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 three
  sectors
  
• Foreign Exchange Markets
• Currency markets
• International Money Markets (short term markets)
• Eurocurrency Markets (dominated by global banks)
• Traditional financial centers (London and New
  York) and
  
• Offshore Financial Centers and Offshore Financial
  Markets (Cayman Islands, Singapore, etc).
  
• International Capital Markets (long term
  markets)
  
• Bond markets
• Equity markets

3
International Money Markets

• The International Money Market represents the
  short and intermediate term borrowing and
  investment market.
  
• Global firms have access to the international
  money markets either through (1) intermediaries
  or through (2) the direct markets.
  
• Global banks play a key role in the international
  money markets as lenders, depository institutions
  and as investment bankers.
  
• See Appendix 1 for a discussion of global banks.
• From a financing side, major international money
  market instruments include
  
• Eurocurrency Loans (Euro-Lines of Credit) offered
  by banks.
  
• Eurocredits (Syndicated) offered by banks.
• Euronotes (direct market instruments)
• Euro-Medium-Term Notes (direct market
  instruments)
  
• Eurocommercial Paper (direct market instruments)

4
Financing in the Money Markets
5
The Eurocurrency Market

• The core of the international money market is the
  euro-currency market, which is defined as
  
• The market for borrowing and lending currencies
  that are held in the form of deposits in banks
  located outside the countries where the
  currencies are issued as legal tender.
• For example, Eurodollars are U.S.
  dollar-denominated deposits held in banks located
  outside of the United States.
  
• Euroyen are yen-denominated deposits held in
  banks located outside of Japan.
  
• Banks accepting euro deposits can be local
  banks (domestic), or foreign banks operating in
  a local market (e.g., U.S. banks in London).
  
• Eurocurrencies can be either deposited or lent
  within the international money market.

6
Creation of a Eurocurrency Deposit Example

• Assume a German company sells a product to a U.S.
  company and charges 1,000,000 for the sale.
  
• The U.S. company pays by instructing its bank in
  New York to transfer 1,000,000 into the account
  of the German company (assume the German company
  has an account at a New York bank).
• The German company then instructs its U.S. bank
  to transfer the dollar deposit to a U.S. dollar
  time deposit account at its bank in London.
  
• The London bank can now lend out these dollars to
  its corporate clients and/or can lend out these
  deposits to other banks in the London Interbank
  Market.

7
Brief History of the Eurocurrency Market

• Market originated in the 1950s, when communist
  governments (mainly the Soviet Union) needing
  dollars for international trade and concerned
  about the potential freeze of their dollar
  accounts in U.S. banks, shifted their deposits to
  London
• The original bank in the London market accepting
  these deposits was the Banque Commercial pour
  I'Europe du Nord this bank was best known by its
  cable code, EUROBANK hence the term euromarket.
  
• By the 1960s, the practice of euro-deposits was
  extended to regular business customers.
  
• In 1964, the market size was estimated at 20
  billion dollars, with the majority in the form of
  US dollar deposits.
  
• As the economies of Europe and Asia grew, the
  market was extended to additional currencies
  other than the US dollar.
  
• By 1995, the market had grown to 7 trillion, but
  the US dollar share was down to 44.
  
• Market is estimated to be growing about 25 per
  year!

8
The Meaning of the Euro Prefix

• In the Eurocurrency Market, the prefix euro is
  used to denote the particular offshore currency
  in which the transaction is occurring, e.g.,
  
• Euro-dollars, euro-yen, euro-pounds, euro-euros.
• Eurocurrencies are only the major currencies of
  the world.
  
• Although the market originated in London, today
  eurocurrency markets exist all over the world.
  
• Banks accepting euro deposits and making euro
  currency loans are commonly referred to as
  Eurobanks.
  
• Important Do not confuse this offshore currency
  term with the single European currency, the
  Euro.
  

9
Functions of the Eurocurrency Markets

• The Eurocurrency market serves two valuable
  functions for global firms
  
• (1) Investment Market Eurocurrency deposits are
  a convenient way for global firms to earn a
  return on their short term excess (idle)
  funds.
• Eurodollar time deposits normally have maturities
  from overnight to six months, but may be as long
  as five years they are not insured.
  
