Lecture 13: International Money Markets

The Eurocurrency Markets

Where is this Financial Center?

Grand Cayman

Stingray City Turtle Burgers

Grand Cayman Islands as an Offshore Financial Center

Offshore Financial Center: Countries or jurisdictions with financial centers that contain financial institutions that deal primarily with nonresidents and/or in foreign currency on a scale out of proportion to the size of the host economy (OECD definition). Characterized by a low (or

zero) tax environment and specializing in providing corporate and commercial services (including investment services) to non-resident entities on a confidential basis. .

Grand Cayman Islands (population 52,000): 533 banks, with approximately US$415 billion in

deposits (making it fifth largest financial center in the world). Other financial companies include insurance, cash management, asset management (including hedge funds).

Foreign companies generally register as an “exempted company” because they are guaranteed against any future taxes for at least 30 years. In addition, its list of shareholders is not open to public inspection, they do not have to file annual returns and no annual audits are required.

Total start-up costs to form an exempted company range between $2,300 and $3,000. Annual maintenance costs and government fees thereafter run about $2,000

There are no personal income taxes, no corporate income taxes, no capital gains taxes, no withholding taxes, no estate, gift or inheritance taxes, no sales taxes in the Cayman Islands. The Caymans have no tax treaties with any nation.

Examples of Offshore Financial Centers: IMF Data (1999)Africa Asia and

PacificMiddle East Europe Western

Hemisphere

Djibouti Cook Islands Bahrain Gibraltar Bahamas

Liberia Guam Israel Isle of Man Barbados

Mauritius Hong Kong Lebanon Liechtenstein Bermuda

Seychelles Macao Luxembourg Cayman Islands

Tangier Philippines Malta Panama

Singapore Monaco Puerto Rico

Tahiti Switzerland St. Lucia

The International Financial Market It is the overall financial environment in which global

businesses and global investors operate. It is represented by the following three sectors: (1) Foreign Exchange Markets

Currency markets (including foreign exchange regimes) (2) International Money Markets (Markets for short term

funds) Traditional Financial Centers servicing both their domestic

markets and non-residents (e.g., London, New York, Chicago, Tokyo)

Offshore Financial Centers Markets consisting primarily of non-resident financial institutions and non-resident clients: (e.g., Cayman Islands, Singapore, Hong Kong).

(3) International Capital Markets (Markets for long term funds) Bond markets (Lecture 14) Equity markets (Lecture 15)

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) financial intermediaries (primarily large global banks) or through access to (2) direct financial markets. Intermediary markets include:

Eurocurrency Loan Market (i.e., Euro-Lines of Credit) Eurocredits Market (i.e., Syndicated Eurocredits)

Direct markets include: Short Term and Medium Term Euro-notes Market Eurocommercial Paper Market

The Eurocurrency Market The international money market has as its core the

euro-currency deposit market, also called the offshore currency market.

A Eurocurrency is a freely convertible currency deposited in a bank outside its country of origin. For example, Eurodollars are U.S. dollar-denominated time

deposits in banks located outside of the United States. This deposit market supports the borrowing and

lending of “offshore” currencies. Banks accepting euro-currency deposits can be

local banks (i.e., domestic to the financial market), or foreign banks operating in the local market (including U.S. banks). These banks are referred to as Eurobanks. Major

Eurobanks include Citi, Deutsche, and UBS.

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 a potential freeze of their dollar accounts in US banks, shifted their deposits to London. The first bank in the London market accepting these dollar deposits was

the Banque Commercial pour I'Europe du Nord was also known by its cable code, EUROBANK.

In the 1970s the market received a further boost when OPEC countries “re-cycled” their dollar earnings into the London markets. London’s advantage was two fold: (1) deposits were not subject to

reserve requirements and (2) unlike the U.S. at that time there were no limitations on interest which could be paid on such deposits.

London banks recycled these deposits in the form of loans to governments and corporates.

Eurocurrency Market Structure The Eurocurrency market is essentially a wholesale

market (as opposed to a retail market). Participants include large global banks and other large

financial institutions, large multinational corporations, and governments.

Estimated size of market (2011): $6 trillion. Transactions tend to be large (multiples of $1,000,000). Approximately 80% of the market is interbank. The market is confined to time deposits. The market is essentially unregulated and deposits

are not insured. The Eurocurrency market is primarily a Eurodollar

market (approximately 2/3rds). Eurocurrency markets exist all over the world, but

the major and largest market is in London (with an estimated 20% of the total market).

Interest Rates in the Interbank Eurocurrency Market In the London interbank Eurocurrency market

there are two important interest rates: (1) London Interbank Bid Rate: The interest

rate which a Eurobank will offer on (“deposit rate”); referred to at LIBID.

(2) London Interbank Offer (Ask) Rate: The rate which a Eurobank will charge to lend a eurocurrency (“lending or “borrowing rate”); referred to as LIBOR. LIBOR rates will always be higher than LIBID rates

(by about 1/8%).

LIBOR and the BBA Each morning a panel of banks submit their LIBOR

data for 15 different maturities (overnight out to 1 year) in 10 currencies (including the US dollar) to the British Bankers’ Association (BBA). BBA LIBOR is an average of this data. LIBOR is announced around 11:00am in London. For up to date data see:

http://www.global-rates.com/interest-rates/libor/libor.aspx For a list of panel banks and historical data see:

http://www.bbalibor.com/rates/historical\ LIBOR is important because it is used by banks to

scale loan rates (i.e., as a benchmark rate) to clients in the retail market.

