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Giddy International Financial Markets/1
International
Financial Markets
Prof. Ian GiddyStern School of Business,
New York University
Copyright 2002 Ian H. Giddy International Financial Markets 2
What are the Global Financial Markets?
l The Foreign Exchange Market
l Eurocurrency Markets and Lending
l International Bond Markets
l International Equity Markets
l Using the Global Capital Markets:Investors and Issuers Perspectives
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Copyright 2002 Ian H. Giddy International Financial Markets 3
Policies and Exchange Rate Regimes
l Exchange rate systems--fixed vs
floating
l Managed floating
l EMS-type currency blocs
l De facto blocs--the dollar
Copyright 2002 Ian H. Giddy International Financial Markets 4
The Eurocurrency Market
A Eurodollar is a dollar deposited in a bankwithin a jurisdication outside the UnitedStates
l Separation of currency, institution andjurisdiction
l Why do people want Eurocurrency depositsand loans?
l Why is LIBOR the worlds key benchmarkrate?
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Copyright 2002 Ian H. Giddy International Financial Markets 8
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 TheEuromarkets Domestic Market B
Trea- Bank Euro Euro Bank Trea-
sury Deposit Deposit Deposit Deposit sury
Bill Market Market Bill
Trea- Corp- Euro Euro Corp- Trea-
sury orate B ond Bond orate sury
Bond Bond Market Market Bond Bond
Copyright 2002 Ian H. Giddy International Financial Markets 9
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
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Copyright 2002 Ian H. Giddy International Financial Markets 10
Foreign Exchange
l Mechanics and calculations
l How banks make money
l How banks hedge
l Tasks of the corporate FX manager
Copyright 2002 Ian H. Giddy International Financial Markets 12
Foreign Exchange Quotations
Spot Forward points
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Copyright 2002 Ian H. Giddy International Financial Markets 13
Exchange Rates
CurrencyHowquoted
Spot(2 businessdays)
Forward(90 days)
Britishpounds(GBP)
US$perGBP
1.632 1.617
Japaneseyen (JPY)
Yen perUS$
117.5 116.3
Copyright 2002 Ian H. Giddy International Financial Markets 14
Foreign Exchange Quotations
Bid Offer
Spot
Forward points
Rule:
add if bidoffer
Outright forward
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Copyright 2002 Ian H. Giddy International Financial Markets 15
Exchange Rates
CurrencyHowquoted
Spot(2 businessdays)
Forward(90 days)
Britishpounds(GBP)
US$perGBP
1.632 1.617
Japaneseyen (JPY)
Yen perUS$
117.5 116.3
Copyright 2002 Ian H. Giddy International Financial Markets 16
A Typical Forward Contract
l We agree today to pay a certain pricefor a currency in the future
SonySony B of AB of A
JPY
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Copyright 2002 Ian H. Giddy International Financial Markets 17
How Does the Bank Hedge a Forward
Contract?
Hedging approaches:
uOpen
uForward
uSpot plus swap
uRollover
uMoney market
Copyright 2002 Ian H. Giddy International Financial Markets 18
How Banks Hedge
SHORT LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward
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Copyright 2002 Ian H. Giddy International Financial Markets 19
Currency Risk Exposure
(The Normal Distribution)
Probability
Return onlarge companystocks
68%
95%
> 99%
3
48.2%
2
27.9%
1
7.6%
0
12.7%
+ 1
33.0%
+ 2
53.3%
+ 3
73.6%
Copyright 2002 Ian H. Giddy International Financial Markets 20
Covered Interest Arbitrage
Moneymarket 1
Moneymarket 2
Spot Forward
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Copyright 2002 Ian H. Giddy International Financial Markets 21
Foreign exchange and Eurocurrency dealingare interrelated activities and so are done onthe same trading floor.
The Dealing Room
CUS- FOR- ForeignTOMER SPOT WARD Exchange
Dealing
Money
FUNDING EUROCURRENCY MarketDealing
Diagram of a Dealing Room
The Dealing Room
Copyright 2002 Ian H. Giddy International Financial Markets 22
Foreign exchange and Eurocurrency dealingare interrelated activities and so are done onthe same trading floor.
