International Financial Markets and Instruments

1. International Financial Markets and Instruments An Introduction

2. Introduction In this chapter, we look at the size of international financial transactions and assets, the interaction of financial markets, and their effect on the forward exchange rate, the spot exchange rate and interest rates, and the types of instruments that can be used in international finance

3. International Bank Deposits and Lending International liabilities of banks stood at about $8 bil in 1994, almost twice the size of merchandise trade The breakdown of cross-border claims shows that the U.S. dollar is the denomination of choice, followed by the mark, and the yen. (In 1999 the $ is used for almost 47 % of all international debt securities)

4. Denomination of Claims Claims can be in the domestic currency of the claimant (33.7 %) are of this type (see Table 2) Or Claims can be in a foreign currency (i.e. a German company can have a U.S. $ deposit in a British bank) - the majority are of this type

5. Gross and Net International Bank lending Gross lending includes all loans made by banks to foreigners, loans made by banks to domestic residents in foreign currency Net lending excludes interbank deposits (i.e. if a German bank lends $2 mil to a U.S. bank and a U.S. bank lends $3 mil to the German bank, then the net lending is only $1 mil.

6. Gross and Net International Bank Lending

7. BIS BIS is the Bank for International Settlements Located in Geneva, Switzerland acts as clearinghouse for central bank settlements sponsors conferences of central bankers on international monetary cooperation Member countries: Group of ten: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, UK,and U.S also, Austria, the Bahamas, Bahrain, the Cayman Islands, Denmark, Finland, Hong Kong, Ireland, Luxembourg, Netherlands Antilles, Norway, Singapore, and Spain, plus the branches of U.S. banks in Panama

8. Breakdown of Gross Lending by type 1. Domestic bank loans in domestic currency to nonresidents bank in Canada lends C$ to U.S. firm 2. Domestic bank loans in foreign currency to nonresidents bank in France lends US$ to U.S. firm (or marks) 3. Domestic bank loans in foreign currency to domestic residents bank in France lends C$ to a French citizen The first of these types is called traditional foreign bank lending

9. Eurocurrency market 2. and 3. above are examples of transactions in currencies other than the domestic currency of the bank in question Used to be called Eurodollar market because most transactions were in dollars and took place in Europe started post WWII when the $ was free to move and most European countries had currency controls now Eurocurrency doesn�t capture market because transactions take place all over the world

10. How do Eurocurrency transactions arise? say a US exporter sells a good in Britain, is paid in $ and chooses to leave the money in London, this is a Eurocurrency deposit the London bank�s deposit is matched by a claim by the London bank on a US bank (double entry bookkeeping) the London bank can lend out the $, based on its fractional reserve system. For example, a $1 million deposit with 10% reserve can lead to total lending of $10 million ($900 X $810 X�) Eurocurrency market

11. More history during cold war, Russia shifted $ deposits out of U.S. into Europe Britain had foreign exchange controls to deal with fixed exchange rate U.S. had big official reserve transaction deficits (therefore $ were available in Europe) U.S. had ceiling on interest payable on deposits (regulation Q), and so, money flowed to Europe where there were no ceiling on U.S. dollar deposit interest rates Eurocurrency market

12. Demand side tight US money supply in late 60s led borrowers to seek investment money in Europe US introduced a tax on borrowing by foreigners result: US banks demanded money overseas since lending interest was lower and deposit interest was higher Supply side oil shock caused OPEC countries to acquire a lot of dollars, much of which was deposited in British and European banks Eurocurrency market

13. Eurocurrency market Some terms Eurobanks Banks making loans on the Eurocurrency market, they are not necessarily in Europe (for example, the Banks of Singapore) LIBOR London Interbank Offered Rate This is the average of the interbank rates for dollar deposits in London, based on quotes of five major banks (issued at 11 a.m.) rate at which Eurobanks lend among thems

14. Implications international capital mobility has increased significantly, improved allocation of international financial capital interest rates are not equalized across markets, but they are closely related because Eurocurrency will flow to its best earning potential, this market has pushed interest rates closer together, enhancing international financial integration Eurocurrency market has also decreased financial stability (due to �bandwagon effect) central banks do not have as much control over policy as in the past. Eurocurrency market

15. International bond market Promises to pay, issued by governments and corporations To be precise, a note is an issue with less than 10 year maturity, a bond has more than 10 year maturity Often, bond used for both short and long term notes.

