Factors affecting the stock market development

Part A

Question A

As an investor on the behalf of the company I would like to be more conservative about foreign investments. First and most important step in the investment decision making is a thorough analysis on both of the countries economics and the future performance of both of the economics. After the thorough analysis I will assume whether it is more profitable to invest in Poland or it is better to invest in some other businesses. In this situation it is risky to invest in Poland and in order to minimize risk cover the position from the exchange rate changes between USD and PLN, therefore using the forwards. The best decision here is to lock the forward contract on PLN at $0.39, thus providing the better opportunity to invest in Poland funds.

Question B

The spot rate is 1 PLN is equal to $0.4

Forward rate is 1 PLN is equal to $0.39

Interest rates are 14% in Poland and 9% in USA

The investment capital is $50 Million

Step 1

Convert USD to PLN at rate $0.40 per 1 PLN

Step 2

Invest PLN125 Million in 1 year Polish Treasures at 14%

Step 3

Convert back PLN to USD at rate $0.39 per 1 PLN

Step 4

Determine the profit or loss

So the expected profit is $5,575,000 and the expected return is 11.25%

Question C

The arbitrage risk is always high. The first risk the investor take is the loss probability. The demand for PLN can rise unexpectedly therefore bringing the value of PLN down. The exchange rate can also be brought down by unexpected bad news in Poland or good news in USA, for instance it is advised not to “short” in the market every first Friday of the month because of the uncertainty on the market caused by Non-Farm Payroll news. Applying this example to the situation, let’s say, if the Non-Farm Payroll increases, it will positively impact on USD and the current arbitrage strategy will not work.

Also the risk occurs in the costs of the transaction such as taxation, commissions and other costs, which can be a possible reason to not make the current arbitrage strategy only because it are too high.

Question D

As it was said above as an investor on the behalf of the company I would rather be a conservative investor or even defensive investor than an aggressive investor. The arbitrage always has the aggressive strategy inside because of obtaining higher risk. The U.S Treasures are less risky; therefore I would choose to invest in U.S Treasuries.

On the other hand, If I had my own funds to invest I would still choose the U.S Treasuries, firstly because of they are less risk and secondly because they provide 9% yield whereas the normal rate for U.S Treasuries in the last decade is fluctuating from 2% to 4%. According to rateinflation.com the inflation rate in US is only 1.658%. Therefore 9% -1.658% would be 7.342% minus taxable income.

Part B

Introduction

The stock market of any country is closely connected with development of national economy, and also with the events occurring in the world financial markets. The stock market experiences up and downs under the influence of any economic and political, internal and external factors. Nowadays, because of the modern international capital interlacing the fluctuations in stock markets of some countries can have a certain impact on other countries’ stock markets. Stock markets sensitively react to political events and currency shock

A key determinant of the development of the stock market is capitalization ratio. Mentioned ratio rose hugely in between 1980s and 1990s in the countries like Brazil, Chile, India and Mexico. For instance in Chile it went from 10 to over 84% of GDP.

Gurley and Shaw (1955, 1960, 1967), McKinnon (1973) and Shaw (1973) contributed that the relationship between financial development and economic growth has been an important issue of debate.

The financial system consists of financial institutes such as banks, insurance companies, and pension funds and bond and stock markets. Both of them are dependent from each other. Demirguc- Kunt and Levine (1996a), Singh (1997), and Levine and Zervos (1998) stated that the stock market development plays an important role in predicting future economic growth. First, the financial markets grow providing the economic to grow, the economic growth affect the growth of financial markets.

Factors affecting the stock market development

There are some factors affecting the stock market development. Here will be provided the comparison of the determinants given in the different papers. The following papers will be reviewed and referenced here:

· “The Determinants of Stock Market Development in Emerging Economies: Is South Africa Different?” By Charles Amo Yartey

· “Macroeconomic Determinants of Stock Market Development” By Valeriano F. Garcia and Lin Liu*

· “The Determinants of Stock Market Development: The Case for the Nairobi Stock Exchange” by Josiah Aduba, Jacinta Mwelu Masila and Erick Nyakundi Onsongo

· “Stock Market Development and Economic Growth in Developing countries: Evidence from Panel VAR framework” by Boopen Seetanah, Rajit Sawkut, Vinesh Sannasee and Binesh Seetanah

· “Macroeconomic and institutional determinants of stock market development in MENA region: new results from a panel data analysis” by Monther Cherif and Kaothar Gazdar

Paper 1

According to Charles there are several factors which affect the stock market development the strongest. Charles believes that the key measurement of the stock market development is the market capitalization as a proportion of GDP.

