Loans rates
Functions of a Generic Capital Market:
A capital market brings together all those who want to invest money and those who want to borrow money. Those who want to invest money include corporations with surplus cash, individuals, and non-bank financial institutions (e.g. pension funds, insurance companies). Those who want to borrow money include individuals, companies, and governments. Between these two groups are the market makers. Market makers are the financial service companies that connect investors and borrowers, either directly or indirectly. They include commercial banks (e.g. Citibank, U.S. Bank Corp.) and investment banks (e.g. Merrill Lynch, Goldman Sachs).
Commercial banks perform an indirect connection function. They take cash deposits from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a high rate of interest, making loans rates a profit from the difference in interest rates (commonly referred to as the interest rate spread). Investment banks perform a direct connection function. They bring investors and borrowers together and charge commissions for doing so. For e.g. Merrill Lynch may act as a stockbroker for an individual who wants to invest some money. It's personnel will advise her as to the most attractive purchases and buy stock on her behalf, charging a fee for the service.
Capital market loans rates to corporations are either equity loans or debt loans. An equity loan is made when a corporation sells stock to investors. The money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay wages, & so on. A share of stock gives its holder a claim to a firms profit stream. The corporation honors this claim by paying dividends to the stockholders. The amount of the dividends is not fixed in advance. Rather, it is determined by management based on how much profit the corporation is making. Investors purchase stock both for their dividend yield and in anticipation of gains in the price of the stock, which in theory reflects future dividend yields. Stock prices increase when a corporation is projected to have greater earnings in the future, which increases the probability that it will raise future dividend payments.
A debt loan requires the corporation to repay a predetermined portion of the loan amount (the sum of the principal plus the specified interest) at regular intervals regardless of how much profit it is making. Management has no discretion as to the amount it will pay investors. Debt loans include cash loans rates from banks and funds raised from the sale of corporate bonds to investors. When an investor purchases a corporate bond, he purchases the right to receive a specified fixed stream of income from the corporation for a specified number of years (i.e. until the bond maturity date).
ATTRACTIONS OF THE GLOBAL CAPITAL MARKET
A global capital market benefits both borrowers and investors. It benefits borrowers by increasing the supply of funds available for borrowing and by lowering 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. This places an upper limit on the supply of funds available to borrowers. In other words, the liquidity of the market is limited. A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on.
Perhaps the most important drawback of the limited liquidity of a purely domestic capital market is that the cost of capital tends to be higher than it is in an international market. The cost of capital is the price of borrowing money, which is the rate of return that borrowers must pay investors. This is the interest rate on debt loans and the dividend yield and expected capital gains on equity loans rates. In a purely domestic market, the limited pool of investors implies that borrowers must pay more to persuade investors to lend them their money. The larger pool of investors in an international market implies that borrowers will be able to pay less.
Problems of limited liquidity are not restricted to less developed nations, which naturally tend to have smaller domestic capital markets. Even very large enterprises based in some of the worlds most advanced industrialized nations in recent years have tapped the international capital markets in their search for greater liquidity and a lower cost of capital, such as Germanys Deutsche Telekom.
The Investors Perspective: Portfolio Diversification
By using the global capital market, investors have a much wider range of investment opportunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to below what could be achieved in a purely domestic capital market.
By diversifying a portfolio internationally, an investor can reduce the level of risk even further because the movements of stock market prices across countries are not perfectly correlated. For e.g. one study looked at the correlation between three stock market indexes. The Standard & Poors 500 (S&P 500) summarized the movements of large U.S. stocks. The Morgan Stanley Capital International Europe, Australia, and Far East Index (EAFE) summarized stock market movements in other developed nations. The third index, the International Finance Corporation Global Emerging Markets Index (IFC), summarized stock market movements in less developed emerging economies.
An increasingly common perception among investment professionals is that in the past 10 years the growing integration of the global economy and the emergence of the global capital market have increased the correlation between different stock markets, reducing the benefits of international diversification.
The risk-reducing effects of international portfolio diversification would be greater were it not for the volatile exchange rates associated with the current floating exchange rate regime. Floating exchange rates introduce an additional element of risk into investing in foreign assets. The uncertainty endangered by volatile exchange rates may be acting as a brake on the otherwise rapid growth of the international capital market.
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