Final_Thesis.doc

8/14/2019 Final_Thesis.doc

1/111

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition, policy mattersand risk management

MSc in Finance & International Business, Thesis

Department of usiness StudiesAuthor:

!eynep "uyucu

Supervisor:

Morten alling

Turmoil in the International Interbank and FX

Swap Markets: theories, parit condition, polic

matters and risk mana!ement

Aarhus School o" Business, #niversit o" Aarhus

September $%%

Side 'af '''


2/111


Abstract

The object of this study was to evaluate the tension in the

international interbank and foreign exchange markets during the

recent financial turmoil, 2007-2009 !nformation was mainly

extracted from recent articles with newest "ossible data, #ank of

!nternational $ettlement, and key central banks !n order to analyse

the tension in the interbank markets by factors as credit and

li%uidity risk have been em"hasised, whereas the analysis of the

foreign exchange swa" markets, the covered interest "arity &'!()

set forth by *eynes &+92) in his Tract on onetary .eform, and

further elaborated by Tsiang &+9/9) has been a""lied rder to

ex"lain the widened s"reads in the 1ibor-!$, unsecured and

secured along with term rate s"reads, credit default swa"s &'$),

foreign exchange swa" im"lied dollar rates, through factors such as

credit risk, li%uidity risk, market li%uidity, funding li%uidity The

em"irical framework was analysed and discussed according to the

a""lied theories !t was concluded that, in "articular after the

1ehman brothers default there has been a heightened s"reads in

both markets Thus, after the central banks interventions, there has

been observed a more release in the market, though credit risk has

been reduced along with the intervention of fiscal authorities Thus,

it is necessary to identify the underlying dynamics, in order to a""ly

the correct tools to reduce the market turmoil

Keywords: Turmoil in international interbank and 34 swa" markets, credit default risk, li%uidity risk,

funding risk central bank and fiscal authorities5 interventions

Side $af '''


3/111


6eorge #ernard $haw once remarked that the lack of money is the

root of all evil 8hile this is clearly an overstatement, there have

been "eriods, like the reat e"ression of the +90s, for which the

statement rings true #ut there have also been numerous e"isodes in

history in which too much money as been the root of all evil#

- $loyd % Thomas

Side (af '''


4/111


Table o" )ontent&'()T*+ : I-T+.D/&TI.-%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%0

&'()T*+ 1: Theoretical Frameworks%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%2

&'()T*+ 3: rief Summary of *4ents leading to the crisis in the Interbank and FX Swap Market%%%%%%%%%%%%35

&'()T*+ 2: Descripti4e Statistics%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%30

&'()T*+ 0: *M)I+I&($ (-($6SIS 7 DIS&/SSI.- %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%02

&'()T*+ 8: (nalysis and Discussion of the &entral anks Inter4entions%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%89

&'()T*+ : &'()T*+ : )*+S)*&TI;*%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%95

&'()T*+


5/111


)/A*T+0 ': IT01-#)TI1

6ow could this ha""en: ;o one thought that the financial system could colla"se $ufficient

safeguards were in "lace There was a safety net< central banks that would lend when needed,de"osit insurance and investor "rotections that freed individuals from worrying about the security

of their wealth= IS =1559th?: 2>0?% This abo4e stated @uotation has been a concern for the

whole world economy% (s a result it has been announced that the world economy has been

positioned in the worst recession, since the Second Aorld Aar=Danmarks -ationalbank =1559?:

?%

The deterioration in the /S subprime mortgage sector that surfaced in the summer of 155 rapidly

spilled o4er to other segments such as the international interbank and FX swap markets% Since then

the financial markets, in particular the core money markets ha4e been characterised by turmoil

=Danmarks -ationalbank =155


6/111


tension% Finally, chapter siC analyse and discuss the central banks enrichments of the problem

statement along with fiscal authorities inter4entions% &hapter se4en contains the perspecti4e and

chapter eight the conclusion%

1.1 Problem statement

63inancial crisis dee"ened in $e"tember 200>, li%uidity in the interbank market has further dried

u" as banks "referred hoarding cash instead of lending it out= 'eider et al =1559?: ?% (s a

resulted the turmoil 6s"illed over through the short-term foreign exchange &34) swa" market6

=aba =1559?: 12?% Despite FX 6markets a""ear to have increased in efficiency over time

"rofitable arbitrage o""ortunities do tend to arise during "eriods of uncertainty and turbulence

and may "ersist for some time before they are arbitraged away==Taylor =9


7/111


Moreo4er, what is li@uidity risk Ahat are the types of li@uidity risk in the financial markets (nd

what are underlying factors li@uidity risk depends on

Furthermore, the thesis will bring light to the theoretical framework of the FX swap market% It will

analyse what the co4ered interest arbitrage and what co4ered interest rate parity condition =&I)?s

are Furthermore, it will eCamine the link between the &I) and the FX Swap markets%

The second main obHect of the thesis is to describe the problem statement with possible statistical

data eCplanation factors behind the tension obser4ed in the international interbank and FX swap

markets% Therefore, the first part of the second main part of the thesis, initially intends to describe

the fundamental characteristics of the international interbank markets% Ahat is the interbank

market 'ow does this market function Thereafter, the de4elopment in the international interbank

through measures reflecting the theoretical framework i%e% how did the $ibor>.IS spreads, secured

and unsecured spreads along with term rate spreads, credit default swap =&DS? spreads de4eloped

in the /S interbank market, *uropean interbank market, /" interbank market and =Gapanese

market?, during the time period of 155>1559%This will be followed by a description of the FX swap

market i%e% what is the FX swap market 'ow does the FX swap market function (nd again the

de4elopment of the FX swap implied dollar rates%

The third part of the thesis will empirically analyse and discuss the statistical data obser4ed in the

second main part, in the light of the applied theories% Ahat triggered lack of li@uidity eCperienced in

the international interbank market Ahat was the relation between the interbank market and the

li@uidity facilities of the central banks Ahat were the underlying dynamics behind the tension in

the international interbank markets (gain, what triggered the spill o4er to the FX swap market

Ahat was the underlying reason behind the FX swap spread i%e% de4iation of co4ered interest parity=&I)? obser4ed in part two% Furthermore, there will be an in4estigation of the central bank responses

along with fiscal authorities inter4entions during the financial turmoil in the international interbank

and FX swap markets% Ahat ha4e the main central banks implemented as a response to the financial

crisis 'a4e these actions been able to eliminate the tensions obser4ed in part 1 i%e% credit and

li@uidity risk Ahy ha4e go4ernments inter4ened in the crisis Ahat are the most remarkable

actions by these go4ernments

Side 2af '''


8/111


(nd finally, the fourth part of the thesis presents the perspecti4e and the conclusion% There will be a

re4iew of how to weather such a future financial crisis in the international financial markets through

new regulations%

1.2 Delimitation & Assumptions

The (nalysis of the tension in the international interbank and foreign eCchange =FX? swap markets

presented in this paper is based on certain assumptions and certain factors which are delaminated,

that are discussed below% Though, assumptions and delimitation can also occur through the paper,

where it is seen necessary for the sake of a more clear understanding%

This paper is founded primarily on the most se4ere effected marketsJcurrencies in the K>5 markets

i%e% the /S dollar, *uro, Sterling markets% This relies in the reasoning of eCtended a4ailable

information on these groups as recent maHor researches ha4e been conducted in this study area

=Michaud 7 /pper =155


9/111


of the paper and limited paper sie% Furthermore, there will solely be focus on the greatest three

eCternal agencies i%e% S7)Bs, MoodyBs and Fitch, and their short term credit ratings, as this paper

simply in4estigates the short term international money markets =&rouhy =155?: 18?L (shcraft 7

Schuermann =155


10/111


e4er eCperienced a temporary shortage of cash, and due to the fact that money markets ser4e

businesses, the a4erage transaction sie is 4ery large =Madura =1555?: 3?% There are se4eral types

of money market instruments3 which are issued in the primary market2 by corporations and

go4ernments to obtain short term funds through sale in the secondary market =Madura =1555?: 10?,

