International Financial Markets
International Financial Markets
International Financial Markets
Euronotes:
Short-term promissory notes issued by a corporation and sold to
private or institutional investors
Typical maturity is 3 to 6 months
Sold originally at a discount from face value. Trade
in secondary markets
Underwritten by international investment/commercial banks
4
Euro Medium Term Notes
Similar to domestic medium term notes, with
maturities of 9 month to 10 years.
Fill the gap between S-T and L-T euro debt
instruments
Eurocommercial Paper
Unsecured short-term notes issued by corporations
and banks in the Eurocurrency Markets
Typical maturities from 1 to 6 months
Placed directly with investors through dealers.
5
Eurocredit (bank loans denominated in eurocurrencies and extended by
banks in countries other than in whose currency the loan is denominated)
Loans of one year or longer extended by Eurobanks to
MNCs or governmental agencies.
6
The Foreign Exchange Market: An Outline
Organization: Functions, Participants, Size…
Spot market: Quotations
Bid/Ask Spreads
Cross rates
Location arbitrage
Triangular Arbitrage
Transaction costs.
Forward Market: Quotations
Maturities
Bid-Ask spreads
Premium/Discount
7
Use of the Fwd. Mkt. by MNCs
The Forward Swap: The Swap Price
Derivative Securities: The Forward Market
The Futures Market
The Options Market
The Swaps Market
The Eurocurrency Markets: Definitions
Eurodollars / Euro-currencies
Evolution of the Market
Deposit Creation
The Eurocredit Market: ……
The Eurobond Market: …….
8
✦ The Foreign Exchange Market is the world's
largest financial market.
The Bank for International Settlements estimates
daily trading volume of about $3.2 trillion. (WSJ 09/26/07)
10
An international payment system should provide:
✦ Security of value - instrument adequately transfers appropriate
value Security of medium - instrument hard to fake.
✦ Storage security – instrument can’t be easily stolen or its value
appropriated.
✦ Portability – instrument can be used to transport sufficient
value.
✦ Negotiability – others will accept the instrument.
✦ Convenience – low cost and speed of instrument transfer.
✦ Legal recognition and formalism – rules of the system
adequately regulated by state.
11
Global Settlement System
✦ CLS Bank International, a New York-based
settlement network, is supported by over 70 of the
world’s largest banking and financial institutions.
✦ CLS offers a unique real-time processing that
enables simultaneous FX settlement across the
globe thereby eliminating settlement risks caused
by delays arising from time-zone differences.
12
✦ Trading takes place somewhere in the world 24 hours a
day and frequently between individuals or institutions
located in different countries.
✦ Most trading activities take place in a few currencies like
the US Dollar, the Euro, the British Pound, the Japanese
Yen, the Canadian Dollar, and the Swiss Franc
✦ The foreign exchange market is not confined to any one
country but dispersed throughout the world’s leading
financial centers: London, New York, Tokyo, Paris,
Zurich, Amsterdam, Hong Kong, Frankfurt, Toronto,
Milan, Singapore, Berlin, Vienna, Chicago...
✦ Foreign Exchange traders not only buy and sell
currencies but, they create prices.
13
✦ Market Makers are those traders in the major money-
center banks around the world who are always ready
to buy or sell by quoting the bid/ask prices.
They create the market by creating bid/ask prices and
dealing at those prices.
✦ The difference between the two prices is called the
“spread."
✦ Participants in the FX market include importers,
exporters, portfolio managers, central banks, brokers,
commercial banks, arbitragers, speculators, tourists,
governments, etc.
14
The Foreign exchange market can be subdivided into:
✦ The Retail Market: permits the firms and individuals to obtain
foreign exchange for business or personal use.
✦ The Interbank Market: major participants are foreign
exchange traders employed by large banks.
Also large Multinational Corporations often maintain trading
departments that operate directly in this market. Traders in
the interbank market are called “dealers." They make the
market.
✦ Brokers: bring buyers and sellers together for a small
commission thereby helping to preserve the anonymity.
✦ Arbitragers: seek to profit from price differences in different
foreign exchange markets.
15
✦ Speculators: buy and sell in the hope that a price change
will result in a profit.
✦ Governments: Central Banks, Treasury Departments and
other Government Agencies sometimes participate in the
market in order to influence the exchange rate of a
particular currency.
For Example:
✦ FED buys dollars in foreign exchange market to
increase the value of the dollars.
