14-3c International Stock Markets

over floating rate bonds. While dollar-denominated bonds had the highest volume in 2000, euro-denominated bonds were the largest in volume in 2014. It is also important to note that financial institutions issue more international bonds than governments, international organizations, and corporations combined.

Stock markets enable firms to issue new equity and raise long-term capital. However, it should be recognized that bonds are a much more important source of long-term financing for capital investments in land, buildings, equipment, and fixed assets. Unlike bonds that often are purchased by institutional investors, such as insurance companies that hold the debt securities to maturity, outstanding stocks are actively traded on a daily basis. Stock markets in developed countries and emerging-market countries allow investors around the world to invest in firms on a global basis. Many individuals have retirement savings in pension plans that can be invested in a myriad of mutual funds, which are funds managed by investment companies that pool savings and invest in stocks, bonds, real estate, commodities, and so forth. A mix of bond and stock investments is normally recommended. Stock investing is popular due to the fact that stocks have outpaced other types of financial instruments in terms of returns over periods of five years or more. For example, Chinese stock markets have provided about 70 percent returns on stock investments between 2003 and 2008. By comparison, U.S. long-term bond investments have earned about 4 percent per year for a total return of about 22 percent over this same time period.

Of course, there is the possibility that stock prices can fall dramatically and result in large losses to investors. For example, the Dow Jones Industrial Average of the 30 largest U.S. firms decreased from about 13,000 in May 2008 to 7,500 in February 2009 for a loss of more than 40 percent in an eight-month period. Diversifying stock investments in different sectors of the economy and different countries can help to manage this risk. When stock prices in one sector or country rise, they may fall in another sector or country.

Exhibit 14.6 shows the stock prices of two stocks (which will be called “stock 1” and “stock 2”) over time. Stock 1 has more volatile price movements than stock 2. If a person invests half of his or her money in stock 1 and half in stock 2, the combined portfolio (P) would have much lower volatility than either stock. This reduction in volatility proves that

Exhibit 14.6 DiVersiFiCaTion Can reDuCe risk For inVesTors

Diversification: Stock risk is reduced by combining stocks into a portfolio.

Stock 1

Portfolio P

Stock Price Stock 2

1 2 3 4 5 6 Time in Years

© Cengage Learning 2014

diversification reduces risk to investors. Professor Harry Markowitz discovered this fundamental investment concept. He argued that investors need to buy securities with price patterns that were different from one another over time. If two securities had the same price pattern, they would not afford any diversification. If their price patterns were the opposite of one another, all risk could be eliminated; however, it is not typically possible to find such a situation. Markowitz received a Nobel Prize in Economics for his work on diversification.

In view of Markowitz’s well-known concept of diversification, it is surprising that investors typically invest most of their retirement and other savings in their home countries. This so-called home bias means that investors are not reducing their risk as much as possible. A variety of reasons may explain this potentially irrational behavior. Investors may prefer domestic companies due to a belief that they have a better understanding of their products and services or perhaps due to the desire to support businesses in their own countries. The home bias is somewhat reduced if investors buy stocks in large domestic firms with international activities, which represent international investments. Nonetheless, most experts agree that home bias likely increases investor risk.

One problem in international investing is that diversification may not work when bad news affects exchanges in different countries at the same time. An example of this kind of contagion is the October 1987 international stock market crash, which revealed that major stock markets around the world can experience large downward price trends in tandem. On October 19, 1987 (referred to as Black Monday), stock prices in Hong Kong began collapsing and spread throughout the day into Europe and then North America as their stock markets opened for trading. Within one week, Hong Kong fell 46 percent, Australia 42 percent, the United Kingdom 26 percent, the United States 23 percent, and Canada 23 percent. It was the largest one-day decline in stock market history. Large stock market declines also occurred on September 17, 2001, which was the first day markets opened following the September 11, 2001 terrorist attacks. Similar concerted downward movements in global stock markets occurred from October 2008 to mid-year 2009 as the financial and economic crises at that time deepened around the world. When stock markets in many countries move down in concert with one another, international diversification benefits are reduced. Fortunately, these crisis episodes are transitory and disappear during more normal times. Hence, diversification is an effective way to reduce risk for long-term investors.

To lower the transaction costs of global investors, there has been increasing consolidation of stock exchanges over the past decade. Computer and telecommunications advances have broken barriers of distance and allowed faster and larger volume of trading in securities. Recent notable mergers include:

• New York Stock Exchange (NYSE) and Euronext, which comprises a group of European countries’ exchanges; • NASDAQ (National Association of Securities Dealers Automated Quotation system) and American Stock Exchange (AMEX); • London Stock Exchange and Borsa Italiana in Italy; and • Chicago Mercantile Exchange (SME) and the Chicago Board of Trade, which had traditionally been rivals.

It is likely that consolidation among exchanges in North America, South America, Europe, Asia, and the Middle East will continue in the future. This consolidation wave is increasing competition for securities trading with the benefits of more investment opportunities for investors and greater ability to access capital at low costs for firms. In turn, it facilitates global economic growth, thereby increasing jobs and the standards of living around the world.

diversification

buying securities in a portfolio with price patterns over time that are different from one another, which reduces the volatility of the portfolio

home bias

investing most of retirement and other savings in one’s home country, which reduces diversification

contagion

when stock markets in many countries move down in concert with one another and thereby reduce international diversification benefits