=$e4inson =1550?: 21?% .ne of the 4ery important instruments is interbank loans, which are traded in

one of the money market segment called interbank market%

.*&D =155? defines the international interbank market as the followingL 6The international

interbank market is an international money market in which banks lend to each other @ either

cross-border or locally in foreign currency @ large amounts of money, usually for "eriods between

overnight and six months==.*&D =155?: 2?% The definition created by .*&D will be applied as

it defines it clear and shar", and the aim of this thesis to in4estigate the international interbank

market due to the detected recent turmoil in there% In the thesis the term interbank market is applied

as international interbank market, eCcept an eCplicit interbank market is gi4en% Thus, the short term

instrument maturities can be eCtended to 1 months%

'ollateraliAed ebt bligation &')< ( &D. is a type of asset backed security, a financial tool

that repacks indi4idual loans into a product that can be sold on the secondary market% The portfolio

of the underlying of the &D. can consist of bank loan, corporate bond etc% &D.Bs are called asset>

backed commercial paper, if the package consists of corporate debt, and mortgage backed

securities, if the loans are mortgages% If the mortgages are made to those with a less than prime

credit history are called subprime mortgages =)lesner =1550>1?%

3orward exchange rate< The forward eCchange rate in this paper will be eCpressed as the unit price

in local currency of foreign eCchange bought or sold for future deli4ery% Ahile the forward

premium =or discount when negati4e? is to be understood as the discrepancy between the forward

and spot eCchange rates as percentage of the spot eCchange rate =Tsiang =909?: 8?%

$i@uidity #is easier to recogniAe than to define= =oF =155


11/111


term and "rojected long-term funding commitments while su""orting selective business ex"ansion

in accordance with the bankBs strategic "lan==)lesner =155


12/111


rate parity =&I)? set forth by "eynes &+92) in his Tract on onetary .eform, and further

elaborated by Tsiang =909?%

*ach of these two markets will be described and the de4elopment of the tension will be described in

the following measuresL $ibor>.IS spread, secured and unsecured term rates, &DS spreads and FX

swap implied dollar rates will be described, which aims to connect the theoretical frameworks with

the statistical data a4ailable, as the theories will be reflected in these measurements% Furthermore, in

the fourth part of the thesis there will be a discussion of the underlying dynamics behind the

measurements in the light of the applied theoretical framework% This will be followed by an analysis

of the central banks actions and the effecti4eness of the applied inter4entions along with the fiscal

authorities%

1.! "ource Critic

Due to the nature of the study subHect i%e% to analyse the international interbank market and the

financial turmoil it is weathering, it is @uite important to gather as much information as possible to

be able to gi4e a fair portrait% Thus, this paper is founded on a great range of litterateur which is

financial, economic and empirical% Moreo4er both international and Danish litterateur will be

applied to illustrate 4arious perspecti4es as possible, in the frame of the problem statement%

Moreo4er, it has to be stated that a maHor part of the data is eCtracted from loomberg 8,and (arhus

school of usiness do not ha4e access to this website, therefore, the maHor set of data collected is

from sources such as prominent authors that ha4e engaged in the field and maHor central banks, as

*uropean &entral ank, Federal +eser4e ank, ank of *ngland, ank of France stability reports,

and bulletins

Therefore, the applied sources are percei4ed to be highly reliable% The Hudgements on the data are

based on the latest possible sources after eCamined carefully and compared to the maHority of the

data due to clear and cohort answers% 'ence it cannot be reHected that the data applied are based on

4arious time ones, and do not co4er eCactly the time frame from the second half of 155, and until

1559 due to limited a4ailability% It should be noted that while e4ery effort has been taken to make

this paper as accurate as possible, changes in statistics, legislations or other factors may mean that

some 4ariation could occur and a result of this it may not be 4ery comparable%

6This has been confirmed by Mr% -aohiko aba and &hristian /pper with an email, stating that loomberg has been a key source of

origin in data collecting, both for $ibor>.IS, &DS, and FX swap implied dollar rates spreads applied in chapter 2% =aba =1559?: 0?%

owngrade .isk< In order to estimate the default risk, in4estors rely on credit analysis conducted by

nationally recognised statistically rating firms, which eCpress their estimates in the form on credit

rating=(nson =1552?: 13?% The following subsection will further elaborate on the main three credit

rating agencies% Downgrade risk is thereby defined as the risk that a recognised rating firms such as

Standard 7 )oorBs, Moodys In4estors Ser4ices, or Fitch +atings reduces its outstanding credit

rating for an issuer based on an e4aluation of the current earning supremacy of the issuer in

opposition to its capacity to repay its debt obligations as they become due% (n impro4ement in the

credit @uality of an issue or issuer is rewarded with a superior credit rating, referred to as an

upgrade, whereas a weakening is referred to as a downgrade =(nson =1552?: 2?%

The conse@uences of a downgrading of a credit rating will depend on the following circumstancesL

the market price of the debt securities will fall, and thereby in4estors will suffer a loss% If the issuer

prepares to issue more debt securities, in4estors will demand a higher rate of interest to compensate

for the higher risk% In some situations, the issuer may agree to a condition whereby the interest

(lthough credit ratings are pro4ided for the benefit of in4estors, the issuer bear the cost in4ol4ed as it is the interest of the issuer to re@uest a rating

as it raises the profile of the issue of debt capital, and in4estor may refuse a purchase that is not accompanied with a recognised rating% In theory,credit rating is not applied to an organisation itself, but to a particular debt security that the firm has issued% 'ence, in general practice it is common

for the market to refer to the creditworthiness of firm itself, in terms of the rating of their debt% *%g% a highly rated firm may be referred to as a triple( rated#, although it is the debt issues of the company that are rated as triple ( =(nson =1552?: 13?%

Side '5af '''


16/111


payable on the securities to be raised if their credit rating is downgraded to or below certain le4el

=&oyle =1551?: 32?%

'redit $"read .isk< ( credit loss may occur i%e% the credit standing of the issuer is percei4ed by the

market to ha4e diminished% The market will subse@uently re@uire an interest rate premium i%e% a

higher credit spread? to co4er the higher credit risk forcing the security price to drop% ( wider credit

spread could also reflect the perception of the market that the return on a security with a gi4en

credit @uality must be higher, e%g% in association with a repeated downturn =Danmarks -ationalbank

=1553?: 98?%

Therefore, credit spread risk is the risk that the spread o4er a reference rate would increase for an

outstanding debt obligation% The difference between credit risk and downgrade risk is that the latter

concerns a particular formal credit re4iew by an independent rating agency, whereas the former is

the reaction to percei4ed credit weakening of the financial markets =(nson, Mark =1552?: 0>8?%

'orcher =1550? presents 4arious factors that could be presented as an eCplanation for this disability

i%e% poor economic conditions, high interest rates, or when an organisation has accumulated large

losses, owes many other counterparties, or when a creditor or counterparty of an entity face

financial difficulty or failure ='orcher =1550?: 53>2?%

$'' )redit 0atin! A!encies

6iven the im"ortant role of ratings in the investment and risk management "rocesses, and in

regulation, the turmoil has also raised %uestions about the effectiveness of credit rating agencies5

&'.?s5) assessments of risks==IS =155


17/111


The asel &ommittee


18/111


subHect to the in4estor or borrowers own liability and risk =(ndersen et al% =99


19/111


3actors 'onsidered in .ating

There are 4arious factors rating agencies considered when representing their ratings% (nson et al%

=1552? describes these as the four &s of credit i%e% character, capacity, collateral and co4enants% The

first & includes the foundation of sound credit i%e% the ethnical reputation as well as the business