✦ FED sells dollars in foreign exchange markets to
reduce the value of dollars.
Coordinated efforts among central banks are often used.
For example, the US FED bought the Mexican peso to
help prop up its value in early 1995. 16
Other Participants (mainly in the forward markets)
✦ Traders: Use forward contracts to eliminate or cover the
risk of loss on export or import orders that are
denominated in foreign currencies.
✦ Hedgers: Hedgers, mostly Multinational corporations,
enter into forward contracts to protect domestic currency
value of foreign currency denominated asset and liabilities
on their balance sheets.
The increasing importance attached to exchange rates
results from the globalization or internationalization of
modern business, the continuing growth in world trade,
the trend towards economic integration and the rapid
pace of change in the technology of money transfer.
17
✦ The Clearing System: Modern technology plays a central
role in the international transfer of funds or settling foreign
exchange transactions.
✦ In the U.S., electronic funds transfer takes place
through the “Clearing House Interbank Payment
System” (CHIPS).
This is a computerized network developed by the
New York Clearing House Association for transfer of
international dollar payments.
It links about 150 depository institutions that have
offices or affiliates in New York City.
✦ The New York Fed has established a settlement account for
member banks in which the account of a paying bank is
charged and the receiving banks account is credited.
18
Electronic Trading:
✦ In 1992, Reuters introduced a new service that added
automatic execution to the screen quotations used in
telephone trading thereby creating a genuine screen-
based market.
Other vendors like Telerate and Quotron, followed.
✦ Electronic trading systems offer automatic matching
in which traders enter buy and sell orders directly into
their terminals anonymously.
✦ These prices are visible to all market participants and any
trader anywhere in the world can execute a trade by hitting
two buttons!
19
Several questions are commonly asked in relation
to the foreign exchange rates. These include:
01) Why do exchange rates change
02) Why is it so difficult to forecast exchange rates
03) How can the Foreign exchange rates be forecasted
04) Why governments intervene in the exchange market
05) How to effectively hedge foreign exchange risks
06) How to speculate in the foreign exchange markets
07) How to evaluate the comments on exchange rates
found in the financial press
08) Government policy issues with respect to exchange
21
Provisions of credit:
✦ Movement of goods and services between countries
takes time. This gives rise to financing of inventory in
transit and sales inventory.
✦ The foreign exchange market provides a means of
transfer of credit.
Specialized instruments like Bankers' acceptances and
letters of credit, are made possible through the foreign
exchange market.
24
✦ Since the direct and the indirect quotations are alternative
means of stating exchange rates, the two methods are
related. One is the inverse of the other. Thus
$ = 1
£ £/$
or,
¥ = 1
$ $/¥
✦ Most interbank quotes are quoted around the world are
stated in "European" terms which means the foreign
currency price of one dollar, e.g., SF/$ = 1.2378, ¥/
$ = 132, etc.
✦ The alternate way, dollar price of one unit of foreign
currency, is called "American" Terms e.g. $/£ = 1.7535.25
Spot Rates:
✦ A spot transaction is the purchase of foreign exchange
for immediate delivery (usually, delivery within the
following 2 business days).
Forward Rates:
✦ A forward exchange rate or forward rate, is the price
agreed on today for purchase or sale of foreign currency
for future delivery (transfer/settlement) and payment.
The
rate is agreed on at the time the contract is made, but
normally payment and delivery are not required until
maturity.
✦ Forward maturities normally are 30, 60, 90, 180, 360 days
in to the future. Odd maturities may be negotiated for26one
to two weeks or even up to 5 years.
Cross Rates:
✦ Frequently, the need arises to obtain the
relationship (price) between two currencies from
their relationship with (quotation in) a third
currency.
✦ Formally, given two currencies A & B.
If $/A and $/B are given, then the value of A in
terms of B (or B per unit of A) is given by:
$/A = $ *
B = B
$/B A $ A
This is the cross rate. 27
Examples: Given $/£ and $/SF, then
$/£ = $ * SF = SF
$/SF £ $ £
the bid for one currency is also the ask of another currency.
✦ In outright quotations the full price is given to all its
decimal points.
✦ In points quotations abbreviations are used.
