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International Financial Markets and Instruments

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Title: 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 doesnt capture market because
    transactions take place all over the world

10
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)

11
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

12
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

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
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.

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
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

17
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

18
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.

19
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

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
    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

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

24
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25
Financial Linkages and Eurocurrency Derivatives
  • BE AFRAID

BE AFRAID IF YOU DONT KNOW DERIVATIVES
Advertisement in business pages of Globe and
Mail, early Jan. 01
26
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

27
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

28
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)

29
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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
    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.

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 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

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

45
  • 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

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 52250

47
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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.
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