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Capital Markets 2.0 - New Requirements for the Financial Manager?

Capital Markets 2.0 - New Requirements for the Financial Manager?

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H. Wohlenberg and J.-C. Plagge

1 Introduction

A capital market is defined as a market for securities where corporations and

governments can raise and invest long-term capital. The capital market can be

divided into the primary and the secondary market. The primary market resembles

the market for emissions. Here the issuer (seller) faces the investor (buyer) of

securities, often intermediated by financial institutions such as investment banks.

On the secondary market, already issued securities are traded among investors.1

Capital markets nowadays are the subjects of numerous changes. In the last

decades, markets have evolved from the state of segmentation to more integration.

This process has been pressed ahead by issuers cross-listing their shares in foreign

capital markets. In addition, governmental institutions have started to cooperate on

regulations and market connectivity.

Significant efforts have been undertaken to open up and harmonize stock

exchanges within as well as across national borders. For example, investors should

be guaranteed the best execution among a set of possible trading places as it is

intended by the “Markets in Financial Instruments Directive” (MiFID) introduced

by the European Commission in 2007. The EU passport, to name another example,

grants financial institutions domiciled in the European Union the right to offer services

such as order collection and execution of orders in any other member state without the

need to obtain a special local permission.

On the other hand, the trend towards general harmonization provokes certain

antagonistic developments: (1) fragmentation of liquidity arising from an increasing

number of new trading venues, (2) decreased transparency, and (3) increased

regulatory controls.

In this chapter, we will focus on the coexistence of these antagonistic developments

and examine how they affect primary tasks of the financial manager, such as:

• Provision of funding for projects or transactions

• Optimization of the capital structure with regards to total cost and risk

• Management of investor relations

Section 2 summarizes opportunities arising for financial managers from increased

globalization, liberalization and innovation. Section 3 discusses the challenges

produced by the concurrently emerging antagonistic factors fragmentation,

intransparency, and regulatory control with regards to financial decision-making.

In Section 4, opportunities and challenges are subsumed and conclusions drawn as to

how the financial manager has to change decision-making in the new capital market



Perridon et al. (2009), pp. 161–162.

Capital Markets 2.0 – New Requirements for the Financial Manager?


2 Opportunities from Networked Capital Markets

Networked capital markets are characterized by three major attributes: increased

globalization, liberalization, and innovation.



The goal of the financial manager when raising funds for projects or transactions

should be to raise capital at the lowest possible cost as well as risk.

Companies initially wishing to raise capital used to do so by tapping local

markets only. There are plenty of reasons why funding a company locally might,

in the first instance, be in the company’s best interest. These reasons range from

aspects such as limited needs for capital and the familiarity of the financial management with regulatory issues involved in the fund raising process to a high level of

awareness in the company’s home market.

However, in the new capital market world, stakeholders have multiple

connections to potential counterparties or intermediaries worldwide. In more

and more financial decisions, leveraging the access to international capital is



Globalization and International Funding

Over the course of the past few decades, ever more companies in Europe and across

the world started to reach beyond national borders to finance themselves. They did

so in various ways, e.g. by cross-listing ordinary shares in foreign markets, by

issuing so-called depository receipts that often gave the issuer more freedom with

regard to regulatory or judicial requirements of the target market or by leveraging

with the help of international debt markets.

In this section, we will summarize empirical findings in the field of international

funding and investment and point out the intentions underlying such efforts.

Cost of Capital: The price a company has to pay when raising additional capital is

a function of supply and demand. The cost of capital can thus be derived from the

investors’ total required return given the risk profile of the investment. In this context,

the issuer’s marginal cost of equity is negatively related to the uniqueness of the

investment opportunity and the overall availability of funding. As every company

represents a more or less unique investment case, extending the number of investors

addressed should lead to greater demand. A company with access to a global

audience of investors might therefore be able to keep its marginal cost of capital

constant where the cost of a domestically restricted firm already starts to increase.2


Eiteman et al. (2010), p. 365 et seq.


H. Wohlenberg and J.-C. Plagge

This will leave the latter with a significant disadvantage when raising capital to fund

new projects is required.