USD LIBOR, November 9, 2011

USD LIBOR Panel, As of May 2011

EURIBOR Market Euribor stands for Euro interbank offered rate. These interest rates for the Euro deposits are

compiled by the European Banking Federation (FBE—Fédération Bancaire de l'Union Européenne) Rates are released at 11:00 AM Brussels time, each

business day. Rates are quoted for one week and monthly maturities out

to a year. Overnight rates are referred to as EONIA (Euro Overnight Index

Average) rates Euribor is more widely used than Euro Libor. For up to date EURIBOR data see:

http://www.global-rates.com/interest-rates/libor/libor.aspx

EURIBOR, November 9, 2011

Eonia (Euro Overnight Index Average) Rates

The Eurocurrency Markets and Global Firms The Eurocurrency market serves two valuable

functions for global firms: (1) Investment Market: The market allows global firms

to earn a return on their excess (i.e., “idle”) funds. Can be tailored to the needs of clients as Eurocurrency

time deposits have maturities from overnight to 12 months.

They generally offer higher rates than domestic deposits. (2) Borrowing Market: Eurocurrency loans are an important

source of short-term and intermediate term loans for global firms (generally to finance working capital needs). These Eurocurrency loans generally carry lower interest

rates than domestic loans.

Interest Rate Comparisons: Investing Market November 3, 2011

Maturity Eurodollar deposit rates (London)

Certificate of Deposits U.S. (Secondary Market)

Commercial Paper U.S. Non-financial Firms

U.S. Treasury Bills (Secondary Market)

1-month 0.35% 0.20% 0.13% 0.01%

3-months 0.49% 0.37% 0.17% 0.01%

6-months 0.68% 0.51% n.a. 0.04%

Source: http://www.federalreserve.gov/Releases/H15/update/

Interest Rate Comparisons: Borrowing MarketNovember 3, 2011

12-Month LIBOR Prime Lending Rate

Prime - LIBOR

U.S. 0.95% 3.25% 2.30%

Japan 0.55% 1.48% 0.93%

Canada 1.71% 3.00% 1.29%

U.K. 1.77% 3.96% 2.19%

Germany 2.01% 3.77% 1.76%

Australia 4.96% 7.28% 2.32%

Switzerland 0.31% 2.73% 2.42%

Sweden 2.85% 3.39% 0.54%

Denmark 1.66% 4.30% 2.64%

LIBOR and Domestic Interest Rates Summary: LIBOR rates will generally parallel the

rates on equivalent borrowing and deposit opportunities in each country’s domestic financial market. As noted: lending rates will generally be lower than

equivalent domestic market rates, and deposit rates will generally be higher than equivalent domestic market rates.

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 (arising from less regulations and domestic lending requirements – e.g., compensating balances).

External Financing of the Global Firm

Intermediary Markets:Banks & other financial inst.

Direct Markets:Capital markets & money markets

Sources of

External Funds

forthe

GlobalBusiness

Firm

Financing in the Parent Country’s Financial Market(Debt and Equity)

Bank Loans: Local Currency Debt

Eurocurrency Financing: Banks and Direct Markets

Long-term Bond Financing: Foreign and Offshore Bonds

Financing with Debt in

Foreign Countries’ Financial Markets

Joint Venture with Foreign Partners

Issuing Shares to Foreign Shareholders

Financing with Equity in

Foreign Countries’ Financial Markets

Eurocurrency Loans (Euro-Lines) Eurocurrency loans (also called euro lines)

are short term lines of credit against eurocurrencies offered by Eurobanks. Specifically 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 are two cost elements in a Euroline: (1) There is a fee for the line of credit itself (about 1/4 to

1/2 of 1% per annum on the unused portion of the line). (2) Plus an interest rate applied against any borrowed

amount. Interest rate on borrowed amount is scaled to LIBOR

Eurocredits Eurocredits are short- to medium-term euro-

currency loans made by Eurobanks. Often these loans are too large for one bank to

underwrite, thus many banks will form a syndicate to share the size and risk of the loan (hence, they are called syndicated eurocredits).

Eurocredits generally feature a “roll over provision.” At maturity, the loan can be extended by mutual

agreement between lender and borrower. At roll over, the interest rate is re-scaled to the new

LIBOR.

Rolling Over a Eurocredit

11 22 33 44 55 66Today

Loan is re-scaled at new Loan is re-scaled at new LIBORLIBOR every six months, every six months, with interest payments made on those roll-over dateswith interest payments made on those roll-over dates

Example: Roll Over of a 6 Month Euro-Credit

years

etc. etc.etc. etc.etc.

Euronotes Euronotes are 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 and can trade in secondary markets.

Euro-Medium-Term Notes (MTNs) MTNs are 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.” With this type of program, 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 (many do on the London Stock Exchange).

These instruments generally bridge the maturity gap between Eurocommercial paper and Eurobonds.

Eurocommercial Paper Eurocommercial paper are 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 is becoming more important. Placed directly with investors through a dealer.

Through a “Eurocommercial Program” with a dealer who places the issues with potential investors.

Appendix 1

Offshore Financial Centers

History: Offshore Financial Center Origins of offshore financial centers:

In the 1920, wealthy American, UK and Canadian citizens established offshore trusts in the Bahamas and the Cayman Islands (to minimize their taxes). See:

http://www.offshore-manual.com/taxhavens/CaymanIslands.html

In the 1960s and 1970s, US banks established offshore branches to escape US regulations and to book euro-currency loans.

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. See following slides for IMF data.

Examples of Offshore Financial Centers: IMF Data (1999)Africa Asia and

PacificMiddle East Europe Western

Hemisphere

Djibouti Cook Islands Bahrain Gibraltar Bahamas

Liberia Guam Israel Isle of Man Barbados

Mauritius Hong Kong Lebanon Liechtenstein Bermuda

Seychelles Macao Luxembourg Cayman Islands

Tangier Philippines Malta Panama

Singapore Monaco Puerto Rico

Tahiti Switzerland St. Lucia

Source: