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

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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

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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.

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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

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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

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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 doesnt capture market because
  transactions take place all over the world

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Eurocurrency market

• 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 banks 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)

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Eurocurrency market

• 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

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Eurocurrency market

• 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

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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
Eurocurrency market

• 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.

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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.

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International bond market Some terms

• 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

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International bond market

• 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

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International bond market

• 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.

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International bond market

• 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

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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
  firms 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

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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.)

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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

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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

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Financial Linkages and Eurocurrency Derivatives

• BE AFRAID

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Mail, early Jan. 01
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Financial Linkages and Eurocurrency Derivatives

• 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

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Financial Linkages and Eurocurrency Derivatives

• 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 pxa

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Financial Linkages and Eurocurrency Derivatives

• 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)

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Financial Markets Including Eurocurrency markets
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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.

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• 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

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• 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

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• 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)

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• 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
  LIBOR3. 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.

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• 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 holders margin account for
  each forward interest contract.
• you dont ever have to borrow or lend the money
  to make profit off a future contract, you only
  need to bet in the right direction

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• 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

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• 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

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• 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.

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• 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

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• 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

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• 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

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• 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.

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How to read the tables

• Start with Interest rate futures p. 97
• Then options, p. 100

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• Open, High and Low are the face value for 100
  basis points, for 1 year (360 days). (note 1
  basis pt. 25 because 1 mil.0.0001/425
• Therefore a three month contract starting in
  March has a 1 year face value of 94.51, or
• the interest rate (yield) on the contract is
  100- 94.51 5.49
• So, to buy 3 million in March would cost 549 X
  25 X 3 41,175

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• 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 52250

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• 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?

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Assignment 2

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