The Dealing Room
CUS- FOR- ForeignTOMER SPOT WARD Exchange
Dealing
Money
FUNDING EUROCURRENCY MarketDealing
Diagram of a Dealing Room
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Copyright 2002 Ian H. Giddy International Financial Markets 23
Funding a Eurokrona Loan
Three ways to fund:
lTake domestic krona deposit
lTake EuroKrona deposit3 MO
NKR
DEP
3 MONKR
DEP
Copyright 2002 Ian H. Giddy International Financial Markets 24
Funding a Eurokrona Loan
Three ways to fund:
lTake domestic kronadeposit
lTake EuroKrona deposit
lFund with dollars, hedgedinto krona
lTake E$ depositlDo FX swap: sell USD spot,
buy USD forward
3 MOE$
DEP
FX
SWAP
3 MOE$
DEP
FX
SWAP
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Copyright 2002 Ian H. Giddy International Financial Markets 28
Linkages Between Eurocurrency Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change inexchange rate
Expected
% change in
exchange rate
Covered interest
rate parity
Unbiased
forward rate
Uncovered interest
rate parity
Copyright 2002 Ian H. Giddy International Financial Markets 29
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 = forwardpremium or
discount
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Copyright 2002 Ian H. Giddy International Financial Markets 30
Example: Anglos Funding
l Anglo-American, the natural resourcesconglomerate, is seeking 3-month US$funding.
uAnglo can fund in the US CP market at5.5%
uOr in the Eurosterling market at 6.7%
uThe BP is:
spot $1.5484, 3-mo forward $1.5454
uWhich is cheaper?
Copyright 2002 Ian H. Giddy International Financial Markets 31
Anglos Answer
Its cheaper for Anglo-American to borrow
in the US CP market. Reason:
uUS: simply borrow for 3 monthsqCost: $1(1+5.5%/4) = 1.01375
uUK: borrow British pounds, change intodollars at spot rate, cover by buyingsterling at 3-mo forward rate to repay thepoundsqCost: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478
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Copyright 2002 Ian H. Giddy International Financial Markets 32
TIME
EXCHANGERATE Spot
Forward
Actual
Today In three
months
Unbiased Forward Rate Theory
Copyright 2002 Ian H. Giddy International Financial Markets 33
TIME
EXCHANGERATE Spot
Forward
Actual
Probabilitydistributionof actualexchange rate
Today In three
months
Unbiased Forward Rate Theory
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Copyright 2002 Ian H. Giddy International Financial Markets 34
Unbiased Forward Rate
Forward premium or discount
= Expected annual rate of change
of the exchange rate
That is,
P$/DM = E(R$/DM )
Copyright 2002 Ian H. Giddy International Financial Markets 35
TIME
EXCHANGE RATE
Spot
Forward
Actual
Probabilitydistributionof actualexchange rate
Today In threemonths
International Fisher Effect
INTEREST
RATE
DIFFERENTIAL
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Copyright 2002 Ian H. Giddy International Financial Markets 36
International Fisher Effect
/E$ = /EDM + E(R$/DM )
That is,
Interest-rate differential
equalsExpected annual rate of change of
exchange rate
Copyright 2002 Ian H. Giddy International Financial Markets 37
Cost of Hedging
Type of Hedge Cost of HedgingForward Forward premium
Money Market Hedge(Borrow to matchassets)
Interest ratedifferential
Do nothing Expected rate ofchange ofexchange rate
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Copyright 2002 Ian H. Giddy International Financial Markets 42
Law of One Price
p=Sp*The Price of Tin
In New York On the Kuala On the
Lumpur London Metal
Market Metal
Exchange
273c per lb. 15.37 ringgit US$5830 per
= US$6.02 per kilogram tonne
per kilograma =US5.70 = US5.83
per kilogramb per kilogramc
a1 avoirdupois pound = 0.45359 kilogramsb
US$1 = 2.6965 Malaysian ringgit on the date of calculationc 1 tonne = 1000 kilogram.
