Professional Documents
Culture Documents
Eurocurrency Market
Eurocurrency Market
A PROJECT
ON
Eurocurrency market
YEAR 2015-16
DECLARETION BY STUDENT
MR. BHAVYA P. SAVLA The student of M.com Part-I (2015-16) Roll No: 112 hereby
declare that the project for the strategic management titled.
Eurocurrency market
Submitted by me for semester-II during the academic year 2015-16 is based on actual
work carried out by me under the guidance and supervision of Professor V. Manikandan
I further stated that this work is original and not submitted anywhere else for the
examination.
Signature of Student.
EVALUATION CERTIFICATE
This is to certify that the undersigned have assessed and evaluated the project
Eurocurrency market
Submitted by Bhavya P. Savla Student of M.Com part I. This project is original and best of
our knowledge and has been accepted for internal assessment.
Prof. V Manikandan
Internal Examiner
Prof. V Manikandan
External Examiner
I/C PRINCIPAL
ACKNOWLEDGEMENT
It given me immense pleasure to present this project while I taking this opportunity to thank
all of them who helped me to prepare this project and timely guidance received which help
me greatly in the competition of the project.
I would acknowledge my deep sense of gratitude to Prof. V. Manikandan. For his kind cooperation in this project at all stages.His constant support, encouragement and guidance
without which the successful completion of this project would have been impossible.
I would like to thanks our respected principle, librarians and other teaching and non- teaching
staff for their corporation in this project.
Last but not least I would also like to thanks all our friends for their suggestions and valuable
help.
Once again I would like to thanks all those people who have helped me to complete this
project on time.
INDEX
SR
No.
1.
Eurocurrency Market
Page
No.
6-15
2.
16-34
3.
35-38
4.
39-42
5.
43-45
Chapter Name
INTRODUCTION
One of the most controversial issues surrounding the development of Euro-currency
banking concerns the ability of Euro-markets to expand autonomously the stock of
money and credit outside the control of national authorities. The rapid expansion of
international banking aggregates, which have grown by around 25 per cent, per
annum, is said itself to provide evidence of monetary expansion in the Euro-markets.
A short-hand name frequently used to describe this process is the Euro-currency
credit or deposit multiplier.
Two important questions in this issue are: the ability of the Eurocurrency banking
system to expand because a proportion of the funds the banks lend out is redeposited
with them - endogenous money or credit creation and the Euro-currency multiplier
proper; and second, the role of the Euro-markets in increasing the credit-creating or
multiplier potential of the banking system as a whole, i.e. the domestic and
international banking systems combined. When these effects are large they are said
to undermine national monetary policies, in the first case because the monetary
expansion is beyond the direct control of domestic authorities (unlike, for example,
domestic bank deposits in Germany and the United States, Euro-currency deposits
are not subject to legally imposed reserve ratios or direct credit controls); in the
second, because the relationship between the domestic control variable - the supply
of domestic bank reserves - and the stock of money is weakened when deposits are
placed in the Euro-currency market.
This paper reviews the models that have been used to estimate and explain the size
of these "multiplier" effects, and their implications for the rate of expansion of the
Euro-market. Two distinct approaches have been adopted: one characterises the
depositing and redepositing process by fixed coefficients (discussed in Section I),
the other suggests that the size of any multiplier is variable and reflects general
portfolio considerations and interest rate adjustments (Section II). Both depend on
making "plausible" guesses at the likely size of the coefficients and interest rate
adjustments in order to estimate the size of the multiplier. As estimates are, however,
based on ex ante guesses without any ex post verification, the size of the monetary
influence of Euro-banking remains an untested hypothesis. Some new approaches
have therefore evolved to explain the growth and influence of the Euro-market in
terms of empirically observed "institutional" links between the Euro-markets and
national banking systems (Section III). These suggest that it is completely
inappropriate lo treat the Euro-market as a closed or autonomous banking system
and that the role of the Euro-markets in adding to the volume of credit can only he
seen in the context of the world financial system as a whole. The paper concludes
with a short summary of the main analytical conclusions.
Throughout, this paper, as with much of the literature on the subject, focuses on the
role of Euro-banks in intermediating between private non-banks rather than between
banks, although this latter activity is numerically the largest function of the Euromarket. The main issue of importance is the impact of the Euro-markets on the
liquidity of the non-banking sector and whether this is significantly increased by the
activities of Euro-banks outside the control of national authorities. By increasing the
flow of liquidity between national money markets, Euro-markets might enhance the
credit-creating ability of some national banking systems and thus the liquidity of the
non-banking sector. The channelling of funds to domestic commercial or central
banks may also provide balance-of-payments finance which can be used to sustain
the level of world activity. To that extent, Euromarkets will have larger expansionary
effects on the wealth and liquidity of private non-banks. But that is a separate issue
and may be regarded as being caught by national policies. These effects would,
however, be factors explaining any Euro-currency re-depositing multiplier. Another
issue which is briefly considered, because of its policy implications, is the role of
central-bank deposits in explaining the size of any Euro-currency multiplier.
Euromarkets
These can broadly be classified as Eurocurrency and Eurobond markets. We want to
focus on how MNCs can use these international markets to meet their financing
requirements.
Eurocurrency market
Definition and background
The Eurocurrency market consists of banks (called Euro banks) that accept deposits
and make loans in foreign currencies. A Eurocurrency is a freely convertible
currency deposited in a bank located in a country which is not the native country of
the currency. The deposit can be placed in a foreign bank or in the foreign branch of
a domestic US bank.