· Income Level

Charles found that the real income is highly correlated with the size of the stock market. The higher income the better stock market develops. He applied the log GDP per capita in US Dollars to measure income level.

· Banking Sector Development

To determine the correlation between the banking sector development and the stock market development, Charles includes a measure of banking sector development in the regression. According to Charles most of the studies use M2 relative to GDP as a measure of financial depth. However, he stated that according to King and Levine (1993), this measure does not tell us whether the liabilities are those of the central bank, commercial banks or other depository institutions. The nature of the relationship between developments of stock market and banking sector is in the square of bank credit to the private sector as a percentage of GDP in the regression. The expectation is that the credit to the private sector is positively correlated with the capitalization of the stock market. However, very high levels of banking sector development can lead to substitutability between debt and equity making the coefficient of the square of bank credit negative.

· Savings and Investment

It is commonly known that the higher and larger the saving, the higher the amount of capital flows through the stock market. However Charles states that there is no high correlation between income and savings and investments. Thus it is expected that the savings and investments are the important determinants of development of the stock market.

· Stock Market Liquidity

The gap or the difference between the emerging and developed economies is highly correlated to the difference between the levels and liquidity of the stock market of the particular country. For instance US stock market and Russian stock market have a big difference between them. US stock market is highly liquid, people, institutions and companies are very active in trading of stocks, and whereas in Russia people and companies are too conservative to trade on stock market therefore it is less liquid. Also this gap can be explained by GDP which is high in US and lower in Russia. Charles explained that the liquid market eases the investments, therefore the capital flow into new and old businesses are getting higher.

· Macroeconomic Stability

It is true that the higher the macroeconomic stability, the more incentive firms and investors to participate in the stock market. Also the profitability of the private sector can be affected by changing the interest rate, the monetary, fiscal, and exchange rate policies. Garcia and Liu (1999) stated that determination of the impact of macroeconomic stability on market capitalization is done by using two measures: real interest rate and current inflation.

· Private Capital Flows

For the last few decades FDI (Foreign Direct Investments) has the important role in developing the emerging stock markets. Errunza (1982) stated that the impact of FDI on the development of the stock market is broader than the benefits from initial flows.

· Institutional quality

According to Charles investors who invest in foreign emerging stock markets face three risks, which are economic risk, financial risk and political risk. It is commonly known that countries with emerging economies are corrupted higher that the developed countries.

Paper 2

The authors of this paper consider two key determinants of the stock market development which are institutional and macroeconomic. The institutional approach looks at institutional factors such as property rights, clearance and settlement issues, transparency and the inside information problems, taxation issues, and accounting standards. The macroeconomic approach looks at factors such as income growth, savings and investment, financial development, and inflation.

· GDP

Authors applied the formula where the total market value of all listed shares is divided by GDP and used the formula as a proxy for stock market development.

· Real Income and income growth rate

Authors consider that the real income is highly correlated with the stock market size. They said the higher the intermediation volume through stock markets the higher real income growth. High income level promotes the faster stock market development.

· Savings and investments

The authors of this paper agree with the author of the previous paper. However they said that probably the sizable capital flows had negatively affected on Latin America’s stock market development.

· Financial Intermediary Development

Both of the banking sector and MIS (Market intermediate savings) can be a substitute to each other. From the “demand for funds” point of view, the Modigliani-Miller theorem (1958) states that in a perfect market with symmetric information, the market value of all the securities issued by a firm is independent of the firm’s source of finance and consequently firms could go either to the banking sector or to the stock markets to finance their capital.

· Stock market liquidity

Liquidity is usually defined as the ease and speed at which agents can buy and sell securities. It is one of the most important functions the stock markets provide (Miller, 1991). They agree with Charles’ paper that the liquidity is highly important for the development of the stock market.

Paper 3

The researchers have done the research on previous performance of the economics and stock market itself in the capital of Kenya, Nairobi. They provided the graphics for each of the determinants such as Banking Sector Development, Income per Capita, Domestic Savings, Stock Market Liquidity, Macroeconomic stability, Foreign Capital Investment and Institutional quality. The graphics and the table are provided in the appendices section of this assignment.