@ualifications and operating record of the board of directors, management, and eCecuti4e

responsible for the use of the borrowed funds and repayment of those funds% For instance, MoodyOs

try to understand the business strategies and policies formulated by the management% They further

analyse the strategic direction, financial philosophy, conser4atism, track record, succession

planning, and control systems etc% The second & considered in rating is the capacity or the ability of

an issuer to repay its obligations, whereas the neCt factor considered is collateral, where it is

assessed whether the assets guarantee to the debt and the debt holder% 'ere MoodyBs, analyses the

financial statement of the specific firm% The last factor considered is the co4enant condition of the

lending agreement% &o4enants mirror restrictions on how management functions the company and

conducts it financial affairs% ( default or 4iolation of any co4enant may carry great weight as an

early warning enabling in4estors to take actions before the situation deteriorates further% Therefore,

co4enants play a significant role in minimiing risk to creditors as it assist pre4ent unconscionable

transfer of wealth from debt to e@uity holders =(nson et al% =1552?: 10>1?L Michel =155?: 181>83?%

( 4ery crucial element to emphasise is that in the international money market, credit risk is not the

only risk faced by participants but currency risk also plays a 4ital role due to the in4ol4ement of

foreign eCchange rates etc% =Krabbe =998?: 11?% (ccording to factors considered in rating, it is

noticeable that currency risk has been ignored in credit rating analysis =SF+& =155?: 2?%

Furthermore, in general, swap arrangements also in4ol4e credit risk i%e% the credit risk to a dealer is

the possibility the counterparty of the dealer may default when the 4alue of the swap to the dealer ispositi4e =Krabbe =998?: 33?% Thus, the following sub>chapter aims to describe the effect of the

turmoil to the foreign eCchange swap markets from a theoretical framework%

17.ther factors eCamined by MoodyBs are for instance, industry trends =here it is eCamined the 4ulnerability of the company to economic cycles, the

barriers to entry, and the eCposure of the company to technological changes?, regulatory en4ironment, basic operating and competiti4e position,financial position and sources of li@uidity, company structure, parent company support agreements, and special e4ent risk =(nson et al% =1552?: 1?%

Side 'af '''


20/111


$'$ 7i;uidit 0isk

( well functioning money market is 4ery important, in order to ensure that financial market

participants can adHust their li@uidity positions and to pro4ide funds for growth =IS =155t?: ?L

;an Kreuning =1553?: 8?% $i@uidity risk is defined as the risk of insufficient li@uidity funds on

hand to meet obligations i%e% the ability of the bank to meet its liabilities when they fall due

='effernan =1550?:50?L ;an Kreuning =1553?: 8


21/111


restarts the margin call again% Kenerally, all types of institutions are eCposed to li@uidity risk, hence

in particular interbank markets, which ha4e an intermediary role, and thus eCposed to a higher

eCtend% (s the broader financial systems along with the economy of the world are strongly

dependent on the core money markets meet their function as supplier of li@uidity =)lesner =155


22/111


loss of li@uidity in a money market generally has more serious effects than a loss of li@uidity in

markets for longer term instruments, due to the large amount of money market instruments become

due each day% Furthermore, de4elopments in the global financial markets ha4e highlighted that

gi4en pressure on li@uidity and balance sheets, combined with heightened credit concerns, made

banks reluctant to pro4ide others with term funding11i%e% interbank market loans with terms longer

than o4ernight =IS =155t?: 1?%

Part %%

6? much less well documented as"ect of the turmoil is how the turbulence in money markets =in

particular interbank markets?s"illed over to foreign exchange &34) swa" markets= =IS =155


23/111


higher than that in the other, after the risk of eCchange fluctuation is eliminated by a forward

eCchange transaction in the opposite direction =Tsiang =909?: 9?% In other words, if the interest

rates are higher in the domestic country than in the foreign country, then the currency of the foreign

country would be selling at a premium in the forward market, while if interest rates are lower in the

domestic country, then the foreign currency would be selling at a discount in the forward market 13

=Krabe =998?: 58?% The notation for the formulation abo4e is as the followingL

Ahere Strepresents the domestic currency price of foreign currency in the spot market at time t, F t

is the price of foreign currency deli4erable forward at time t, id tit is the domestic interest rate at

time t and in iftis the corresponding interest rate abroad at time t%

The proposition states that short>term funds would tend to flow from dollar money market to

pounds sterling money market if FtJ St=P ift? Q =P i

dt? =?

.n the other hand, funds would tend to be transferred from pounds sterling money market to dollar

money market, if FtJ St=P ift? R =P i

dt? =1?

Ki4en N55 in4ested for three months in /S money market would be N55 =P i dt?, and if the same

amount in dollars is con4erted into sterling at the current spot rate and in4ested for three months in

/" money market and then con4erted back into dollars at the current forward rate for sterling for

three months deli4ery, it would become If 55N C FtJ St=P ift?%

If 55N C FtJ St=P ift? Q N55 =P i

dt?, arbitragers would gain a net profit by a temporary transfer of

funds from dollar money market to pounds sterling money market, whereas if

55N C Ft J St =P ift? R N55 =P i

dt?, the net profit would be gained by a transfer of funds from

pounds sterling money market to dollar money market% Figure 2% describes the steps that an

arbitrager would implement to perform a &I( transaction% Figure 2% 12, illustrates the conditions

where 55N C Ft J St =P i

f

t? Q N55 =P i

d

t? and for the other condition where55N C FtJ St=P i

ft? R N55 =P i

dt? it would ha4e been the other way around i%e% transfer of funds

from pounds sterling to dollar money market instead of from dollar to pounds sterling money

market%

23*%g% if interest rates are higher in /S than in /", then the forward pounds sterling would cost more /S dollars than will the spot pounds sterling%

The forward pounds sterling will be at a premium and the forward dollar at a discount% If interest rates are higher in the /" than in the /S, then theforward sterling pound would cost fewer dollars than will the spot sterling pound% The forward sterling pound will be at a discount and the forward

dollar at a premium =Krabe =998?: 58?%24See (ppendiC 2

Side $(af '''


24/111


Tsiang =909? emphasise that it has been argued that, gi4en arbitrage funds do not run out, such

arbitrage operations10would tend to eliminate this ine@uality through some or all of the following

possible effects: raising the spot rate of sterling in terms of dollars =S+?, lowering the forward rate

=F+?, raising the short term interest rate in the /S =id t? and lowering the one in /" =if t?% (s a

conse@uence, the e@uilibrium relationship between the spot and forward eCchange rates in one side

and the interest rates in the two financial centres on the other side is said to beL

F+JS+ =P ift? =P id

t? =3?

In other words, the process of co4ered interest arbitrage dri4es the international currency and

money markets toward the e@uilibrium described by the co4ered interest rate parity% Thus, co4ered

interest arbitrage should continue until interest rate parity is re>established, due to the fact that

arbitragers are able to earn risk free profits by repeating the cycle as often as possible =Da4id et al%

=99


25/111


differential between the two money markets concerned =Tsiang =909?: 15?% The abo4e statement has been reformulated by Da4id et al% =99


26/111


emphasied the shortcoming of the interest rate parity theorem, hence this will be further elaborated

on in chapter 0%

$$( +;uilibrium between Interest 0ates and +>chan!e 0atesFigure 1% depicts the no arbitrage condition i%e% e@uation =3?% The interest rate difference is

measured on the 4ertical aCis, which illustrates the percentage difference between foreign =pounds

sterling denominated? and domestic =dollar>denominated? interest rates, and the horiontal aCis

depicts the forward premium or discount on the pounds sterling% The interest rate parity line

illustrates the e@uilibrium state, hence transaction costs grounds the line to be a band rather than a

thin line% In general, transaction costs arise from foreign eCchange and in4estment brokerage costs

on shorting and going long securities =Da4id et al% =99


27/111


$ource< &avid et al &+99>)< +2C)

-ote: The gi4en, percentage difference between if>idand the percentage premium on foreign currency =U? are ficti4enumbers, in order to gi4e a more clear understanding this chapter%

)oint C corresponds to one possible e@uilibrium position, where a >2 E interest differential on

sterling securities would be offset by a 2 E premium on the forward sterling% The point abo4e the

line i%e% the dise@uilibrium point /, would encourage the interest rate arbitrager% That is the situationpresented in figure 1%12 E =annual basis?, while the premium19on the forward

sterling is 2%


28/111


may apply capital controls that would pre4ent eCecution of forward contracts% 'ence, this risk is

fairly distant for co4ered interest arbitrage between maHor financial centres, as a great deal of the

funds used for co4ered interest arbitrage is in *urodollars, howe4er, this could be a concern for

countries with political and fiscal instabilities Da4id et al% =99


29/111


Ft,tPs J St =Pift,tPs?