35
£ ($/£) SF ($/SF)
BID: SF = SF *
$ = 1 *
1.7109 = 2.7300
£ $ £ .6267 1
37
ASK: SF = SF *
$ = 1 *
1.7136 = 2.7418
£ $ £ .6250 1
Hence the cross rates with B/A spreads are:
SF/£ = 2.7300 - 2.7418
or = 2.7300 – 418
38
A "swap transaction" involves the sale of a foreign
currency with a simultaneous agreement to repurchase at
some later date in the future; OR
The purchase of the foreign currency with an agreement to
resell at sometime in the future.
Generally a forward swap is an arrangement in which two
parties agree to exchange specific amounts of currencies on
one date and to reverse the exchange, usually at a different
exchange rate, on a later date. The arrangement can be a
spot-forward or forward-forward swap.
These forward swaps differ from currency swaps in that
there are no exchanges of interest payments and are
usually for shorter time periods.
• Spot - fwd swap: Spot now with fwd later;
39
• Fwd - fwd swap: fwd at t with fwd at t+30.
Example:
City Bank buys SF5 million from the Swiss Bank for $2
million (spot) and simultaneously agrees to sell the SF
back in 6 months for $ 2.1 million.
41
Exercises:
✦ 1. A trader quotes the SF against the $ at a Bid/Ask
(buy/sell) price of:
SF/$ = 2.3697 - 2.3725.
The principle of buy low and sell high applies.
The smaller number 2.3697 is the bid price and
the larger number 2.3725 is the ask price.
Obtain the bid/ask prices for $/SF.
42
3. A bank is currently quoting the following rates:
i) SF/$ = 2.3697-2.3725
$/£ = 1.5525-1.5535
What SF/£ cross rates bid/ask would the bank quote?
45
Examples:
46
Using The Forward Contract: an Example
✦ A U.S. importer of German BMW receives a bill of € 2m
for the 700 series. The Bill is payable in 90 days.
Spot $/ € = 1. 3467. The 90-day forward $/ € = 1.3495.
The Forward contract is a means of locking in the price at
which euros will be acquired in 90 days. Discuss.
48
Some Common Terms:
Depreciation -- Devaluation -- Weakening
Appreciation -- Revaluation -- Strengthening
Soft Currency -- Expected to decrease in value
Hard Currency -- Expected to maintain its value
to increase in value.
Dollar is Mixed -- The $ did not move in one
54
Triangular Arbitrage:
Example 1:
Consider the following quotes in New York, Frankfurt,
and London. (Assume no transaction costs)
FRANKFURT ($/€ = 1.2471)
LONDON (€/£ = 1.4544)
NEW YORK ($/£ = 1.8590)
✦ Is Triangular Arbitrage feasible? Show why/why not.
✦ Describe a strategy to profit from triangular arbitrage.
✦ What percentage profit is possible?
55
Solution:
London
€/£ = 1.4544
57
Example 2:
Assume no transaction cost. Suppose £1 = $1.8095 in NY,
$1 = C$1.3215 in Toronto and C$1 = £ 0.4342 in London.
Show whether or not triangular arbitrage opportunities exist
How could a trader profit from triangular arbitrage?
Compute the percentage profit possible.
Solution:
NY Toronto
$/£=1.8095 C$/$=1.3215
London
£/C$= 0.4342
58
Given New York and Toronto quotes:
£ = £. $ = 1 * 1 = 0.4182
C$ $ C$ 1.8095 1.3215
The C$ is worth more in London than implied by cross rates
from NY and Toronto.
It will be profitable to acquire C$ and sell it for £ in London.
C$ → £ → $ → C$
Given C$ 1000
1000* 0.4342 * 1.8095 * 1.3215 = C$1,038.28
Profit = 3.828% 59
Example 3: Assume zero transaction costs:
A: ¥/U$ = 106.50, B: C$/U$ = 1.3215 , C: ¥/C$ = 82.905
✦ Determine if triangular arbitrage is feasible.
✦ State what you would do to profit from arbitrage.
✦ Obtain the percentage profit possible.
Solution:
A B
¥/U$ = 106.50 C$/U$ = 1.3215
C
¥/C$ = 82.905
60
By cross rates from A & B,
¥ = ¥ . U$ = 106.50 . 1 = 80.590
C$ U$ C$ 1.3215
The C$ is more valuable at C:
Borrow C$ and sell it for ¥ at C, Sell ¥ for U$ at A and
the U$ for C$ at B.
e.g. C$ → ¥ → U$ → C$
Given 1C$:
1 * 82.905 * 1 * 1.3215 = C$1.02772
106.50
Profit ≈ 2.8%
61
Transaction Costs:
Assume transaction cost is .6% (.25%, .35%).
