Factors to Consider before Investing in International Equity Markets

 

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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 opportunities to prosper.

But then, before investing in the international equity markets, one needs to learn how these markets are composed, elements that control them and other factors that influence the markets and investment returns

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.

This article is aimed at expounding investors` knowledge on the factors that affect the returns from international equity markets.

Market Structure, Trading Practices, and Costs

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 buyers 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.

Read also: Impacts of capital market on shareholders return

Trading In International Equities

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

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.

 Read also: How to Invest Wisely in the Capital Market when the Market is Attaining new Highs

Factors Affecting International Equity Returns

The ultimate goal of any investment is to maximize profits or returns. Therefore any investor going to international equity market must put into considerations these factors that affect international equity market returns. Macroeconomic factors, exchange rates, and industrial structures affect international equity returns. These factors are known as macroeconomic factors. They are:

·       Exchange rates

·       Demand and supply of currency in Forex market

·       Foreign exchange policies

·       Industrial production

·       Interest rates

·       Inflation

·       Monetary assets

Macroeconomic Factors

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.

Exchange Rates

Due to demand and supply, there is always an exchange rate that keeps changing over time. The rate of exchange is the price of one currency expressed in terms of another. Due to increased or decreased demand, the currency of a country always has to maintain an exchange rate. The more the exchange rate, the more is the demand of that currency in forex markets.

Exchanging the currencies refer to trading of one currency for another. The value at which an exchange of currencies takes place is known as the exchange rate. The exchange rate can be regarded as the price of one particular currency expressed in terms of the other one, such as £1 (GBP) exchanging for US$1.50 cents.

The equilibrium between supply and demand of currencies is known as the equilibrium exchange rate.

Industrial Structure

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.”

Economic Exposure – An Example

Consider a big U.S. multinational with operations in numerous countries around the world. The company’s biggest export markets are Europe and Japan, which together offer 40% of the company’s annual revenues.

The company’s management had factored in an average slump of 3% for the dollar against the Euro and Chinese Yuan for the running and the next two years. The management expected that the Dollar will be bearish due to the recurring U.S. budget deadlock, and growing fiscal and current account deficits, which they expected would affect the exchange rate.

However, the rapidly improving U.S. economy has triggered speculation that the Fed will tighten monetary policy very soon. The Dollar is rallying, and in the last few months, it has gained about 5% against the Euro and the Yuan. The outlook suggests further gains, as the monetary policy in China is stimulative and the European economy is coming out of recession.

The U.S. company is now facing not just transaction exposure (as its large export sales) and translation exposure (as it has subsidiaries worldwide), but also economic exposure. The Dollar was expected to decline about 3% annually against the Euro and the Yuan, but it has already gained 5% versus these currencies, which is a variance of 8 percentage points at hand. This will have a negative effect on sales and cash flows. The investors have to take into account the currency fluctuations and the stock of the company falls 7%.

Monetary Assets

Monetary assets are cash in possession of a corporation, country, or a company. There is always some demand and an equivalent amount of supply for each country’s currency. The cash in hand determines the strength of an economy.

Monetary assets have a dollar value that will not change with time. These assets have a constant numerical value. For example, a dollar is always a dollar. The numbers will not change even if the purchasing power of the currency changes.

We can understand this concept by contrasting them against a non-monetary item like a production facility. A production facility’s value – its price denoted by a number of dollars – may fluctuate in future. It may lose or gain value over the years. So a company owning the factory may record the factory as being worth $500,000 one year and $480,000 the next. But, if the company has $500,000 in cash, it will be recorded as $500,000 every year.

In other words, monetary items are just cash. It can be a debt owed by an entity, a debt owed to it, or a cash reserve in its account.

For example, if a company owes $40,000 for goods delivered by a supplier. It will be recorded at $40,000 three months later even though, the company may have to pay $3,000 more because of inflation.

Similarly, if a company has $300,000 in cash, that $300,000 is a monetary asset and will be recorded as $300,000 even when, five years later, it may be able to only buy $280,000 worth of goods compared to when it was first recorded five years ago.

Demand and Supply of Currency in Forex Market

The demand for currencies in forex markets arise from the demand for a country’s exports. Also, speculators who are looking for a profit relying on the changes in currency values create demand.

The supply of a particular currency is derived by domestic demands for imports from the foreign nations. For example, let us suppose the UK has imported some cars from Japan. So, UK must pay the price of cars in Yen (¥), and it will have to buy Yen. To buy Yen, it must sell (supply) Pounds. The more the imports, the greater will be the supply of Pounds onto the Forex market.


Interest Rate

What is Interest Rate Parity?                                

Interest Rate Parity (IRP) is a theory in which the differential between the interest rates of two countries remains equal to the differential calculated by using the forward exchange rate and the spot exchange rate techniques. Interest rate parity connects interest, spot exchange, and foreign exchange rates. It plays a crucial role in Forex markets.

IRP theory comes handy in analyzing the relationship between the spot rate and a relevant forward (future) rate of currencies. According to this theory, there will be no arbitrage in interest rate differentials between two different currencies and the differential will be reflected in the discount or premium for the forward exchange rate on the foreign exchange.

The theory also stresses on the fact that the size of the forward premium or discount on a foreign currency is equal to the difference between the spot and forward interest rates of the countries in comparison.

Example

Case I: Home Investment

In the US, let the spot exchange rate be $1.2245 / €1.

So, practically, we get an exchange for our €1000 @ $1.2245 = $1224.50

We can invest this money $1224.50 at the rate of 3% for 1 year which yields $1261.79 at the end of the year.

Case II: International Investment

We can also invest €1000 in an international market, where the rate of interest is 5.0% for 1 year.

So, €1000 @ of 5% for 1 year = €1051.27

Let the forward exchange rate be $1.20025 / €1.

So, we buy forward 1 year in the future exchange rate at $1.20025/€1 since we need to convert our €1000 back to the domestic currency, i.e., the U.S. Dollar.

Then, we can convert € 1051.27 @ $1.20025 = $1261.79

Thus, when there is no arbitrage, the Return on Investment (ROI) is equal in both cases, regardless the choice of investment method.

Arbitrage is the activity of purchasing shares or currency in one financial market and selling it at a premium (profit) in another.

Read also: Investment Opportunities for Nigerians in 2022 and Beyond

Foreign Exchange Policy

Foreign exchange policy of the country is very critical in deciding whether or not to invest in a country`s equity market. You should look at the possibility of repatriating your profits through dividend. Some countries do not give priority to you as you aim to repatriate your profits; they make the process difficult for foreign investors to repatriate their profits, an attempt to ensure that funds do not leave their economies.


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