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ECON 671 – International Finance

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International Financial Markets and Institutions

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International Financial Markets

• Capital MarketsCapital Markets: financial claims with maturities greater than 1 year.• often called long-term financial claims

• Money MarketsMoney Markets: financial claims with maturities less than 1 year.• often called short-term financial claims, or “near-

monies”.

• i.e. can buy/sell quickly with low transaction costs

• Money markets are used by large firms to invest or borrow s-t flows

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Onshore Banking• Onshore bankingOnshore banking system for a country consists of all

banking activities conducted in the domestic currency.• Commercial BankingCommercial Banking involves the taking of deposits and

the making of loans.• talk about rise of non-bank banks in U.S.

• Investment BankingInvestment Banking acts on behalf of firms that wish to borrow, but generally do not extend these loans.

• act as underwriter on new security issues• buy from issuer, sell to dealers and investors.

• scale often leads to syndicates to spread risk, spread contacts• profit from difference between buy and sell prices• often maintain secondary market• act as agent on new issues

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International Banks in U.S.• Commercial BankCommercial Bank - chartered in U.S., foreign owners, same

reg’ns as domestic banks.

• Subsidiary BankSubsidiary Bank - separate entity, same reg’ns as domestic banks, funded by parent.

• Agency of Foreign BankAgency of Foreign Bank - only limited banking, no deposits, trade finance and money market services, funded with borrowings from parent.

• Branch of Foreign BankBranch of Foreign Bank - full banking powers, can accept deposits, funded by parent.

• International Banking Facility (IBF)International Banking Facility (IBF) - not separate entity, set of books at parent, can accept deposits, extend credit to foreign residents, not subject to U.S. res. reqs. or interest rate ceilings.

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Intro to Offshore Banking

• Offshore BankingOffshore Banking system composed of deposits, loans, and other instruments denominated in a currency, but issued outside the country where that currency is the legal tender. More commonly known by affixing the Euro- prefix to a quantity.• Eurodollar DepositsEurodollar Deposits are U.S. dollar deposits held outside

the U.S. in places like London, Paris, or the Cayman Islands.

• Eurodollar LoansEurodollar Loans are U.S. dollar loans made outside the U.S. in places like London, Paris, or the Cayman Islands. Provide an alternative to the U.S. domestic market for raising U.S. dollar funds.

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Offshore Banking• Euro-Currency DepositsEuro-Currency Deposits are deposits denominated in a

currency that is different from the currency of the financial center in which it is held. The term offshore deposit is more precise.• composed of time deposits with maturities from one week or less, to

upwards of three years.• majority of deposits are less than six months, so int’l money market.• normally not counted as part of the narrow domestic money supply, as

time deposits are known as near-monies, only counted in broad def’ns.• similar to domestic CD’s except for fact that are traded abroad.

• Euro-Currency LoansEuro-Currency Loans are loans denominated in a currency that is different from the currency of the financial center in which it is held. • Term offshore loan more precise. Composed of lending with maturities

on average less than six months.

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Offshore Financial Markets

• Customers in offshore banking markets are large organizations such as multinational companies, governments, and international organizations.• Multinationals move around large liquid pools of funds

looking for highest rates of return in Euro-deposit markets.

• Multinationals also obtain loans with minimum disclosure & regulations at competitive rates using Euro-loans.

• competitive returns attract funds of government, particularly central bank holdings of foreign exchange reserves.

• developing countries especially made use of Euro-loans in late 1970’s and early 1980’s.

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International Interbank Market• substantial amount of activity in Euro markets involves

InterbankInterbank market.• Eurobank holding excess funds, and with no customers available, can

lend its excess reserves to other Eurobanks, without reserves, but with clients for loans.

• interest rate charged by Eurobanks lending in the interbank market is referred to as the interbank offered rates.

• most widely publicized is the LIBORLIBOR, London interbank offered rate. More recently EURIBOREURIBOR from Frankfurt.• average of interbank offered rates used to set customer lending rates.

• interbank market operates just like the federal funds market in the U.S.

• it allows Eurobanks to achieve more efficient use of existing funds by allowing them to shift immediately to where needed.

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Rationale for Euro-Markets• Most important feature is offshore currency markets are

outside the regulation and intervention of national governments.• initially popular in the mid-1960’s as a way around national banking

restrictions for U.S. banks, and exchange rate controls for many other countries.