A financial manager who has increased access to international capital markets

might be able to take on projects that local companies due to much higher costs of

capital and to being restricted to local funding, simply cannot afford.

However, next to this liquidity aspect, there is segmentation as a second phenomenon the financial management needs to be aware of when determining

whether to tap international capital markets.

According to Eiteman et al. (2010), “a national capital market is segmented if the

required rate of return on securities in that market differs from the required rate of

comparable expected return and risk traded on other securities markets”.3

Reasons for market segmentation are manifold. They might be due to investors’

inhibitions or to official restrictions. Investors’ inhibitions could simply be caused

by a lack of information regarding the target market, by fear of expropriation or

also by discriminatory taxation for foreign investors. Official restrictions could be

exchange and border controls restricting foreigners’ access to local capital markets

or reducing their freedom to repatriate capital and dividends. Some countries,

predominantly emerging markets, also formally restrict the fraction of the local

firm’s equity that can maximally be owned by foreign investors.

The effects resulting from segmentation have been extensively studied in the

financial literature.

Errunza and Losq (1985) for example created a theoretical environment in which

investors from country A could invest in their home market’s stocks as well as into

the stocks of a second country B. Investors resident in country B, however, were

prohibited from investing into country A’s stocks. They found that in such an

environment, country B’s stocks were priced with a super risk premium. When

listing its shares internationally, this extra premium would decrease accordingly.

Thus, segmentation usually leads to higher expected returns and therefore

depresses stock prices for securities listed in a segmented market. Local investors

expect a premium motivating them to invest in the company’s equity.

This is of essential importance for the financial manager. When the company is

resident in a segmented capital market, it might be able to lower its cost of capital

by escaping from market segmentation.

The major reason for the expected premium can be demonstrated by considering

the diversification theory introduced by Markowitz (1952). Additionally, Solnik

(1974) as well as Grauer and Hakansson (1987) showed that investors should invest

internationally in order to further lower their diversifiable, non-systematic risk. This

is possible because the different capital markets are less than perfectly correlated.

This fact further exploits the diversification effect. As Hietala (1980) hypothesised,

investors restricted from diversifying internationally might require a higher rate of

return on local stocks, since they cannot diversify away the specific country risk.


Eiteman et al. (2010), p. 367.

Capital Markets 2.0 – New Requirements for the Financial Manager?


In a global context, by contrast, the expected return is derived from a global

capital asset pricing model which only takes into account a company’s risk contribution to the global portfolio when deriving its expected return. Contrary to locally

restricted investors, global investors do not require a risk premium for the specific

country risk.

Thus, companies might be able to significantly reduce their cost of capital by

escaping local segmentation and tapping global capital markets.

Investment barriers could also consist of investors’ inhibitions e.g. due to a lack

of information regarding a target market and its companies. This often results in the

unwillingness of local investors to invest in foreign companies. This home bias still

seems to be distinct in the investment behaviour of the majority of investors even in

developed markets. According to a study by Kilka (1998), compared to an ideal

allocation of only 4%, German investors invest 88% into German assets. According

to more recent research, the share of domestic investment is still around 80%.

Efforts aiming at increasing transparency – such as the obligation of investment

firms to introduce processes and procedures to ensure best execution as intended by

the European MiFID – should help mitigate the investors’ inhibitions to engage in

cross-border investments.

To summarize, having increased access to international investors seems to be a

good base to lower cost of financing as investors should be interested in investing

internationally as long as their portfolios are not yet sufficiently internationally

diversified. If such resources are tapped at lower cost, investing may even positively

affect capital cost on domestic markets as pricing for securities or transactions will

become transparent.

With Capital Markets 2.0, its harmonization between the rules of markets on one

side, and the increased sophistication of market participants on the other side, the

number of market participants has grown for all markets. Even if a company just

seeks financing based on national financing products it meets a significantly grown

number of potential counterparties.


Globalization and Capital Structure

After examining the impact of segmentation on the cost of capital, we will now

investigate the effect of globalization on a company’s capital structure.

