financialmarkets (1)

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International Financial Markets

and Instruments

An Introduction


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Introduction

In this chapter, we look at

the size of international financial

transactions and assets,

the interaction of financial markets, andtheir 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


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International Bank Deposits and

Lending International liabilities of banks stood at

about $8 bil in 1994, almost twice the sizeof merchandise trade

The breakdown of cross-border claimsshows that the U.S. dollar is thedenomination of choice, followed by themark, and the yen. (In 1999 the $ is usedfor almost 47 % of all international debtsecurities)


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Denomination of Claims

Claims can be in the domestic currency ofthe 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 thistype


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Gross and Net International Bank

lending Gross lending includes

all loans made by banks to foreigners,

loans made by banks to domestic residents inforeign currency

Net lending excludesinterbank deposits (i.e. if a German bank lends

$2 mil to a U.S. bank and a U.S. bank lends $3mil to the German bank, then the net lending isonly $1 mil.


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Gross and Net International Bank Lending

Gross and Net International Bank Lending, Dec. 31, 1995 and 1998

Part A 1995 1998

1) Total cross-border bank claims $7925.8 $9665.4

2) Local claims in foreign currency 1297.9 1382.8

3) Gross international bank lending $9223.6 $11,048.24) Minus: Interbank deposits 4578.6 5563.2

5)Net international bank lending $4645.0 $5485.0

Part B

6) Claims on inside-area countries $7987.4 $9630.510) Claims on outside-area countries 994.3 1200.7

11) Unallocated claims by area 242.0 216.9

Gross international bank lending $9223.6 $11048.2


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BIS 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


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Breakdown of Gross Lending by type

1. Domestic bank loans in domestic currency to

nonresidentsbank in Canada lends C$ to U.S. firm

2. Domestic bank loans in foreign currency to

nonresidentsbank in France lends US$ to U.S. firm (or marks)

3. Domestic bank loans in foreign currency to

domestic residentsbank in France lends C$ to a French citizen

The first of these types is called traditional

foreign bank lending


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Eurocurrency 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 placein Europe

started post WWII when the $ was free to move

and most European countries had currencycontrols

now Eurocurrency doesnt capture market

because transactions take place all over the world


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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 onits fractional reserve system. For example, a $1

million deposit with 10% reserve can lead to

total lending of $10 million ($900 X $810 X)

Eurocurrency market


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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 wherethere were no ceiling on U.S. dollar deposit interest

rates

Eurocurrency market


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Demand sidetight US money supply in late 60s led borrowers

to seek investment money in Europe

US introduced a tax on borrowing by foreignersresult: 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

Eurocurrency market


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Eurocurrency market

Some terms Eurobanks

Banks making loans on the Eurocurrency

market, they are not necessarily in Europe (forexample, the Banks of Singapore)

LIBORLondon Interbank Offered Rate

This is the average of the interbank rates fordollar deposits in London, based on quotes offive major banks (issued at 11 a.m.)

rate at which Eurobanks lend among thems


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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 integrationEurocurrency market has also decreased financial

stability (due to bandwagon effect)

central banks do not have as much control over policy as

in the past.

Eurocurrency market


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International bond market

Promises to pay, issued by governments and

corporations

To be precise, a note is an issue with lessthan 10 year maturity, a bond has more than

10 year maturity

Often, bond used for both short and long

term notes.


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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 paymentamount promised in each year of the life of the bond

For example $60 per year on a $1,000 bond

International bond market: Some terms


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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



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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 multinationalloan syndicate to residents of many countries. The

bonds may be denominated in a number of currencies.



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Note table p. 79

Most international bonds are type 1. Foreign bondsMost issuers are in developed countries (75%)

The most popular currency is the U.S. $

Commercial banks and finanacial institutions issue themost bonds, followed by governments, thencorporations

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



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International Stock markets

a stock (or equity) is a share of a publicly tradedcompany.

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 worthmore when sold than when purchased, the holder earns a profit

More Stocks are traded internationally, as investors seek

international portfolio diversification to reduce risk


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Stock 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.)


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More 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


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Mutual 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 emergingeconomies: 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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Fi i l Li k d E


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Financial Linkages and Eurocurrency

Derivatives

BE AFRAID

BE AFRAIDBE AFRAID

BE AFRAID

IF YOUDONT KNOW

DERIVATIVES

Advertisement in business pages of Globe and Mail, early Jan. 01


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Recall link between interest rates shows thatinvestments will be in equilibrium if

Investment decisions involve two types of

risk

1. exchange rate risk

2. interest rate risk


Derivatives

TRRPxaii LondonNY )(


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We can eliminate exchange rate risk by

using the forward market

Where TR are transaction costs

and, if the exchange market is inequilibrium, thenp=xa


Derivatives

TRRPpii LondonNY )(

Fi i l Li k d E


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If we include the Eurocurrency market in our

analysis, we now have six markets and sixfinancial variables (prices). The variables are:

Interest rates:

U.S. interest rateU.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)


Derivatives


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Fi i l M k t I l di


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Financial Markets Including

Eurocurrency markets

T l f H d i ( i t t t h )


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Tools 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.