Ahere Stis the FX spot rate between the sterling and dollar at time t, F t,tPsis the FX forward rate

contracted at time t for eCchange at time tPs, and i t,tPsf it,tPs

sterlingis the uncollateralised euro cash

fiCed interest rate from time t to time tPs% F t,tPs J St corresponds to the sterlingJdollar forward

discount rate that is used for the FX swap price @uotation35%

The relati4e cost factor plays a significant role in the use of the FX swap to raise dollars i%e% whether

an institution would be encouraged to borrow domestic currency funds in the uncollateralised spot

market and use the FX swap to raise dollars, should depend on whether the FX swap implied dollar

rate is lower than the rate of the uncollateralised dollar funds% In other words, the choice between

in4esting in collateralised =FX swap? 4ersus uncollateralised dollar funding, dependence on the

perspecti4e of co4ered interest parity as it implies a comparison of one uncollateralised rate e%g%

dollar, 4ersus an uncollateralised rate e%g% sterling combined with an FX swap =sterling for dollar?%

The e@uality of dollar rates and of FX swap implied dollar rates defines a the following conditionL

Pit,tPsd Ft,tPs J St =P rt,tPs

f? =a?

Ahere it,tPsd is defined as the uncollateralised dollar cash fiCed interest rate% *@uation =a?

corresponds to the co4ered interest parity condition as presented abo4e in section 222%

(s mentioned abo4e, &I) states that interest rate disparities between currencies should be perfectly

reflected in the FX forward discount rates for the reason that, otherwise arbitrageurs could transact

in interest and eCchange markets to make a risk free profit%

( fair amount of research has been de4oted to the empirical 4alidation of the condition and 4arious

empirically studies ha4e shown that the parity condition is not always satisfied% The reasons for the

de4iation of the &I) will be further elaborated on the chapter 0%

30

More, correctly the price of FX swap is usually @uoted as F t,tPs > St% +eferring back to the interest rate parity i%e% e@uation =3?, the forward rate isgi4en as a function of the spot rateL Ft,tPs St==Pi

d? J=Pif? ?, therefore the spot rate should be the swap rate F t,tPs > St= Krabbe =998?: 59?%

Side $af '''


30/111


)/A*T+0 (: B0I+F S#MMA0? 1F +@+TS 7+A-I T1 T/+ )0ISIS I T/+

IT+0BA9 A- FX S8A* MA09+T

&redit> li@uidity crises are not a new phenomenon, the first credit crunch was obser4ed in 988,

which was due to the municipal bond market =Aray =999?: 3?% This period was followed by maHor

disruptions in financial markets, the (sian currency crisis in 99, and the +ussian 3 and the

$T&M31crisesB in 99


31/111


the loans to transfer part of the risk to counterparties and obtain the li@uidity for new lending 30% This

meant that as the banks had little incenti4e to take care of appro4ing loan applications and

monitoring loans as they only faced the 6"i"eline risk=of holding a loan for few months until the

risks were passed on =)lesner =155?: 3?L "empa =155


32/111


.4erall, a combination of cheap credit and low lending standards resulted in the housing rage that

laid initially basis for the credit crunch followed by the li@uidity crisis =)lesner =155?: 3?L

runnemeier =1559?:


33/111


spreads to other markets through the &D.Bs and other compleC products39% (s the cost of insuring a

basket of mortgages of certain ratings against default increased downgrading on related (S and

other structured instruments occurred% This resulted in a series of write>downs and loss of

confidence in the 4alue of (S globally% (s a part of the originate and distribute# model, many

banks created separate entities, SI;s, which were dependent on the originate banks but not included

in their balance sheets25% SI;s were established to fund the &D.s through (&)s% The maHor

obstacle relied in the fact that (&)Bs are typically short term in4estments that mature between 3>8

months, were issued subse@uently with the security of payments from &D.Bs =*& =155?: 31?%

This of course resulted in a duration gap% Thus, as the li@uidity in the securitiation market dried up,

outstanding (&) could not be rolled o4er, and SI;s had to sell assets in order to obtain li@uidity,

as many of the eCposures were effecti4ely financed on a rolling basis by short term funds =IS

=1559>5th?: ?% The already ongoing sale of special li@uid &D.s resulted in rapid decrease in

market prices of high V@uality tranches2% The degraded market li@uidity resulted in li@uidity

inHections from the li@uidity facilities of the originated banks, which meant an increase of call risk

as the risk flow returned to the balance sheets of the banks%

(long with shortage of li@uidity, maHor banks wrote>down mortgage related securities e4en further%

(lthough the aggregate amount of write downs21was higher in the united state, the amount of write

downs of *uropean banks is remarkable% The e4ents in the /S impacted financial intermediaries in

*urope as credit risk from /S ended up in the hands of global in4estors =*& =155I?: 5?L *&

=155?: 3>31?% (s figure 3%1 depicts in Guly 155 the market for short term (&) started to dry up

=runnermeier =1559?:


34/111


3igure utstanding ?#'(43and Fnsecured '(

$ource< runnermeier &2009)G)

(ll this resulted in dramatic li@uidity degradation due to the sharp decline in the risk appetite of

global in4estors and increase in market 4olatility, which hit core money market markets on 9

(ugust 155 =)lesner =155


35/111


)/A*T+0 .: -+S)0I*TI@+ STATISTI)S

This section aims to describe the financial situation in the international interbank markets and the

FX swap markets by the use of a4ailable statistics% This chapter is di4ided into two main parts, thefirst part describes the international interbank market, and thereafter describe the tension de4eloped

in the international interbank markets through two measures that reflect the li@uidity risk and the

credit risk% The second part of the paper international FX swap markets followed by a description of

the market 4ia e@ui4alent measures%

4.1 %nternational %nterban( Mar(ets

This sub>section, primarily aims to pro4ide an o4er4iew of the fundamental characteristics of the

International Interbank Markets% Initially, a brief historic introduction to the international interbank

markets will be presented, which will be followed by a description of what he interbank market is,

and how it is functioned is described% Thereafter, there will be a brief introduction of the role of

money market rates%

.'' Brie" /istoric Introduction o" the International Interbank Market

63inancial markets have existed for several years ie since mankind settled down to growing cro"s

and trading tem with others 3inancial markets are in different forms and o"erate in varied ways,

which serve the same functions such as "rice settings, asset valuation, arbitrage, raising ca"ital,

commercial transactions, investing, and risk management==$e4inson =1550?: >1?%

*4en though that there eCists e4idence that foreign currency deposits were held by banks before

Aorld Aar II, it is only since the late 905s that the interbank markets ha4e grown rapidly and

consistently22=(r4ind =992?: 12?% The growth in the international trade increased the demand for

international currencies and the interbank market was created as a result of legal transactions of

pri4ate in4estors looking for the best returns on their in4estments =(r4ind =992?: 10, 1?% 'ence,

the interbank market eCpanded significantly in recent years as a result of the general outflow of

money from the banking industry20 =$e4inson =1550?: 3?% Today, the interbank market is an

44Dufey and Kiddy identified three necessary conditions for the functioning of eCternal markets, which were not, satisfied until the late 905s and

thereby the reason for why the interbank market did not start growing until the late 905s % ?Foreign>based entities must possess the freedom tomaintain and transfer demand deposit balances i%e% no restrictions on nonresident inpayments, outpayments, and transfers, 1? Interbanks must be ableto offer eCternal deposits and loans at competiti4e rates in a con4enient location, 3? Demand for eCternal currency deposits and loans =Dufey and