Determining the company’s optimal capital structure is part of the traditional

treasury tasks of the financial management. With advancing internationalization,

this task becomes even more complex as quite numerous peculiarities need to be

taken into account when deciding on questions such as a firm’s optimal leverage


The existing literature yields two different approaches in order to determine a

firm’s optimal capital structure. According to the traditionalist approach, an optimal

capital structure can be determined based on minimizing the weighted average cost

of capital (WACC) as a function of the company’s leverage ratio. Modigliani and

Miller (1958), on the other hand, suggested a different view. According to their


H. Wohlenberg and J.-C. Plagge

hypotheses, the weighted average cost of capital is independent of a company’s

leverage ratio and equals the capitalization rate of the respective risk class.

In an environment with a corporate income tax, they suggest that in a perfect

market firms use 100% debt financing.4

Nowadays, most scientists agree that the real world offers a mix of both

approaches. Especially “when taxes and bankruptcy costs are considered, a firm

has an optimal financial structure determined by that particular mix of debt and

equity that minimizes a firm’s cost of capital for a given level of business risk”.5

This explains why companies in the Modigliani-Miller theory are not entirely

financed by debt. Firms balance bankruptcy costs against tax advantages of debt.

Against the background of internationalization, the question arises whether the

above-mentioned approaches are affected by overcoming national boundaries.

State-of-the-art literature on corporate international finance shows that there are,

indeed, quite a few peculiarities that must be taken into account. There has been

extensive research examining and explaining the observed capital structure of

companies operating internationally. Research results, however, show interesting


In order to explain the differences between internationally operating and domestic

companies, research mainly focuses on the risk associated with the firms’ operating

activities and resulting cash flows.

The risk of a corporation’s cash flows mainly determines the cost of capital it has

to pay for raised capital, debt and equity alike.

With regard to equity, it is the volatility of a company’s stock price movement

that contributes to the required rate of return expected by potential investors. The

more volatile the stock price movement, the higher the required rate of return.

The link between stock price movements and a company’s cash flows can best be

illustrated when probing valuation theory. In a simplified example, an indicator for

the market value of a firm’s equity can be derived by discounting the forecasted

future cash flows of a company and by subtracting its debt. A company’s actual

market value can be calculated by multiplying the observed stock price with its

outstanding shares. This observable market value, in turn, is directly influenced by

the expected future cash flows. When these cash flows fluctuate, the market value

should also fluctuate and with it the share price observed. Thus, the more risky a

company’s operations, the more volatile its future cash flows, the more volatile the

stock price movements and the higher the required rate of return. So, in which way

will investors’ increased global access affect volatility? In a perfect world, new

investors will increase liquidity. More liquidity usually means lower volatility

which in return allows more leverage. However, this equation only works if new

investors don’t operate in a segmented market or if the segment has the crucial size.



Chen et al. (1997), 28, p. 565.

Eitemann et al. (2010), p. 410.

Capital Markets 2.0 – New Requirements for the Financial Manager?


When looking at debt, we see it is mainly the risk of potential bankruptcy which

drives the cost of debt. The greater the risk of failure, the higher the risk premium to

be paid in excess of the risk free rate. Research mainly focuses on the bankruptcy

risk and its implications for the cost of debt and a firm’s capital structure. As is the

case with equity, cash flows also play an important role in the determination of the

cost of debt. The general hypothesis is that the more stable a company’s cash flows,

the lower the risk of failure, the lower the cost of debt and the higher the financial

leverage ratio. Interest has to be paid independent of the company’s economic

situation. A higher financial leverage, therefore, yields higher financial risk but, due

to the fixed character of the costs to be paid, it also yields higher financial

opportunities. If the company’s return on assets surmounts the given cost of debt,

the return on equity rises with rising leverage. The return generated in access of

these predefined costs can, in the extreme, be entirely distributed to the equity

holders. The downside of a high leverage ratio proves itself when the return on

assets lies below the determined interest rate. In this scenario, the debtors will stick

to their ex ante negotiated price which leads to a decrease in the return on equity

with a subsequent rise in the leverage ratio. It will also increase the risk of

bankruptcy. In case a company would like to increase its leverage-ratio c. p., the

cost of additional debt starts to increase since the possibility of failure becomes

more likely.

