ECON 671 – International Finance

1. ECON 671 – International Finance

2. International Financial Markets and Institutions

3. International Financial Markets • Capital Markets: financial claims with maturities greater than 1 year. • often called long-term financial claims • Money Markets: financial claims with maturities less than 1 year. • often called short-term financial claims, or “near-monies”. • i.e. can buy/sell quickly with low transaction costs • Money markets are used by large firms to invest or borrow s-t flows

4. Onshore Banking • Onshore banking system for a country consists of all banking activities conducted in the domestic currency. • Commercial Banking involves the taking of deposits and the making of loans. • talk about rise of non-bank banks in U.S. • Investment Banking acts on behalf of firms that wish to borrow, but generally do not extend these loans. • act as underwriter on new security issues • buy from issuer, sell to dealers and investors. • scale often leads to syndicates to spread risk, spread contacts • profit from difference between buy and sell prices • often maintain secondary market • act as agent on new issues

5. International Banks in U.S. • Commercial Bank - chartered in U.S., foreign owners, same reg’ns as domestic banks. • Subsidiary Bank - separate entity, same reg’ns as domestic banks, funded by parent. • Agency of Foreign Bank - only limited banking, no deposits, trade finance and money market services, funded with borrowings from parent. • Branch of Foreign Bank - full banking powers, can accept deposits, funded by parent. • International Banking Facility (IBF) - not separate entity, set of books at parent, can accept deposits, extend credit to foreign residents, not subject to U.S. res. reqs. or interest rate ceilings.

6. Intro to Offshore Banking • Offshore Banking system composed of deposits, loans, and other instruments denominated in a currency, but issued outside the country where that currency is the legal tender. More commonly known by affixing the Euro- prefix to a quantity. • Eurodollar Deposits are U.S. dollar deposits held outside the U.S. in places like London, Paris, or the Cayman Islands. • Eurodollar Loans are U.S. dollar loans made outside the U.S. in places like London, Paris, or the Cayman Islands. Provide an alternative to the U.S. domestic market for raising U.S. dollar funds.

7. Offshore Banking • Euro-Currency Deposits are deposits denominated in a currency that is different from the currency of the financial center in which it is held. The term offshore deposit is more precise. • composed of time deposits with maturities from one week or less, to upwards of three years. • majority of deposits are less than six months, so int’l money market. • normally not counted as part of the narrow domestic money supply, as time deposits are known as near-monies, only counted in broad def’ns. • similar to domestic CD’s except for fact that are traded abroad. • Euro-Currency Loans are loans denominated in a currency that is different from the currency of the financial center in which it is held. • Term offshore loan more precise. Composed of lending with maturities on average less than six months.

8. Offshore Financial Markets • Customers in offshore banking markets are large organizations such as multinational companies, governments, and international organizations. • Multinationals move around large liquid pools of funds looking for highest rates of return in Euro-deposit markets. • Multinationals also obtain loans with minimum disclosure & regulations at competitive rates using Euro-loans. • competitive returns attract funds of government, particularly central bank holdings of foreign exchange reserves. • developing countries especially made use of Euro-loans in late 1970’s and early 1980’s.

9. International Interbank Market • substantial amount of activity in Euro markets involves Interbank market. • Eurobank holding excess funds, and with no customers available, can lend its excess reserves to other Eurobanks, without reserves, but with clients for loans. • interest rate charged by Eurobanks lending in the interbank market is referred to as the interbank offered rates. • most widely publicized is the LIBOR, London interbank offered rate. More recently EURIBOR from Frankfurt. • average of interbank offered rates used to set customer lending rates. • interbank market operates just like the federal funds market in the U.S. • it allows Eurobanks to achieve more efficient use of existing funds by allowing them to shift immediately to where needed.

