International Financial Markets Prof. Ian GIDDY Stern School of Business New York University

InternationalFinancial Markets

Prof. Ian GIDDYStern School of Business

New York University

Copyright ©2003 Ian H. Giddy International Financial Markets 2

What are the Global Financial Markets?

The Foreign Exchange Market

Eurocurrency Markets and Lending International Bond Markets International Equity Markets Using the Global Capital Markets:

Investors’ and Issuers’ Perspectives


The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

Separation of currency, institution and jurisdiction

Why do people want Eurocurrency deposits and loans?

Why is LIBOR the world’s key benchmark rate?


The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

Separation of currency, institution and jurisdiction

Why do people want Eurocurrency deposits and loans?

Why is LIBOR the world’s key benchmark rate?


US Domestic German

Market EUR0CURRENCY MARKET Domestic Market

Euro-Euro

Eurodollar Market

Market

Japanese

Euro-Yen Domestic

Market Market

Eurocurrency Market Linkages


The International Money Markets

Source: ft.com


Interest Rate Linkages in the International Money Market

Two stories to tell: Domestic vs. Euro Eurocurrency A vs. Eurocurrency B

Domestic Market A The Euromarkets Domestic Market B

Trea- Bank Euro Euro Bank Trea-

sury Deposit Deposit Deposit Deposit sury

Bill Market Market Bill

Trea- Corp- Euro Euro Corp- Trea-

sury orate Bond Bond orate sury

Bond Bond Market Market Bond Bond


Domestic versus Euro

The Eurodollar Premium

Market price of risk

versus

Cost of regulation

Eurodollar vs. U.S. Interest Rate

Effective cost of domestic deposit

= (interest rate + FDIC fees)

(1 - reserve requirement)

Capital controls and divided credit markets


Foreign Exchange

Mechanics and calculations How banks make money How banks hedge Tasks of the corporate FX manager


Foreign Exchange Quotations

Spot Forward points


Exchange Rates

CurrencyHowquoted

Spot(2 businessdays)

Forward(90 days)

Britishpounds(GBP)

US$perGBP

1.5645 1.5634

Japaneseyen (JPY)

Yen perUS$

111.35 109.85



Bid Offer

Spot

Forward points

Rule:

add if bid<offer,

subtract if bid>offer

Outright forward



Bid OfferSpotForward pointsRule:add if bid<offer,subtract if bid>offerOutright forward

1.5645 1.565511 10.5

1.5634 1.5644.5


Exchange Rates

CurrencyHowquoted

Spot(2 businessdays)

Forward(90 days)

Britishpounds(GBP)

US$perGBP

1.5645 1.5634

Japaneseyen (JPY)

Yen perUS$

111.35 109.85


A Typical Forward Contract

We agree today to pay a certain price for a currency in the future

SonySony B of AB of A

JPY


How Does the Bank Hedge a Forward Contract?

Hedging approaches:OpenForwardSpot plus swapRolloverMoney market


How Banks Hedge

SHORT LONG

Today

T+2

T+90

Methods:

- Spot + swap

- Spot + rollover swap

- Money market

- Outright forward


Currency Risk Exposure(The Normal Distribution)

Probability

Return onlarge companystocks

68%

95%

> 99%

– 3 – 48.2%

– 2 – 27.9%

– 1 – 7.6%

012.7%

+ 1 33.0%

+ 2 53.3%

+ 3 73.6%


Covered Interest Arbitrage

Moneymarket 1

Moneymarket 2

Spot Forward


Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing

Money

FUNDING EUROCURRENCY Market

Dealing

Diagram of a Dealing Room

The Dealing Room


Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing

Money

FUNDING EUROCURRENCY Market

Dealing

Diagram of a Dealing Room


Funding a Eurokrona Loan

Three ways to fund:Take domestic krona

depositTake EuroKrona deposit

3 MONKR

DEP

3 MONKR

DEP


Funding a Eurokrona Loan

Three ways to fund:Take domestic krona

depositTake EuroKrona depositFund with dollars, hedged

into kronaTake E$ depositDo FX swap: sell USD spot,

buy USD forward

3 MOE$

DEP

FX

SWAP

3 MOE$

DEP

FX

SWAP


Linkages Between Eurocurrency Rates

Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity

Uncovered interest

rate parity



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity

Unbiased

forward rate

Uncovered interest

rate parity


Interest-Rate Parity

$1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt

where St is the spot exchange rate (dollars per British

Pound) and Fnt is the forward rate.

to a close approximation,

(/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100

Interest-rate differential = forward

premium or

discount


Example: Anglo’s Funding

Anglo-American, the natural resources conglomerate, is seeking 3-month US$ funding.Anglo can fund in the US CP market at

5.5%Or in the Eurosterling market at 6.7%The BP is:

spot $1.5484, 3-mo forward $1.5454 Which is cheaper?