[Note of caution! The prefix Euro has little or nothing to do with the newly emerging
currency in Europe.]
In the Eurocurrency market, investors hold short-term claims on commercial banks
which intermediate to transform these deposits into long-term claims on final
borrowers.
The Eurocurrency market is dominated by US $ or the Eurodollar. Occasionally,
during weak dollar periods (latter part of 1970s and 1980s), the Euro Swiss franc
and the Euro DM markets increased in importance.
originated post WWII in France and England thanks to the fear of Soviet Bloc
countries that dollar deposits held in the US may be attached by US citizens with
claims against communist governments.
By using Euromarkets, banks and financiers are able to circumvent / avoid certain
regulatory costs and restrictions. Some examples are:
a) Reserve requirements
b) Requirement to pay FDIC fees
c) Rules or regulations that restrict competition among banks
interbank loans are made is called the London interbank offer rate (LIBOR).
This example demonstrates that the Eurocurrency market is a chain of deposits and a
chain of borrowers and lenders. The majority of Eurocurrency transactions involve
transferring control of deposits from one Eurobank to another Eurobank. Loans to
non-Eurobank borrowers account for less than half of all Eurocurrency loans.
The Eurocurrency market operates like any other financial market, but for the
absence of government regulations on loans that can be made and interest rates that
can be charged.
10
Eurocurrency loans
11
The interest rate on the EuroDM loan is LIBOR + 1.75 %, with LIBOR reset every 6
months. If the initial LIBOR6 rate for DM is 6 %, the first semiannual debt service
payment is:
[(0.06 + 0.0175) / 2] * DM 500 mn = DM 19.3750 mn.
Therefore the borrowers effective annual rate (EAC) for the first six months is:
[DM 19.3750 mn / DM 490 mn] * 2 * 100 = 7.9082 %
This EAC changes in every reset period (in this case 6 months) with LIBOR6.
ii) Multicurrency loans
Though most Eurocurrency loans are Eurodollar loans, these often come with a
multicurrency clause.
availability) to switch from one currency to another on any rollover (or reset) date.
This option allows the borrower to match currencies with cash inflows and outflows
(which is an effective way of managing exposure to currency risk, and thus an
effective risk-management technique). The option also allows borrowers to take
advantage of its own expectations regarding currency changes and search for funds
with the lowest effective cost.
Interest rates in national and Eurocurrency markets are closely linked through
arbitrage.
US $ credit markets
US lending rate
US deposit rate
UK deposit rate
The difference between the Euro$ deposit rate and the Eurosterling deposit rate is
given by the forward discount or premium (which approximates the expected change
in the dollar/pound exchange rate).
12
A.
Eurobond markets
Eurobonds are bonds sold outside the country whose currency they are dominated in.
They are similar in many ways to public debt sold in domestic capital markets.
However, the Eurobond market is entirely free of official regulation and is selfregulated by the Association of International Bond Dealers.
Borrowers in the Eurobond market are typically well known and have impeccable
credit ratings (for example, developed countries, international institutions, and large
MNCs). The Eurobond market has grown rapidly in the last two decades, and it
exceeds the Eurocurrency market in size.
i) Currency denomination
About 75 % of Eurobonds are dollar denominated. The most important nondollar
currencies for Eurobond issues are DM and FF (now rapidly replaced by the euro),
the JY and the BP [The Swiss central bank ban has led to the absence of SF
Eurobonds].
ii) Fixed rate Eurobonds
Fixed-rate Eurobonds pay coupons once a year, unlike the semiannual coupon,
domestic bonds in the US market. Borrowers compare the all-in cost, that is, the
effective interest rate, on Eurobonds and domestic bonds.
This interest rate is calculated as the discount rate that equates the present value of
the future interest and principal payments to the net proceeds received by the issuer,
or as the IRR of the bond.
iii) Comparing Eurobond issue with a US domestic issue
To compare a Eurobond issue with a US domestic issue, therefore, the all-in cost of
funds on an annual basis must be converted to a semiannual basis or vice versa.
Thus,
Semiannual yield = [1 + Annual yield]^0.5 1, and
(1)
(2)
13
Illustration II
P & G plans to issue a 5-year bond with a face value of $ 100 million.
Its
investment banker estimates that a Eurobond issue would have to bear a 7.5 %
coupon and that fees and other expenses will total $ 738,000 providing net proceeds
to P & G of $ 99,262,000.
Exhibit 1 shows the cashflows associated with the Eurobond issue. The all-in cost
(IRR) of this issue, which is an annual rate, is shown as 7.68 %. As a cross check,
the third column shows that the PV of the cashflows, using a discount rate of 7.68 %,
sum to P & G s net proceeds of $ 99,262,000.
Alternatively, P & G can issue a $ 100 million, 5-year bond in the US market with a
coupon of 7.4 %. With estimated issuance costs of $ 974,000, P & G will receive net
proceeds of $ 99,026,000.
Exhibit 2 shows the cashflows associated with this issue and its all-in cost (IRR) of
3.82 %. Note that the cashflows are semiannual, as is the all-in cost. Again, the
third column does a cross-check to confirm the 3.82 % all-in cost.