10. Rationale for Euro-Markets • Most important feature is offshore currency markets are outside the regulation and intervention of national governments. • initially popular in the mid-1960’s as a way around national banking restrictions for U.S. banks, and exchange rate controls for many other countries. • no reserve restrictions on Euro-deposits for U.S. banks. Provides way for banks to borrow without bearing as high a cost of foregone interest on reserves. • changing perceptions of political risk involved in offshore markets have added to their attraction in recent years. • small possibility of sever intervention by national governments, blocking access to funds in offshore market, hence Euro-market rates generally higher than domestic rates. • offshore markets served as market for multinationals and pools of capital to seeking to diversify & avoid regulation.

11. Eurodollar Deposits and Monetary Expansion

12. Euro$ Deposits • Investigate the link between the onshore and offshore banking markets more concretely. • Link between domestic $ deposits and Euro$ deposits established by relation between correspondent bank & the Eurobank. • Correspondent bank is a bank whose domestic currency is the same as the Eurocurrency being used. • In this case a U.S. bank issuing US$ deposits and loans. • Correspondent bank is repository for the domestic currency that backs the Eurobank’s transactions in the Eurocurrency.

13. Expansion of Euro$ Deposits • Example: U.S. Multinational decides to move dollars deposited at a U.S. bank into a Eurodollar deposit at EuroBank. • Presumably higher interest rates offered in the Euromarket. • Assume that the U.S. Bank is also the U.S. Correspondent Bank of EuroBank. • Next slide traces out the transaction through the T-Accounts of the three parties. • Note that Total World Supply of US dollars equals US$ deposits at US Bank plus Euro$ deposits at EuroBank.

14. Reserves at US Bank +$1 Deposits of US MN +$1 Deposits of US MN -$1 Deposits of EURO-BANK +$1 Deposits at US Bank -$1 Deposits at EURO-BANK +$1 Effects of Initial Transaction U.S. Correspondent Bank EURO-BANK Assets Liabilities Assets Liabilities U.S. Multi-Nat’l Assets Liabilities

15. Results for Euro$ Deposits 1. U.S. onshore deposits did not change, so domestic U.S. money supply not affected by U.S. Multi-Nat’l move to Euro-market. 2. Amount of deposits held by U.S. Multi-Nat’l did not change, but deposit now held at EuroBank as a Euro-$ deposit. 3. EuroBank holds US$ reserves with Correspondent bank in the U.S. No US$ physically leave the country as a result of the transaction. • Amount of US$ outside US, as add’l $1 of offshore dollars in the Euro$ deposit at EuroBank. • Net Effect on world supply of US$ is zero as U.S. Multi-Nat’l deposit offset by Reserve holding of EuroBank.

16. Expansion of Euro$ Deposits • Assume EuroBank keeps only 3% of US $ deposit as reserves and • lends out the rest ($0.97) to Japan Multi-Nat’l to finance purchase of asset from German Multi-Nat’l. • Assume German Multi-Nat’l deposits 20% of proceeds in EuroBank ($0.194) and rest into US Bank ($0.776). • EuroBank’s Euro$ deposits have increased to $1.194. • EuroBank holds US$ reserves with U.S. correspondent bank. No US$ physically leave the country as a result of the transaction.

17. Reserves at US Bank +$1 -$.97 +$.194 +$.224 EURO-BANK Deposits +$1 -$.97 +$.194 +$.224 Loan to Japan MN +$.97 Deposit of German MN +$.194 Deposits of German MN +$.776 Asset Sale to Japan MN -$.97 Purchase Asset +$.97 Loan from EURO-BANK +$.97 Deposits at EURO-BANK +$.194 Deposits at U.S. Bank +$.776 Secondary Transaction EURO-BANK U.S. Bank Assets Liabilities Assets Liabilities Deposits of US MN -$1 Deposits of US MN +$1 German Multi-Nat’l Assets Liabilities Japan Multi-Nat’l Assets Liabilities