• no reserve restrictions on Euro-deposits for U.S. banks. Provides way for banks to borrow without bearing as high a cost of foregone interest on reserves.

• changing perceptions of political risk involved in offshore markets have added to their attraction in recent years. • small possibility of sever intervention by national governments,

blocking access to funds in offshore market, hence Euro-market rates generally higher than domestic rates.

• offshore markets served as market for multinationals and pools of capital to seeking to diversify & avoid regulation.

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Eurodollar Deposits and Monetary Expansion

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Euro$ Deposits• Investigate the link between the onshore and

offshore banking markets more concretely.• Link between domestic $ deposits and Euro$ deposits

established by relation between correspondent bank & the Eurobank.

• Correspondent bankCorrespondent bank is a bank whose domestic currency is the same as the Eurocurrency being used. • In this case a U.S. bank issuing US$ deposits and loans. • Correspondent bank is repository for the domestic

currency that backs the Eurobank’s transactions in the Eurocurrency.

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Expansion of Euro$ Deposits• Example: U.S. Multinational decides to move dollars

deposited at a U.S. bank into a Eurodollar deposit at EuroBank.• Presumably higher interest rates offered in the

Euromarket. • Assume that the U.S. Bank is also the U.S. Correspondent

Bank of EuroBank.• Next slide traces out the transaction through the T-

Accounts of the three parties.• Note that Total World Supply of US dollars equals US$

deposits at US Bank plus Euro$ deposits at EuroBank.

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Effects of Initial Transaction

U.S. CorrespondentBank

Assets Liabilities

EURO-BANK

Assets Liabilities

U.S. Multi-Nat’l

Assets Liabilities

Deposits ofUS MN -$1

Deposits atUS Bank -$1

Deposits ofEURO-BANK +$1

Reserves atUS Bank +$1

Deposits atEURO-BANK +$1

Deposits ofUS MN +$1

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Results for Euro$ Deposits1. U.S. onshore deposits did not change, so domestic U.S.

money supply not affected by U.S. Multi-Nat’lU.S. Multi-Nat’l move to Euro-market.

2. Amount of deposits held by U.S. Multi-Nat’lU.S. Multi-Nat’l did not change, but deposit now held at EuroBankEuroBank as a Euro-$ deposit.

3. EuroBankEuroBank holds US$ reserves with Correspondent bank in the U.S. No US$ physically leave the country as a result of the transaction.

4. Amount of US$ outside US, as add’l $1 of offshore dollars in the Euro$ deposit at EuroBankEuroBank.

5. Net Effect on world supply of US$ is zero as U.S. Multi-Nat’lU.S. Multi-Nat’l deposit offset by Reserve holding of EuroBankEuroBank.

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1. Assume EuroBank keeps only 3% of US $ deposit as reserves and

2. lends out the rest ($0.97) to Japan Multi-Nat’lJapan Multi-Nat’l to finance purchase of asset from German Multi-Nat’lGerman Multi-Nat’l.

3. Assume German Multi-Nat’l deposits 20% of proceeds in EuroBank ($0.194) and rest into US Bank ($0.776).

4. EuroBank’s Euro$ deposits have increased to $1.194.

5. EuroBank holds US$ reserves with U.S. correspondent bank. No US$ physically leave the country as a result of the transaction.

Expansion of Euro$ Deposits

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Secondary TransactionU.S. Bank

Assets Liabilities

EURO-BANK

Assets Liabilities

German Multi-Nat’l

Assets Liabilities

Deposits ofUS MN -$1

Deposits ofUS MN +$1

Japan Multi-Nat’l

Assets Liabilities Asset Sale toJapan MN -$.97

PurchaseAsset +$.97

Loan fromEURO-BANK +$.97

Loan toJapan MN +$.97

Deposits atEURO-BANK +$.194

Deposit ofGerman MN +$.194

Reserves atUS Bank +$1

-$.97 +$.194 +$.224

EURO-BANKDeposits +$1

-$.97 +$.194 +$.224

Deposits atU.S. Bank +$.776

Deposits ofGerman MN +$.776

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Euro-Dollar Multiplier• Define world supply of US$ in hands of non-bank

public, both onshore and offshore banking systems:

MMSS = M = MUSUS + ED - RE + ED - RE• MUS = U.S. supply of dollars• ED = Eurodollar deposits• RE = Eurobank Reserves held as deposits at U.S. banks

• Subtract RE to avoid double-counting as in MUS

• remember Eurobank reserves are US deposits!!!• Assumption 1.Assumption 1. Banks voluntarily hold some level

of reserves against their Eurodollar deposits.RE = re RE = re xx ED ED

• where rere = Eurobanks’ reserve/deposit ratio = 0.03

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Euro-Dollar Multiplier

• Assumption 2.Assumption 2. Individuals do not keep all deposits in Euromarket. Allocate them among offshore and onshore banking systems.

