Title: International Financial Markets and Instruments
1International Financial Markets and Instruments
2Introduction
- 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
3International 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)
4Denomination 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
5Gross 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.
6Gross and Net International Bank Lending
7BIS
- 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
8Breakdown 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
9Eurocurrency 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
10Eurocurrency 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)
11Eurocurrency 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
12Eurocurrency 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
13Eurocurrency 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
14Eurocurrency 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.
15International 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.
16International 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
17International 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
18International 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.
19International 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
20International 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
21Stock 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.)
22More 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
23Mutual 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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25Financial Linkages and Eurocurrency Derivatives
BE AFRAID IF YOU DONT KNOW DERIVATIVES
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26Financial 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
27Financial 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
28Financial 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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30Financial Markets Including Eurocurrency markets
31Tools 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.
44How 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
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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?
49Assignment 2
- Look for it on the web or in your email by
Monday! - Due date changed to Feb. 20, due to reading week.