the international capital markets
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The InternationalCapital Markets
Prof. Ian GiddyNew York University
New York University/ING Barings
Copyright ©1999 Ian H. Giddy Capital Markets 2
Instruments and Markets
Corporate BondsCorporate Bonds
DomesticDomestic InternationalInternational
Copyright ©1999 Ian H. Giddy Capital Markets 3
International Financial Markets
The Eurocurrency market Foreign exchange Covered interest arbitrage International portfolio investment returns Hedging international portfolios International diversification: passive vs
active
Copyright ©1999 Ian H. Giddy Capital Markets 4
“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”
Separation of currency, institution and jurisdiction
Why do people want Eurocurrency deposits and loans?
Why is LIBOR the world’s key benchmark rate?
The Eurocurrency Market
Copyright ©1999 Ian H. Giddy Capital Markets 5
The Eurocurrency Market
“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”
Separation of currency, institution and jurisdiction
Why do people want Eurocurrency deposits and loans?
Why is LIBOR the world’s key benchmark rate?
Copyright ©1999 Ian H. Giddy Capital Markets 7
Where the Eurocurrency Market Fits In
US Domestic German
Market EUR0CURRENCY MARKET Domestic Market
Euro-Deutsche Mark
Eurodollar Market
Market Foreign
Exchange
Market Japanese
Euro-Yen Domestic
Market Market
Euro-Commercial Euro-Floating Rate Straight
Paper Market Note Market Eurobond Market
Copyright ©1999 Ian H. Giddy Capital Markets 8
The Global Bond Market
Domestic bonds Foreign bond
(Issued within country of currency, by non-resident issuers)
Eurobonds(Issued and sold in a jurisdiction outside the
country of the currency of denomination) Global Bonds(Issued in the domestic and the Eurobond
markets simultaneously)
Copyright ©1999 Ian H. Giddy Capital Markets 9
Characteristics of Eurobonds
Issued outside country of currency Not subject to domestic registration or disclosure
requirements In most cases take form of private placements Placed through syndicates in many countries who sell
principally to nonresidents Bonds are structured so as to be free of withholding
tax Bearer formBut... Eurobonds usually influenced de facto by government
and banks of country of currency
Copyright ©1999 Ian H. Giddy Capital Markets 10
International Bond Markets are Linked
Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps
BONDMARKETSWITHINCOUNTRYOFCURRENCY
BONDMARKETSOUTSIDECOUNTRYOFCURRENCY
CurrencySwaps
Long-datedForwardExchange
Domestic US
- Gov't- Corporate
ForeignBonds
"Yankee"
DomesticJapanese
- Gov't- Corporate
ForeignBonds
"Samurai"
EurodollarBond Market
EuroyenBond Market
Copyright ©1999 Ian H. Giddy Capital Markets 11
Exchange Rate Risk
Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies
Copyright ©1999 Ian H. Giddy Capital Markets 12
Policies and Exchange Rate Regimes
Exchange rate systems--fixed vs floating
Managed floating EMU-type currency blocs De facto blocs--the dollar
Copyright ©1999 Ian H. Giddy Capital Markets 13
“A Euro is a basket of individual European currencies” True or false?
The Euromarket vs the Euro
C
Copyright ©1999 Ian H. Giddy Capital Markets 14
Domestic Policies, Domestic Prices and Interest Rates, and Exchange Rates
Country A Country B
DOMESTIC DOMESTICECONOMIC ECONOMICPOLICIES POLICIES
INFLATION INFLATION RATE RATE
EXCHANGERATE
INTEREST INTEREST RATE RATE
FORWARDRATE
Copyright ©1999 Ian H. Giddy Capital Markets 15
Foreign Exchange Mechanics and Calculations
“Money never leaves homes” Funds transfer, chips, and timing Relative interest rates
1. Forward premium or discount
2. Points
3. Spot and forward Spot and forward
1. Points
2. Forward premium or discount
3. Relative interest rates
Copyright ©1999 Ian H. Giddy Capital Markets 16
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 ©1999 Ian H. Giddy Capital Markets 17
A Typical Forward Contract
We agree today to pay a certain price for a currency in the future
SonySony B of AB of A
JPY
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Foreign Exchange Quotations
Spot Forward points
Copyright ©1999 Ian H. Giddy Capital Markets 19
Foreign Exchange Quotations
Bid OfferSpotForward pointsRule:add if bid<offer,subtract if bid>offerOutright forward
Copyright ©1999 Ian H. Giddy Capital Markets 20
Foreign Exchange Quotations
Bid OfferSpotForward pointsRule:add if bid<offer,subtract if bid>offerOutright forward
111.35 111.450.52 0.517
110.83 110.933
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110
115
120
125
130
135
140
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
EXCHANGERATE, YENPER US$
FORWARDPREMUIM,PERCENTPER ANNUM
FORWARD(LEFT SCALE)
SPOT (LEFT SCALE)
FORWARD PREMIUM(RIGHT SCALE)
MONTHLY DATA, 1987-1989
FORWARD PREMIUM = [(SPOT-FORWARD)/SPOT]*(12/3)*100
The Forward Rate Tracks the Spot Rate
Copyright ©1999 Ian H. Giddy Capital Markets 22
Covered Interest Arbitrage
Moneymarket 1
Moneymarket 2
Spot Forward
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Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.