According to Equation (1) above, the equivalent semiannual all-in cost for the
Eurobond issue is (1.0768)^0.5 1 = 3.77 %. Thus, the all-in cost of the Eurobond
is lower, making it preferable if all other terms and conditions on the two bonds are
the same.
Alternatively, using Equation (2) above, we can convert the US bond yield to its
annual equivalent and compare that figure to the Eurobond yield of 7.68 %. This
computation would have yielded an annualized all-in cost of the US bond issue
equal to (1.0382)^2 1 = 7.78 %. As before, the Eurobnd issue is preferable
because its all-in cost is 10 basis points lower.
14
Objectives
METHODOLOGY OF PROJECT.
15
Importance of Project
It is important not only to me but also to the society as well as nation.
Limitation of Project.
Since, I am a college going student, and these project is for university purpose, review
of my project is very limited. I have very limited time and insufficient money, and
hence I have gather very limited data. And because of lack of time, financial crunch,
limited resources, etc , I could not survey much at a primary level.
16
5.
Due to absence of regulation, deposits in this market are unsecured. Due to this
deposits are received only on short term basis (max: one year) whereas loans are
demanded on medium to long term basis. This creates an asset-liability mismatch
which results in Euro-banks being exposed to both liquidity and interest rate risks.
6. To eliminate interest rate risk Euro-banks developed the credit roll-over concept
which involves resetting the interest rates on loans at fixed pre-decided intervals. To
achieve this loans/credits are provided on floating rates of interest. To ensure that
the Interest rates are reset on a fair and equitable basis the concept of reference
rates called LIBOR. (LIBOR London Interbank Offered Rate) was developed.
7.
Each Euro-Currency credit (loan) specifies the periodicity of the roll-over and the
LIBOR to which it is referenced. To provide a uniform profit margin for the lender a
MARKUP is specified over and above the LIBOR. The interest cost to the
17
Euro-Currency
deposit
market
involving
short
term
deposits.
from
investors
through
banks
operating
as
underwriters.
THE
COMPETITIVE
ADVANTAGES
OF
THE
EURO-CURRENCY
MARKET
As the alternative mechanisms of the domestic markets for credit creation and
capital movement, Euro-currency markets must have some competitive advantages.
The main reason of the continuing success of Euro-banking despite the relaxation of
18
regulation on US banks is that they are able to offer higher deposit rate and lower
loan rates than US banks, i.e. the interest rate spread is lower for Euro-banks than
US banks.
SL
Rate of
Interest
SL
SD
SD
D
DL
O
Volume Ooffofsit
SL: the loan supply of the domestic market;
SL: the loan supply of the Euro-currency market
SD: the deposits supply of the domestic market
SD: the deposits supply of the Euro-currency market
DL: the demand of deposits in the domestic market
AB: interest margin in the domestic market
CD: interest margin in the Euro-currency market
Figure 1
The lower Euro-banks interest margin can be accounted for the following factors:
First, Euro-banks, unlike the US banks have no official regulation. They are not
official imposed reserve requirement on banks foreign currency liabilities. Thus
Euro-banks do not need to hold reserve assets. This means they have a lessconstrained asset structure. For example, up until 1990 the Federal Reserve imposed
a 3 per cent reserve requirement on US banks so that for every $100 taken in only
$97 could be lent out; on an interest rate of 10 per cent this amounted to a need to
charge 10.31 per cent to cover the cost of the reserves.
Second, the economies of scale derived in international business, the more
competitive structure of the Euro-currency market. For the size of the Euro-bank
19
deposits and loans is much greater than that of the domestic banks, the cost involved
with per unit dollar deposit and loan transaction is much lower than that of the
domestic banks.
Third, the Euro-banks have a low entry standard which makes the Euro banking
business very competitive. Compared with the Euro-banks, due to the official
regulation and reserve requirement imposed from the central bank, the domestic
banks have more to do to cover the high operation cost and transaction cost.
Fourth, unlike the domestic banks which need to pay the deposit insurance to make
sure their savings are safe and thus eliminate the bank panics, the Euro-banks have
not to do so.
Finally, in the domestic banking business, the domestic banks may have low quantity
customers just like the ordinary savings and deposits from the residents. But since
Euro-currency market is a wholesale market, the Euro-banks only based on the high
quantity customers which means that they can charge a lower risk premium than the
domestic banks do.
Liabilitie
Assets
s
+10m
+10m
20
Net
+10m
+10m
change
However the Euro bank B will not hold that deposits in London but in that bank in
New York. Therefore at this point there is no direct effect on the U.S. money supply
or volume of the bank deposits since only the ownership of the deposits has been
changed in the transaction. However it has increase the total volume of the world
deposits as the U.S. bank has not lost deposits but the Euro bank has gain a deposit
of 10 million dollars which increase the lending capacity of the Euro bank. Then
Euro bank B has to find the customer to lend the deposit for gaining profit from the
differential between the loan-deposit interest rates. Suppose the Euro bank B lends
the deposits on the inter bank market to the Euro bank C. The balance sheet of bank
C is just the same as depicted in the above table and since the bank C will also hold
its dollar deposit in the U.S. bank. Thus the total dollar deposits in the world have no
changes but the ownership does. Continuing bank C has to seek to lend the deposit
and by chance a company in France will borrow the deposits and sell it spot for
French francs and the Banque de France will buy the dollar in order to prevent
upward appreciation of the Francs. The Banque de France will hold the dollar
deposits in the U.S. banks. If the Banque de France deposits in the euro-currency
market the process will repeated and the multiple creation of the euro market credit
will occur.