Kiddy =992?: 5>?%45This process is referred to as disintermediation =$e4inson =1550?: 3?%

Side (5af '''


36/111


unsecured segment28of the core money markets2, where banks conduct their transactions at great

amounts% The international interbank markets do not eCist in a particular place or operate in alliance

to a single set of rules, neither do they offer a single set of posted prices, with a gi4en current

interest rate for money2


37/111


payments% This, eCchange of li@uidity is illustrated by the figure below% Ki4en a ank , which

li@uidity re@uirement eCceeds its borrowing from the central banks% In a steady period, ank

would co4er its borrowing in the money market from ank (, which is assumed to ha4e a li@uidity

surplus%

$ource< anmarks ;ationalbank &200>-+H)< 9)

'ence, in a situation of turmoil, obstacles may occur in the market e%g% if ank ( constructs its own

contingency li@uidity, preferring deposits at the central bank where the funds can be made a4ailable

at short notice% ank ( places more li@uidity than normal at the central bank, while the central bank

lends a larger amount to ank against collateral, whereby the short term money market is partly

replaced by balances at the central bank% SubHect to the recent tensions in the money markets,

4arious numbers of central banks ha4e had to adHust their li@uidity management =Danmarks

-ationalbank =155%W?: 39?L Au =155


38/111


G+++ .ole of oney arket/#enchmarks/G

Interest rates at which banks eCtend short term loans to one another ha4e assumed international

significance% Therefore, well established benchmarks are 4ital to the efficient functioning of the

instruments in the market% 'ence, the importance of benchmarks for short term interest rates goes

beyond their use in contracts% They attach the short end of the yield cur4e, and thereby con4eying

information regarding eCpected future policy rates and other macroeconomic fundamentals% Money

market rates are also used as a reference to terms of many financial deri4ati4es00%

( main re@uirement of a benchmark has been characteried as being li@uid% Mo4ements in

benchmark yields should not be dri4en by order imbalances but rather only reflect new information

concerning fundamentals =Aooldridge =155?: 00?% Kyntelberg and Aooldridge =155


39/111


loans to healthy, creditworthy institutions% Thus, a bank that belie4es another bank to face credit

default will charge higher interest rate or may e4en refuse to lend at all =Kyntelberg and Aooldridge

=155


40/111


G+22 The Euro-?rea !nterbank arket

/ntil 9 (ugust 155, the unsecured euro interbank market were characteried by 4ery low spread

around fi4e basis points, and insignificant amount of li@uidity deposit at the *& ='eider et al%

=1559?: 1?L Danmarks -ationalank =155W?: 339?%

6et, the fortune of the *uropean interbank market was not much different from the /S interbank

market% Time one frictions resulted in large swings o4er the day in the demand for /S dollar

interbank funds% (s *uropean banks ha4e few local sources of dollar funding, they preferred to

secure funds from the interbank market early in the /S trading session% 'ence, /S banks with

eCcess reser4es choose to defer lending until later in the trading day, when their net funding

position became more definite% The disparity intensified the upward pressure on the /S dollar

o4ernight interbank rate in *urope =&KSF =155-o%3?: 2?% 'ence, as the figure also shows, the

time period after the default of $ehman brothers, was characterised by crucial higher compared to

the period prior to the default% (s of 1< September 155


41/111


and /"% This indicates different risk factors in the banking sectors =Taylor and Ailliams =155


42/111


for borrowers% .n the other hand, when asset prices decrease during financial turmoil, the balance

sheet contracts and therefore become reluctant to lend% Such beha4ior reduces the sie of eCposure

to other financial intermediaries% Such manner reduces their sie of eCposure to other banks, then

the aggregated li@uidity declines =(drian and Shin =155


43/111


.'( Secured and #nsecured Spreads

'owe4er, Taylor and Ailliams =155+epo =go4ernment? spread as it is the difference in rates between secured and unsecured

lending between banks at the same maturity =Taylor and Ailliams =155


44/111


Figure 2%8$"reads between $ecured and Fnsecured Three-onth e"osit .ates

'owe4er, the greatest spread has been obser4ed in the fourth @uarter of 155month,

siC>month and one>year maturities% Aithin few days after the turmoil onset, the spreads increased

from around 5 basis points =bps? to around 5 =bps?, and remained at these le4els until later

summer 155Mitsubishi, &hase, &itibank, G) Morgan ank of (merica and /S represents the international banks% The a4eraging method of ( $ibor and*uribor is @uite similar, although solely the top and bottom 0 per cent are reHected in the process% Thus, the difference in topping and tailing will

result in being a greater ratio of smaller banks to larger banks in *uribor =www%bbalibor%comJbba:1559?%83The *urepo represents the an a4erage general collateral =K&? repo rate from euro repo transactions =www%eurepo%org?

Side ..af '''

$ource< &anmarks ;ationalbank &2009-H+)< G7)-ote: The rate of interest on a 3>month interest>rate swap has been applied as the collateralised rate% The most recent obser4ationsare from 3 March 1559% )lease, ignore the red line%
http://www.bbalibor.com/bbahttp://www.bbalibor.com/bba


45/111


Figure 2%$"reads between $ecured and Fnsecured Three-onth e"osit .ates

*isenschmidt and Tapking =1559? highlight another 4ital obser4ation i%e% to end of @uarter effects in

the market during the turmoil% For instance, the one>month *uribor =unsecured? spreads has been

higher in the last month of each @uarter, in particular in the last month of 155, in contract to other

months since the onset of the turmoil% &orrespondingly, the one>week *uribor spread has also been

higher in the last week of each @uarter than in other weeks%

*& =155Gune? emphasise that close to the year or @uarter ends, or the end any other important

financial reporting period, institutions often attempt to impro4e their apparent financial health

preparation for public disclosure of their accounts, also known as window dressing This is

eCecuted, in order to impro4e appearance to shareholders, analysts or, in the case of financial firms,

e4en to ensure that regulatory re@uirements% In particular, financial firms may reduce their credit

eCposure and increase their li@uidity position% Furthermore, it is stated that concerns related to

window dressing can lead to increased li@uidity risk as many banks reduce their lending when

engaged in these abo4e mentioned acti4ities, which is reflected in the increase in o4ernight rates as

the year>end or @uarter>end come near =*& =155Gune?:


46/111


the fourth @uarter of 155< is in particular 4ery high% Spreads between one year maturities reached

around below 105 bps%, siC months around 155 bps%, while three>month was around 5 bps%

(nalysing the maturity situation further, according to *& =1559mm? the unsecured market

remained mainly on o4ernight market% In the second @uarter of 155< o4ernight acti4ities represented

around 5 per cent of the total lending and borrowing acti4ity in the *uropean unsecured market%

*& =1559>*MMS? states that 98 per cent of unsecured transactions appeared at maturities of less

than one month in 155month increased% Ahile, the lending side, there was a significant decrease in

eCposure with maturities longer than three months, in particular for one year maturity, which

decreased from 15 per cent to 9 percent of total eCposure =*& =1559mm?: 2?% *isenschmidt and

Tapking =1559? argue that banks can only attain funds from borrowing at the *uribor but lending at

funds at *uribor is hardly possible as prime banks prefer to borrow repeatedly o4ernight at the low

unsecured o4ernight rates rather than for a longer period at the higher *uribor =*isenschmidt and

Tapking =1559?: 8?% This reflects that in a period of ele4ated li@uidity risk or funding risk, banks

choose to lend li@uidity short term in the unsecured market rather than long term due to the

uncertainties of funding defaults%

.'. )redit Measures: )-S Spreads

This second part of the first main parts aims to describe the credit default swap spreads for the

maHor economies% It is to be noticed that the fi4e year bank credit default spreads for selected

Gapanese banks were not possible to be obtained, and therefore it is omitted in this subsection%

