ADRs are denominated in dollars, trade on a US stock exchange, and can be purchased through the investor’s regular broker. This is easier than purchasing and trading in US stocks by entering the US exchanges.
Dividends received on the shares are issued in dollars by the custodian and paid to the ADR investor, and a currency conversion is not required.
ADR trades clear in three business days as do U.S. equities, whereas settlement of underlying stocks vary in other countries.
ADR price quotes are in U.S. dollars.
ADRs are registered securities and they offer protection of ownership rights. Most other underlying stocks are bearer securities.
An ADR can be sold by trading the ADR to another investor in the US stock market, and shares can also be sold in the local stock market.
ADRs frequently represent a set of underlying shares. This allows the ADR to trade in a price range meant for US investors.
ADR owners can provide instructions to the depository bank to vote the rights.
There are two types of ADRs: sponsored and unsponsored.
Sponsored ADRs are created by a bank after a request of the foreign company. The sponsoring bank offers lots of services, including investment information and the annual report translation. Sponsored ADRs are listed on the US stock markets. New ADR issues must be sponsored.
Unsponsored ADRs are generally created on request of US investment banking firms without any direct participation of the foreign issuing firm.
GRS are a share that are traded globally, unlike the ADRs that are receipts of the bank deposits of home-market shares and are traded on foreign markets. The GRS are fully transferrable — GRS purchased on one exchange can be sold on another. They usually trade in both US dollars and euros.
The main advantage of GRS over ADRs is that all shareholders have equal status and the direct voting rights. The main disadvantage is the cost of establishing the global registrar and the clearing facility.
Macroeconomic factors, exchange rates, and industrial structures affect international equity returns.
Solnik (1984) examined the effect of exchange rate fluctuations, interest rate differences, the domestic interest rate, and changes in domestic inflation expectations. He found that international monetary variables had only weak influence on equity returns. Asprem (1989) stated that fluctuations in industrial production, employment, imports, interest rates, and an inflation measure affect a small portion of the equity returns.
Adler and Simon (1986) tested the sample of foreign equity and bond index returns to exchange rate changes. They found that exchange rate changes generally had a variability of foreign bond indexes than foreign equity indexes. However, some foreign equity markets were more vulnerable to exchange rate changes than the foreign bond markets.
Roll (1992) concluded that the industrial structure of a country was important in explaining a significant part of the correlation structure of international equity index returns.
In contrast, Eun and Resnick (1984) found that the correlation structure of international security returns could be better estimated by recognized country factors rather than industry factors.
Heston and Rouwenhorst (1994) stated that “industrial structure explains very little of the cross-sectional difference in country returns volatility, and that the low correlation between country indices is almost completely due to country-specific sources of variation.”