Chapter 21 International Financial Markets and Instruments An

Chapter 21 International Financial Markets and Instruments: An Introduction Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Learning Objectives § Summarize the fundamental components of international financial markets. § Illustrate how global money markets, interest rates, and foreign exchange markets are interdependent. § Describe the types and roles of international currency and monetary derivatives. 21 -2

International Bank Lending § Banks’ balance sheets commonly have loans and deposits that are international in origin. § As of 2008, gross international bank lending was $37. 5 trillion! 21 -3

International Bank Lending § Gross international bank lending can be divided into three components: • domestic bank loans in domestic currency to foreigners, • domestic bank loans in foreign currency to foreigners, and • domestic bank loans in foreign currency to domestic residents. § The first is called “traditional foreign bank lending. ” § The second and third represent the eurocurrency market. 21 -4

The Eurodollar Market § Eurodollar deposits arise when a U. S. exporter wishes to sell goods to a foreigner, is paid in dollars, and wishes to leave the dollars in an account in a foreign bank. § The Eurodollar market began to be important in the 1950 s, as the USSR chose to put dollar-denominated deposits in British (rather than American) banks. § Other factors, such as the oil shocks in the 1970 s, increased Eurodollar holdings. 21 -5

The Significance of Eurodollar Markets § The rise of Eurodollar markets has significantly increased the international mobility of financial capital. § This means that interest rates have been increasingly linked across countries, and have moved toward each other. § One drawback is that financial problems quickly spread worldwide, such as happened in 2008. 21 -6

The International Bond Market (Debt Securities) § Government and corporations can borrow money by issuing bonds. § Bonds have a face value – this is the amount that will be paid to the lender when the bond matures. § Foreign bond markets and eurobond markets together comprise the international bond market. § The stock of this sort of debt was $23. 9 trillion as of 2008. 21 -7

Significance of the International Bond Market § As with the Eurodollar markets, the increasing importance of international bond markets has increased the international mobility of financial capital, and countries’ interest rates have moved toward each other. § This increased interdependence also helps spread financial problems. 21 -8

International Stock Markets § Ownership in companies (common stock) is another asset that is traded internationally. § Exact figures on the volume of international stock transactions are difficult to obtain, but most believe these have increased. § This may create a tendency for movements of stock prices across countries to become more similar to each other. 21 -9

Significance of the Rise of International Stock Markets § The increasing importance of international stock markets has facilitated the flow of financial capital to its most productive use. § This increased interdependence can also allow financial problems to spread quickly, as was demonstrated in 2008. 21 -10

Basic International Financial Linkages: Review § As we learned in Chapter 20, investors will be indifferent between domestic and foreign investment when (ihome – iforeign) ≈ p = xa – RP, where p is the forward exchange rate premium. 21 -11

Basic International Financial Linkages: An Example § How does the Eurodollar market change our understanding of financial linkages? § Suppose Lending i. NY 7% Lending i. London 8% Lending i. Euro$ London 6. 5% Lending i. Eurosterling NY 7. 5% Deposit i. NY 5% Deposit i. London 6% Deposit i. Euro$ London 5. 5% Deposit i. Eurosterling NY 6. 5% Spot e$/£ 1. 691 3 -months forward e$/£ 1. 687 21 -12

Basic International Financial Linkages § If covered interest arbitrage parity holds, after dividing the annual interest rate difference by 4 to approximate a 3 -month rate we get (ihome – iforeign) ≈ p (0. 07 -0. 08)/4 ≈ (1. 687 – 1. 691)/1. 691 -0. 0025 ≈ -0. 0025. 21 -13

Basic International Financial Linkages § What happens if the Federal Reserve raises U. S. interest rates by ½ of a percentage point? Now, the eurodollar deposit rate will rise to 6% and the eurodollar lending rate will rise to 7%. § We’d also expect the forward rate to rise (the dollar depreciates) and the spot rate to fall (the dollar appreciates). 21 -14

International Financial and Exchange Rate Adjustments S' $ S$ i i' NY money market i D€ $ 21 -15

International Financial and Exchange Rate Adjustments § The higher interest rate in New York increases demand for eurodollars. § This will put upward pressure on the eurodollar rate. 21 -16

International Financial and Exchange Rate Adjustments S$ i i' i 0 London money market (eurodollars) D$ D‘$ $ 21 -17

International Financial and Exchange Rate Adjustments § The higher U. S. interest rate leads to an increased supply of pounds on the spot market; this additional supply is hedged in the forward market. 21 -18

International Financial and Exchange Rate Adjustments e$/£ S£ S'£ Spot market e$/£ e'$/£ D£ £ 21 -19

International Financial and Exchange Rate Adjustments e$/£ e'$/£ e$/£ St€ Forward market D£ D'£ € 21 -20

International Financial and Exchange Rate Adjustments § Further adjustments might occur in the U. K. ’s money market and the eurosterling market that would lead to higher interest rates there, but the Bank of England may intervene to prevent this. 21 -21

Hedging Eurodollar Interest Rate Risk § New instruments, called derivatives, have emerged to hedge interest rate risk. § Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, etc. 21 -22

Commonly Used Derivatives § § § § Maturity mismatching Future rate agreements Eurodollar interest rate swaps Eurodollar cross-currency interest rate swaps Eurodollar interest rate futures Eurodollar interest rate options Options on swaps Equity financial derivatives 21 -23

The Current Global Derivatives Market § Futures have been traded on metals and agricultural commodities for more than a century, so the idea of derivatives isn’t new. § However, in the past 25 years there has been an explosion in the use of global derivatives. § Annual growth rates have been in the range of 20%-30%. 21 -24

Values of Selected Global Derivatives, 1987 -2008 (in billions of dollars) 1987 2008 A. Exchange-traded instruments $730 $59, 797 Interest rate futures 488 19, 271 Interest rate options 123 35, 161 Currency futures 15 102 Currency options 60 126 Stock mkt index futures 18 729 Stock mkt index options 28 4, 409 B. Over-the-counter instruments 866 683, 725 Interest rate swaps 683 356, 772 Currency swaps 183 16, 307 0 62, 162 Interest rate swaps 21 -25

The Current Global Derivatives Market § Why have derivatives become so important? § Participants in the international financial markets have discovered that derivatives can • increase their returns and/or • lower their risk. § Derivatives allow for an unbundling of exposure to foreign exchange risk, interest rate risk, and price risk. 21 -26

The Current Global Derivatives Market § However, as the global financial crisis of 2007 -08 has shown, derivatives cannot eliminate risk. 21 -27