The key in this case is that the total volume of the world credit increases as the
transfer of funds from U.S. to the euro-dollar market that improve the lending
capacity of the euro banks without reducing that of the U.S. banking system. It also
implies increased velocity of the money. Another essential point is that the dollar has
never leave the United States. Moreover in this case, there is a rise in the foreign
exchange reserves of the Banque de France which results the rise in the highpowered money and the money supply in France.
Thus, the euro currency market must have some competitive advantages that enable
the euro market to provide the credit that would not be given by the domestic
institutions. Considering this issue, it is suitable to use the analytic framework when
discussing the non-bank financial intermediation in two aspects. One is that the
21
intervention.
Thus
because
of
the
interventionbuying
dollar
deposits/selling the domestic currency, the money supply of the central bank will
increase and also the high-powered money. Therefore banks will receive more
deposits which will raise the lending capacity of the domestic banks. And the total
volume of the credit in that country will increase.
22
(4) Identically, if the U.S. residents are facing an excess demand of credit which will
drive up the lending interest rates, they will excess into the euro currency market to
borrow the money for the lower lending interest rates compared with the domestic
banks. Also, if the U.S. residents face another situation of the higher credit
worthyness criteria which means they encounter a high requirement for the
borrowing, they will borrow in the euro currency market.
(5) Actually due to the competitive pressure, Euro banks create a demand of credit that
otherwise will not occur. This is the case in early 1970s, the euro banks were
inducing developing countries to borrow in the euro currency markets on a larger
scale than they had initially planed.
(6) The volume of the world credit will increase to the extent that capital flows through
the euro markets from countries where the banking system has an excess demand of
funds to those having excess supply of the money. This is to say that without the role
euro currency market as the intermediation, the credit effect of increasing the total
volume of the world credit will not exist.
Moreover, Euro-currency market increases the arbitrage opportunity. Normally,
arbitrage involves in two different currencies, for instance, one investor may
arbitrage between sterling and dollar. However, the existence of Euro-currency
market changes this situation. The arbitrage between two different currencies is only
one possibility. The reason for that is after the emergence of the Euro-currency
market; there may be two dollar markets in which one is the dollar deposits in
Untied States and the market of Euro dollars in London. Thus the arbitrage can
happen between the US dollars and the London dollars. This is to say arbitrage may
not always involve in different currencies, but it may involve in the same currency
between two different locations. Also for example, there are Euro-dollar market,
Euro-sterling market, Euro-frank market and Euro-yen market in London. This add
an another arbitrage possibilityarbitrage between different currencies in the
same location.
Thirdly, the Euro-currency market is an important mechanism that banks protect
themselves by acting as a market maker in forward exchange market. As a market
maker in forwards, banks involve themselves in the forward exchange risk. However
the reason for that is they can protect themselves through the Euro-currency market
23
24
(swiss), Euro-sterling and Euro-yen. The use of the prefix Euro is somewhat
misleading because dollar deposits held by banks in Hong Kong or Tokyo are
equally outside the legal jurisdiction of the US authorities and also constitute Eurodollar deposits. This more widespread geographical base means that Euro currency
markets are often referred to offshore markets.
The initial boost of the Euro-currency market trace back to the summer of 1957 with
the sterling crisis: the Bank of England reimposed restriction of sterling financing of
the non UK trade. Because UK banks can not use sterling for external purpose, they
resorted to using dollars for their external operations. And the deficit on the US
balance of payments emerged in the late 1950s resulted in increased foreign holdings
of dollars. By mid-1958, a European market in dollar deposits and loans had
become established.3 There are other causal factors that induce the development of
the Euro-currency market, such as monetary policy and capital control in the US; the
breakdown of the Bretton Woods and the floating of the Exchange rates; recycling
and the international debt crisis and the interbank market and the financial
innovation.
EUROCURRENCIES
The Eurocurrency market is an important source of debt available to the MNE. A
Eurocurrency is any currency that is banked outside of its country of origin.
Eurodollars, which constitute a fairly consistent 65-80 percent of the market, are
dollars banked outside of the United States. Dollars held by foreigners on deposit in
the United States are not Eurodollars, but dollars held at branches of U.S. or other
banks outside of the United States are Eurodollars. Similar markets exist for EuroJapanese yen (Euro-Yen), Euro-German marks (Euro-Deutsche marks), and other
currencies,
such
as
British
pounds,
Swiss
francs,
and
French
francs.
The Eurocurrency market is worldwide. Large transactions take place in Asia (Hong
Kong and Singapore), the Caribbean (the Bahamas and the Cayman Islands), and
Canada, as well as in London and other European centers. However, London is the
key center for the Eurocurrency market, given that nearly 20 percent of all
Eurocurrency transactions in 1989 took place in London. Luxembourg is the center
for Euro-Deutsche mark deposits, with Brussels and Paris the centers for Euro-
25
Sterling
deposits.
demand
for
Eurocurrencies
comes
from
individuals,
firms,
and
governments that require funds for operating capital, investment, and the
payment of principal and interest on debt. Eurocurrencies exist partly for the
convenience and security of the user and partly because of the cheaper lending rates for the borrower and better yield for the lender. The security issue
arose because some governments feared currency controls in the United
States and decided that they wanted to, hold their U.S. dollars offshore.