With a .60% Trans. cost, each stage the arbitrager
receives 99.4% of what he previously received.
There are three transactions in this example and
these can be incorporated as follows:
62
Derivative Securities Markets: An Overview
These are forwards, futures, options, and swaps.
63
✦ Currency Futures Contract:
Permits the exchange/trading (purchase or sale) of
a specified number of contracts of a currency at
specified exchange rate for future delivery.
Prices are determined by an auction process on the
floor of an organized futures exchange.
Unlike the forward contracts, the futures contract
entails daily settlements (marking to the market)
and the posting of a margin.
Currency futures contracts contain standard units
of the underlying currencies. 64
✦ Currency Options Contract:
Is an exchange traded contract which grants the
buyer (holder or owner) the right, but not the
obligation, to purchase or sell a specified number
of contracts of the underlying currency at a
prescribed price (the strike price or exercise price)
within a given period of time.
The buyer pays a premium to acquire this right.
Contract sizes are standardized.
65
✦ A Swap contract is a contractual agreement evidenced
by a single document in which two parties, called
counterparties, agree to make period payments to
each other.
The agreement spells out the instrument to be
exchanged (which may or may not be the same), the
applicable interest rate on each instrument (which
may be fixed or floating), the timetable for making
payments, and other provisions.
Swap contracts are tailor-made to meet the needs of
the counterparties with the aid of swap specialists
who serve as brokers and/or market makers.
Swaps trade in the OTC market.
66
The Eurocurrency Markets
Definitions:
✦ A Eurodollar is a U.S.-dollar denominated bank deposit
held outside the U.S. More generally, a Eurocurrency
deposit is a domestic-currency denominated bank deposit
held outside the domestic geographical area.
✦ Eurocurrencies are typically time deposits denominated in
currencies other than those of the countries in which they
are located.
✦ Therefore, the eurodollar (eurocurrency) market is an
international money market focused on short-tern credit
flows while the eurobond market is an international capital
market focused on long-term bonds.
67
✦ The most important Eurocurrencies are the Euro-
Canadian dollar, Euro-Euro, Euro-Swiss franc,
Euro-sterling, and Euro-yen.
68
✦ The Eurocurrency market therefore consists of
those banks, called Eurobanks, that accept
deposits and make loans in foreign currencies.
69
The Evolution of the Market:
The development and expansion of the Eurocurrency
markets have their roots in overt and covert events.
70
2) The Soviet Union: provided impetus for the early
growth of the market. As the cold war heated up,
the Soviet Union began to worry about the U.S.
Government freezing its deposits in New York.
The Soviets needed to maintain dollar accounts for
international trade and investment.
The dollar was then virtually the only currency
acceptable worldwide.
eurocurrency depositors.
◆ Taxes and fees levied on euro banking operations
76
Eurocurrency markets need not be located in Europe,
though they originate in Europe.
These include:
✦ FIBOR: Frankfurt interbank offered rate
✦ PIBOR: Paris interbank offered rate
✦ SIBOR: Singapore interbank offered rate
✦ MIBOR: Madrid interbank offered rate
✦ EIBOR: Emirate interbank offered rate (interest rate charged
by banks in the United Arab Emirates for interbank transactions)
81
Eurodeposit Creation:
✦ Eurocurrency deposits are subject to the same
multiple expansion feature of a domestic banking
system.
✦ Funds are deposited in a Eurobank which lends
them to deficit spending units and, in effect,
creates new deposits.
82
Example:
Stage A:
Assume that IBM purchases computer components from a
UK supplier, COMPUK, for $1m and pays with a check
drawn on its Chase Manhattan Bank in New York.
Assume also that COMPUK deposits the check in
Westminster Bank, London.
84
Eurodollar Deposit Expansion: Main Features
Stage A
Chase, NY Westminster, London
Deposits of IBM Deposit at Chase Deposits of COMUK
Foreign Bonds
Underwritten by a syndicate and sold within the
country of the denominated currency.
Borrower/issuer is from another country
These include Yankee, Samurai, and Bulldogs bonds.
90
Note Issuance Facilities and Euronotes:
✦ Eurobanks have responded to the competition from
the Eurobond market by creating a new instrument
called the “Note Issuance Facility” (NIF) which is
a low-cost substitute for syndicated credits.
92