As seen above, a general idea of internationalizing aims at better diversifying the

company’s cash flows in order to minimize the potential risk of failure. Findings by

Hughes et al. (1975) indicate that such a diversification benefit apparently really

exists. Better diversification in turn helps support higher leverage-ratios for international corporations and, thus, directly affects the company’s capital structure.

According to the traditional scientists, the optimal level of debt is derived by a

trade-off between the tax shelter of debt and the expected bankruptcy costs. If the

expected bankruptcy costs can be reduced by better diversification, multinational

organizations should have a cheaper access to debt and, thus, higher leverage ratios

than their domestic counterparts. The same applies to the perspective of investors.

Tapping new investors with the need for international diversification may therefore

unfold lower cost financing. Also, depending on risk exposures of respective

investors, appetite for different industries may vary significantly from country to


Nevertheless, when entering into callable financial structures, the counterparty

risk in international transactions has to be factored into the capital cost calculation

especially. Imagine a situation where a debtor is under significant pressure and

therefore has to call the financing in tight market situations. In extreme circumstances

this may even lead to insolvency. As the lenders are well informed about each other

such counterparty risk may immediately increase the cost of debt even on domestic


In Sect. 3, we will show that there also exist various additional negative effects

mitigating the diversification benefits from internationalization. These effects can

even reverse the above reasoning and expose financial managers to lower leverage




H. Wohlenberg and J.-C. Plagge

Globalization and Investor Relations Management

Companies funding themselves internationally must be aware of numerous additional requirements when managing investor relations. Foreign capital markets

usually have quite different standards regarding the disclosure of financial information expected by investors and regulators.

One of the most prominent examples is the US capital market. Foreign

companies wishing to cross-list their share in the United States have to meet a

variety of requirements such as quarterly reports and road shows. In many cases the

respective home markets renounce such requirements. Additionally, the recently

introduced Sarbanes-Oxley Act places high hope on a company’s internal control

systems. International players are often hiring dozens of accountants and external

consultants to meet the necessary preconditions.

It might appear that some standards are a little too meticulous. In general,

however, they are meant to increase transparency and decrease investors’

inhibitions as well as to grant competitiveness by applying the same regulation on

all investable assets. Especially against the background of international financing

and investing this might be of vital importance. As brought forward by Lee and

Kwok (1988), agency problems tend to rise in an international environment. Debtors

are at greater pains to monitor the corporation’s activities and to discipline the

company’s management. This may increase the company’s systematic risk.

Against this background, it seems necessary to accompany internationalization

by various additional requirements destined to successfully manage international

investor relations.

However, these additional tasks take time and resources that, if not handled with

caution, might easily offset the benefits resulting from international financing. The

decision to internationalize a company’s financial activities has to be closely

evaluated in advance. Additional costs mainly accruing from increased efforts in

the field of investor relations management have to be balanced against benefits such

as potentially lower costs of equity and debt.



Companies have often cross-listed their shares in more integrated foreign capital

markets in order to expand the shareholder base or to overcome market segmentation. Next to such company-specific actions, the attempt to integrate capital markets

has now also entered the agenda of regulators. Jorion and Schwartz (1986) defined

integration as a situation where investors earn the same risk-adjusted expected

return on similar financial instruments in different national markets.

In Europe as well as in the United States, efforts to liberalize markets and to

enforce stronger competition among venues to the benefit of investors have been


Capital Markets 2.0 – New Requirements for the Financial Manager?


In January 2007, all EU member states were obliged to implement the Markets

in Financial Instruments Directive (MiFID) into national law. The MiFID is the

new constitution for the European financial market and the centerpiece of the

European Commission’s Financial Services Action Plan (FSAP). It sets out uniform

regulations for the provision of investment services within the European Economic

Area (EEA) and aims at creating a common competitive environment for investment firms and stock exchanges.6

By harmonizing regulatory conditions the directive intends to improve the

ability of investors to invest more easily across borders of EEA member states.

Additionally, the directive intends to optimize the conditions for order execution.

