INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 10
• Topic International Money Markets
• The Eurocurrency Markets and
• International Banking

2
Recall From Lecture 2 Defining the International
Monetary System?

• It is the overall financial environment in which
  global businesses operate.
  
• It is represented by the following two sectors
• Foreign Exchange Markets
• Currency markets (and foreign exchange regimes).
• International Money and Capital Markets
• Eurocurrency Markets (dominated by global banks)
• Traditional financial centers (London, New York,
  etc) and
  
• Offshore Financial Centers and Offshore Financial
  Markets (Cayman Islands, Singapore, etc).
  
• Bond markets
• Equity markets

3
Financing Global Operations

• The global firm can finance its overseas
  activities through either
  
• Internal sources of funds (i.e., within the
  corporate family).
  
• Funds from the parent or sister subsidiaries.
• External sources of funds (i.e., outside of the
  corporate family).
  
• Funds raised in the parent countrys financial
  markets.
  
• Funds raised in financial markets outside the
  parent country
  
• Can be either debt or equity funds.

4
Internal Financing of a Global Firm
5
External Financing of the Global Firm
6
International Sources of Debt
7
International Money Markets

• International Money Market is represented by the
  short/intermediate term funds market
  
• Involves borrowing or lending/investing for short
  and intermediate periods of time.
  
• The major international money markets are
• Eurocurrency Markets
• Eurocredits Market
• Euronotes Market
• Euro-Medium-Term Notes Market
• Eurocommercial Paper Market

8
The Eurocurrency Market

• The core of the international money market is the
  euro-currency market, which is defined as
  
• The money market for borrowing and lending
  currencies that are held in the form of time
  deposits in banks located outside the country
  where the currency was issued as legal tender.
• For example, Eurodollars are U.S.
  dollar-denominated time deposits in banks located
  outside of the United States.
  
• Euroyen are yen-denominated time deposits in
  banks located outside of Japan
  
• Banks accepting euro deposits can be local
  (domestic to the financial market) banks, or
  foreign banks operating in the local market
  (including U.S. banks).

9
The Meaning of the Euro Prefix

• In the Eurocurrency Market, the prefix euro is
  used to denote a currency which is other than the
  legal tender of the country in which the
  transaction is occurring, e.g.,
• Eurodollars, euroyen, europounds, euroeuros.
• The market is often referred to as the offshore
  market.
  
• Note the term euro does not mean the currencies
  are being deposited and lent only in Europe.
  
• Also do not confuse this term with the single
  European currency, the Euro.
  
• Banks accepting euro deposits and making euro
  currency loans are commonly referred to as
  Eurobanks.

10
Purposes of the Eurocurrency Markets

• Eurocurrency markets serve two valuable purposes
  for global firms
  
• (1) Investment Market Eurocurrency deposits are
  an efficient and convenient money market device
  for earning a return on excess corporate
  liquidity and
• (2) Borrowing Market the Eurocurrency market is
  a major source of short-term and intermediate
  term loans to finance working capital needs.

11
Eurocurrency Market Structure

• The Eurocurrency market is two tiered
• Wholesale (interbank) market where large global
  banks trade euro-currencies among themselves
  (1,000,000 minimum).
  
• There are two important interest rates in this
  market
  
• Interbank Offer Rate The rate charged by banks
  with excess currency deposits to lend to other
  banks. (lending or borrowing rate)
  
• Interbank Bid Rate The rate at which a bank will
  accept deposits from another bank. (deposit
  rate)
  
• Offer rates will be higher than bid rates by
  about 1/8
  
• Retail market where global banks accept
  euro-deposits from clients and make euro-currency
  loans to clients.
  
• Clients Corporates and governments.