• Minimum investment of 100,000 there is no
  secondary market for deposits.
  
• For an example see http//www.wachovia.com/corp_i
  nst/page/0,,7_26_252_923,00.html
  
• (2) Borrowing Market Eurocurrency loans are a
  major source of short-term and intermediate term
  loans for global firms to finance their working
  capital needs.

10
Eurocurrency Market Structure

• The Eurocurrency market is two tiered
• Wholesale (or interbank) market where large
  global banks trade euro-currencies among
  themselves (1,000,000 minimum).
  
• Represents about 50 of the offshore market.
  Gross data (see next slide) includes wholesale
  market
  
• Retail market where global banks accept
  euro-deposits from clients and make euro-currency
  loans to clients.
  
• Represents about 50 of the offshore market. Net
  data (see next slide) includes only retail
  market.
  
• Major retail clients include global firms and
  governments.
  

11
Size of Eurocurrency Deposit Market (Billion of
Dollars), 1964-1995
12
London Eurocurrency Interbank Market

• London is currently the major Eurocurrency
  interbank market.
  
• Within the London market there are two important
  interest rates
  
• Interbank Bid Rate (LIBID) The rate at which a
  bank will buy eurocurrency deposits from another
  bank (deposit rate).
  
• Interbank Offer Rate (LIBOR) The rate charged by
  banks to lend eurocurrency deposits to other
  banks (borrowing rate).
  
• Offer (LIBOR) rates will be higher than bid
  (LIBID) rates by about 1/8 or less.
  

13
LIBOR, November, 2007

• http//markets.ft.com/ft/markets/reports/FTReport.
  asp?dockeyMNY-121107
  

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Importance of LIBOR Rates

• (1) Used by foreign exchange 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 between currencies.
  
• (2) Used by global banks in scaling retail
  market 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.
• However, lending rates will generally be lower
  than equivalent domestic market rates, and
  
• deposit rates will generally be higher than
  equivalent domestic market rates (see next
  slide)
  
• This interest rate structure reflects
• Smaller spreads (between deposit rates and
  lending rates) in the offshore markets than in
  the domestic markets due to cost advantages in
  the market.

16
Eurodollar Deposit Rates and CD Rates, November
8, 2007

• CDs (secondary market) United States
• 1-month 4.65
• 3-month 4.85
• Eurodollar deposits (London)
• 1-month 4.66
• 3-month 4.90
• Spreads Eurodollar deposits CDs rates
• 1-month 0.01
• 3-month 0.15
• Source
• http//www.federalreserve.gov/Releases/H15/update/
  
  

17
Typical Spreads in Domestic and Eurocurrency
Credit Markets
18
Eurocurrency Loans (Euro-Lines)

• Eurocurrency loans (also called euro lines)
  Short term lines of credit against various
  eurocurrencies offered by banks.
  
• 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
  (about ¼ to ½ per annum on the unused portion
  of the line) plus an interest rate applied
  against any borrowed amount.
• Interest rate on borrowing is scaled to LIBOR

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Eurocredits

• Eurocredits Short- to medium-term eurocurrency
  loans made by Eurobanks.
  
• Often these loans are too large for one bank to
  underwrite, thus
  
• A number of banks will form a syndicate to share
  the size and risk of the loan (hence, syndicated
  eurocredits).
  
• Eurocredits feature a roll over provision.
• The loans maturity can be extended by mutual
  agreement between lender and borrower.
  
• At roll over, the interest rate is re-scaled to
  the new LIBOR.

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Example of a Roll Over Eurocredit
Example Roll Over of a 6 Month Euro-Credit
years
1
2
3
4
5
6
Today
etc.
etc.
etc.
Loan is re-scaled at new LIBOR every six months,
with interest payments made on those roll-over
dates

20
21
Euronotes

• Euronotes Short term promissory notes issued by
  a corporation and sold to institutional or
  private investors.
  
• Maturity is typically three to six months.
• Euro-notes are underwritten by international
  investment banks or international commercial
  banks through Euronote Programs.
  
