International Financial Markets Prof Ian GIDDY Stern School

What are the Global Financial Markets? l The Foreign Exchange Market Eurocurrency Markets and

The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a

Eurocurrency Market Linkages US Domestic Market EUR 0 CURRENCY MARKET Eurodollar Market Euro-Euro Market

The International Money Markets Source: ft. com Copyright © 2003 Ian H. Giddy International

Interest Rate Linkages in the International Money Market Two stories to tell: l Domestic

Domestic versus Euro The Eurodollar Premium Market price of risk versus Cost of regulation

Foreign Exchange Mechanics and calculations l How banks make money l How banks hedge

Foreign Exchange Quotations Spot Copyright © 2003 Ian H. Giddy Forward points International Financial

Exchange Rates Spot How (2 business Forward Currency quoted days) (90 days) British US$

Foreign Exchange Quotations Bid Offer Spot Forward points Rule: add if bid<offer, subtract if

Foreign Exchange Quotations Bid Spot Forward points Rule: add if bid<offer, subtract if bid>offer

A Typical Forward Contract l We agree today to pay a certain price for

How Does the Bank Hedge a Forward Contract? Hedging approaches: u. Open u. Forward

How Banks Hedge SHORT LONG Today T+2 T+90 Methods: - Spot + swap -

Currency Risk Exposure (The Normal Distribution) Probability 68% 95% > 99% – 3 –

Covered Interest Arbitrage Copyright © 2003 Ian H. Giddy International Financial Markets 19

Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and

Funding a Eurokrona Loan Three ways to fund: l Take domestic krona deposit l

Linkages Between Eurocurrency Rates Interest rate differential Forward premium Copyright © 2003 Ian H.

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Forward premium Copyright

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Uncovered interest rate

Interest-Rate Parity $1 (1 + / E$) = ($1/ S t )(1 + /EBP)

Example: Anglo’s Funding l Anglo-American, the natural resources conglomerate, is seeking 3 -month US$

Anglo’s Answer It’s cheaper for Anglo-American to borrow in the US CP market. Reason:

Case Study: Ecobank's cross-currency loan funding Assignment: You have been asked to fund a

Ecobank Source: ecobank. xls Copyright © 2003 Ian H. Giddy International Financial Markets 32

Ecobank Cost of GBP: 3 19/32 = 3. 5938% l Cost of EUR, hedged

Unbiased Forward Rate Theory EXCHANGE RATE Spot Forward Actual Today Copyright © 2003 Ian

Unbiased Forward Rate Theory EXCHANGE RATE Probability distribution of actual exchange rate Spot Forward

Unbiased Forward Rate Forward premium or discount = Expected annual rate of change of

International Fisher Effect INTEREST RATE DIFFERENTIAL Copyright © 2003 Ian H. Giddy International Financial

International Fisher Effect /E$ = /EDM + E(R$/DM ) That is, Interest-rate differential equals

Cost of Hedging Copyright © 2003 Ian H. Giddy International Financial Markets 41

Corporate Hedging Decisions: Ivoire Rubber Exporting rubber to Mexico, get paid in Mexican pesos.

Corporate Hedging Decisions: Ivoire Rubber Continue funding in U. S. dollars. The peso might

Ivoire Rubber Copyright © 2003 Ian H. Giddy International Financial Markets 44

Ivoire Rubber Copyright © 2003 Ian H. Giddy International Financial Markets 45

Cost of Hedging Copyright © 2003 Ian H. Giddy International Financial Markets 46

Tuesday: Bank and Bond Financing Connexion loan Don Pedro Hydro Westpac Eurobonds Copyright ©

Cap des Biches: Choices for the BCEAO Foreign-exchange intervention l Money-market intervention (consider interaction

Cap des Biches: Choices for GTI-Dakar “We must decide whether it’s worth covering our

Cap des Biches: Choices for GTI-Dakar n n n Renegotiate the $30 million loan,

Copyright © 2003 Ian H. Giddy International Financial Markets 53

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International Financial Markets Prof. Ian GIDDY Stern School of Business New York University

What are the Global Financial Markets? l The Foreign Exchange Market Eurocurrency Markets and Lending l International Bond Markets l International Equity Markets l Using the Global Capital Markets: Investors’ and Issuers’ Perspectives l Copyright © 2003 Ian H. Giddy International Financial Markets 2

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? Copyright © 2003 Ian H. Giddy International Financial Markets 3

Eurocurrency Market Linkages US Domestic Market EUR 0 CURRENCY MARKET Eurodollar Market Euro-Euro Market Euro-Yen Market Copyright © 2003 Ian H. Giddy German Domestic Market Japanese Domestic Market International Financial Markets 5

Interest Rate Linkages in the International Money Market Two stories to tell: l Domestic vs. Euro l Eurocurrency A vs. Eurocurrency B Domestic Market A Treasury Bill Treasury Bond Copyright © 2003 Ian H. Giddy Bank Deposit Corporate Bond The Euromarkets Euro Deposit Market Euro Bond Market Domestic Market B Bank Deposit Corporate Bond Treasury Bill Treasury Bond International Financial Markets 7

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 Copyright © 2003 Ian H. Giddy International Financial Markets 8

Exchange Rates Spot How (2 business Forward Currency quoted days) (90 days) British US$ 1. 5645 1. 5634 pounds per (GBP) GBP Japanese Yen per 111. 35 109. 85 yen (JPY) US$ Copyright © 2003 Ian H. Giddy International Financial Markets 11