16. Maturity: Date at which bond issuer must pay the bearer the amount promised Face value: Value of the bond at the date of maturity (the amount the issuer promises to pay the holder of the bond) Coupon payment amount promised in each year of the life of the bond For example $60 per year on a $1,000 bond International bond market: Some terms

17. Coupon rate: Coupon payment divided by face value of the bond Bond underwriter: Banks or other financial institutions that conduct the sale of the bonds (for a fee) for the issuing entity Loan syndicate: Group of banks that join together to market the bonds International bond market

18. 2 Types 1. Foreign bond market A borrower in one country issues bonds in the market of another country through a syndicate in the host country, denoted in the currency of the host country 2. Eurobond market A borrower in one country issues bonds in the market of many countries, with the help of a multinational loan syndicate to residents of many countries. The bonds may be denominated in a number of currencies. International bond market

19. Note table p. 79 Most international bonds are type 1. Foreign bonds Most issuers are in developed countries (75%) The most popular currency is the U.S. $ Commercial banks and finanacial institutions issue the most bonds, followed by governments, then corporations Note: Eurobond market started along with Eurodollar market Note: (Table 5) eal bond yields for developed countries range from 1.9 % (Switzerland) to 7.0 Italy, with 8 of 13 countries within 1 % of mean International bond market

20. International Stock markets a stock (or equity) is a share of a publicly traded company. A stock bestows a measure of ownership on the holder, its earning are uncertain Stock earning include Dividends : payments to stockholders based on a firm�s recent profits Appreciation in the value of the stock: if the stock is worth more when sold than when purchased, the holder earns a profit More Stocks are traded internationally, as investors seek international portfolio diversification to reduce risk

21. Stock market terms P/E ratio Price/earning ratio The P/E is a company's price-per-share divided by its earnings-per-share. If IBM is trading at $60 a share, for instance, and earnings came in at $3 a share, its P/E would be 20 (60/3). That means investors are paying $20 for every $1 of the company's earnings. If the P/E slips to 18 they're only willing to pay $18 for that same $1 profit. (This number is also known as a stock's "multiple," as in IBM is trading at a multiple of 20 times earnings.)

22. More Terms For definitions of stock market terms http://biz.yahoo.com/edu/ed_stock.html Price/Earnings Ratio - SmartMoney.com Price/Earnings Growth Ratio - SmartMoney.com Price/Sales Ratio - SmartMoney.com Price/Cash Flow Ratio - SmartMoney.com Price/Book Value Ratio - SmartMoney.com Short Interest - SmartMoney.com Beta - SmartMoney.com Margins - SmartMoney.com Inventories - SmartMoney.com Current Assets/Liabilities - SmartMoney.com Efficiency Ratios - SmartMoney.com Dividend/Yield - SmartMoney.com

23. Mutual Funds At least 4 kinds of internationally focussed funds 1. Global funds (U.S. and other countries) 2. International funds (no home country assets, only international) 3. Emerging market funds (specialize in emerging economies: Argentina, Malaysia, Chile, China) 4. Regional Funds: pick a region: Asia, Latin America, Europe 5. Green, or Responsible? Funds: Only invest in companies with clean environmental and fair labour practices

25. Financial Linkages and Eurocurrency Derivatives BE AFRAID

26. Recall link between interest rates shows that investments will be in equilibrium if Investment decisions involve two types of risk 1. exchange rate risk 2. interest rate risk Financial Linkages and Eurocurrency Derivatives

27. We can eliminate exchange rate risk by using the forward market Where TR are transaction costs and, if the exchange market is in equilibrium, then p=xa Financial Linkages and Eurocurrency Derivatives

28. If we include the Eurocurrency market in our analysis, we now have six markets and six financial variables (prices). The variables are: Interest rates: U.S. interest rate U.K. interest rate Eurodollar interest rate (foreign-held dollar funds) Eurosterling interest rate (foreign-held British pounds) Exchange rates: Spot rate (dollars/pound) Forward exchange rate (dollars/pound) Financial Linkages and Eurocurrency Derivatives

30. Financial Markets Including Eurocurrency markets

31. Tools for Hedging (vs. interest rate changes) by Financial Institutions 1. Maturity mismatching: simplest acquire two or more financial contracts whose maturities overlap Example: Fund manager knows she will receive $100,000 in 3 months and needs to hold funds for dollar payment of a financial obligation in six months Manager wants current deposit rate for 3 months when money is received She can borrow $100,000 for 3 months and invests $100,000 for six months starting now.

32. 2. Future Rate Agreement contract between two parties to lock in a given interest rate starting at some given point in the future for a given time period sometimes called forward-forward (or forward rate contract) How it works: two parties agree on a particular lending or borrowing rate at some future date for a specific amount and loan period. At the time of borrowing, the borrower gets the loan in the market, and the rate guarantor compensates the borrower (or receives compensation) for any deviation between the agreed upon rate and the market rate

33. Example: Prof. Brown wants to borrow $50,000 in three months for a period of one year. Mr. Green agrees to guarantee a loan rate of 7.0 %. in three months Prof. Brown borrows the money in the market. If the market rate is 6.8% then Prof. Brown pays Mr. Green 0.3 % (also called 3 basis points) of $50,000 for one year. Note: The forward-forward involves the exchange of a floating interest rate for a fixed interest rate the rate that is often used as the floating rate is based on LIBOR

34. 3. Eurodollar interest rate swap involves more than one period, can involve a fixed rate and a floating rate, or two different floating rates (i.e. LIBOR, and some average of country interest rates) an exchange of one floating rate for another is called floating-floating or basis swap Example: Mr. Brown has a Eurodollar loan on which he pays LIBOR + 3 basis points Ms Green has a loan at 6.5 %. Ms Green agrees to pay Mr. Brown the 6-month LIBOR +3, Mr. Brown agrees to pay Ms Green 7.0 % (6.5 % + 50 basis points). Mr. Brown gets a fixed rate, Ms. Green gets a lower rate loan (because she gets 50 basis points)