G+G+ 3ive- Jear #ank '$ $"reads for $elected #anksefore, eCamining the de4elopment in the &DS spreads for selected banks, there will be a brief

description of a &DS, which intends to gi4e a better understanding of why it is applied as a credit

measure in the literature%

&redit default swaps82are insurance against credit risk, it is a contract that guarantee to co4er losses

on certain securities in the e4ent of a default% ( &DS is a bilateral agreement between two parties, a

82$ately, many institutions ha4e engaged in trading with credit risk, and one of the most widely used are credit default swaps, &DS, a type ofinsurance contracts% The notional amount of outstanding &DS has increased from N32,2 trillion in December 1558 to N81 trillion at year end 155, andthereby decreased to N3


47/111


buyer and a seller of credit protection% The seller compensates the buyer if the issuer fails to ser4ice

the debt holding =such as bonds, notes, loans and commercial papers?, which has been issued by a

third party, called the reference entity% .ne of the parties agreement purchases, for an agreed period,

protection against a credit e4ent i%e% the case when the reference entity default or failure to meet its

payment obligations% Ki4en that the reference entity defaults or fails to meet its payment obligation

the contract must be settled i%e% the buyer recei4es the difference between the 4alue of the asset and

its nominal 4alue% Most of the &DS has a maturity of fi4e years =omfim =1550?: 89?L Danmarks

-ationalbank =155W3?: 53>52?% The insurance premium of a &DS is called the credit default

swap premium or the &DS spread% The spread is @uoted in basis points per annum of the contracts

notational 4alue and is generally paid @uarterly =(delson =1552?: 3?%

In the literature, a range of authors ha4e agree on to identify the attribution of counterparty risk,

credit default swaps spreads are used to measure the default risk of the banks i%e% the probability that

banks may default on their debt ='ui =1559?: ?L IS =1559abc?: 2


48/111


Figure 2%


49/111


eCchange markets to be N3%1 trillion in 155, which is growth of 89 per cent since (pril 1552, and

therefore is also one of the most li@uid markets =IS =155n?: ?%

The foreign eCchange markets consist of four different markets88which function separately, yet are

4ery closely connected% 6et, most foreign eCchange trading8occurs in the deri4ati4es market% In

principle, the term describes a large number of financial instruments, as well as options and futures,

while in general practice, it refers to instruments such as forwards contracts, FX>swaps, F+(s, and

barrier options =$e4inson =1550?: 2>?% More than half of the increase in turno4er accounts for by

the growth in FX swaps, which increased


50/111



51/111


Figure 2%9$"read between 34 swa"-im"lied rates and 1ibor

(fter 9 (ugust for three currencies an upward trend was obser4ed, the spreads between the FXswap>implied dollar rates and dollar $ibor also increased, mo4ing from Guly le4els, i%e% close to 30

basis points in the euro, 10 basis points in sterling, and 0 basis points in the yen%

(necdotal e4idence suggest *uropean financial institutions that needed /S dollars, hence faced

keen concerns o4er their own credit risk in dollar cash markets, turned to the FX swap market to

raise dollars using both the euro and sterling as funding currencies =aba et al =155


52/111


li@uidity further deteriorated subHect to the fact that institutions intensified in@uest for counterparty

risk were concentrated on the dollar borrowing side of the market as well%

'ence, another eCplanation has been that the reported $ibor has been fewer representati4es of

actual interbank rates during distress instant, and the gap may ha4e been greater for dollar $ibor

than $ibor for other currencies% +egardless, the FX swap implied dollar rates appeared more

sensiti4e to the increased demand for dollar funding than reported dollar $ibor rates 8


53/111


end>Gan, there were eCpectations of renewal demand in swap market for dollar li@uidity later in

155


54/111


)/A*T+0 5: +M*I0I)A7 AA7?SIS & -IS)#SSI1

The last main part of the thesis has described the de4elopment financial turmoil in the

international interbank and the FX swap markets from 155 to 1559% The obHecti4e of this chapter isto analyse and discuss the empirical frameworks in the light of the applied theories and the

presented statistics in the pre4ious chapters% Identifying the underlying factors is @uite important, in

analysing the de4elopment of the main central banks inter4entions in these markets, and its

effecti4eness% Therefore, this chapter is to be percei4ed as a link to the following chapter, where the

central banks actions and effecti4eness are analysed%

!.1 %nternational %nterban( Mar(ets

The aim of this section is initially to analyse the factors that triggered the tensions obser4ed in

the international interbank market as seen in chapter 2 i%e% the $ibor>.IS spreads and &DS spreads%

Thereafter there will be a discussion of the underlying factors behind the widened spreads obser4ed

in the interbank markets%

5'' Factors tri!!ered the Tension in Interbank Markets

.ne of the main responsibilities of interbank markets is to reallocate li@uidity among banks that are

subHect to particular distress% If banks hoard li@uidity and as a result they are able to co4er the

particular distress from their own li@uidity holding, then their unwillingness to lend to other banks

is not an issue% 'ence, if, the li@uidity hoarding pre4ents the reshuffling of li@uidity to deficient,

but sol4ent banks, then the poorly functioning interbank market would be a issue warranting central

banks pro4ision =(llen and &arletti =155


55/111


increased spreads i%e% 25?L

&ecchetti =155


56/111


The amounts deposited with the *& were triggered by the collapse of Aashington Mutual, ten

days after the $ehman failure, 0 September 155


57/111


tender procedure with full part at the policy rate, *& was satisfying demand for li@uidity =*&

=155)+0 .ct?%

Meantime, as the figure 0%1 below also illustrate, banks began to bring funds to the *&, the

a4erage daily 4olume in the o4ernight unsecured interbank market =*onia? hal4ed and the net

amount of central bank li@uidity outstanding decreased rapidly% (t the start of the crisis in (ugust

155, the *onia increased in 4olume% The year prior to 9 (ugust 155, the a4erage daily 4olume

was recorded to 25%9 billion, which increased by 1 per cent to an a4erage of 01%1 billion

between 9 (ugust 155 and 18 September 155< ='eider et al =1559?: 12?%

The net amount of central bank li@uidity outstanding shown in the figure abo4e, is the total stock of

li@uidity pro4ided minus the amount absorbed in all open market operations and recourses to its

standing facilities%

Moreo4er, a similar trend the figures illustrate is that, although the *& pro4ided large amounts of

li@uidity during September 155-;ov 200>


58/111


e4idence about the reluctance of banks to borrow at high rates, in order to a4oid signaling that they

are poor banks%

In the literature, there is a great discussion of the underlying reasons for the tension in the

international interbank market% It is 4ery significant to diagnose the underlying reason for the

increased spreads as obser4ed in the market, &hapter 2, in order to determine type of necessary

policy response =Taylor =1559? : 5?, which is discussed in chapter 8% Therefore, this section aims to

eCamine the underlying reason behind the spreads obser4ed in the international interbank market in

the theoretical frame i%e% the role of credit and li@uidity risk%

5'$ )redit and 7i;uidit 0iskKenerally, 6there should be an arbitrage that allows a bank to borrow overnight, lend for three

months, and hedge the risk that the overnight rate will move in the federal funds futures market

leaving only a small residual level of credit and li%uidity risk that accounts for the small s"read

observed before the beginning of the crisis ? relevant %uestion is why banks were unable to do so=

=&ecchetti =155


59/111


li@uidity tools% +ather, it has been suggested that it has been an inherently a counterparty risk

matter, which is connected to the underlying cause of the financial crisis, as eCplain in chapter 3 i%e%

a fundamental problem in the financial sector relating to risk% Taylor =1559? further states that the

turmoil is not like the Kreat Depression where printing money or pro4iding li@uidity is the solution

=Taylor =1559?: 5?%

'owe4er, there is also a range of e4idence academic literature that apply the Diamond and Dyb4ig