Eurocurrency Expansion
The key to Eurocurrency expansion is the fractional reserve concept. The
total size of the Eurocurrency market is much greater than the actual cash
deposited. Once a Eurocurrency (assume dollar) deposit is made in a London bank,
the bank may use that asset as a basis for making a dollar-denominated loan to
someone else. The fraction of the original deposit not loaned out is called the
fractional reserve. Since there are no reserve requirements on Eurocurrency deposits,
it is up to the individual bank to determine how much protection it requires in the
form of reserves. The expansion occurs when the initial loan is spent, deposited in
another bank, or used as a basis for another loan.
Even though there are no specific Eurocurrency controls, banks are subject to
solvency rules, and Eurocurrency assets and liabilities are a part of the overall assets
and liabilities of the bank that are subject to capital ratios and capital provisions. In
26
some cases, such as in Britain with the Bank of England, liquidity is monitored very
closely; a Central Bank can issue more of its own currency to ease a liquidity crisis,
but it would be hampered by a liquidity crisis caused by another currency.
Market Size
The size of the market is difficult to determine and depends on whether the gross or
net size is being discussed (the net size eliminates transfers between banks). Gross
liabilities usually are just over twice the net size of the market. In 1971 the total
gross Eurocurrency market size was about $150 billion. As Fig Q , shows, the
market grew to $4,561 trillion by March 1988. It was
Estimated that the market reached $6.1 trillion by September 1989.6 Figure 9.2
illustrates that the dollar portion of the Eurocurrency market has remained over 70
percent for most of the past decade, although the importance of the dollar has
diminished in recent years, especially as the dollar has fallen in value. By 1988 the
dollar portion had slipped to less than 70 percent. As the dollar rises in value,
however, the dollar portion of Eurocurrencies will also rise.
27
facto, Austria and Switzerland have joined the system and it is believed that the
Scandinavian countries will follow. Experts believe that eventually Britain will
succumb to the pressure to participate in the exchange rate: "Otherwise, it would
find itself left out in the cold, even though it is Europe's leading financial center"
(Seipp, 1989, p. 302).
The trend now is for the EMS to be extended, with the ultimate goal one of setting
up a European central bank system comparable to the Federal Reserve in the United
States. Europe appears headed in this direction though there is nothing in the C
market enabling legislation that actually specifies a common currency to replace the
peso, mark, pound sterling, franc and lira (Brimelow, 1990, p. 88). However, plans
for one are being considered.
Such a move would happen in stages. Excluding the pound, most European
Community currencies already are held fairl the euro-currency market in Europe and
its role
Y steady to each other thanks to the EMS. "Over time, this relationship is to become
tighter, central banks will coordinate policy more, and eventually both currencies
and central banks will merge-one currency, one central bank" (Brimelow, 1990,
p.88).
Under EMS, most European currencies are tied to the deutschemark. And,
traditionally West Germany's Bundesbank is the most sensitive to inflation of any
central bank in Europe. Therefore, leaders in other countries have always been able
to blame Germany for imposing monetary discipline on then (Brimelow, 1990, p.
88). However, they have also found this discipline hampering to their freedom of
action in manipulating their domestic economies. For instance, in France, inflation
remains high because the franc is generally thought to be fixed too high relative to
the deutschemark (Brimelow, 1990, p. 88).
Under the new plan of merging central banks, the French and others will got to use
some influence in establishing monetary rates. This possibility has the Germans
somewhat nervous. Though publicly supportive, there are signs they would be
reluctant to entrust their monetary fate to those less committed to sound fiscal
28
practices. Indeed, it is for this reason that Switzerland has said it will not join its
franc in a common European currency even if invited.
Bowing to pressure, Prime Minister Margaret Thatcher finally has said Britain
would join this "exchange rate mechanism" on three conditions: When Britain's
inflation rate fell.
Eurocurrency Spreads
A number of fundamental factors explain the smaller spread in the Eurocurrency
markets.
1. Operations: It is a wholesale market; It typically operates in units of $1 million; It
services large and well-known clients; All these lead to low overhead cost.
2. Regulations: No deposit insurance; Market interest on voluntary reserves; tax
incentives.
3. Asset-liability management: Clients are known with high-quality credits smaller
default risk; Floating rate interest + maturity matching reduced interest rate risk; No
prepayment risk.
29
correlation evolution, while with the measures based on regression quantiles we can
analyse changes in correlations over the long run. Finally, through a simple visual
inspection, we also check whether the euro had any major effect on equity and bond
markets volatilities.
IMPACT OF THE EURO ON TERM PREMIA
Applying an LR test to check whether the estimated market-price-of-risk parameters
have changed after the introduction of the euro reveals that not only the macro
parameters are statistically different in the two sub-samples, but also the parameters
that determine how risk factors are priced in the term structure are significantly
different before and after the euro.13 Hence, it would seem that the behaviour of
term premia is different now compared to before the introduction of the euro, and
that this is due partly to changes in the dynamics of the macro state variables, and
partly to changes in the way the market requires compensation for bearing risk
associated with these macro factors.
