International Finance
Lecture 4
Page 1
International Finance
• Course topics
– Foundations of International Financial
Management
– World Financial Markets and Institutions
– Foreign Exchange Exposure
– Financial Management for a Multinational
Firm
Page 2
World Financial Markets and Institutions
• International Banking and Money Market
• International Bond Market
• International Equity Markets
• Futures and Options on Foreign Exchange
• Currency and Interest Rate Swaps
• International Portfolio Investment
Page 3
International Banking and
Money Market
• _____________ Banking
• International Money Market
• International Debt Crises
Page 4
International Banking
• What are the main business activities of banks and near
banks? How do they make a profit?
–
• International banks
– Take deposits, issue loans denominated in different
________, facilitate ___________trade, and trade
currencies
• Rapid growth in international banking
1.Rapid growth of international ___________
2.Banks abroad can pursue activities not ___________in
home country
3.Tap into Eurodollar market
Page 5
Canadian banking industry
• The banking industry includes 19 ___________banks,
23 ___________bank subsidiaries and 21 foreign bank
___________operating in Canada.
• In total, these institutions manage almost $1.8 trillion in
assets.
• More details at Canadian Bankers Association webpage,
including how Schedule I, II, and III banks differ from
each other.
Page 6
The big six
• Bank of Montreal
•
•
•
•
•
– http://www.bmo.com/
The Bank of Nova Scotia
– http://www.scotiabank.ca/
CIBC
– http://www.cibc.com/
National Bank of Canada
– http://www.nbc.ca
Royal Bank of Canada
– http://www.royalbank.com
Toronto-Dominion Bank
– http://www.td.com
Page 7
International focus of the Big Six
Page 8
Schedule II Banks in Canada
Page 9
Ten Largest U.S. Banks
Page 10
Types of International Banking Offices
• Correspondent bank
• Representative office
• Foreign branch
• Subsidiary and affiliate bank
• Edge Act Banks (in the USA)
• Offshore banking center
Page 11
International Banking Offices
• Correspondent bank
– i.e. two banks maintain a correspondent bank account with
each other. Service: mostly currency conversions,
additionally, _______________________________________
on the correspondent bank.
• Representative office
– If one or more important clients for a domestic bank are
located overseas, the bank may send an ___________with a
cell phone and a computer to work in that foreign country
and offer service to the bank’s clients. Extra service:
_______________________________________________.
Page 12
Foreign Branches
• A foreign branch bank operates like a local bank, but is
legally part of the the parent.
– Subject to both the banking regulations of
___________country and ___________country.
– Can provide a much fuller range of services than a
representative office.
– Foreign branches are not subject to Canadian
___________requirements or deposit insurance
• Branch Banks are the most popular way for Canadian
banks to expand overseas. (USA, Europe, shell
branches in offshore centers).
Page 13
International Banking Offices
• Subsidiary and Affiliate Banks
– A ___________bank is a locally incorporated bank
wholly or partly owned by a foreign parent.
– An ___________bank is one that is partly owned but
not controlled by the parent.
– Canadian parent banks like foreign subsidiaries
because they allow Canadian banks to underwrite
securities.
• Edge Act Banks
– In the U.S., Edge Act banks are federally chartered
subsidiaries of U.S. banks that are physically located
in the U.S. that are ___________to engage in a full
range of international banking activities.
Page 14
Offshore Banking Centers
• An offshore banking
center is a country whose
banking system is
organized to permit
external accounts beyond
the ___________scope of
local economic activity.
• The host country usually
grants complete freedom
from host-country
governmental banking
regulations.
Page 15
• The IMF recognizes as
major _______
banking centers:
– the Bahamas
– Bahrain
– the Cayman Islands
– Hong Kong
– the Netherlands
Antilles
– Panama
– Singapore
Cost of Banking Crises in Other Countries
Page 16
International Banking Regulation
•
•
•
International bank crises, along with the regulation
(bad) experience in ___________, suggests that
regulation often ___________.
In many banking crises, the existence of government
safety net increases moral ___________incentives and
regulatory ___________makes things worse.
Problems in regulating international banking
1.
2.
•
Lack of knowledge or ability to closely monitor bank
operations in other countries
Hard to identify which agency is responsible
Trend: cooperation and standardization of regulatory
___________ (i.e. Basel Accord)
Page 17
Capital Adequacy Standards
• Bank capital adequacy refers to the amount of equity
___________and other securities a bank holds as
reserves.
