6.5 Structure and functions of the global capital market
Let's begin by defining a capital market.
A capital market is the place where investors and borrowers meet, generally with the assistance of match-makers called brokers. Investors may be individuals, companies or institutions such as insurance companies, superannuation funds and the like who have money to invest. Borrowers may be individuals, companies or governments who need money to create goods and services needed by society. Brokers in the capital market may be financial institutions such as the short-term money market, life insurance offices, building societies, finance companies, credit unions, savings and trading banks and branches of foreign banks.
The international capital market is essentially the same, but the brokers whom Hill (2005) calls market makers are principally commercial banks (for example, National Australia, Westpac, Dresdner, Citibank) and investment banks (for example, Bankers Trust, Rothschild, Merrill Lynch).
The function of a capital market is of course to provide capital (that is, money) and the cost of this capital is called interest . However, money may be loaned in two forms, only one of which attracts interest. This form is a debt loan in which the borrower pays interest at some agreed rate at particular times (for example, monthly, annually). The interest must be paid regardless of whether or not the borrower has made a profit. Debt loans may be cash loans from banks or funds raised by the sale of corporate or government bonds. Interest is paid on the bonds until their maturity date.
The other form of loan is an equity loan , which relates to the sale of a company's shares. A share entitles the holder to a claim on the firm's profits which are known as dividends . Dividends are analogous to interest paid on a debt loan, but they do not carry a guarantee. Dividends are subject to the dividend policy of the company: they may or may not be paid each year and the rate is likely to vary according to the company's fortunes.
It is appropriate now to ask the question of what makes the international capital market so special. The simple answer is size! The international market has more of everything than any domestic capital market: more borrowers, more investors and, by extension, more money. There is also more competition in both lending and borrowing. The net effect is that the cost of capital to borrowers is less than in the case of the smaller domestic market.
From the viewpoint of the investor, the international capital market offers more scope for diversification of a share portfolio: there is a far greater range of investments from which to choose. Why should this be so important? The answer lies in the phenomenon of risk and, more particularly, systematic risk. Systematic risk is risk that affects all shares because of common macro-economic factors. Another definition (Hill 2005, p. 384) is that systematic risk is the level of non-diversifiable risk in an economy. However, the significance of systematic risk for an investor in the international capital market is that the level of systematic risk is lower than in a domestic capital market. Hill (2005) covers this well. Before you read these pages, let's make a few more observations about the structure of the international capital market.
The first point is that the global capital market could not exist, nor could it have grown as it has, without modern communication technology. Technology has several consequences in this context:
- 24 hour trading is possible
- all players have instant access to movements in the market
- an event in one place has the potential to trigger a domino effect around the world because of this instant access
A second point is that the world's history and geography both have an impact on the location of major trading centres. London is the busiest trading centre because it was the economic hub of the one time British Empire 'on which the sun never set'. It is still a hub for British companies with massive investments around the globe. London also is a convenient link between Europe to the east and America to the west. New York is a major centre because of the underlying strength of the US economy and because it is the base for many US companies with overseas investments. Tokyo 's importance reflects the post World War II growth of the Japanese economy and the strength of its currency.
The third and last point in this trio is the composition of the financial institutions in the global capital market. The major banks in the market are not just British, American and Japanese. Germany and France are also major players.
In your text
Hill 2005, Chapter 11, pp. 379-390.
Activity 6.4
Why has the international capital market grown so rapidly in recent decades? Do you think this growth will continue into the 21 st century?
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