However, it turns out that, despite these significant changes to the estimates, average
premia are virtually identical before and after the euro introduction. shows the term
structure of average yield premia during the pre-euro period (1975-1998) and during
the euro period (1999-2004). The yield premium can be viewed as the component of
zero-coupon bond yields that are not due to expectations of future interest rates - i.e.
the difference between observed yields and the yields that would prevail if the
expectations hypothesis of the term structure of interest rates were to hold; provides
a definition based on the HTV model. The third curve in, labelled "reprojected",
shows the impact of changes to the price of risk parameters by displaying the
counterfactual average yield premia that would be obtained during the euro period if
macro dynamics were allowed to differ from the pre-euro period, but if, at the same
time, the market price of risk parameters (0 and 1) were held constant at the
estimated pre-euro values. It is clear from the figure that the price of risk parameters
have adjusted in such a way that they offset the (average) effect of the changed
macro dynamics.
The Eurocurrency Market
30
A eurocurrency is
any
currency
banked
outside
of
its
country
of
origin. Eurodollars, which account for about two-thirds of all eurocurrencies, are
dollars banked outside of the United States. Other important eurocurrencies include
the euro-yen, the euro-deutsche mark, the euro-franc, and the euro-pound. The
term eurocurrency is actually a misnomer because a eurocurrency can be created
anywhere in the world; the persistent euro- prefix reflects the European origin of the
market. As we shall see, the eurocurrency market is an important, relatively low-cost
source of funds for international businesses.
Genesis and Growth of the Market
The eurocurrency market was born in the mid-1950s when Eastern European holders
of dollars, including the former Soviet Union, were afraid to deposit their holdings
of dollars in the United States lest they be seized by the US government to settle US
residents' claims against business losses resulting from the Communist takeover of
Eastern Europe. These countries deposited many of their dollar holdings in Europe,
particularly in London. Additional dollar deposits came from various Western
European central banks and from companies that earned dollars by exporting to the
United States. These two groups deposited their dollars in London banks, rather than
US banks, because they were able to earn a higher rate of interest (which will be
explained).
The eurocurrency market received a major push in 1957 when the British
government prohibited British banks from lending British pounds to finance nonBritish trade, a business that had been very profitable for British banks. British
banks began financing the same trade by attracting dollar deposits and lending
dollars to companies engaged in international trade and investment. Because of this
historical event, London became, and has remained, the leading center of
eurocurrency trading.
The eurocurrency market received another push in the 1960s when the US
government enacted regulations that discouraged US banks from lending to non-US
residents. Would-be dollar borrowers outside the United States found it increasingly
difficult to borrow dollars in the United States to finance international trade, so they
turned to the eurodollar market to obtain the necessary dollar funds.
31
The US government changed its policies after the 1973 collapse of the Bretton
Woods system (see Chapter 10), removing an important impetus to the growth of the
eurocurrency market. However, another political event, the oil price increases
engineered by OPEC in the 1973 - 74 and 1979 - 80 periods, gave the market
another big shove. As a result of the oil price increases, the Arab members of OPEC
accumulated huge amounts of dollars. They were afraid to place their money in US
banks or their European branches, lest the US government attempt to confiscate
them. (Iranian assets in US banks and their European branches were frozen by
President Carter in 1979 after Americans were taken hostage at the US embassy in
Tehran; their fear was not unfounded.) Instead, these countries deposited their
dollars with banks in London, further increasing the supply of eurodollars.
Although these various political events contributed to the growth of the
eurocurrency market, they alone were not responsible for it. The market grew
because it offered real financial advantages--initially to those who wanted to deposit
dollars or borrow dollars and later to those who wanted to deposit and borrow other
currencies. We now look at the source of these financial advantages.
32
33
eurobank might pay the depositor 8.5 percent (which is still above the rate paid by
the New York bank), charge borrowers 9.5 percent (still less than the New York bank
charges), and cover its operating costs even better. Thus, the eurobank has a
competitive advantage vis--vis the New York bank in both its deposit rate and its
loan rate.
Clearly, there are very strong financial motivations for companies to use the
eurocurrency market. By doing so, they receive a higher interest rate on deposits and
pay less for loans. Given this, the surprising thing is not that the euromarket has
grown rapidly but that it hasn't grown even faster. Why do any depositors hold
deposits in their home currency when they could get better yields in the
eurocurrency market?
Drawbacks of the Eurocurrency Market
The eurocurrency market has two drawbacks. First, when depositors use a regulated
banking system, they know that the probability of a bank failure that would cause
them to lose their deposits is very low. Regulation maintains the liquidity of the
banking system. In an unregulated system such as the eurocurrency market, the
probability of a bank failure that would cause depositors to lose their money is
greater (although in absolute terms, still low). Thus, the lower interest rate received
on home-country deposits reflects the costs of insuring against bank failure. Some
depositors are more comfortable with the security of such a system and are willing to
pay the price.
Second, borrowing funds internationally can expose a company to foreign exchange
risk. For example, consider a US company that uses the eurocurrency market to
borrow euro-pounds--perhaps because it can pay a lower interest rate on euro-pound
loans than on dollar loans. Imagine, however, that the British pound subsequently
appreciates against the dollar. This would increase the dollar cost of repaying the
euro-pound loan and thus the company's cost of capital. This possibility can be
insured against by using the forward exchange market (as we saw in Chapter 9) but
the forward exchange market does not offer perfect insurance. Consequently, many
companies borrow funds in their domestic currency to avoid foreign exchange risk,
even though the eurocurrency markets may offer more attractive interest rates.