Paper 4

· Banking Sector

The authors of this paper agree with the authors of the previous papers and say that it is noteworthy that Rousseau and Xiao (2007) in their study of China found that banking sector development was central to the Chinese success but however could not establish any significant relationship for the case of stock market development.

· Savings

The authors stated the statement of Tsuru (2000) who explained the finance‐growth link by arguing that financial development can promote economic growth via its positive impact on capital productivity or the efficiency of financial systems in converting financial resources into real investment. However, its effect on the saving rate is ambiguous and could affect the growth rate negatively. ‘In net terms, the impact on welfare is likely to be positive, since increased efficiency of investment in the long term can offset any reduction in the propensity to save’ Tsuru (2000). Stock markets provide an alternative channel for savings mobilization and better resource allocation (N’Zué 2006). They enable savings mobilization for financing “immense works” (Bagehot 1906, Hicks (1969), Greenwood and Smith 1996). More efficiently mobilized savings cause capital accumulation, which firms tap to finance large projects via equity issues. This, undoubtedly, spurs economic growth (Levine and Zervos 1998a, 1998b; Adjasi and Biekpe 2006).

· Liquidity

Focusing on liquidity, Bencivenga, et. al. (1996) and Levine (1991) argue that stock market liquidity plays a key role in economic growth. Without the liquidity in the stock market, many profitable long term investments would not be a profitable. The more liquid the market, the more it ease the savers to sell their shares, therefore the companies raise the capital on favorable terms. Liquidity has also been argued to increase investor incentive to acquire information on firms and improve corporate governance (Kyle, 1984; Holmstrom and Tirole, 1993), thereby facilitating growth.

Paper 5

The authors stated that the income level has to have a positive impact on stock market development. To identify whether the data is 100% true they use the previous year’s income level. Also the authors calculate the saving rate used a ratio of gross saving to GDP. The investment rate is considered as the important determinant of stock market development and calculated by using ratio of gross fixed capital to GDP. Financial Intermediary development is another determinant which plays an important role in stock market development like Stock Market Liquidity and Macroeconomic Stability.

Conclusion

The authors of all of the papers referenced in this assignment agree on that the determinants of the stock market development are the same. However some papers mentioned about the foreign investment rate as one of the important determinants and it is a mistake to not include it in the list. Also there are some more important determinants such as the politics of the partner country. For example if Poland changes its interest rate Russian economics will face the changes also because of Russia supplies Poland with the gas. There are a lot more determinants such as bad news, disasters, employment rates, non-farm payrolls and changes in currency rate however they are less important than the determinants mentioned in the papers.

References

Demirguc-Kunt, Asli, and Ross Levine, 1996, “Stock Markets, Corporate Finance and Economic Growth: An Overview,” The World Bank Economic Review, Vol. 10 (2), pp. 223–239.

Demirguc-Kunt, Asli, and Ross Levine, 1996, “Stock Markets, Corporate Finance and Economic Growth: An Overview,” The World Bank Economic Review, Vol. 10 (2), pp. 223–239.

Demirguc-Kunt, Asli, and Vojislav Maksimovic, 1998, “Law, Finance, and Firm Growth,” Journal of Finance, Vol. 53, pp. 2107–2137

Garcia, F. Valeriano, and Lin Liu, 1999, “Macroeconomic Determinants of Stock Market Development,” Journal of Applied Economics, Vol. 2 (1), pp. 29–59.

King, G. Robert and Ross Levine, 1993, “Finance and Growth: Schumpeter Might be Right,” The Quarterly Journal of Economics, Vol., 108 (3), pp. 717–737.

Miller, Merton. 1991. Financial Innovations and Market Volatility. Blackwell, Cambridge.

Modigliani, F., and Miller, M.H. 1958. “The Cost of Capital, Corporation Finance, and the Theory of Investment” American Economic Review, 48 (3): 261-297/

Shaw, Edward, 1973, Financial Deepening in Economic Development, (New York: Oxford University Press).

Rousseau P and Sheng X, 2007. Banks, stock markets, and China's ‘great leap forward’ Emerging Markets Review Volume 8, Issue 3, September 2007, Pages 206‐217

Tsuru K., 2000. Finance and Growth: Some theoretical considerations, and a review of the empirical literature, Economics Department Working papers no 228.

Appendices

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