Anglo’s Answer

It’s cheaper for Anglo-American to borrow in the US CP market. Reason:US: simply borrow for 3 months

Cost: $1(1+5.5%/4) = 1.01375

UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the pounds

Cost: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478


Case Study: Ecobank's cross-currency loan funding

Assignment:

You have been asked to fund a 3-month USD3 million loan made by your bank's Paris branch.

Assuming the bank can borrow at market rates in any of the major money markets, which is the most cost-effective funding source?


Ecobank

Data Bid Ask/OfferGBP deposits 3.5 3.59375EUR deposits 2.46875 2.53125Spot GBP/EUR 1.4266 1.4282Forward points 0.0042 0.00322Outright forward 1.42243 1.42487

ResultCost of GBP deposit: 3.5938%Cost of EUR deposit hedged: 4.1641%

Source: ecobank.xls


Ecobank

Cost of GBP: 3 19/32 = 3.5938% Cost of EUR, hedged into GBP:

[1.4282(1+2 17/32/400)/1.4224-1]4

= 4.1641



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity

Unbiased

forward rate

Uncovered interest

rate parity


TIME

EXCHANGE RATE Spot

Forward

Actual

Today In three

months

Unbiased Forward Rate Theory


TIME

EXCHANGE RATE Spot

Forward

Actual

Probabilitydistributionof actualexchange rate

Today In three

months

Unbiased Forward Rate Theory


Unbiased Forward Rate

Forward premium or discount

= Expected annual rate of change

of the exchange rate

That is,

P$/DM = E(R$/DM )



Interest rate

differential

Interest rate

differential

Forward

premium

Forward

premium

Expected

% change in

exchange rate

Expected

% change in

exchange rate

Covered interest

rate parity

Unbiased

forward rate

Uncovered interest

rate parity


TIME

EXCHANGE RATE

Spot

Forward

Actual

Probabilitydistributionof actualexchange rate

Today In threemonths

International Fisher Effect

INTEREST

RATE

DIFFERENTIAL


International Fisher Effect

/E$ = /EDM + E(R$/DM )

That is,

Interest-rate differential

equals

Expected annual rate of change of

exchange rate


Cost of Hedging

Type of Hedge Cost of HedgingForward Forward premium

Money Market Hedge(Borrow to matchassets)

Interest ratedifferential

Do nothing Expected rate ofchange ofexchange rate


Corporate Hedging Decisions:Ivoire Rubber

Exporting rubber to Mexico, get paid in Mexican pesos. Funding is in U.S. dollars.


Corporate Hedging Decisions:Ivoire Rubber

Continue funding in U.S. dollars. The peso might get stronger in the next three months, from $1=128 pesos to $1=126 pesos. This could be the cheapest

Switch funding to pesos, despite the slightly higher cost

Borrow in dollars, but hedge the exchange risk in the forward market.


Ivoire Rubber

US dollar 3-month loan rate

5 9/16%

Peso 3-month loan rate

7 15/16%

Spot exchange rate today

MP128.210 per USD

Forward exchange rate today

MP129.005 per USD

Forward discount, % per annum

-2.5


Ivoire Rubber

Type of Hedge Cost of HedgingForward 2.5%


2.375%

Do nothing 2/128 x 4= 6.25% gain(or 2.5% loss?)


Cost of Hedging

Type of Hedge Cost of HedgingForward Forward premium


Interest ratedifferential

Do nothing Expected rate ofchange ofexchange rate

Concepcion


Connexion loan

Tuesday: Bank and Bond Financing

Don Pedro Hydro

Westpac Eurobonds


Cap des Biches:Choices for the BCEAO

Foreign-exchange intervention Money-market intervention (consider

interaction with monetary policy) Fiscal policy--the demand side Tariffs and subsidies Exchange controls and capital controls

(and jawboning)


Cap des Biches:Choices for GTI-Dakar

“We must decide whether it’s worth covering our dollar exposure, given the forward premium and relative interest rates.”


Cap des Biches:Choices for GTI-Dakar

“We must decide whether it’s worth covering our dollar exposure, given the forward premium and relative interest rates.”

What is the probability of a devaluation? How much? What should GTI-Dakar do?


Cap des Biches:Choices for GTI-Dakar Renegotiate the $30 million loan, replacing it with a loan

denominated in Euros Keep the USD loan in place, but enter into a 6-year

currency swap to effectively convert GTI's payments into Euros.

Hedge the dollar-Euro risk by buying dollars forward, with rolling 3-month forward contracts

Hedge against a possible devaluation of the CFA franc, by selling francs in the 3-month forward market.

Leave the dollar loan unhedged, and pass the cost of any foreign exchange losses on to Senelac, the buyer of GTI's power

Do nothing now but watch the situation carefully and hedge if the risk becomes too great.


Documents

International Financial Markets Prof. Ian GIDDY Stern School of Business New York University