12
LIBOR, November 27, 2006

• Fixed by the BBA, 1100 London time
  http//www.bba.org.uk/bba/jsp/polopoly.jsp?d103
  
• Source http//www.marketprices.ft.com/markets/cur
  rencies/money
  

13
Interbank LIBOR Rates Over Time

• LIBOR Rates (lending/borrowing), Overnight rates
• Oct 22, 2004 Nov 2, 2005 Nov 24,
  2006
  
• US Libor 1.79875 4.05000 5.28688
• Euro Libor 2.06563 2.08375 3.33438
• Libor 4.81313 4.44875 5.11375
• Yen Libor 0.03375 0.04000 0.35000
• Source The FT
• http//www.marketprices.ft.com/markets/currencies/
  money
  

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Importance of LIBOR Rates

• Used by FX market maker banks to calculate
  forward rates on currencies.
  
• Recall Under the interest rate parity the
  forward rate must offset market interest rate
  differentials.
  
• In equilibrium, the forward rate offsets the
  LIBOR differential.
  
• Used by global banks in scaling lending rates
  to corporate and sovereign entity borrowers
  
• Lending rate LIBOR X basis points
• Where X basis points is the lenders estimation
  of the unique risk associated with a particular
  borrower.

15
LIBOR, LIBID and Domestic Rates

• LIBOR and LIBID rates will generally parallel the
  rates on equivalent borrowing and deposit
  opportunities in each countrys domestic
  financial market.
• Deposit rates will generally be higher than
  domestic equivalent rates.
  
• Lending rates will generally be lower than
  domestic equivalents.
  
• This interest rate relationship reflects
• To compete with domestic markets, the euro
  markets must offer some incentive, and they can,
  because
  
• euro-deposits do not carry reserve requirements.
• Thus the full amount of the deposit can be lent
  out by banks.

16
LIBOR Rates (London) and Domestic Interest Rates,
November 24, 2006

• 3 Month LIBOR 3 Month Govt
  Rate (T-Bill)
  
• US 5.37500 5.03
• Euro 3.83650 3.53
• 5.22813 5.04
• Yen 0.49875 0.45
• LIBOR Source The FT
• http//www.marketprices.ft.com/markets/currencies/
  money
  
• Government Interest Rate Source Bloomberg
• http//www.bloomberg.com/markets/index.html

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Eurocurrency Loans (Euro-Lines)

• Eurocurrency loans (also called euro lines)
  These are short term lines of credit against
  eurocurrencies made by Eurobanks to corporates
  and governments.
• Specifically these are arrangements between a
  Eurobank and a customer allowing the customer to
  borrow up to a pre-specified amount of a
  designated euro-currency.
• There is a fee for the line of credit itself and
  then an interest rate applied against any
  borrowed amount.
  
• Interest rate scaled to LIBOR

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Eurocredits

• Eurocredits are short- to medium-term
  euro-currency loans made by Eurobanks to
  corporates and governments.
  
• The Eurobanks that constitute the lending market
  are the same Eurobanks that constitute the
  shorter term Eurocurrency loan (or line of
  credit) market.
• Often these loans are too large for one bank to
  underwrite.
  
• When this is the case, a number of banks form a
  syndicate to share the risk of the loan.
  
• Eurocredits feature an adjustable roll over
  provision.
  
• The loans maturity can be extended by mutual
  agreement between lender and borrower.
  
• On Eurocredits originating in London the roll
  over rate is LIBOR.

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Roll Over Feature of a Eurocredit
Six months periods
years
1
2
3
4
5
6
Today
etc.
etc.
etc.
Loan is re-rated at LIBOR every six months, with
interest payments made on those roll-over dates

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Euronotes

• Defined
• Short term promissory notes (i.e., debt) issued
  by a corporation in the Eurocurrency market and
  sold to investors.
  
• Maturity is typically three to six months.
• Euronotes are underwritten by international
  investment banks or international commercial
  banks.
  
• Issued through Euronote Programs.
• This program identifies the dealer who will act
  on behalf of the borrower in placing issues with
  investors.
  
• Euronotes are sold at a discount from face value
  and pay back the full face value at maturity.

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Euro-Medium-Term Notes (MTNs)

• MTNs are fixed or floating rate promissory notes
  issued by a corporation or Government to
  investors.
  
• Maturities of 9 months to 10 years (but most
  under 5 years)
  
• Thus they bridge the gap between short-term and
  longer-term euro debt instruments
  
• MTNs are offered on an on-going basis rather than
  all at once like a bond.
  