34
Life goes on in the international bond market, according to the attached example of
the daily report on the primary market as reported in the London Financial Times.
But how many of the bonds that were brought to market on this day September 2001
35
were ordinary, "plain vanilla" deals? Examine each of the issues, taking into account
any associated commentary and footnotes, and try to identify in each case (1) what
the investor is getting, (2) the effective cost to the issuer, and (3) what the
underwriting banks are getting. Pay particular attention to reasons for the differences
in coupons between different issues. Which of these deals would you describe as
"structured financing," and why?
36
Merrill Lynch brought a $100 million convertible deal for Battle Mountaingold to a
lukewarm reception given today's weakness in the price of gold. The borrower is a
US gold producer with interests in Australia and Papua New Guinea.
The par-priced bond were trading at 99 1/8 bid among fair demand from Swiss
institutions and gold funds based in France. A Merrill official said that the paper was
one of the few gold instruments that carried a good yield in addition to upside
potential.
Credit Suisse First Boston was the lead manager of a 150m three-year bond
for Holderbank Inc., the Swiss cement concern. The bonds offered a 6 1/8 per cent
coupon, and were snapped up by eager Swiss investors.
CSFB was quoting the paper at 100 1/8 bid before the European governments
market backed off, when the price moved to 99 7/8 bid, still very comfortably inside
the 0.22 per cent full underwriting fees. Traders opined that the terms were very
generous, and speculated that Holderbank might even have been able to borrow the
funds more cheaply by going direct to the banks for a loan. "It's a gift," said one
official.
Also in the Euro sector, Credit Commercial de France was the lead manager of a
fungible 750m deal for SNCF, the state railway authority. Combined with the
already outstanding 2bn of bonds, the deal produced the largest recent Eurodenominated issue on the Eurobond market.
The new paper gave little away to investors, with pricing at 37 basis points over
French Governments putting it in line with the trading level of the outstanding
bonds. CCF said that the issue was trading slightly outside fees, at less 1/8 bid.
Cofiroute, a French road management company that builds and maintains
motorways, issued a 300m 15-year bond priced at 38 basis points over swaps. The
company is rated AA- and draws its revenues from motorway tolls. With such
issuers "you always know what your cash-flow is going to be," said a spokesman for
BNP Paribas, a lead manager in the deal. "It is a safe but unusual name in the market
and it attracted a lot of French pension funds and insurance companies." Only 20%
37
was sold outside France. BNP Paribas is also marketing a dual currency deal from
Schlumberger, an oil drilling equipment company. The deal would comprise 1.4bn
and GBP500m and could come to the market as early as next week.
An unusual 100mn kroon deal for Tallinn-based Hansabank traded around full fees,
and was in demand from German as well as French funds. Proceeds were swapped
into floating-rate US dollars. The Estonian kroon is linked to the Euro.
In a new product aimed at high net worth Asian investors and institutions, Credit
Agricole Indosuez and Momentum, the US-based fund house, have teamed up to
launch a capital-guaranteed note tied to hedge fund performance. This structured
note assures investors 100 percent of the initial investment at maturity, plus an
option on a selection of Momentum's fund of hedge funds.
Fuqua Industries, a US consumer products group, announced in Switzerland a partial
buy-back offer on its Sfr100m 6 per cent deal issued by UBS Warburg in 1999. The
borrower said it is willing to buy up to Sfr30m of the deal at 82 per cent plus accrued
interest. Before the offer, which is open until tomorrow, the paper was trading at
around 76 points.
Borrower
Amou
nt m.
Coupo
Price
n%
Moodys/S&
Maturit
P
Fees
y
Ratings
Bookrunn
er
Celworks
Trust
2001-1 (a)
US$25
0
4 3/8
99.80
Mar
2008
Aaa/AAA
0.30
Salomon
Marui
Corp*
US$20
0
3/8
100
Sep
2005
A3/A-
1.75
Nomura
5 1/2
100
Sep
Ba2/BB-
2.12
Merrill
Battle
US$10
Mountaingol
38
2016
Lynch
ING
BaringsBBL
Aa3/AA-
0.22
CSFB
ING Groep
600
NV (S)
6 1/2
100
Holderban
k
150
6.125
100.12 Dec
5
2004
4 1/2
98.55
Nov
2007
Aa1/AAA
0.07
CCF
Cofiroute
300
5.875
99.11R
Oct
2016
-/AA-
0.40
BNP
Paribas
Hansabank
EEK10
7.625
0
101
3/8
Sep
2004
Aa2/AA
0.35
Deutsche
100
3/4
Mar
2003
-/-
0.75
CAI,
HSBC
C. Agricole
Indosuez
A$15
(d)
Undated A1/A
39
As the world's reserve currency, the U.S. dollar is the most actively traded currency;
pairs involving the dollar make up the majority of transactions.
Most
currency
trading
strategies
fall
into
two
broad
40
Investors with no intention of directly trading foreign currencies, however, can benefit
from a better understanding of the links between international currencies because
these currency movements can ultimately affect the value of other financial assets.
Four major currency pairs are the most popular: EUR/USD, the euro and the U.S.
dollar; USD/JPY, the U.S. dollar and the Japanese yen; GBP/USD, the British pound
sterling and the U.S. dollar; and USD/CHF, the U.S. dollar and the Swiss franc.
Because they are the two most popular currencies in the world, the euro and the U.S.
dollar are the most actively traded currency pair.