The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing
Money
FUNDING EUROCURRENCY Market
Dealing
In the Dealing Room
The Dealing Room
Copyright ©1999 Ian H. Giddy Capital Markets 24
Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.
The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing
Money
FUNDING EUROCURRENCY Market
Dealing
Diagram of a Dealing Room
Copyright ©1999 Ian H. Giddy Capital Markets 25
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 ©1999 Ian H. Giddy Capital Markets 26
Example: Guidant’s Cash
Guidant, the medical instruments company, is seeking to invest 3-month US$ money.Guidant can invest in the US CP market at
5.5%Or in the Eurosterling market at 6.7%The BP is:
spot $1.5484, 3-mo forward $1.5454 Which is better?
Copyright ©1999 Ian H. Giddy Capital Markets 27
Guidants’s Answer
It’s better for Guidant to invest in the GBP instrument and hedge. Reason:US: simply invest for 3 months
Result: $1(1+5.5%/4) = 1.01375
UK: take the US dollars, change into British pounds at spot rate, cover by selling sterling at 3-mo forward rate to convert the money back into dollars
Result: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478
Copyright ©1999 Ian H. Giddy Capital Markets 28
TIME
EXCHANGE RATE Spot
Forward
Actual
Today In three
months
What if Guidant didn’t hedge?
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TIME
EXCHANGE RATE Spot
Forward
Actual
Probabilitydistributionof actualexchange rate
Today In three
months
Unbiased Forward Rate Theory
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Issues
What are the risks involved in investment in foreign securities?
How do you measure benchmark returns on foreign investments?
Are there benefits to diversification in foreign securities?
Copyright ©1999 Ian H. Giddy Capital Markets 31
International Equity Investments
Equity returns in local currency Exchange rate changes Other factors?
Copyright ©1999 Ian H. Giddy Capital Markets 32
Equity Returns: Domestic vs Global
Yardeni.com
International charts
Copyright ©1999 Ian H. Giddy Capital Markets 33
Int’l Investment Choices
Direct Stock Purchases ADRs Mutual Funds
Open endClosed end
Global companies
Copyright ©1999 Ian H. Giddy Capital Markets 34
Obstacles to International Investment Might Include:
Information barriers. Political and capital control risks. Foreign exchange risks. Restrictions on foreign investment and
control. Taxation. Higher costs.
Copyright ©1999 Ian H. Giddy Capital Markets 35
Foreign Exchnage Risk in International Investing
Foreign Exchange Risk Variation in return related to changes in
the relative value of the domestic and foreign currency
Total Return = Investment return plus return on foreign exchange
Not possible to completely hedge a foreign investment
Copyright ©1999 Ian H. Giddy Capital Markets 36
Returns with FX
Return in US is a function of two factors
1. Return in the foreign market
2. Return on the foreign exchange
Copyright ©1999 Ian H. Giddy Capital Markets 37
Returns with FX
(1 + rUS) = (1 + rFM) (1 + rFX)
rUS = return on the foreign investment in US Dollars
rFM = return on the foreign market in local currency
rFX = return on the foreign exchange
Copyright ©1999 Ian H. Giddy Capital Markets 38
Return Example: Dollar Appreciates
Initial Investment : $100,000
Initial Exchange: $2.00/ Pound Sterling
Final Exchange:$2.10/ Pound Sterling
Return in British Security: 10%
Return in US Dollars
(1 + rUS) = (1.10) (1.05) = (1.155)
rUS = 15.5%
Copyright ©1999 Ian H. Giddy Capital Markets 39
Return Example: Dollar Depreciates
Initial Investment : $100,000
Initial Exchange: $2/ Pound Sterling
Final Exchange: $1.85/ Pound Sterling
Return in British Security: 10%
Return in US Dollars
(1 + rUS) = (1.10) (.9250) = (1.0175)
rUS = 1.75%
Copyright ©1999 Ian H. Giddy Capital Markets 40
Exchange Rate Risk
Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and hence to nominal equity returns.
Relativemonetaryand fiscalpolicies
Relativemonetaryand fiscalpolicies
Relativeinflation
Relativeinflation
Exchangerate
change
Exchangerate
change
Copyright ©1999 Ian H. Giddy Capital Markets 41
Turkey, 1995
Turkish Lira:Down 33.5%
Copyright ©1999 Ian H. Giddy Capital Markets 42
Turkey, 1995
Turkish Lira:Down 33.5%
Turkish prices:up 83.8%!