35. 4. Eurodollar cross-currency interest rate swap permits the holder of a floating interest rate investment or debt denominated in one currency to change it into a fixed-rate interest rate investment or debt in another currency. It also permits the switching from a fixed to flexible interest rate. Combination of interest rate swap and currency hedge Example: Mr. Brown has a loan in � worth $50,000. at LIBOR+3. Ms. Green has a loan in $, at 7 %. Mr. Brown and Ms. Green can swap loans (with Mr. Brown paying a premium to ensure his interest rate). This might occur if Ms. Green has income expected in �, or Mr. Brown expected the $ to depreciate.

36. 5. Eurodollar interest rate futures similar to currency futures, these lock in interest rates at fixed future dates, based on future rate listed on contract date. sold in units of $1 million through CME gains and losses on future rate contract are settled daily holders of contracts must maintain a margin account for every 1 basis point decline (increase) in the current interest rate compared with the settlement (fixed) rate, $25 is added to (subtracted from) the holder�s margin account for each forward interest contract. you don�t ever have to borrow or lend the money to make profit off a future contract, you only need to bet in the right direction

37. 5. Eurodollar interest rate futures (continued) LONG HEDGE: If an investor is expecting to obtain money (say $1,000,000) to invest at a future date, and expects interest rates to decline, she can buy a futures interest rate contract at a fixed rate for delivery when her money is due to arrive. If the rate falls, she will settle the margin account, take her earnings from that margin account, along with her money and invest both at the new lower interest rate. Because she is investing both the margin earnings and the $1,000,000, she earns the same as if she had received the higher rate of interest

38. Long hedge if interest rates rise, she pays her margin account, and then invests the $1,000,000 less the margin and invests at the new higher interest rate, thereby again guaranteeing herself (in this case at most) the future interest rate. Short hedge borrowers can guarantee against rise in interest rates by selling a futures contract for the period in the future during which they are going to be in need of funds if the interest rate rises, the seller receives funds from the margin account if the interest rate falls, the seller pays into the margin account, and then can borrow at the lower market interest rate at maturity

39. Eurodollar strip To hedge for longer than three months, an investor can do so by buying a series of futures contracts For example: for one year starting in September, the iinvestor can buy a Dec. futures contract, a March futures contract, a June futures contrac and a September futures contract. As Dec. matured, he would roll it into the March contract, and keep doing this. Stack futures contracts can hedge for as long as 7 years, investors can also buy 3-month contracts and roll them into 1-year contracts, this mixture is called a stack.

40. 6. Eurodollar Interest rate option Call option: obtains the right to purchase a Eurodollar time deposit bearing a certain interest rate on a specific date the buyer will pay an up-front option premium if the market interest rate is above the option rate, the buyer will not exercise the option Put option: obtains the right to sell a Eurodollar time deposit (acquire, or borrow Eurodollars0 bearing a certain interest rate on a specific date the buyer will pay an up-front option premium A call option effectively puts a floor on the interest rate

41. Caps, floors and collars options, like futures contracts can be traded in the same financial centers in standardized three-month contracts in $ 1 million-face-value units, with expiration dates in March, June Sept. and Dec. Options contract can be constructed for longer periods of time in the same way futures contracts were, using strips and stacks A multi-period hedge that guarantees that an interest rate will not rise above a certain rate is called a cap A multi-period hedge that guarantees that an interest rate will not fall below a certain rate is called a floor A multi-period hedge that guarantees that an interest rate will not move too far from a certain rate is called a collar

42. 7. Options on swaps gives the buyer the right to enter a future swap (swaption) or to cancel a future swap purchasing a call option gives the buyer the right to receive a fixed rate in a swap and pay a floating rate purchasing a put option gives the buyer the right to pay a fixed rate in the swap and receive a floating rate. buying a call option to cancel a swap, a callable swap - gives the side paying the fixed and receiving a floating rate the right to cancel buying a put option to cancel a swap, a putable swap - gives the side paying the floating rate and receiving a fixed rate the right to cancel

43. 8. Equity financial derivatives equity swap an investor can swap the returns on a currently owned equity with another investor for a price. this allows the international investor to earn returns from an investment in a country without actually owning the equity, and therefore without paying local execution fees it also protects the identity of the investor.

44. How to read the tables Start with Interest rate futures p. 97 Then options, p. 100

46. Strike price quoted as 100 � yield, each basis point is worth $25 To deposit $ 5 mil. In May at 5.5 % would cost 0.18 % or $25 X 18 X 5=2250

48. Using above table: 1. How much would it cost to if you wanted to guarantee a borrowing rate of 5.25 % in March for $8 mil. ? 2. If the interest rate in March were 5.5 %, how much would you have gained or lost from having bought the option? 3. Cost to guarantee a deposit rate of 5.75 % in Mar. for $ 3 mil?

49. Assignment 2 Look for it on the web or in your email by Monday! Due date changed to Feb. 20, due to reading week.