Most foreign currencies trade against the U.S. dollar more often than in a pair with
any other currency. For this reason, it is important for investors interested in the
currency markets to have a firm grasp of the fundamentals of the United
States economy and a solid understanding of the direction in which the U.S. dollar is
going.
While the U.S. dollar is the currency of a single country, the euro is the single
currency of 16 European countries within the European Union, collectively known
as the "eurozone" or the European and Economic Monetary Union (EMU).
The primary factor that influences the direction of the euro/U.S. dollar pair is the
relative strength of the two economies.
Because of Japan's large amount of trade with the United States, Asia, Europe, and
other countries, multinational corporations have a regular need to convert local
currency into yen and vice versa.
The Japanese central bank has been kept its interest rates very low to spur economic
growth following a long period of economic decline. These low interest rates have
made the Japanese yen extremely popular in the carry trade.
The U.S. dollar/Japanese yen pair features low bid-ask spreads and excellent liquidity.
As such, it is an excellent starting place for newcomers to the currency market as
well as a popular pair for more experienced traders.
41
Although the U.K. is a member of the European Union, the country remains outside
the Eurozone (the European Monetary Union, or EMU) and maintains its own
currency, the British pound sterling (known as the pound).
The British pound/U.S. dollar pair is one of the most liquid in the currency market.
As with the euro/U.S. dollar, the most important factor in determining the relationship
between the U.S. dollar and the British pound is the relative strength of the countries'
respective economies.
One unique aspect of trading the British pound is that there is often conjecture that the
U.K. may choose to join the eurozone (or European Monetary Union, known as the
EMU). If this were to happen, the U.K. would have to give up the pound and use
only the euro.
Although the country remains outside the European Union to maintain its
neutrality, Switzerland does enjoy extensive trade with its European neighbors, the
United States and other countries around the world.
Because of Switzerland's historic political neutrality and reputation for stable and
discreet banking, the Swiss franc is commonly viewed as a safe haven in
international capital markets.
Although it is somewhat less liquid than the euro and the pound, the Swiss franc is
still an easy currency to trade.
The factor most likely to cause large movements in the value of the Swiss franc is
international political and economic instability.
The commodity currencies are currencies from countries that possess large quantities
of commodities or other natural resources.
Commodity currency trading typically focuses on three countries that are rich in
natural
resources
and
also
have
liquid,
freely
floating
42
The Canadian economy is also closely linked to the state of the U.S. economy,
because weaker growth in the U.S. can result in decreased exports for Canada.
Australia finds it necessary to import large quantities of goods not produced
domestically. These imports can result in large trade deficits that pressure the
Australian dollar.
New Zealand is a small island nation blessed with many natural resources and a large
agricultural sector. These resources result in the New Zealand economy's heavy
exposure to international commodity prices.
The primary determinant of the movement of the commodity currencies is the price of
commodities.
The currencies of Canada, Australia, and New Zealand are all actively traded but are
less liquid than those of the United Kingdom, Japan or the eurozone.
A currency trading pair that does not involve the U.S. dollar is known as a currency
cross rate.
Because currency cross rates, by definition, do not include the U.S. dollar, the most
heavily traded cross pairs do involve the second most commonly used currency, the
euro.
An investor interested in cross rates does not need to be as concerned with the
fundamentals of the U.S. economy as an investor trading more traditional pairs.
A second unique characteristic of cross rates is that they are usually somewhat less
liquid (and less actively traded) than traditional pairs, bringing both benefits and
drawbacks for investors.
Perhaps the most important factor in cross-rate movements is not what affects them,
but what does not. Cross rates are not directly influenced by the direction of the U.S.
dollar.
43
44
3. Gibson, Heather D., 1989, The Eurocurrency markets, domestic financial policy
and international instability, Macmillan, 2-27.
4. Llewellyn, D.T., Euro currency markets: their credit effects and the dynamics of
monetary policy in International lending in a fragile world economy, 88-116.
5. Mayer, Helmut W., Credit and liquidity creation in the euro currency market,
Bank for International Settlements Monetary and Economics.
6. Johnston, R. B., 1983, The economics of the Euro-market: history, theory and
policy, Macmillan, 2-50,220-250.
7. Valdez, S., An introduction to Western financial markets. 133-147.
8. Aliber, Robert Z., "The Interest Rate Parity Theorem: A Reinterpretation," Journal
of Political Economy, 81 (November/December 1973), pp. 1451-1459.
9. Clarke, William, The City in the World Economy, London, Institute of Economic
Affairs, 1965.
10. Einzig, Paul, The Euro-Dollar System: Practice and Theory of International
Interest Rates, 5th ed., London, Macmillan, 1973.
11. Emery, Robert F., "The Asian Dollar Market," International Finance Discussion
Papers, Federal Reserve Board, November 1975; processed.
12. Friedman, Milton, "The Euro-Dollar Market: Some First Principles," Morgan
Guaranty, Survey (October 1969), pp. 4-14.
13. Gurley, J. G., and E. S. Shaw, Money in a Theory of Finance, Washington,
The Brookings Institution, 1960.
14. Herring, Richard J., and Richard C. Marston, National Monetary Policies and
International Financial Markets, Amsterdam, North-Holland, 1976.
15. Machlup, Fritz, "Euro-Dollar Creation: A Mystery Story," Banca Nazionale del
45
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