International Financial Marketspages.stern.nyu.edu/~igiddy/ifmppt/markets.pdflEurocurrency A vs....

Giddy International Financial Markets/1

InternationalFinancial Markets

Prof. Ian GiddyStern School of Business,

New York University

What are the Global Financial Markets?

l The Foreign Exchange Market

l Eurocurrency Markets and Lending

l International Bond Marketsl International Equity Marketsl Using the Global Capital Markets:

Investors’ and Issuers’ Perspectives

Policies and Exchange Rate Regimes

l Exchange rate systems--fixed vsfloating

l Managed floatingl EMS-type currency blocsl De facto blocs--the dollar

The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

l Separation of currency, institution and jurisdiction

l Why do people want Eurocurrency deposits and loans?

l Why is LIBOR the world’s key benchmark rate?

The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

l Separation of currency, institution and jurisdiction

l Why do people want Eurocurrency deposits and loans?

l Why is LIBOR the world’s key benchmark rate?

Where the Eurocurrency Market Fits In

US Domestic GermanMarket EUR0CURRENCY MARKET Domestic

Market

Euro-Deutsche MarkEurodollar MarketMarket Foreign

ExchangeMarket Japanese

Euro-Yen DomesticMarket Market

Euro-Commercial Euro-Floating Rate StraightPaper Market Note Market Eurobond Market

Interest Rate Linkages in the International Money Market

Two stories to tell:l Domestic vs. Eurol Eurocurrency A vs. Eurocurrency B

Domestic Market A The Euromarkets Domestic Market B

Trea- Bank Euro Euro Bank Trea-sury Deposit Deposit Deposit Deposit sury

Bill Market Market Bill

Trea- Corp- Euro Euro Corp- Trea-

sury orate Bond Bond orate suryBond Bond Market Market Bond Bond

Domestic versus Euro

The Eurodollar Premium

Market price of risk

versus

Cost of regulation

l Eurodollar vs. U.S. Interest Rate

Effective cost of domestic deposit

= (interest rate + FDIC fees)

(1 - reserve requirement)

l Capital controls and divided credit markets

Foreign Exchange

l Mechanics and calculationsl How banks make moneyl How banks hedgel Tasks of the corporate FX manager

Foreign Exchange Quotations

Spot Forward points

Exchange Rates

CurrencyHowquoted

Spot(2 businessdays)

Forward(90 days)

Britishpounds(GBP)

US$perGBP

1.632 1.617

Japaneseyen (JPY)

Yen perUS$

117.5 116.3

Foreign Exchange Quotations

Bid OfferSpotForward pointsRule:add if bid<offer,subtract if bid>offerOutright forward

Exchange Rates

CurrencyHowquoted

Spot(2 businessdays)

Forward(90 days)

Britishpounds(GBP)

US$perGBP

1.632 1.617

Japaneseyen (JPY)

Yen perUS$

117.5 116.3

A Typical Forward Contract

l We agree today to pay a certain price for a currency in the future

SonySony B of AB of A

How Does the Bank Hedge a Forward Contract?

Hedging approaches:uOpenuForwarduSpot plus swapuRolloveruMoney market

How Banks Hedge

SHORT LONG

Methods:- Spot + swap- Spot + rollover swap- Money market- Outright forward

Currency Risk Exposure(The Normal Distribution)

Probability

Return onlarge companystocks

– 3 – 48.2%

– 2 – 27.9%

– 1 – 7.6%

012.7%

+ 1 33.0%

+ 2 53.3%

+ 3 73.6%

Covered Interest Arbitrage

Moneymarket 1

Moneymarket 2

Spot Forward

Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

The Dealing RoomCUS- FOR- Foreign

TOMER SPOT WARD ExchangeDealing

FUNDING EUROCURRENCY MarketDealing

Diagram of a Dealing Room

The Dealing Room

Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

The Dealing RoomCUS- FOR- Foreign

TOMER SPOT WARD ExchangeDealing

FUNDING EUROCURRENCY MarketDealing

Diagram of a Dealing Room

Funding a Eurokrona Loan

Three ways to fund:lTake domestic krona depositlTake EuroKrona deposit

3 MONKRDEP

Funding a Eurokrona Loan

Three ways to fund:lTake domestic krona

depositlTake EuroKrona depositlFund with dollars, hedged

into kronalTake E$ depositlDo FX swap: sell USD spot,

buy USD forward

3 MOE$

Linkages Between Eurocurrency Rates

Interest ratedifferential

Forwardpremium

Expected% change in

exchange rate

Expected% change in

exchange rate

Covered interestrate parity

Unbiasedforward rate

Uncovered interestrate parity

Interest-Rate Parity

$1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt

where St is the spot exchange rate (dollars per British Pound) and Fn

t is the forward rate.

to a close approximation,

(/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100

Interest-rate differential = forwardpremium ordiscount

Example: Anglo’s Funding

l Anglo-American, the natural resources conglomerate, is seeking 3-month US$ funding.uAnglo can fund in the US CP market at

5.5%uOr in the Eurosterling market at 6.7%uThe BP is:

spot $1.5484, 3-mo forward $1.5454 uWhich is cheaper?