ED = ED = + + xx M MSS is the preference for Eurodollar deposits on the part of the

non-bank public. = .20 represents fraction of each additional $ available to

public that is deposited in the Eurodollar market.• Combine these two behavioral assumptions, with

definition of world supply of money to find how the U.S. domestic money supply influences the Eurodollar market.

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Euro-Dollar MultipliersMS = MUS + ED - RE

MS = MUS + (1 - re)EDMS = MUS + (1 - re)[ + MS]

• solving for the overall world supply of dollars yields:

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1 1S USM M re

re

Effect of U.S. Domestic Monetary Policy:Effect of U.S. Domestic Monetary Policy:

Effect of Change in Preference for Euro$:Effect of Change in Preference for Euro$:

1

1.241 1

S US USM M Mre

11.20

1 1S re

Mre

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International Equity Markets

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International Stock Markets• Developed countries have their own stock market(s)

• U.S., Japan, U.K. stock markets the three largest.• Emerging economies stock markets grew rapidly in 1990’s• National stock markets are primarily local markets but increasing

international linkages.• Multiple listing by firms: Depository receipts, costly, cosmetic.• International mutual funds or closed end country funds.

• Each market identified with an Index• Japan:Japan: Tokyo Stock Exchange uses Tokyo Stock Price Index (TOPIX)

or Nikkei 225.• U.K.:U.K.: London Stock Exchange uses Fin. Times Industrial Ordinary

Index (FT 30) or FTSE 100• Germany:Germany: Frankfurt Stock Exchange uses DAX (30 stocks)• France:France: Paris Bourse uses CAC 40 Index.• International Index:International Index: Morgan Stanley Capital Int’l Europe, Australia,

Far East Index (MSCI-EAFE Index) 2,000 firms in 21 nations.

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Global Diversification• Benefits to International DiversificationBenefits to International Diversification

• Including securities from other nations reduces a portfolio’s risk without affecting its return.

• International markets are les than perfectly correlated.• Largest influence on prices are domestic events and policies.

• Geography and politics influence degree of correlation.

• Obstacles to International InvestmentObstacles to International Investment• Information barriers: language, accounting standards.• Political & Capital Controls• Foreign Exchange Rate Risk• Restrictions on Investment and Control• Taxation: Withholding tax versus tax treaties.• Higher Costs: Lack of competition, infrastructure.

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Diversification – Risk vs. Return

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Global Diversification – U.S. vs Global Stockmarkets

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Global Diversification – Small vs. Large Companies

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Trading Systems & Market Makers• Ownership & Control StructuresOwnership & Control Structures

• Privately-owned exchangesPrivately-owned exchanges with SRO’s & competition.• SRO’s, negotiable commissions, exchanges compete for business.• U.S., Canada, U.K., Japan, & Hong Kong

• Public or Quasi-public ExchangesPublic or Quasi-public Exchanges• Gov’t selects brokers, endows monopoly, sets fixed commissions.• France, Belgium, Spain, & Italy. Recent liberalization moves.

• Bank-Centered ExchangesBank-Centered Exchanges• Majority of trading occurs through banks, gov’t regulated.• Germany, Switzerland, & Austria.

• Trading ProceduresTrading Procedures• Continuous vs call markets, open outcry pits versus

computerized CLOB’s.• Specialist market-makers versus competitive dealers.

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Interest Rate and Currency Swaps

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Swap Contracts• A SwapSwap is an agreement between two parties to

exchange cash flows over some period in the future.• Parties to the swap are called counterpartiescounterparties.

• Similar to series of futures contracts.

• Two major types of swaps: Interest RateInterest Rate & CurrencyCurrency swaps.

• Characteristics of Swaps Market• Face-to-face counterparties affords privacy.