=9


60/111


nationwide decline in housing prices, and the counterparty risk in4ol4ed in this phase of the o4erall

financial crisis, triggered the li@uidity crisis that emerged in summer 155 =runnermeier =1559?:

9


61/111


!.2 %nternational )* "+ap Mar(ets

This chapter aims to in4estigate the spill o4er effect of the financial crisis in the FX swap market

and thereby analyse the underlying dynamics behind the turmoil eCperienced in the international FX

swap markets% Thus, the first part of this section aims to analyse the underlying dynamics behind

the turmoil spill o4er from the interbank market to the FX swap market% The second part will

eCamine the underlying factors of the FX swaps spread i%e% the de4iation from &I) obser4ed in

chapter 2%

5$' Turmoil Spill over o" "rom the International Interbank Market to FX Swap Markets

Mel4in and Taylor =1559? characterie the entrance of the crisis in the FX as 6relatively late=% In

the early summer of 155, it was apparent that se4eral markets along the money markets were hit by

the crisis% (s FX market participants were watching other markets with growing ner4ousness,

wondering when, if and how the market turmoil would eCtend to eCchange rates, their fears became

true on 8 (ugust 155 as the crisis spilled o4er to the most li@uid financial markets, FX markets 1,

including the FX swap markets =Mel4in and Taylor =1559?: 1?L aba et al% =155


62/111


intense growth in the /S dollar assets of *uropean banks o4er the past decade that sharply outpaced

the growth in their retail deposits =McKuire and 4on )eter, =155


63/111


Figure 0%2 shows a reduction of the interbank lending, in particular by French, elgian and Kerman

banks accounted for much of the decline% French anks reported a decline to around N105 billion,

whereas Kerman banks a bit less than N105 billion% These two banks were also those with the

highest consolidated foreign claims compared to the elgian banks, which only reported around

N855 billion in the beginning of 155


64/111


basis points in September 155, which indicates a large de4iation from short term co4ered interest

parity =&I)? =aba =1559d?: 12?L ='ui et al =1559?: 3?% (lthough, the spread narrowed largely

immediately after 155< began, it resurged from early March%

aba =1559d? and aba and )acker =155


65/111


(nother study conducted by aba and )acker =1559b?, again related to the recent turmoil in the FX

swap market, find that the de4iation from &I) in the *uro FX swap market has been due to

reassessment of counterparty risk based on the data from (ugust 155 to September 155< =aba

and )acker =1559b?:


66/111


per annum% This implies that an arbitrage transaction must gi4e at least 5%< percent before

arbitragers, mainly -ew 6ork banks are willing to mo4e funds between the dollar and the pound

sterling or between the dollar and the &anadian dollar =ranson =989?: 532?% It is to be noticed

that "eynes =912? suggested it to be 5%05 percent, and *inig =98? suggested 5%58 percent

="eynes =912?: 39?L *inig =98?: 05?%

.ther studies such as Frenkel and $e4ich =90? measure de4iations from &I) for the /%S%>/%"%

eCchange rate, where they estimate the transactions costs for arbitrage to be 5%20E>>5%0E per

annum, which is slightly lower than the estimate by ranson =989? and *inig =98? =Frenkel and

$e4ich =90?: 318, 33?% alke and Aohar =99


67/111


order to make a persistent conclusion whether transaction costs play an important role in the

de4iation from the recent turmoil in the FX swap market, more studies needs to be conducted%

/2 ata im"erfections> Kerman and euro>deposit interest rates% Taylor =9


68/111


993? suggests that de4iations from &I) in the *uro>market are in general eliminated within two

days with this time decreasing as one mo4es from the 95s through the 9


69/111


)/A*T+0 6: AA7?SIS A- -IS)#SSI1 1F T/+ )+T0A7 BA9S

IT+0@+TI1S

6;either the recent massive money injections, the coordinated lowering of interest rates nor the use

of "ublic funds to reca"italiAe banks have done much to restart interbank lending This action did

not solve the underlying "roblem "reventing interbank lending< extreme information asymmetry=

=Financial Times =1559 -o4%?% The abo4e @uotation depicts the se4erity of the turmoil as a range

of measures ha4e not sol4ed the eCisting problems in the interbank markets% This section aims to

eCplore the maHor 4arious measurements taken into account by the greatest central banks, and

analyse the effect of the employed measurements in weathering the recent financial crisis%

#.1 ,$erall Central -an( MeasuresIS =155-o%3? stress that central banks responded to the strain in the international interbank

markets by adHusting their operations in a range of manners 0 to ease the li@uidity demand of the

banks =Danmarks -ationalank =155%W?L 3


70/111


mechanism, e%g% &ertain asset prices, yields and funding conditions o4er and abo4e the impact of

the policy rate% The latter element is @uite 4ital as funding conditions were worsening in the market%

In this situation, the li@uidity operations would play a more acti4e role and become an essential part

of the o4erall monetary policy stance% .perations in this range usually result in substantial changes

in the balance sheet of the central banks, in terms of sie, composition and risk profile% IS

=1559abc? referred to this time of acti4ities to balance sheet policy% *ach operation that has an

impact on the balance sheet, the effect will be demonstrated on the balance sheet of the central

banks%

The 4arious forms of balance sheet policycan be distinguished by the specific market that is

targeted% 6et, the balance sheet policy employed in this recent crisis has targeted term money

market rates and risk spreads% This is definite as illustrated in chapter 2 with high term rates, and

credit and li@uidity spreads% IS =1559abc? argue that in principle, the effects of balance sheet

policy may be con4eyed through two focal channels% The first is the signaling effect i%e% operations

performed by central banks or communication, influence public eCpectations about chief factors

that support the market 4aluation of the assets, which is assessed @uite powerful% These factors

comprise eCpectations regarding the future course of policy, inflation, relati4e shortage of different

assets or their risk and li@uidity profilesfree claims on the public sector, the resultingimpro4ement in the o4erall risk profile of bank balance sheets may augment both the willingness and the ability of banks to lend%

Side 2%af '''


71/111


#.2 ,$er$ie+ of Central -an( Measures

The central banks responses can be di4ided into three board types according to how the associated

operations are related to their near obHecti4es, figure 8%


72/111


3igure C+0 'entral #ank .es"onses to the 'risis

$ource< !$ &2009-79th)< 97K #!$ &200>-;o+)< C)

-otes: Fed Federal +eser4eL *& *uropean &entral ankL o* ank of *nglandL oG ank of GapanL o& ank of&anadaL +( +eser4e ank of (ustraliaL S- Swiss -ational ank% Z yesL blank space no%? Including front>loading of reser4es in maintenance period% 1? *Cpand range o4er which reser4es are remunerated% 3? $ower thediscount rate relati4e to the target federal funds rate% 2? )ay interest on eCcess reser4e balances =&omplementary Deposit Facility?% 0?+educe rate and eCpand term on discount facilityL allow participation of primary dealers =)rimary Dealer &redit Facility?% 8 IncludingfiCed rate full>allotment operations%

6$' Achievin! the 1""icial Stance o" Monetar *olic

The operational target for central banks is to ensure that the o4ernight money market interest ratereflects the official interest rate =Danmarks -ationalbank =155?: 19?% (t the onset of the crisis,

there was obser4ed a strong increase in demand for central bank li@uidity i%e% central bankreser4es,

hence as the crisis unfolded, commercial banks desired increased li@uidity beyond central bank s

was capable of =IMF =155


73/111


(fter an intermeeting statement on (ugust 155 that downside risks to growth had increased

substantially, the Federal .pen Market &ommittee =F.M&?3J2 percent at its meeting in < September 155 =Federal +eser4e System

=155mn?: ?% (s shown in figure 8%1, o4er the following se4en month i%e% from .ctober 155 to

(pril 155-o%3 =155


74/111


in 3 December 155, whereas the policy remained on hold in the December 155 and 3 March

155< meetings)+cc?: ?L S- =155)+cc, )+cd?: ?%

Ahen eCamining other economies, the financial market turmoil had a less affect in the outlook

sufficiently to affirm an easier monetary policy stance% (s shown in the figure 8%1, for instance, the