Copyright ©1999 Ian H. Giddy Capital Markets 43
Hedging International Equity Investments
Buy foreign equity and hedge the anticipated future value, P+E(r)?
Use short-term, value-adjusted, roll-over hedges?
Do nothing, because equities bear no currency sign?
AnticipatedAnticipatedActualActualInitialInitial
Copyright ©1999 Ian H. Giddy Capital Markets 44
Measuring Benchmark Returns
Indexes EAFE Index Issues in Measuring Performance
WeightingCross-Holdings
Other PossibilitiesCountry and Region Funds
Copyright ©1999 Ian H. Giddy Capital Markets 45
Diversification Benefits
Evidence shows international diversification is beneficial
Possible to expand the efficient frontier above domestic only frontier
Possible to reduce the systematic risk level below the domestic only level
Copyright ©1999 Ian H. Giddy Capital Markets 46
Systematic Risk Level with International Diversification
RiskRisk
SecuritiesSecurities
Int’lDomDom
Copyright ©1999 Ian H. Giddy Capital Markets 47
The Minimum-Variance Frontier
Efficient frontier
Individual assets
Global minimum-variance portfolio
E(r)
Copyright ©1999 Ian H. Giddy Capital Markets 48
Efficient Frontier with International Diversification
ReturnReturn
RiskRisk
* *
*
**
* *
*DomDom
Int’lInt’l
Copyright ©1999 Ian H. Giddy Capital Markets 49
The Global Efficient Frontier
10 15 20 25 30 5
5
10
15
20
25
30
STOCKSANDBONDS
STOCKSONLY
EAFESTOCKS& BONDS
EAFE STOCKS
WORLD STOCKS & BONDS
WORLD STOCKS
US STOCKS & BONDSUS STOCKS
US BONDS
AVERAGE RETURN% PA
RISK, % PA
Copyright ©1999 Ian H. Giddy Capital Markets 50
International Portfolio Optimization: Passive vs Active Portfolios
(Let the proportions of all possible assets vary until the optimal proportions are found.)
The results of
letting the
computer
find the best
proportions for
various levels
of return:
0.1
0.11
0.12
0.13
0.14
0.15
0.16
0.17
0.18
0.19
0.2
0.21
0.22
0.23
0.05 0.1 0.15 0.2 0.25 0.3 0.35
RETURN
RISK(STANDARD DEVIATION)
Same risk as 100% USA,but higher return
100% USA portfolio
100% Japan
Minimum riskportfolio Market capitalization
weighted portfolio
Copyright ©1999 Ian H. Giddy Capital Markets 51
Evidence Suggests Index Funds are Not for the International Investor
For the international investor the capitalization-weighted portfolio may not be the optimal one. The reason is market segmentation. The world stock market is not efficient yet, the evidence suggests, at least not in the "mean-variance efficiency" sense that is required by the CAPM.
Because of real exchange risk (deviations from PPP), what is the optimal portfolio for an investor in one country may not be the optimal portfolio for an investor in another, even if there were a single risk-free asset acceptable to both.
Studies confirm these propositions
Copyright ©1999 Ian H. Giddy Capital Markets 52
Emerging Equity Markets
Copyright ©1999 Ian H. Giddy Capital Markets 53
Can globally mobile investors capture value & control?
MacroFactors
• Currency overvaluation• Capital restrictions
StructuralFactors
• Acctg & disclosure requirements• IAS compliance• Bankruptcy regime• Creditor rights• Govt-corporate nexus• Trading infrastructure
• Price-Value ratio, Sharpe ratio, EVA• D/E ratio• Currency & maturity mismatch• IAS conformity• Insider control• Objective research coverage• Trading liquidity
Firm-levelFactors
Copyright ©1999 Ian H. Giddy Capital Markets 54
www.bankofny.com/adr
adr.com
Copyright ©1999 Ian H. Giddy Capital Markets 55
Brady Bonds
Origin? Types? Ecuador’s Bradies
DiscountParPast due interestInterest equalization
What next?
Copyright ©1999 Ian H. Giddy Capital Markets 56
Correlations: Domestic vs Global
creditmetrics.com
correlation engine
Copyright ©1999 Ian H. Giddy Capital Markets 57
Summary
The Eurocurrency market is most closely tied to the foreign exchange market
Covered interest arbitrage links spot-forward differential to interest rates
Foreign portfolio returns = equity + FX International diversification pays Hedging international portfolios is tricky
Copyright ©1999 Ian H. Giddy Capital Markets 61
Ian H. Giddy
Ian Giddy
NYU Stern School of Business
Tel 212-998-0332; Fax 212-995-4233
ian.giddy@nyu.edu
http://giddy.org
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