Foreign Exchange Quotations Bid Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward Copyright © 2003 Ian H. Giddy Offer 1. 5645 11 1. 5655 10. 5 1. 5634 1. 5644. 5 International Financial Markets 13

Currency Risk Exposure (The Normal Distribution) Probability 68% 95% > 99% – 3 – 48. 2% Copyright © 2003 Ian H. Giddy – 27. 9% – 1 – 7. 6% 0 12. 7% +1 33. 0% +2 53. 3% +3 73. 6% Return on large company stocks International Financial Markets 18

Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUSFORThe Dealing. SPOT Room WARD TOMER Foreign Exchange Dealing Money FUNDING Copyright © 2003 Ian H. Giddy EUROCURRENCY Market Dealing International Financial Markets 20

Diagram of a Dealing Room Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor. The Dealing Room CUSTOMER SPOT FORWARD Foreign Exchange Dealing Money FUNDING Copyright © 2003 Ian H. Giddy EUROCURRENCY Market Dealing International Financial Markets 21

Funding a Eurokrona Loan Three ways to fund: l Take domestic krona deposit l Take Euro. Krona deposit l Fund with dollars, hedged into krona 3 MO E$ FX DEP SWAP l Take E$ deposit l Do FX swap: sell USD spot, buy USD forward Copyright © 2003 Ian H. Giddy International Financial Markets 23

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Forward premium Copyright © 2003 Ian H. Giddy Expected % change in exchange rate International Financial Markets 25

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Forward premium Copyright © 2003 Ian H. Giddy Uncovered interest rate parity Expected % change in exchange rate International Financial Markets 26

Linkages Between Eurocurrency Rates Interest rate differential Covered interest rate parity Uncovered interest rate parity Expected % change in exchange rate Forward premium Unbiased forward rate Copyright © 2003 Ian H. Giddy International Financial Markets 27

Interest-Rate Parity $1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt where St is the spot exchange rate (dollars per British Pound) and Fnt is the forward rate. to a close approximation, (/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100 Interest-rate differential = forward premium or discount Copyright © 2003 Ian H. Giddy International Financial Markets 28

Example: Anglo’s Funding l Anglo-American, the natural resources conglomerate, is seeking 3 -month US$ funding. u. Anglo can fund in the US CP market at 5. 5% u. Or in the Eurosterling market at 6. 7% u. The BP is: spot $1. 5484, 3 -mo forward $1. 5454 u. Which is cheaper? Copyright © 2003 Ian H. Giddy International Financial Markets 29

Anglo’s Answer It’s cheaper for Anglo-American to borrow in the US CP market. Reason: u. US: simply borrow for 3 months q Cost: $1(1+5. 5%/4) = 1. 01375 u. UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3 -mo forward rate to repay the pounds q Cost: Copyright © 2003 Ian H. Giddy ($1/1. 5484)(1+6. 7%/4)1. 5454 = 1. 01478 International Financial Markets 30

Case Study: Ecobank's cross-currency loan funding Assignment: You have been asked to fund a 3 -month USD 3 million loan made by your bank's Paris branch. Assuming the bank can borrow at market rates in any of the major money markets, which is the most costeffective funding source? Copyright © 2003 Ian H. Giddy International Financial Markets 31

Unbiased Forward Rate Theory EXCHANGE RATE Probability distribution of actual exchange rate Spot Forward Actual Today Copyright © 2003 Ian H. Giddy TIME In three months International Financial Markets 36

International Fisher Effect /E$ = /EDM + E(R$/DM ) That is, Interest-rate differential equals Expected annual rate of change of exchange rate Copyright © 2003 Ian H. Giddy International Financial Markets 40

Corporate Hedging Decisions: Ivoire Rubber Continue funding in U. S. dollars. The peso might get stronger in the next three months, from $1=128 pesos to $1=126 pesos. This could be the cheapest l Switch funding to pesos, despite the slightly higher cost l Borrow in dollars, but hedge the exchange risk in the forward market. l Copyright © 2003 Ian H. Giddy International Financial Markets 43

Concepcion

Cap des Biches: Choices for the BCEAO Foreign-exchange intervention l Money-market intervention (consider interaction with monetary policy) l Fiscal policy--the demand side l Tariffs and subsidies l Exchange controls and capital controls (and jawboning) l Copyright © 2003 Ian H. Giddy International Financial Markets 49

Cap des Biches: Choices for GTI-Dakar “We must decide whether it’s worth covering our dollar exposure, given the forward premium and relative interest rates. ” Copyright © 2003 Ian H. Giddy International Financial Markets 50

Cap des Biches: Choices for GTI-Dakar “We must decide whether it’s worth covering our dollar exposure, given the forward premium and relative interest rates. ” What is the probability of a devaluation? n How much? n What should GTI-Dakar do? n Copyright © 2003 Ian H. Giddy International Financial Markets 51

Cap des Biches: Choices for GTI-Dakar n n n Renegotiate the $30 million loan, replacing it with a loan denominated in Euros Keep the USD loan in place, but enter into a 6 -year currency swap to effectively convert GTI's payments into Euros. Hedge the dollar-Euro risk by buying dollars forward, with rolling 3 -month forward contracts Hedge against a possible devaluation of the CFA franc, by selling francs in the 3 -month forward market. Leave the dollar loan unhedged, and pass the cost of any foreign exchange losses on to Senelac, the buyer of GTI's power Do nothing now but watch the situation carefully and hedge if the risk becomes too great. Copyright © 2003 Ian H. Giddy International Financial Markets 52