• The Bank for International Settlements (BIS) and the
1988 and 2003 Basel Accords are a key part of the
international institutions and standards that govern
how much bank capital is “enough” to ensure the
safety and soundness of the banking system.
www.bis.org
Page 18
Calculating capital requirements
First Bank
Assets
Liabilities
Reserves
Canada securities
$3 m
$10 m
Loans to other banks
Municipal bonds
Residential mortgages
Commercial loans
Consumer loans
Fixed assets
$7 m
$10 m
$10 m
$20 m
$35 m
$5 m
Page 19
Chequable deposits
Nontransactions
deposits
Borrowings
Loan loss reserves
Bank capital
$20 m
$60 m
$11 m
$2 m
$7 m
Calculating capital requirements
• We will introduce two forms of Bank Capital requirements
• The first type is based on the so-called leverage ratio:
Leverage Ratio = Equity Capital/Assets
Well ___________: a bank’s leverage ratio must exceed
5%.
Is First Bank well capitalized?
• Risk-based capital requirements (from the Basel 1988
Accord): assets are allocated into four categories, each
with a different weight to reflect the degree of credit risk
Page 20
Calculating capital requirements
1st category: zero weight, reserves and government
securities in OECD countries
2nd category: 20% weight, claims on banks in OECD
countries
3rd category: 50% weight, municipal bonds and residential
mortgages
4th category: 100% weight, debts of consumers and
corporations
Off-balance-sheet activities are treated in a similar manner
Banks must hold as capital at least 8% of their riskweighted assets.
Page 21
Calculating capital requirements
• Is First Bank well-capitalized according to Risk-
based capital requirements?
Page 22
Capital Adequacy Standards
• While traditional bank capital standards may be enough
to protect depositors from traditional credit risk, they
may not be sufficient protection from derivative risk.
• For example, Barings Bank, which collapsed in 1995
from derivative losses, looked good on paper relative to
capital adequacy standards.
• Value at Risk (VaR) models provide a ___________
measurement of capital adequacy.
www.riskmetrics.com
• We will deal with VaR later in the course. Idea of using
value at risk: compare VaR with bank capital
Page 23
International Money Markets
•
•
•
Money Markets Defined
1. Money market ___________are usually sold in large
denominations
2. They have ___________default risk
3. They mature in one year ___________from their issue
date
Investors in Money Market: Provides a place for
warehousing surplus funds for short periods of time
Borrowers find that money market provides low-cost
source of temporary funds
Page 24
Money Market Instruments
• Treasury ___________
• ___________Funds
• Repurchase ___________
• ___________Certificates of Deposit
• Commercial Paper
• Banker’s ___________
• International Money Market Instruments
Page 25
International Money Market
• Eurocurrency Market
• ___________
• Forward Rate Agreement
• ___________
• Eurocommercial paper
Page 26
International Money Market
• Eurocurrency is a
___________deposit in an
international bank located in a country different
than the country that issued the currency.
– For example, Eurodollars are U.S. dollardenominated time deposits in banks located
___________.
– Euroyen are ___________-denominated time
deposits in banks located outside of Japan.
– A deposit ___________ have to be located in
Europe.
Page 27
Eurocurrency Market
• Most Eurocurrency transactions are interbank
transactions in the amount of $1,000,000 and up.
• Common reference rates include
– LIBOR the London Interbank ___________Rate
– PIBOR the Paris Interbank ___________Rate
– SIBOR the ___________Interbank Offered Rate
• A new reference rate for the new euro currency
– EURIBOR the rate at which interbank time
deposits of € are offered by one prime bank to
another.
• View Eurodollar deposit rates the Federal Reserve
Page 28
Eurocredits
• Eurocredits are ___________to medium-term loans of
Eurocurrency by Eurobanks to corporations, sovereign
governments, and nonprime banks.
• The loans are denominated in currencies other than the
___________currency of the Eurobank.
• Often the loans are too large for one bank to
underwrite; a number of banks form a ___________to
share the risk of the loan.
• Eurocredits feature an adjustable rate. On Eurocredits
originating in London the base rate is LIBOR.
Page 29
Eurocredits
Comparison of US lending and borrowing rates with
Eurodollar rates on August 19, 2002
Page 30
Rolling over debt
• Short-term financing = exposure to interest rate risk.
• Teltrex International borrows $3,000,000 at LIBOR plus a
lending margin ¾ percent per annum on a 3-month
rollover basis. Current LIBOR is 5 17/32 percent. What is
the effective annual interest rate on borrowing?
Page 31
Rolling over debt
• If LIBOR stays the same for the first 3 months and
then changes to 5 1/8 percent, what is the new
effective annual rate, and what is the cost of financing
for Teltrex International during the first six months?
Page 32
Forward Rate Agreements
• Recall, short-term financing/investment = exposure to
•
•
•
•
___________rate risk. Banks use FRA to hedge this risk.
FRA is an interbank ___________ that involves two
parties, a buyer and a seller.
The buyer agrees to pay the seller the excess interest
rate on a notional amount above a floating rate (e.g.,
LIBOR).
The seller agrees to _____ the buyer the excess interest
rate on a notional amount above the agreed rate, Rfix .