Anglo’s Answer

It’s cheaper for Anglo-American to borrow in the US CP market. Reason:uUS: simply borrow for 3 months

qCost: $1(1+5.5%/4) = 1.01375

uUK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the poundsqCost: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478

EXCHANGE RATE Spot

Forward

Actual

Today In threemonths

Unbiased Forward Rate Theory

EXCHANGE RATE Spot

Forward

Actual

Probabilitydistributionof actualexchange rate

Unbiased Forward Rate Theory

Unbiased Forward Rate

Forward premium or discount

= Expected annual rate of changeof the exchange rate

That is,

P$/DM = E(R$/DM )

EXCHANGE RATE

Forward

Actual

Probabilitydistributionof actualexchange rate

International Fisher Effect

INTERESTRATE

DIFFERENTIAL

International Fisher Effect

/E$ = /EDM + E(R$/DM )

That is,

Interest-rate differential equals

Expected annual rate of change ofexchange rate

Cost of Hedging

Type of Hedge Cost of HedgingForward Forward premium

Money Market Hedge(Borrow to matchassets)

Interest ratedifferential

Do nothing Expected rate ofchange ofexchange rate

Law of One Price

p=Sp*The Price of TinIn New York On the Kuala On the

Lumpur London MetalMarket Metal

Exchange273c per lb. 15.37 ringgit US$5830 per= US$6.02 per kilogram tonneper kilograma =US5.70 = US5.83

per kilogramb per kilogramc

a1 avoirdupois pound = 0.45359 kilogramsbUS$1 = 2.6965 Malaysian ringgit on the date of calculationc 1 tonne = 1000 kilogram.All data taken from the Commodities sectionof the London Financial Times.

S t=1-St = I-I*St 1+I*

n JAPAN 1995

n MEXICO 1994

EXCHANGE-RATE

CHANGE

RELATIVE INFLATION

Purchasing Power Parity:Theory and Evidence

Deviations fromPurchasing Power Parity

UNITED STATES

Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

Deviations fromPurchasing Power Parity

Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies, adjusted for change in relative wholesale price of domestic manufactures. A fall in the index indicates improved international competitiveness.

UNITED STATES

JAPANGERMANY

FRANCE ITALY

US Expected Inflation Rate 2%US Expected Inflation Rate 2%

Inflation & Interest Rates

Canadian Expected Inflation Rate 7%Canadian Expected Inflation Rate 7%

US Interest Rate 5%US Interest Rate 5%

Canadian Interest Rate 10%Canadian Interest Rate 10%

US Expected Inflation Rate 2%US Expected Inflation Rate 2%

Canadian Expected Inflation Rate 7%Canadian Expected Inflation Rate 7%

US Interest Rate 5%US Interest Rate 5%

Canadian Interest Rate 10%Canadian Interest Rate 10%

Expected Rate of Changeof the Exchange Rate

Borrow at US Interest Rate 5%Borrow at US Interest Rate 5%

Invest at Canadian Interest Rate 10%Invest at Canadian Interest Rate 10%

Buy Canadian Dollars Forward(at discount of 5%)

Buy Canadian Dollar Futures(at discount of 5%)

The Linkages Again

RELATIVE

EXCESSMONEY

SUPPLY

RELATIVE

INFLATIONRATES

2 3 RELATIVE 4 EXCHANGE

INTEREST RATE

RATES CHANGE

5 6FORWARD

EXCHANGEPREMIUM

OR DISCOUNT

A Framework

Country A Country B

DOMESTIC DOMESTICECONOMIC ECONOMICPOLICIES POLICIES

INFLATION INFLATIONRATE RATE

EXCHANGERATE

INTEREST INTERESTRATE RATE

FORWARDRATE

Turkey, 1995

Turkish Lira:Down 33.5%

Contact Info

Ian H. GiddyNYU Stern School of BusinessTel 212-998-0426; Fax 212-995-4233Ian.giddy@nyu.eduhttp://giddy.org

International Financial Marketspages.stern.nyu.edu/~igiddy/ifmppt/markets.pdflEurocurrency A vs....

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