Furthermore, it provides regulations on the best execution of client orders covering

a broad range of different aspects. Investment firms must introduce processes and

procedures to ensure best execution. When evaluating such executions, aspects

such as price, explicit and implicit costs, speed, and the likelihood of execution and

settlement need to be taken into account.

In the wake of MiFID, a variety of new trading venues, called multilateral

trading facilities (MTFs), such as Chi-X and Turquoise, came into existence.

These pan-European trading venues also intend to harmonize trading and to

reduce trading costs.

Liberalization can be of great benefit for investors and companies alike. Investors

can buy shares at lower (explicit) trading costs which triggers the investor’s inclination to invest in shares.

Companies can profit from these relatively lower trading costs. Investors, now

more inclined to buy the company’s equity, require a smaller return on equity

which, in turn, makes funding cheaper.

Another benefit for companies results from the harmonization of capital markets.

Since regulatory discrepancies decline, cross-border investment is now much

easier. This enlarges the range of investors that companies can tap when they

need to raise funds for projects or transactions. It also leads to a higher supply of

capital and, thus, to lower costs of capital.

In its attempt to mitigate market segmentation, liberalization also works against

the extra premium investors resident in segmented markets require, as described in

Sect. 2.1. Lower cost of equity is an additional benefit for companies seeking funds.

The effect of liberalization on capital structuring is mainly attributed to a

reduction in investment barriers. Cross-border investing leads to more and better

diversified cash flows and again lowers the company’s business risk. Funding with

debt thus becomes cheaper.

Another interesting thought was first brought forward by Black in 1976. He

found that the current value of equity is negatively correlated with future volatility.

A decline in the value of equity relative to the value of debt increases the leverage

ratio which results in higher risk (volatility) of future equity returns.


Deutsche B€orse Group 2007.


H. Wohlenberg and J.-C. Plagge

On the other hand, a rise in the value of equity leads to a decline in the leverage

ratio and, following the above reasoning, to a decrease in risk. Lower risk, in turn,

increases a corporation’s ability to raise debt at lower costs.

The effect capital market liberalization has on the management of investor

relations is supportive to the effects of globalization: On the one hand, transparency with regard to an increase in different trading venues has to be established, and

potential new investors have to be addressed. On the other hand, the harmonization

of rules and regulations across markets significantly reduces the complexity of

communication in capital markets.



Today’s capital markets can be considered as a greenhouse for financial innovation.

Interconnectedness of many market participants and execution venues leads to the

emergence of new financing products and services (e.g. ABS, CDO, 144a placements).

In addition, the expansion grants access to individual players who serve as a

counterparty for a customized financing transaction over the counter. For a CFO

this unfolds new ways of financing which are more targeted and not squeezed into

standard products or contracts.

One example for financing projects or transactions with individual

counterparties rather than publically distributing shares of a company are so-called

“private placements”. Especially when tapping the US capital market, private

placements are a means to avoid tedious and costly registrations with the SEC

which is intended to protect potentially uninformed individual investors. Rule

144a, approved by the SEC in 1990, enables US and non-US investors to offer

shares via a broker–dealer to so-called QIBs (qualified institutional buyers). This is

possible even if a company’s shares are not registered with the SEC. Under Rule

144a, QIBs can then freely resell the purchased shares to other QIBs. Many

countries followed the US example and established private placement markets

generally lowering the burdens of direct cross-border investments.

Euroconvertibles are another example of an often highly individual form of

financing a company’s capital needs.

The issuer of a convertible emits bonds at a coupon usually below the current

market price. By doing so, the issuer can reduce the cost of debt. As compensation

the investor is granted a right to convert the bond into common shares of the

company at a later point in time.

In the wake of market liberalization across Europe, a variety of additional forms

of convertibles came into existence. Euroconvertibles, for example, pay their

interest gross and are free of transfer or transaction taxes (as opposed to domestic

convertibles that pay net of tax and are often subject to transaction taxes).

A third example of innovative financing is the process of asset securitization

which heavily gained importance over the last decade. Asset securitization became

a means of financing with a truly global reach as it often connects issuers and

investors across different local capital markets.

Capital Markets 2.0 – New Requirements for the Financial Manager?