• Issued through a Euro-MTN Program.
• With this program, the issuer can vary the amount
  of notes to be issued at any one depending upon
  its needs and windows of opportunity.
  
• Thus, a Euro- MTN-program offers issuers
  flexibility in the raising of medium and
  longer-term funds.
  
• MTNs are placed by dealers and they can trade in
  secondary markets (generally on the London Stock
  Exchange).

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Eurocommercial Paper

• Unsecured short-term promissory notes issued by
  corporations and banks in the Eurocurrency
  markets.
  
• Maturities typically range from one month to 12
  months.
  
• Typically U.S. dollar denominated (about 75).
• Placed directly with investors through a dealer.
• Through a Eurocommercial Program with a dealer
  who places the issues with potential investors.
  
• Is often of lower quality than U.S. commercial
  paper and as a result yields are higher than in
  the U.S.
  
• Historically, the default rates have been higher
  on Eurocommercial paper than on U.S. paper.

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Example of a Corporate Borrower in the
Eurocurrency Markets

• CWB, a Canadian company, markets western Canadian
  wheat and barley throughout the world.
  
• The company raises money in Canada, the United
  States and in various eurocurrency markets
  through
  
• Eurocommercial Paper Program.
• Euro Medium Term Notes Program.
• Visit their web site to see more (link to
  funding programs, then to eurocommercial paper
  program and euro medium term note program)
  
• http//www.cwb.ca/en/about/treasury_operations/fun
  ding_programs.jsp
  

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Offshore Finance and Offshore Financial Centers

• Offshore Finance is the provision of financial
  services by banks and other agents to
  non-residents.
  
• These services include the borrowing of money
  from non-residents and lending to non-residents.
  
• Offshore Financial Centers (OFC) is
  characterized, at its broadest definition, as any
  financial center where offshore finance activity
  takes place.
• This definition would include all the major
  financial centers in the world (New York, London,
  Tokyo, etc).

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Another Definition of Offshore Financial Centers

• A narrower definition of an offshore financial
  center is
  
• (1) a location where the bulk of financial sector
  activity is offshore on both sides of the balance
  sheet and
  
• (2) where the majority of the institutions
  involved are controlled by non-residents.
  
• Specific characteristics of these OFC would
  include
  
• Locations with relatively large numbers of
  financial institutions engaged primarily in
  business with non-residents
  
• Capital markets with external assets and
  liabilities out of proportion to domestic
  financial intermediation, and
  
• Locations which provide some or all of the
  following services low or zero taxation
  moderate or light financial regulation banking
  secrecy and anonymity

26
Web Sites Offshore Financial Centers

• In 1999, the IMF identified 69 offshore financial
  centers, including, offshore countries.
  
• These included the broad definition of OFCs,
  such as
  
• The United States
• The United Kingdom
• Japan
• As well as areas representing the narrow
  definition of OFCs, such as
  
• The Cayman Islands
• Mauritius
• Isle of Man
• See next slide for complete 1999 list.

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Offshore Financial Centers (1999)

• Africa Asia and Pacific Europe
  Middle East Western Hemisphere
  
• Djibouti Cook Islands Andorra
  Bahrain Anguilla
  
• Liberia Guam Campione (Italy) Israel
  Antigua
  
• Mauritius Hong Kong Cyprus
  Lebanon Aruba
  
• Seychelles Japan Dublin, Ireland Bahamas
• Tangier Malaysia Gibraltar Barbados
• Macao Guernsey Belize
• Marianas Isle of Man Bermuda
• Marshall Islands Jersey British
  Virgin Islands
  
• Micronesia Liechtenstein Cayman Islands
  
  
• Nauru London, U.K. Costa Rica
• Niue Luxembourg Dominica
• Philippines Madeira Grenada
• Singapore Malta Montserrat
• Tahiti Monaco Netherlands Antilles
  
  
• Thailand Netherlands Panama
• Vanuatu Switzerland Puerto Rico
• Western Samoa St. Kitts and Nevis

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Web Sites Offshore Financial Centers

• For a good discussion of Offshore Financial
  Centers visit the following IMF web site
  
• http//www.imf.org/external/np/mae/oshore/2000/eng
  /back.htm
  
• To view one offshore financial center, the Cayman
  Islands, visit the following web site
  
• http//www.ecayonline.com/cayman-offshore-financia
  l.html
  
• Link to Offshore banking and investments

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Offshore Banking Centers

• Offshore Banking Centers Defined
• Offshore Country A country whose government
  allows banks to engage in external banking
  activity.
  