2 F t re Rate Agreement


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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 periodsometimes 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

Example:


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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

3 Eurodollar interest rate swap


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3. Eurodollar interest rate swapinvolves 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 paysLIBOR + 3 basis points

Ms Green has a loan at 6.5 %. Ms Green agrees to payMr. Brown the 6-month LIBOR +3, Mr. Brown agrees topay Ms Green 7.0 % (6.5 % + 50 basis points).

Mr. Brown gets a fixed rate, Ms. Green gets a lower rateloan (because she gets 50 basis points)

4 Eurodollar cross currency interest rate swap


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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 anothercurrency. 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 LIBOR+3.

Ms. Green has a loan in $, at 7 %. Mr. Brown and Ms.

Green can swap loans (with Mr. Brown paying apremium to ensure his interest rate). This might occur if

Ms. Green has income expected in , or Mr. Brown

expected the $ to depreciate.

5 Eurodollar interest rate futures


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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 accountfor 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

5 Eurodollar interest rate futures (continued)


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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 futuresinterest 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 thehigher rate of interest

Long hedge


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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 guaranteeingherself (in this case at most) the future interest rate.

Short hedge

borrowers can guarantee against rise in interest rates byselling 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


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Eurodollar strip

To hedge for longer than three months, an investor can

do so by buying a series of futures contractsFor 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.

Stackfutures 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.

6 Eurodollar Interest rate option


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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 certaininterest 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

Caps floors and collars


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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 inMarch, 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 ratewill not fall below a certain rate is called afloor

A multi-period hedge that guarantees that an interest rate

will not move too far from a certain rate is called acollar

7 Options on swaps


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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 toreceive 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, aputable swap -

gives the side paying the floating rate and receiving a

fixed rate the right to cancel

8 E i fi i l d i i


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8. Equity financial derivatives

equity swap

an investor can swap the returns on a currentlyowned 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 thereforewithout paying local execution fees

it also protects the identity of the investor.


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How to read the tables

Start with Interest rate futures p. 97

Then options, p. 100

Quotes for Tuesday, Feb. 25, 1997


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Eurodollar CME $1 million, pts of 100%Yield Open

Month Open High Low Settle Chg. Settle Chg Interest

Mar 94.51 94.51 94.49 94.51 -.01 5.49 +.01 387,872June 94.38 94.40 94.36 94.37 -.03 5.63 +.03 401,049Sept 94.24 94.26 94.21 94.22 -.03 5.78 +.03 299,364Dec 94.05 94.08 94.01 94.01 -.03 5.98 +.03 220,094Mr98 93.96 93.97 93.90 93.91 -.03 6.09 +.03 187,687

Mr01 93.24 93.24 93.20 93.21 +.01 6.79 -.01 23,874Mr04 92.71 92.72 92.70 92.70 +.01 7.30 -.01 2,036

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.*0.0001/4=25

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 bu 3 million in March would cost 549 X 25 X 3 = 41 175


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Strike price quoted as 100yield, each basis point

is worth $25 To deposit $ 5 mil. In May at 5.5 % would cost

0.18 % or $25 X 18 X 5=2250

Eurodollar Interest Futures Options, Tuesday, February 25, 1997EURODOLLAR (CME) Contracts for $ 1 million; pts of 100 %

Strike Calls --- Settle Puts --- Settle

Price Mar Apr May Mar Apr May

9400 0.51 0.38 -- 0.00 0.01 0.02

9425 0.26 0.16 0.18 0.00 0.04 0.06

9450 0.03 0.02 -- 0.03 0.15 --

9475 0.00 0.00 -- 0.24 -- --

9500 0.00 0.00 -- 0.49 -- --9525 0.00 0.00 -- 0.74 -- --


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Eurodollar Interest Futures Options, Tuesday, February 25, 1997$


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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?

EURODOLLAR (CME) Contracts for $ 1 million; pts of 100 %Strike Calls --- Settle Puts --- Settle

Price Mar Apr May Mar Apr May

9400 0.51 0.38 -- 0.00 0.01 0.02

9425 0.26 0.16 0.18 0.00 0.04 0.06

9450 0.03 0.02 -- 0.03 0.15 --

9475 0.00 0.00 -- 0.24 -- --

9500 0.00 0.00 -- 0.49 -- --

9525 0.00 0.00 -- 0.74 -- --


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Assignment 2

Look for it on the web or in your email by

Monday!

Due date changed to Feb. 20, due to reading

week.

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