international financial markets prof. ian giddy stern school of business new york university
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InternationalFinancial Markets
Prof. Ian GIDDYStern School of Business
New York University
Copyright ©2003 Ian H. Giddy International Financial Markets 2
What are the Global Financial Markets?
The Foreign Exchange Market
Eurocurrency Markets and Lending International Bond Markets International Equity Markets Using the Global Capital Markets:
Investors’ and Issuers’ Perspectives
Copyright ©2003 Ian H. Giddy International Financial Markets 3
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 ©2003 Ian H. Giddy International Financial Markets 4
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 ©2003 Ian H. Giddy International Financial Markets 5
US Domestic German
Market EUR0CURRENCY MARKET Domestic Market
Euro-Euro
Eurodollar Market
Market
Japanese
Euro-Yen Domestic
Market Market
Eurocurrency Market Linkages
Copyright ©2003 Ian H. Giddy International Financial Markets 6
The International Money Markets
Source: ft.com
Copyright ©2003 Ian H. Giddy International Financial Markets 7
Interest Rate Linkages in the International Money Market
Two stories to tell: Domestic vs. Euro Eurocurrency A vs. Eurocurrency B
Domestic Market A The Euromarkets 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 Bond Bond orate sury
Bond Bond Market Market Bond Bond
Copyright ©2003 Ian H. Giddy International Financial Markets 8
Domestic versus Euro
The Eurodollar Premium
Market price of risk
versus
Cost of regulation
Eurodollar vs. U.S. Interest Rate
Effective cost of domestic deposit
= (interest rate + FDIC fees)
(1 - reserve requirement)
Capital controls and divided credit markets
Copyright ©2003 Ian H. Giddy International Financial Markets 9
Foreign Exchange
Mechanics and calculations How banks make money How banks hedge Tasks of the corporate FX manager
Copyright ©2003 Ian H. Giddy International Financial Markets 10
Foreign Exchange Quotations
Spot Forward points
Copyright ©2003 Ian H. Giddy International Financial Markets 11
Exchange Rates
CurrencyHowquoted
Spot(2 businessdays)
Forward(90 days)
Britishpounds(GBP)
US$perGBP
1.5645 1.5634
Japaneseyen (JPY)
Yen perUS$
111.35 109.85
Copyright ©2003 Ian H. Giddy International Financial Markets 12
Foreign Exchange Quotations
Bid Offer
Spot
Forward points
Rule:
add if bid<offer,
subtract if bid>offer
Outright forward
Copyright ©2003 Ian H. Giddy International Financial Markets 13
Foreign Exchange Quotations
Bid OfferSpotForward pointsRule:add if bid<offer,subtract if bid>offerOutright forward
1.5645 1.565511 10.5
1.5634 1.5644.5
Copyright ©2003 Ian H. Giddy International Financial Markets 14
Exchange Rates
CurrencyHowquoted
Spot(2 businessdays)
Forward(90 days)
Britishpounds(GBP)
US$perGBP
1.5645 1.5634
Japaneseyen (JPY)
Yen perUS$
111.35 109.85
Copyright ©2003 Ian H. Giddy International Financial Markets 15
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
Copyright ©2003 Ian H. Giddy International Financial Markets 16
How Does the Bank Hedge a Forward Contract?
Hedging approaches:OpenForwardSpot plus swapRolloverMoney market
Copyright ©2003 Ian H. Giddy International Financial Markets 17
How Banks Hedge
SHORT LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward
Copyright ©2003 Ian H. Giddy International Financial Markets 18
Currency Risk Exposure(The Normal Distribution)
Probability
Return onlarge companystocks
68%
95%
> 99%
– 3 – 48.2%
– 2 – 27.9%
– 1 – 7.6%
012.7%
+ 1 33.0%
+ 2 53.3%
+ 3 73.6%
Copyright ©2003 Ian H. Giddy International Financial Markets 19
Covered Interest Arbitrage
Moneymarket 1
Moneymarket 2
Spot Forward
Copyright ©2003 Ian H. Giddy International Financial Markets 20
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
The Dealing Room
Copyright ©2003 Ian H. Giddy International Financial Markets 21
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 ©2003 Ian H. Giddy International Financial Markets 22
Funding a Eurokrona Loan
Three ways to fund:Take domestic krona
depositTake EuroKrona deposit
3 MONKR
DEP
3 MONKR
DEP
Copyright ©2003 Ian H. Giddy International Financial Markets 23
Funding a Eurokrona Loan
Three ways to fund:Take domestic krona
depositTake EuroKrona depositFund with dollars, hedged
into kronaTake E$ depositDo FX swap: sell USD spot,
buy USD forward
3 MOE$
DEP
FX
SWAP
3 MOE$
DEP
FX
SWAP
Copyright ©2003 Ian H. Giddy International Financial Markets 24
Linkages Between Eurocurrency Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Copyright ©2003 Ian H. Giddy International Financial Markets 25
Linkages Between Eurocurrency Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Covered interest
rate parity
Copyright ©2003 Ian H. Giddy International Financial Markets 26
Linkages Between Eurocurrency Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Covered interest
rate parity
Uncovered interest
rate parity
Copyright ©2003 Ian H. Giddy International Financial Markets 27
Linkages Between Eurocurrency Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Covered interest
rate parity
Unbiased
forward rate
Uncovered interest
rate parity
Copyright ©2003 Ian H. Giddy International Financial Markets 28
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 29
Example: Anglo’s Funding
Anglo-American, the natural resources conglomerate, is seeking 3-month US$ funding.Anglo can fund 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 cheaper?
