Why capital markets are important?

a view from Emerging Markets Click to edit Master subtitle style

July 2011 - Alejandro Borgo

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Characteristics of Capital Markets

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Increase in channels for new financing

In emerging markets with weak capital Banking Channel
Cost: interest rate Medium companies may not access easily:
Banks prefer to give money to big clients instead of

markets the main financing channels are:

medium clients (has almost the same cost). Public sector is needed to promote loans for medium clients

Retained Earnings Channel

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No cost but earnings need to be positive and

the level of reserves according to the

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Diversifies economic risk

Emerging markets have higher rate of

returns due to the risk implied in the economy

country

Income distribution get worsened inside the Some investments are not carried out due to

the level expected rate of return

In a developed capital market different

correlations are found

Easy to diversify risk among other
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investments improving the coverage

Decrease the rate of return of the overall

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Optimal capital structure

Value of the firm = Equity + Debt
Value is not independent of the ratio E/D. In

that sense an optimal E/D value needs to be found

Optimal ratio appears due to the trade-off

between:
Default risk of the debt (increases cost) Not taking advantage of the after-tax cost of

debt (decreases cost)

WACC is an average between the cost of debt

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and the cost of equity. It is a measure of the 4/14/12 cost for financing projects

Optimal capital structure

E(RE) E(RE)

i(1-tc) D*L / EL
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DL / VL =1

DL / EL

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Pricing Projects
Ways to measure an investment without

capital market

Payback period
It doesnt take into account all the cash flows It doesnt take into account the temporal value of

money

Annual return over Invested capital

It doesnt take into account the temporal value of

money

When capital market

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Net present Borgo July 2011 - Alejandro value

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Pricing Projects
In the primary market the Twitter stock was

sold at 45 USD!!!

Secondary market:

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Increases volatility on investments

Two characteristics regarding investments
i. ii.

Capital markets prices projects and companies all the time, everyday Investments are LIQUID, not FIXED anymore

Very easy to undo a decision (just sell)

i + ii = increase volatility of investments

and makes deeper the economic cycle the goverment to lead investment

Keynes saw that problem and claimed for

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Bubbles
In developed capital markets speculators

(stocks prices leaded by headlines) wins over entrepreneurs (stocks prices leaded by fundamentals)
going to win, not the ones with strong financials

Picking the stocks that everybody THINKS are

Speculators doesn't have a view based on

fundamentals

Capital Markets HAS a real basis, they just

cannot go up/down forever

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Examples : .com bubble

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Contagion of Financial Crisis

In developed capital markets the contagion

of financial crisis is bigger

In crisis all the correlations between the

stocks are = 1 !!! Doesnt matter the market

Most people doesnt have a foundamental view (and

the ones that have it, cannot do anything)

Capital markets DIVERSIFY/TRANSFER the risk,

but they DONT ELIMINATE the risk

Capital outflows can make a currency

devaluation

Without regulation capital markets can rule the

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economy July 2011 - Alejandro Borgo

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Annex
Correlation between Capital Market
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development and GDP

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