18. Euro-Dollar Multiplier • Define world supply of US$ in hands of non-bank public, both onshore and offshore banking systems: MS = MUS + ED - RE • MUS = U.S. supply of dollars • ED = Eurodollar deposits • RE = Eurobank Reserves held as deposits at U.S. banks • Subtract RE to avoid double-counting as in MUS • remember Eurobank reserves are US deposits!!! • Assumption 1. Banks voluntarily hold some level of reserves against their Eurodollar deposits. RE = re x ED • where re = Eurobanks’ reserve/deposit ratio = 0.03

19. Euro-Dollar Multiplier • Assumption 2. Individuals do not keep all deposits in Euromarket. Allocate them among offshore and onshore banking systems. ED =  +  x MS •  is the preference for Eurodollar deposits on the part of the non-bank public. •  = .20 represents fraction of each additional $ available to public that is deposited in the Eurodollar market. • Combine these two behavioral assumptions, with definition of world supply of money to find how the U.S. domestic money supply influences the Eurodollar market.

20. Euro-Dollar Multipliers MS = MUS + ED - RE MS = MUS + (1 - re)ED MS = MUS + (1 - re)[ +  MS] • solving for the overall world supply of dollars yields: • Effect of U.S. Domestic Monetary Policy: • Effect of Change in Preference for Euro$:

21. International Equity Markets

22. International Stock Markets • Developed countries have their own stock market(s) • U.S., Japan, U.K. stock markets the three largest. • Emerging economies stock markets grew rapidly in 1990’s • National stock markets are primarily local markets but increasing international linkages. • Multiple listing by firms: Depository receipts, costly, cosmetic. • International mutual funds or closed end country funds. • Each market identified with an Index • Japan: Tokyo Stock Exchange uses Tokyo Stock Price Index (TOPIX) or Nikkei 225. • U.K.: London Stock Exchange uses Fin. Times Industrial Ordinary Index (FT 30) or FTSE 100 • Germany: Frankfurt Stock Exchange uses DAX (30 stocks) • France: Paris Bourse uses CAC 40 Index. • International Index: Morgan Stanley Capital Int’l Europe, Australia, Far East Index (MSCI-EAFE Index) 2,000 firms in 21 nations.

23. Global Diversification • Benefits to International Diversification • Including securities from other nations reduces a portfolio’s risk without affecting its return. • International markets are les than perfectly correlated. • Largest influence on prices are domestic events and policies. • Geography and politics influence degree of correlation. • Obstacles to International Investment • Information barriers: language, accounting standards. • Political & Capital Controls • Foreign Exchange Rate Risk • Restrictions on Investment and Control • Taxation: Withholding tax versus tax treaties. • Higher Costs: Lack of competition, infrastructure.

24. Diversification – Risk vs. Return

25. Global Diversification – U.S. vs Global Stockmarkets

26. Global Diversification – Small vs. Large Companies

27. Trading Systems & Market Makers • Ownership & Control Structures • Privately-owned exchanges with SRO’s & competition. • SRO’s, negotiable commissions, exchanges compete for business. • U.S., Canada, U.K., Japan, & Hong Kong • Public or Quasi-public Exchanges • Gov’t selects brokers, endows monopoly, sets fixed commissions. • France, Belgium, Spain, & Italy. Recent liberalization moves. • Bank-Centered Exchanges • Majority of trading occurs through banks, gov’t regulated. • Germany, Switzerland, & Austria. • Trading Procedures • Continuous vs call markets, open outcry pits versus computerized CLOB’s. • Specialist market-makers versus competitive dealers.