Copyright ©2003 Ian H. Giddy International Financial Markets 30
Anglo’s Answer
It’s cheaper for Anglo-American to borrow in the US CP market. Reason:US: simply borrow for 3 months
Cost: $1(1+5.5%/4) = 1.01375
UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the pounds
Cost: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478
Copyright ©2003 Ian H. Giddy International Financial Markets 31
Case Study: Ecobank's cross-currency loan funding
Assignment:
You have been asked to fund a 3-month USD3 million loan made by your bank's Paris branch.
Assuming the bank can borrow at market rates in any of the major money markets, which is the most cost-effective funding source?
Copyright ©2003 Ian H. Giddy International Financial Markets 32
Ecobank
Data Bid Ask/OfferGBP deposits 3.5 3.59375EUR deposits 2.46875 2.53125Spot GBP/EUR 1.4266 1.4282Forward points 0.0042 0.00322Outright forward 1.42243 1.42487
ResultCost of GBP deposit: 3.5938%Cost of EUR deposit hedged: 4.1641%
Source: ecobank.xls
Copyright ©2003 Ian H. Giddy International Financial Markets 33
Ecobank
Cost of GBP: 3 19/32 = 3.5938% Cost of EUR, hedged into GBP:
[1.4282(1+2 17/32/400)/1.4224-1]4
= 4.1641
Copyright ©2003 Ian H. Giddy International Financial Markets 34
Linkages Between Eurocurrency Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Covered interest
rate parity
Unbiased
forward rate
Uncovered interest
rate parity
Copyright ©2003 Ian H. Giddy International Financial Markets 35
TIME
EXCHANGE RATE Spot
Forward
Actual
Today In three
months
Unbiased Forward Rate Theory
Copyright ©2003 Ian H. Giddy International Financial Markets 36
TIME
EXCHANGE RATE Spot
Forward
Actual
Probabilitydistributionof actualexchange rate
Today In three
months
Unbiased Forward Rate Theory
Copyright ©2003 Ian H. Giddy International Financial Markets 37
Unbiased Forward Rate
Forward premium or discount
= Expected annual rate of change
of the exchange rate
That is,
P$/DM = E(R$/DM )
Copyright ©2003 Ian H. Giddy International Financial Markets 38
Linkages Between Eurocurrency Rates
Interest rate
differential
Interest rate
differential
Forward
premium
Forward
premium
Expected
% change in
exchange rate
Expected
% change in
exchange rate
Covered interest
rate parity
Unbiased
forward rate
Uncovered interest
rate parity
Copyright ©2003 Ian H. Giddy International Financial Markets 39
TIME
EXCHANGE RATE
Spot
Forward
Actual
Probabilitydistributionof actualexchange rate
Today In threemonths
International Fisher Effect
INTEREST
RATE
DIFFERENTIAL
Copyright ©2003 Ian H. Giddy International Financial Markets 40
International Fisher Effect
/E$ = /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 41
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
Copyright ©2003 Ian H. Giddy International Financial Markets 42
Corporate Hedging Decisions:Ivoire Rubber
Exporting rubber to Mexico, get paid in Mexican pesos. Funding is in U.S. dollars.
Copyright ©2003 Ian H. Giddy International Financial Markets 43
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
Switch funding to pesos, despite the slightly higher cost
Borrow in dollars, but hedge the exchange risk in the forward market.
Copyright ©2003 Ian H. Giddy International Financial Markets 44
Ivoire Rubber
US dollar 3-month loan rate
5 9/16%
Peso 3-month loan rate
7 15/16%
Spot exchange rate today
MP128.210 per USD
Forward exchange rate today
MP129.005 per USD
Forward discount, % per annum
-2.5
Copyright ©2003 Ian H. Giddy International Financial Markets 45
Ivoire Rubber
Type of Hedge Cost of HedgingForward 2.5%
Money Market Hedge(Borrow to matchassets)
2.375%
Do nothing 2/128 x 4= 6.25% gain(or 2.5% loss?)
Copyright ©2003 Ian H. Giddy International Financial Markets 46
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
Concepcion
Copyright ©2003 Ian H. Giddy International Financial Markets 48
Connexion loan
Tuesday: Bank and Bond Financing
Don Pedro Hydro
Westpac Eurobonds
Copyright ©2003 Ian H. Giddy International Financial Markets 49
Cap des Biches:Choices for the BCEAO
Foreign-exchange intervention Money-market intervention (consider
interaction with monetary policy) Fiscal policy--the demand side Tariffs and subsidies Exchange controls and capital controls
(and jawboning)
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.”
Copyright ©2003 Ian H. Giddy International Financial Markets 51
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? How much? What should GTI-Dakar do?
Copyright ©2003 Ian H. Giddy International Financial Markets 52
Cap des Biches:Choices for GTI-Dakar 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 53