In a typical ABS construction, the credit-granting company bundles a variety of

different receivables and sells them to a so-called Special Purpose Vehicle (SPV).

This SPV then emits securities backed by the sold receivables (assets) to investors.

Four major reasons are typically associated with asset securitization7:





to potentially reduce funding costs

to diversify funding sources

to accelerate earnings for financial reporting purposes

to potentially relieve regulated entities from capital requirements

(1) and (2) have a direct influence on the financial manager’s task to provide

funding for projects or transactions. (4) influences capital structure decision especially of regulated entities such as banks.

1. In case a company has a low investment grade status, it might be able to significantly reduce its funding costs by extracting certain assets to a SPV, which can be

interpreted as an independent legal entity. Then merely the credit worthiness of the

extracted securities and no longer that of the originating company is relevant for

the cost of funding. If the investment grade of these ABSs exceeds the investment

grade of the company, the costs for funding can be reduced. When funding of

entire (risky) projects is required the setting up of an SPV can also be a way of

reducing risk from the perspective of the company. The risk associated with the

project is then transferred to the SPV.

2. Asset securitization offers a valid alternative to funding by means of corporate

bonds. The company is able to select the funding alternative which offers better

(cheaper) funding.

3. In case certain receivables cannot (yet) be realized as financial earnings, securitization might offer a solution. The discounted spread between the interest, e.g.

from a potential installment sale, and the servicing costs for securitized receivables can directly be realized in a company’s P&L.

Financial companies such as credit granting banks often use ABSs, in order to

reduce and to transfer risk. Banks can sell their receivables to SPVs, thus

removing them from their balance sheet. Market integration on a global level

helped them increase their exposure to regions in which they have no customer

base by investing in ABSs emitted by financial institutions active in those

regions. Such an investment further diversifies their portfolio.

4. ABSs can therefore also be interpreted as the reaction of banks to the introduction of regulations. Regulatory requirements such as the demand of a minimum

amount of capital backing risky assets caused banks to find ways to circumvent

such restriction.

By selling receivables to a SPV, banks do not only free themselves from

credit default risks and raise short term money but they also lower the extent of


Fabozzi et al. (2007), p. 127.


H. Wohlenberg and J.-C. Plagge

risk-weighted assets that need to be backed by equity. This can help release equity

for further business or help maintain a desired capital ratio.

Financial innovation also greatly effects a company’s management of investor

relations. Above all, managing investor relations means providing sufficient information so that the company can be fairly valued. A scarce provision of companyrelated information can easily lead to an unfavorable deviation from its fair value.

Against the background of increasingly complex and often highly individualized

forms of financial products traded over the counter, it is especially important that a

company’s investors are adequately informed. The more complex financial

structures become, the more detailed the provision of information needs to be.

3 Challenges from Fragmentation, Intransparency

and Regulation

Whereas globalization, liberalization and innovation launch new financing

opportunities for companies, the evolution of capital markets also generates

challenges that might reverse the described positive effects.



As recent developments within Europe have shown, the process of liberalization

and harmonization has led to an increased number of new trading venues.

Doubtlessly these new developments are accompanied by benefits such as

increased competition among different venues. Yet, they bear various negative

side effects, too.

One such negative effect is the fragmentation of markets caused by a rising

number of trading places within capital markets. As a consequence, market liquidity

spreads across different venues. When looking at the German market for example,

about 20–40% of the daily value traded in the German bluechip index DAX is

generated on venues other than Xetra, Germany’s primary exchange.

This decentralization of liquidity might very well offset the benefits of best

execution across different trading locations. A general reduction of costs such as

fees, commissions, and taxes can be compensated by an increase in implicit trading

costs. “The term transaction cost consists of two main components: explicit and

implicit transaction costs. Explicit transaction costs are incurred with the orderprocessing and trade settlement by brokers, banks and exchanges. They take the

form of fees, commissions or taxes and are directly charged to the market participant. In reality, securities markets do not obey the theoretical construct of perfect

capital markets, i.e. it is not possible to buy or sell arbitrary quantities of securities

at any time at their current theoretical market price. The difference between the buy

and/or sell price that is actually achieved and the theoretical market price reflects

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