• The program identifies the dealer(s) who will act
  on behalf of the borrower in placing issues with
  investors.
  
• Euro-notes are originally sold at a discount from
  their face value and pay back the full face value
  at maturity they can trade in secondary markets.

22
Eurocommercial Paper

• Eurocommercial Paper Unsecured short-term notes
  issued by corporations and banks in the
  Eurocurrency markets.
  
• Maturities typically range from one month to 6
  months.
  
• Historically, U.S. dollar denominated (about
  75) but euro denominated notes are becoming
  more important.
  
• Placed directly with investors through a dealers
  Eurocommercial Program.

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Euro-Medium-Term Notes (MTNs)

• MTNs Fixed or floating rate notes issued by a
  corporation or government to investors.
  
• Maturities of 9 months to 10 years (but most
  under 5 years)
  
• MTNs are offered on an on-going basis rather than
  all at once like a bond.
  
• Issued through a Euro-MTN Program, whereby the
  issuer can vary the amount of notes to be issued
  at any one time 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 (e.g., on the London Stock
  Exchange).
  

24
Who Uses the Eurocurrency Markets?
25
Rise of the Offshore Financial Center

• Offshore financial centers are best defined as
  those money centers that attract a high level of
  non-resident financial activity.
  
• Offshore financial centers are not new.
• In the 1920, wealthy American, UK and Canadian
  citizens established offshore trusts in the
  Bahamas and the Cayman Islands (to minimize their
  taxes).
• In the 1960s and 1970s, US banks established
  offshore branches to escape US regulations and to
  book euro-currency loans.
  

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Characteristics of Offshore Financial Centers

• Many (but not all) offshore financial centers are
  sparsely populated small island states
  (Switzerland is an exception).
  
• These locations provide some or all of the
  following advantages low or zero taxation
  moderate or light financial regulation banking
  secrecy and anonymity.
• Since the 1980s, the number of offshore financial
  centers (as identified by the IMF) has risen from
  about 30 to just under 70.
  

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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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Appendix 1 Commercial Banks in the Global
Markets
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Importance and Growth Banks in Global Finance

• The early growth of international banking
  activities was largely driven by commercial bank
  financing of the international trade activities
  of their corporate clients.
• This was done though banks in home markets.
• In the latter period, we have seen a physical
  expansion of branches and subsidiaries of banks
  into foreign markets.
  
• These overseas banks have been involved in an
  increasing volume of loans to foreign borrowers,
  private banking services, foreign exchange and
  investment banking activities, etc.
• 1960, for example, only 8 U.S. banks had foreign
  offices by 1987, however, 153 U.S. banks had a
  total of 902 foreign branches.
  
• Similarly, in 1973, fewer than 90 foreign banks
  had offices in the U.S. by 1987, 266 foreign
  banks operated 664 offices in U.S. cities.
  

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International (Global) Banks

• Critical to the functioning of the eurcurrency
  markets are global commercial banks.
  
• Why? 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
• For a discussion of why banks establish a global
  presence, please see Appendix 2

32
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 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.
• All global banks, however, participate in
  eurocurrency deposit market.
  
• Accepting a wide range of major 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
International Banks Ranked by Asset Size, 2006

• 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.
  

36
Appendix 2 Example of a Corporate Borrower in
the Eurocurrency Market

• CWB, is a Canadian company, that sells western
  Canadian wheat and barley throughout the world.
  
• The company raises money in Canada, the United
  States and in various eurocurrency markets
  through a Eurocommercial Paper Program and a Euro
  Medium Term Notes Program.

37
CWBs Web Site

• Visit CWBs web site (as noted below) to see
  their recent eurocurrency borrowing activities.
  
  
• From this site, link to funding programs, then
  go to eurocommercial paper program and euro
  medium term note program.
  
• http//www.cwb.ca/public/en/about/investor/fundin
  g
  

38
Appendix 2 Why Do Banks Establish a Global
Presence and What Organizational Structures do
they Use?
39
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.
  

40
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

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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/

42
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.

44
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.

45
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.
  

46
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.