• Virtually no government regulation

• Limitations• Need to find counterparty willing to exchange desired cash flows.• Swap cannot be altered or terminated early without both agree.• Exposed to creditworthiness of counterparty, potential default

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Plain Vanilla Interest Rate Swap• Plain Vanilla Interest Rate Swap

• One party agrees to paypay series of fixedfixed-rate interest payments and receivereceive series of floatingfloating rate interest payments. This is the Pay-FixedPay-Fixed party to the swap.

• Other party receivesreceives series of fixedfixed-rate interest payments and pays pays series of floatingfloating rate interest payments. This is the Receive-FixedReceive-Fixed party to the swap.

• Features of Plain Vanilla Interest Swap• Contract sets time period for interest payments (swap tenor).tenor).• Sets notional principalnotional principal on which interest payments based.

• Notional Principal is notnot actually exchanged at any time.

• Floating rates in most swaps based on LIBOR+• Generally only the net payment (difference between the two interest

payments is exchanged by counterparties.

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Plain Vanilla Interest Rate Swap

0 1 2 3 4 5

LIBOR0 x $1,000,000

LIBOR1 x $1,000,000

LIBOR2 x $1,000,000

LIBOR3 x $1,000,000

LIBOR4 x $1,000,000

0 1 2 3 4 5

LIBOR0 x $1,000,000

LIBOR1 x $1,000,000

LIBOR2 x $1,000,000

LIBOR3 x $1,000,000

LIBOR4 x $1,000,000

Pay(-)

Pay(-)

Receive(+)

Receive(+)

9% x $1,000,000= $90,000

$90,000 $90,000$90,000$90,000

9% x $1,000,000= $90,000 $90,000 $90,000$90,000$90,000

Party A:Party A: Pay Fixed (Receive Floating) Pay Fixed (Receive Floating)

Party B:Party B: Receive Fixed (Pay Floating) Receive Fixed (Pay Floating)

Example: Pay fixed 9%/Receive floating LIBOR flatExample: Pay fixed 9%/Receive floating LIBOR flat

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Plain Vanilla Currency Swaps• Plain Vanilla CurrencyCurrency swap: one party provides principal in

one currency to its counterparty in exchange for equivalent amount of foreign currency.• Each party then pays interest on currency received in swap at either a

fixed or floating rate.

• Example:Example: Party C has DM but wants US$, while Party D has US$ but wants DM.

• Four possible configurations for plain vanilla currency swap.• Party C pays fixed on $, Party D pays fixed on DM.• Party C pays floating on $, Party D pays fixed on DM.• Party C pays fixed on $, Party D pays floating on DM.• Party C pays floating on $, Party D pays floating on DM.

• Most common type of Currency swap is pay floating on US$ and pay fixed on foreign currency.

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Plain Vanilla Currency Swaps• Simplest swap is fixed-for-fixed, which we examine.• Three different types of cash flows in currency swap.

• At start of swap, counterparties actually exchange principal with one another.

• During term of swap, counterparties make periodic interest payments to each other.

• At end of swap, counterparties exchange principal back.

• Example:Example: Party C has DM but wants US$, while Party D has US$ but wants DM.• U.S. interest rate is 10%, German interest rate is 8%, exchange rate is

$.40/DM (2.5 DM/$).

• Party C wants to exchange DM25 million for Party D’s US$10 million.

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Fixed-for-Fixed Currency Swap

Party C Party D

DM 25 million

$10 million

DM Lender

DM 25 mil

US$ Lender

US$ 10 mil

US$ 1 million

US$ 1 milDM 2 million

DM 2 mil

$10 millionUS$ 10 mil

DM 25 million

DM 25 mil

1. Initial Cash Flow (Exchange of Principal)1. Initial Cash Flow (Exchange of Principal)

Party C Party D

DM Lender US$ Lender

2. Periodic Annual Interest Payments2. Periodic Annual Interest Payments

Party C Party D

DM Lender US$ Lender

3. Final Cash Flow (Repayment of Principal)3. Final Cash Flow (Repayment of Principal)

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Why Swaps?• Two main reasons for Currency Swaps.• Comparative AdvantageComparative Advantage.

• One firm may have better access to the capital market of one country than another firm, and vice versa.

• Each borrows in market where they get lowest rate, then swap into currency that they actually require.

• Hedging Balance Sheet ExposureHedging Balance Sheet Exposure.• One firm may borrow floating but lend fixed by the nature

of its business or vice versa.

• Exposed to duration mismatch risk between its liabilities and assets. Can reduce this exposure by swapping fixed interest payments on its assets for floating rate payments.