All data taken from the Commodities section
of the London Financial Times.
Copyright 2002 Ian H. Giddy International Financial Markets 43
S t=1-St = I-I*
St 1+I*
n JAPAN 1995
n MEXICO 1994
EXCHANGE-RATE
CHANGE
RELATIVE
INFLATION
Purchasing Power Parity:
Theory and Evidence
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Copyright 2002 Ian H. Giddy International Financial Markets 44
Deviations from
Purchasing Power Parity
60
70
80
90
100
110
120
130
140
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996Q1
REALEXCHANGE
RAT
UNITED STATES
JAPAN
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,adjusted for change in relative wholesale price of domestic manufactures. A fall in the indexindicates improved international competitiveness.
Copyright 2002 Ian H. Giddy International Financial Markets 45
Deviations from
Purchasing Power Parity
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,adjusted for change in relative wholesale price of domestic manufactures. A fall in the indexindicates improved international competitiveness.
60
70
80
90
100
110
120
130
140
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
1996Q1
REAL
EXCHANGE
RA
UNITED STATES
JAPANGERMANY
FRANCE ITALY
UK
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Copyright 2002 Ian H. Giddy International Financial Markets 46
US Expected Inflation Rate 2%US Expected Inflation Rate 2%
Inflation & Interest Rates
Canadian Expected Inflation Rate 7%Canadian Expected Inflation Rate 7%
US Interest Rate 5%US Interest Rate 5%
Canadian Interest Rate 10%Canadian Interest Rate 10%
Copyright 2002 Ian H. Giddy International Financial Markets 47
US Expected Inflation Rate 2%US Expected Inflation Rate 2%
Inflation & Interest Rates
Canadian Expected Inflation Rate 7%Canadian Expected Inflation Rate 7%
US Interest Rate 5%US Interest Rate 5%
Canadian Interest Rate 10%Canadian Interest Rate 10%
Expected Rate of Changeof the Exchange Rate
Expected Rate of Changeof the Exchange Rate
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Copyright 2002 Ian H. Giddy International Financial Markets 48
Inflation & Interest Rates
Borrow at US Interest Rate 5%Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%Invest at Canadian Interest Rate 10%
Copyright 2002 Ian H. Giddy International Financial Markets 49
Inflation & Interest Rates
Borrow at US Interest Rate 5%Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%Invest at Canadian Interest Rate 10%
Buy Canadian Dollars Forward(at discount of 5%)
Buy Canadian Dollars Forward(at discount of 5%)
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Copyright 2002 Ian H. Giddy International Financial Markets 50
Inflation & Interest Rates
Borrow at US Interest Rate 5%Borrow at US Interest Rate 5%
Invest at Canadian Interest Rate 10%Invest at Canadian Interest Rate 10%
Buy Canadian Dollars Forward(at discount of 5%)
Buy Canadian Dollars Forward(at discount of 5%)
Buy Canadian Dollar Futures(at discount of 5%)
Buy Canadian Dollar Futures(at discount of 5%)
Copyright 2002 Ian H. Giddy International Financial Markets 51
The Linkages Again
RELATIVE
EXCESS
MONEY
SUPPLY
1
RELATIVE
INFLATION
RATES
2 3
RELATIVE 4 EXCHANGEINTEREST RATE
RATES CHANGE
5 6FORWARD
EXCHANGE
PREMIUM
OR DISCOUNT
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Copyright 2002 Ian H. Giddy International Financial Markets 52
A Framework
Country A Country B
DOMESTIC DOMESTIC
ECONOMIC ECONOMIC
POLICIES POLICIES
INFLATION INFLATION
RATE RATE
EXCHANGE
RATE
INTEREST INTEREST
RATE RATE
FORWARD
RATE
Copyright 2002 Ian H. Giddy International Financial Markets 53
Turkey, 1995
Turkish Lira:
Down 33.5%
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Copyright 2002 Ian H. Giddy International Financial Markets 58
Contact Info
Ian H. Giddy
NYU Stern School of Business
Tel 212-998-0426; Fax 212-995-4233
Ian.giddy@nyu.edu
http://giddy.org
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