• External Banking is defined as accepting deposits
  and making loans in currencies other than the
  home currency of the offshore country.
  
• Offshore Banking Centers are characterized by
• Minimal host country regulations, low taxes, a
  favorable time zone location, and banking secrecy
  laws.
  
• For example, the Cayman Islands.
• Thus, foreign banks are encouraged to establish
  branches or subsidiaries in these centers to meet
  the needs of their global clients.

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U.S. Bank Involvement in Offshore Banking

• In the early 1960s, U.S. banks were attracted to
  the offshore banking markets and specifically the
  eurodollar
  
• However, at that time U.S. banks were prevented
  by law from participating in the eurocurrency
  market from within the United States.
  
• So, U.S. banks established offshore enterprises
  through subsidiary structures.
  
• Today, even though the U.S laws permit offshore
  banking in the U.S., this strategy of locating
  outside the United States is still attractive.
  
• Reason Offshore centers have minimal banking
  regulations (e.g., no FDIC, low/no reserve
  requirements) and low taxes). 

31
International (Global) Banks

• Critical to the functioning of the eurcurrency
  markets are global commercial banks.
  
• Global banks accept euro-deposits and make
  euro-loans.
  
• And they do so within both in the interbank and
  retail markets.
  
• International (i.e., global) banks can be
  distinguished from domestic banks by the
  
• The types of services they offer
• The deposits they are willing to accept
• The loans they are willing to make

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International Banks Services

• Managing Euro-Programs for borrowers.
• Financing of cross border trade (exports)
• Letters of credit bankers acceptances
• Offering foreign exchange services
• Market maker banks.
• Buying and selling foreign exchange for clients
• Offering hedging contracts (forwards and
  options).
  
• Offering interest rate and currency swap
  financing.
  
• Consulting services to global firms
• Hedging strategies international cash
  management.
  
• Underwriting euronotes and eurobonds, foreign
  bonds, and equity issues for global firms.
  

33
International Banking Deposits

• International banks may or may not be involved in
  accepting domestic (i.e., local currency)
  deposits in the various foreign markets in which
  they operate.
• Some governments may not let them
• For example, China historically has not allowed
  foreign banks to engage in this activity (retail
  banking).
  
• All global banks, however, participate in
  eurocurrency deposit market.
  
• Accepting a wide range of foreign currency
  deposits.

34
International Banking Loans

• International banks are lenders of eurocurrency
  deposits
  
• To one another (in the interbank markets)
• And to retail customers.
• Also, participation in syndicated eurocurrency
  loans to large multinational firms and sovereign
  entities.
  
• Many banks involved in these loan agreements.
• Some syndicates have involved up to 200 banks.
• Allows for the pooling of resources and the
  sharing of risk!

35
Who are these International Banks Ranked by
Asset Size, 2005

• 1 UBS (Switzerland)
• 2 Citigroup (United States)
• 3 Mizuho Holdings (Japan)
• 4 HSBC (U.K.)
• 5 Credit Agricole Groupe (France)
• 6 PNB Paribus (France)
• 7 JP Morgan Chase (United States)
• 8 Deutsche Bank (Germany)
• 9 Royal Bank of Scotland (U.K.)
• 10 Bank of America (United States)
• Formed by the 2002 merger of Dai-Ichi Kangyo,
  Fuji Bank and The Industrial Bank of Japan.
  
• Source The Banker http//www.thebanker.com/news
  /fullstory.php/aid/1699/Top_1000_World_Banks.html
  
• For complete list see next slide.

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37
Global Banks, 2005 (note 2003)

• Of the largest 1000 commercial banks
• 197 are American (211 in 2003) accounting for
  29.7 of profits.
  
