EUROCURRENCY MARKETS

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EUROCURRENCY MARKETS

• Eurocurrency markets are markets for both
  deposits and loans in a currency, or currencies,
  other than that of the country in which they are
  located
• Characteristics of Eurocurrency markets
• ? location of market not ownership of financial
  institution or funds
• ? markets for both loans and deposits in foreign
  currency

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• A eurocurrency is a foreign-currency-denominated
  deposit in a bank outside the country where the
  currency is issued as a legal tender
• A Eurobank (or offshore bank) is a financial
  intermediary that simultaneously bids for time
  deposits and makes loans in a currency , or
  currencies, other than that of the country in
  which it is located

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ORIGINS OF EUROCURRENCY MARKETS

• Markets originated in mid-1950s when banks in
  Europe and Canada decided to use their funds in
  to finance trade and investment projects
• Eurobanks could circumvent domestic policies and
  regulations, which made the business more
  attractive
• Both supply and demand factors helped the growth
  of the eurocurrency markets

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• Supply factors
• ? U.S. were held by Europeans for transactions
  in commodities and metals, for hedging purposes
  and as a store of value
• ? Russians and Eastern Europeans were reluctant
  to keep their in the U.S.
• ? Relaxation of exchange controls in Europe in
  1958 and external convertibility of

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• Demand factors
• ? After the use of the was banned for
  financing foreign trade, British merchant banks
  offered overseas loans in
• ? Eurobanks were able to offer higher rates on
  deposits than the rates that domestic U.S. banks
  could offer due to restrictions from regulation Q

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• Onshore banks have a disadvantage compared to
  offshore banks due to
• ? domestic regulations that affect credit
  allocation
• ? domestic regulations that affect a banks
  costs (taxes)
• ? domestic regulations which limit deposit and
  loan rates
• ? domestic regulations that require banks to
  maintain reserves that have lower yields than the
  market return for funds of same risk level

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CREATING EURODOLLAR DEPOSITS
Eurobank
U.S. Domestic Bank
U.S. Corp 100
U.S. Corp 100
U.S. Dom.
-------------------
Bank 100
U.S. Corp - 100
Eurobank 100
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• After eurodollar deposit has been created
• ? U.S. corp has a deposit of 100 in Eurobank
  instead of the U.S. domestic bank
• ? U.S. domestic bank had a liability of 100 to
  U.S. corp, which has been replaced by a liability
  of 100 to Eurobank
• ? Eurobank has 100 asset (deposit at U.S. bank)
  and a liability of 100 to U.S. corp

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EUROBANK LOANS
U.S. Dom Bank
Eurobank
Swiss Bank
Eurobank
US Bank
Swiss
US Bank
- 100
- 100
100
Corp 100
Swiss
Swiss Bank
Corp 100
100
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• After Eurobank gave a loan to Swiss corp
• ? U.S. domestic bank has a 100 liability to
  Swiss corp instead of the Eurobank
• ? Eurobank now has a loan to Swiss corp rather
  than a deposit at U.S. domestic bank as an asset
• ? Swiss bank has 100 liability to Swiss corp
  and 100 asset which is the deposit at U.S.
  domestic bank

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BALANCE SHEET OF EUROBANK
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DEPOSITS AND LOANS IN EUROCURRENCY MARKETS

• Eurobanks accept deposits and issue loans
• Loans, known as eurocredits, are longer-term and,
  thus, carry higher risk of default
• Eurobanks charge higher spreads on their loans
• Eurobanks practice rollover pricing
• A loan extended through rollover involves a
  succession of short-term loans that are
  periodically rolled over at a different interest
  rate

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• Interest rate is fixed for each period and
  updated at beginning of next period
• Interest rate is given by
• i(t) r(t) lending margin
• where r(t) is reference rate (e.g. LIBOR) and
  lending margin depends on borrowers credit
  quality

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• Lending margin can be fixed or floating
• Two types of eurocredits
• ? Term credit
• ? Given time for principal to become gradually
  available
• ? Grace period for full loan amount
• ? Schedule of repayments of principal
• ? Interest paid at given times, usually on
  rollover basis
• ? Revolving credit

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• Eurocurrency time deposits have various
  maturities
• Spot next spot week spot fortnight
• Overnight deposits
• Eurocurrency and domestic deposits are close, but
  not perfect substitutes
• Eurocurrencies face exchange or capital controls
• Eurobanks offer higher rates to attract deposits,
  but rates move closely with domestic interbank
  rates

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• Eurobanks face three types of risks
• ? Foreign exchange risk
• ? Interest rate risk
• ? Credit risk

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IMPLIED FORWARD RATE

• To determine the interest rate risk that arises
  from borrowing and lending at different
  maturities, we must calculate the implicit
  forward rate
• Consider two deposits at time t
• ? one with interest i(t,n) which matures at time
  
• t n
• ? one with interest i(t,T) which matures at time
• t T

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• Implied forward rate is the interest rate i(t
  n, T - n), such that if the earlier maturing
  deposit were reinvested at that rate at time t
  n for maturity at time t T, the final yield
  would be the same as the yield on the deposit of
  the longer maturity
• This is given by
• 1 i(t,T)(T/360) 1 i(t,n)(n/360)1 i(t
  n, T - n)(T - n)/360
• and solving for i(t n, T - n) gives
• i(t n, T - n)(T - n)/360 1
  i(t,T)(T/360)/1 i(t,n)(n/360) - 1

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• E.g. Two deposits
• ? 182 days at annual rate of 10.38
• ? 367 days at annual rate of 10.50
• ? Implied forward rate is 10.09 per annum
• Interpretation if we deposit money for 182 days
  at 10.38 and then reinvest the deposit for
  another 185 days at 10.09, we would obtain the
  same yield as if we deposited the same amount of
  money for 367 days at 10.50

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• Two conclusions
• ? If we borrow long-term and lend short-term, we
  will break even if the maturing short-term loan
  is relent at the implied forward rate
• ? If we borrow short-term and lend long-term, we
  will break even if we refund the long-term loan
  by borrowing again at the implied forward rate

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• If we borrow short-term and lend long-term, we
  make a profit if we refund the long-term loan at
  a rate below the implied forward rate
• If we borrow long-term and lend short-term, we
  earn a profit if we relent the short-term loan at
  a rate above the implied forward rate