+( continued to increase its target cash rate se4eral times between (ugust 155 and early 155)+cc?: ?L +(

=155>)+cd?: ?L +( =155)+cc?: ?% (s well as +iksbank which continued on its pre4ious

policy path i%e% raising its repo rate in late 155, for instance, 35 .ctober 155, the board decided to

increase the repo rate by 5%10 percentage points to 2 per cent, and 1 February 155)+a, )+b?: ?%

'owe4er, as shown in figure 8%3, some central banks had substantially difficulties in maintaining

the o4ernight interest rates close to their targets, with the start of the turmoil% In the /S, 4ital

inHection of reser4es to resist firming of rates early in the day on occasion resulted in marked

softness in rates close to the business and on subse@uent days in the same maintenance period% In

contract, in (ugust 155, the o* did not eCpand reser4e supply, o4ernight rates became rather

ele4ated95

% =IS>-o%3 =155


75/111


$ource< #!$ &200>-;o+)< +2)-ote: ? In billions of local currency unitsL daily data for the *& and the ank of *ngland, weekly a4erages of daily amounts

outstanding for the Federal +eser4e% 1? In per cent% 3? For the Federal +eser4e, primary creditL for the *&, marginal lending facilityLfor the ank of *ngland, lending facility%

It is further stated that stigma is in part of legacy of the days when discount window credit was

pro4ided at a subsidies rate and in4ol4ed allowance and search% )ossibly, stigma may eCist due to

borrowing at a"enaltyrate sends an ad4erse signal about creditworthiness that increase reluctance

of banks to use the facility% (s the figure illustrates, in contract to the /S market, when eCamining

the euro area stigma appears to be less of an issue% During the turmoil, there were no reported

interbank trades at rates abo4e the marginal lending facility =M$F? rate, and it has been obser4ed

that the facility was used as fre@uently as in more tran@uil periods =&ecchetti =155


76/111


after the first month% -e4ertheless, the stability of 4ery short term rates remained 4ulnerable and

central banks had to apply a more acti4e attitude, in order to contain further occurrence of 4olatility,

which is further elaborated on in the sections below =IS>-o%3 =155


77/111


positi4e% anks needs to maintain a margin between deposit and lending rates to remain profitable

=IS =1559>9th?: 93?91%

;arrower corridor on overnight rate

In order to keep the short term rates to the policy target, the *&, o* and the Federal +eser4e

reduced the width of the effecti4e corridor on o4ernight rate by changing the rates applied on end

of>day standing facilities% For instance, 0 December 155(ug?: 2?%Simultaneously, central banks eCpanded

their capacity to reabsorb eCcess reser4es to neutralise the impact on o4ernight interest rates of the

much eCpanded operations% This has been implemented in a number of ways, reflected in the

composition of central bank liabilities in figure I;29, where an increase in the liabilities in

particular after 155


78/111


the crisis% (ccording to IS =155-o%3? this relies in the underlying reasons of term money

market tensions% (s tensions were caused by li@uidity issues, in principle this would be addressable

by central bank inter4entions, in order to impro4e the supply and distribution of li@uidity% 'ence, if

the underlying reasons were dri4en by counterparty credit risk concerns the central bank li@uidity

operations would ha4e been unable to weather the problem, which ha4e been the case, in the early

stages of the crisis at least%

6$$ In"luence 8holesale Interbank Market )onditions

These measures applied is @uite prominent during the initial stage of the crisis, as they focused on

reducing term interbank market spreads, which was fairly high as shown in chapter 2 % In order to

impro4e the continued pressure in term money markets, central banks took two main approaches i%e%

referred to as the indirect and direct methods%

C22+ !ndirect ?""roach

The indirect approach aimed to reassure financial institutions of the sufficient supply of o4ernight

funding% This approach aimed to increase the institutions willingness to eCtent term loans in the

market by increasing the confidence in the financial institutions ability to fund themsel4es reliably

in the o4ernight market% (long with the abo4e mentioned li@uidity management measures to keep

short term market rates stable around policy targets contributed to this effect% The mo4e by the Fed

to enhance the attracti4eness of its standing loan facility was also a step in this direction% The spread

between its lending rate =the discount rate? and the federal funds rate target was narrowed from 55

basis points to 05 basis points in mid> (ugust 155, and then to 10 basis points in mid>March 155


79/111


funds% The contribution of the *& and S- in supplying term /S dollar funding in coordination

with the new Term (uction Facility of the Fed was an inno4ati4e 4ariation on the same theme%

odification of iscount 8indow 3acility and Term ?uction 3acility &T?3)

In an effort to lower the unusual term lending spreads as shown in chapter 2, the Fed took a range of

actions9M+?: ?L &ecchetti =155


80/111


In 1 (pril 155@uality but temporarily illi@uid assets for /" treasury bills% The asset swap can be

undertaken at any point within a siC month drawdown period and ha4e terms of one year =renewable

to up to three years?% (s only legacy assets eCisted as of end 155 are eligible for the swap, the

scheme aimed to impro4e the li@uidity position of the banking system and not to finance new assets

=o* =155


81/111


)igure #.12 %ntrouction of TA) Auctions an ibor ,%" "preas

$ource< &Taylor and 8illiams &200>a)< 2C)-ote: Due to una4ailable data for the rest of the time period i%e% (pril 155< to March 1559, will not be presented%

The 4ertical lines in the figure, depicts the dates of the T(F auctions, along with the one>month and

three month maturities% Subse@uent to the first two auctions, the T(F rate has been between 2 and

8 basis points below the pre4ailing one>month $ibor rate% 6et, Au =155


82/111


Eligible collateral

(nother 4ery crucial de4elopment that 4arious central banks engaged in was to widened, either

temporarily or permanently, the range of eligible collateral and, in some situations counterparties so

as to pro4ide an effecti4e distribution of central bank funds% *%g% in (ugust 155, the o&

announced special operations that accepted temporarily as collateral all securities that were already

eligible for its standing li@uidity facility =S$F?% In December and early 155


83/111


Table #1 enable alue of "ecurities Plege by Depository %nstitutions by 'ating5 As of 26 7uly5 2886

Tpe o" Securities 7endable @alue guaranteed securities , and .ther securities 39

((( 150(aJ(( 28

(1 88

aaJ3 3

.ther in4estment grade2 52

Total 09$ource< &3ed &2009-.)< 9)-ote: $endable 4alue is 4alue after application of appropriate haircuts% ? Includes short>term securities =STSs? with (>P rating orMIK or S)>P municipal bond rating% 1?% Includes STSs with (> rating or S)> municipal bond rating% 3?% Includes STSs with (>1, )>1, (>3, or )>3 rating% 2?% Determined based on credit re4iew by +eser4e ank%

Fed =1559>M+? stress that the category of assets includes most performing loans and most

in4estment grade securities, including &MS, &D., &$., and certain non>dollar denominated

foreign securities, only ((( rated securities are accepted% 'ence, institutions may not pledge as

collateral any instruments they ha4e issued% (dditional collateral is re@uired for discount window

and T(F loans with remaining maturity of more than 1< days> for these types of loans, borrowing

solely up to 0 per cent of a4ailable collateral is permitted =Fed =1559>M+?: 9?%

IS>-o%3 =155


84/111


its history, responded in a coordinated manner to address the /S dollar shortage these financial

institutions were facing =aba 7 )acker =1559>-o%1 end concerns in the financial market by pro4iding li@uidity, the Federal

.pen Market &ommittee =F.M&?58 announced the establishment of temporary swap lines, or

reciprocal currency arrangements#, with the *&, the S-, the o* and the oG in 1 December

1555, which aims to pro4ide li@uidity in /S dollars to o4erseas markets =S- =1559?: 15?L

F+-6? =155


85/111

Turmoil in the International Interbank and FX Swap Markets: theories, parity condition,

Documents

Final_Thesis.doc