• 106 are Japanese (106 in 2003) accounting for 6
  of profits.
  
• 91 are German (82 in 2003) accounting for 2.6
  of profits.
  
• 294 are European Union (EU25) accounting for
  39.6 of profits.
  
• Dominance of the big banks
• Top 5 banks account for 12.3 of capital and
  10.4 of total assets
  
• The most profitable (return on capital)
• U.S. banks 26.3 (29.3 in 2003)
• U.K. banks 26.3
• Japanese 10.7 (5.2 in 2003)
• German 6.8 (a loss in 2003)
• Average return of all 19.86

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Why do Banks Establish International Operations?

• Possible Low Marginal Costs in going global.
• Apply home knowledge to foreign market.
• Knowledge Advantage in global market
• Overseas operations can utilize the parents
  knowledge to compete successfully in foreign
  market
  
• Home (Headquartered) Information Source
• Providing local firms (in foreign countries) with
  information about parents home market
  
• Growth
• Home market may be saturated or experiencing slow
  growth.
  

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Why do Banks Establish International Operations?

• Regulation Advantage
• Global banks may not face the same regulations as
  do their domestic banks (e.g., reserve
  requirements on eurocurrency deposits).
  
• Defensive Strategy
• Following corporate clients overseas
• Providing retail customer overseas services
• Risk Reduction
• Greater stability of consolidated earnings.
• Prestige

40
Example of Global Bank Citigroup

• Financial services firm combining banking,
  insurance, and investments under one global
  organization.
  
• Universal or full service bank
• Currently located in over 100 countries
• Began international operations in 1912!
• Go to home page and view countries and product
  lines
  
• http//www.citigroup.com/citigroup/homepage/

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Services Offered by International Banks

• The particular services offered by a global bank
  is a function of
  
• The regulatory environment.
• What will foreign (host) governments allow?
• Developing countries still somewhat restrictive
  regarding foreign banks.
  
• The type of banking office established.
• Organizational structure will determine type of
  servies to be offered.
  
• See next 4 slides on global banking structures.

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Correspondent Banking Structure

• Correspondent Banking Structure is characterized
  by
  
• Having no physical presence overseas
• Headquarters maintains correspondent
  relationships with other banks in foreign
  markets
  
• Results in correspondent balances held at
  overseas correspondent banks.
  
• Allows a bank to service core clients overseas
  through correspondent banks with little cost.
  
• Facilities foreign exchange conversion for
  clients
  
• Facilities trade financing (clearing bankers
  acceptances) for clients.

43
Representative Office Structure

• Representative Office is characterized by
• A small overseas service facility staffed by
  parent bank personnel.
  
• The office cannot make loans or accept deposits,
  but
  
• Office is there to assist core clients in that
  country with
  
• Country and economic information
• Introductions to government/business contacts
• Credit evaluations of local firms
• This is a potentially useful (and relatively low
  cost) strategy if a global bank has many
  important clients in foreign country and they
  wish to maintain contact with these firms.

44
Foreign Branch Office Structure

• Foreign Branch Office is characterized by
• Since, legally the branch office is part of the
  parent bank
  
• The branch office is subject to regulations both
  at home and in foreign country.
  
• Branch lending limits are based upon parent
  capital (not branch office capital).
  
• Thus, a branch can provide larger loans to
  overseas clients.
  
• This structure allows for fast global clearing of
  checks within the banks organization
  
• Branch to branch and to parent clearing.
• This has been the most popular form of U.S. bank
  expansion abroad.
  

45
Subsidiary Bank Structure

• Subsidiary Bank is characterized by
• A bank locally incorporated (in foreign
  country).
  
• Bank is either wholly owned by parent, or joint
  venture with local partner.
  
• An affiliate bank is a non-controlled subsidiary
  (i.e., arising out of a joint venture).
  
• These banks operate under the banking laws of the
  country in which it is incorporated.
  
• Arrangement was particularly desirable before the
  abolition of U.S. Glass Steagell Act.
  
• U.S. banks incorporated overseas so as to engage
  in investment banking activities.