28. Interest Rate and Currency Swaps

29. Swap Contracts • A Swap is an agreement between two parties to exchange cash flows over some period in the future. • Parties to the swap are called counterparties. • Similar to series of futures contracts. • Two major types of swaps: Interest Rate & Currency swaps. • Characteristics of Swaps Market • Face-to-face counterparties affords privacy. • Virtually no government regulation • Limitations • Need to find counterparty willing to exchange desired cash flows. • Swap cannot be altered or terminated early without both agree. • Exposed to creditworthiness of counterparty, potential default

30. Plain Vanilla Interest Rate Swap • Plain Vanilla Interest Rate Swap • One party agrees to pay series of fixed-rate interest payments and receive series of floating rate interest payments. This is the Pay-Fixed party to the swap. • Other party receives series of fixed-rate interest payments and pays series of floating rate interest payments. This is the Receive-Fixed party to the swap. • Features of Plain Vanilla Interest Swap • Contract sets time period for interest payments (swap tenor). • Sets notional principal on which interest payments based. • Notional Principal is not actually exchanged at any time. • Floating rates in most swaps based on LIBOR+ • Generally only the net payment (difference between the two interest payments is exchanged by counterparties.

31. LIBOR0x $1,000,000 LIBOR1x $1,000,000 LIBOR2x $1,000,000 LIBOR3x $1,000,000 LIBOR4x $1,000,000 9% x $1,000,000 = $90,000 $90,000 $90,000 $90,000 $90,000 9% x $1,000,000 = $90,000 $90,000 $90,000 $90,000 $90,000 LIBOR0x $1,000,000 LIBOR1x $1,000,000 LIBOR2x $1,000,000 LIBOR3x $1,000,000 LIBOR4x $1,000,000 Plain Vanilla Interest Rate Swap Example: Pay fixed 9%/Receive floating LIBOR flat Party A: Pay Fixed (Receive Floating) Receive (+) 5 0 1 2 3 4 Pay (-) Party B: Receive Fixed (Pay Floating) Receive (+) 5 0 1 2 3 4 Pay (-)

32. Plain Vanilla Currency Swaps • Plain Vanilla Currency swap: one party provides principal in one currency to its counterparty in exchange for equivalent amount of foreign currency. • Each party then pays interest on currency received in swap at either a fixed or floating rate. • Example: Party C has DM but wants US$, while Party D has US$ but wants DM. • Four possible configurations for plain vanilla currency swap. • Party C pays fixed on $, Party D pays fixed on DM. • Party C pays floating on $, Party D pays fixed on DM. • Party C pays fixed on $, Party D pays floating on DM. • Party C pays floating on $, Party D pays floating on DM. • Most common type of Currency swap is pay floating on US$ and pay fixed on foreign currency.

33. Plain Vanilla Currency Swaps • Simplest swap is fixed-for-fixed, which we examine. • Three different types of cash flows in currency swap. • At start of swap, counterparties actually exchange principal with one another. • During term of swap, counterparties make periodic interest payments to each other. • At end of swap, counterparties exchange principal back. • Example: Party C has DM but wants US$, while Party D has US$ but wants DM. • U.S. interest rate is 10%, German interest rate is 8%, exchange rate is $.40/DM (2.5 DM/$). • Party C wants to exchange DM25 million for Party D’s US$10 million.

34. DM Lender US$ Lender DM 25 million DM 25 mil US$ 10 mil $10 million 2. Periodic Annual Interest Payments DM Lender US$ Lender US$ 1 million Party C Party D US$ 1 mil DM 2 mil DM 2 million 3. Final Cash Flow (Repayment of Principal) DM Lender US$ Lender DM 25 million Party C Party D DM 25 mil US$ 10 mil $10 million Fixed-for-Fixed Currency Swap 1. Initial Cash Flow (Exchange of Principal) Party C Party D

35. Why Swaps? • Two main reasons for Currency Swaps. • Comparative Advantage. • One firm may have better access to the capital market of one country than another firm, and vice versa. • Each borrows in market where they get lowest rate, then swap into currency that they actually require. • Hedging Balance Sheet Exposure. • One firm may borrow floating but lend fixed by the nature of its business or vice versa. • Exposed to duration mismatch risk between its liabilities and assets. Can reduce this exposure by swapping fixed interest payments on its assets for floating rate payments.