Forward Rate Agreements can be used to:
– Hedge assets that a bank currently owns against
interest rate risk.
– Speculate on the future course of interest rates.
Page 33
Interest Rate
Forward Rate Agreements
Time line
Page 34
Forward Rate Agreements
• In theory ___________could be made at time T2. At that
time, based on the notional amount L and number of days
T2 - T1 :
– If RT1T2 < Rfixed, Bank 1 could pay to Bank 2 the
agreed ___________rate Rfixed, and receive from Bank
2 the variable rate RT1T2.
– This never happens; instead Bank 1 just pays the
__________ (Rfixed - RT1T2) to Bank 2.
– If RT1T2 > Rfixed, Bank 2 could pay to Bank 1 the
agreed fixed rate Rfixed, and receive from Bank 2 the
variable rate RT1T2.
– This never happens; instead Bank 2 just pays the
difference (RT1T2 - Rfixed) to Bank 1.
Page 35
Forward Rate Agreements
• In practice
• Payment L*|Rfixed - RT1T2|*(T2 - T1)/360 is _________
to time T1 and paid at time T1, since the rate is known
at T1 and no real need to wait until T2, unless the
contract allows for reference rate variability between T1
and T2
• Payment under standard FRA is calculated as follows
PAYOFFFRA 
Page 36
L  Rfixed  RT 1T 2  (T2  T1 ) / 360
1  RT 1T 2  (T2  T1 ) / 360
Forward Rate Agreements
• The reference rate Rfixed is normally set at today’s level of
forward rate FT1T2.
• Continuously compounded Forward rate, ___________
FT1T2 = (RT2*T2-RT1*T1)/(T2-T1)
• For example, you observe 6-month LIBOR=5.39% and 3month LIBOR=5.36%, both continuously compounded,
you know that there are 91 days to maturity for 3-month
rate and 182 days until maturity for 6-month LIBOR
• Forward rate
F91182 =
Page 37
Forward Rate Agreements
• Assume that today Bank 1 buys a FRA with notional
amount $3,000,000 from Bank 2 and fixed rate 5.42%
per annum. The FRA starts in 3 months (91 days) and
will last for 3 more month, until day 180.
• No payments are made at this point, but Bank 1 has a
binding agreement to pay 5.42% p.a. to Bank 2 for 3
months, and Bank 2 has a binding agreement to pay the
3-month LIBOR rate for 3 months between day 91 and
180 to Bank 1, the rate to be determined on Day 91.
Page 38
Forward Rate Agreements
• If on day 91 the actual 3-month LIBOR=5%, then
• 5%<5.42%  Bank 1 (buyer) pays to Bank 2 (seller)
the difference:
• If on day 91 the actual 3-month LIBOR=6%, then
• 6%>5.42%  Bank 2 pays to Bank 1 the difference:
Page 39
Forward Rate Agreements
• Value of the FRA
• If forward rate = reference rate, the value is zero
• If forward rate ≠ reference rate, the value is the
discounted payoff assuming the forward rate is realized
• You need to check whether Rfixed < or > FT1T2 to
detrmine profit/loss for long/short position in the FRA.
VFRA 
Page 40
L  Rfixed  FT 1T 2  (T2  T1 ) / 360
1  RT 2  (T2 / 360 )
Forward Rate Agreements
• Example. Now it is day 0 and the FRA specifies that
Rfixed=4%.
Since forward rate > reference rate, expected discounted
value of the payoff =
___________
To buy FRA with such specifications, the buyer would have
to pay to the seller ___________as the seller is
facing the discounted expected need to make a payment
of this amount of money to the buyer
Page 41
Euronotes
• Euronotes are
___________ notes underwritten by a
group of international investment banks or international
commercial banks.
– They are sold at a ___________from face value and
pay back the full face value at maturity.
– Maturity is typically three to six months.
• Euro-Medium-Term Notes
– Typically fixed rate notes issued by a corporation.
– ___________range from less than a year to about ten
years.
– Euro-MTNs is partially sold on a continuous basis –this
allows the borrower to raise funds as they are needed.
Page 42
Eurocommercial Paper
• ___________short-term promissory notes
issued by corporations and banks.
• Placed ___________with the public
through a dealer.
• Maturities typically range from one month
to six months.
• Eurocommercial paper, while typically U.S.
dollar denominated, is often of lower
quality than U.S. commercial paper—as a
result yields are ___________.
Page 43
Discount basis
• Discount securities are quoted on bank discount basis.
rBD
D 360
 
F
t
• rBD= quoted rate
• D – discount, D =
___________
• t – days to maturity
• F – face value
• P - current price
Page 44
Discount basis
• You observe that the quoted bankers acceptance rate is
4.8% and you are considering investment in BA with
face value of US$100,000. How much do you have to
pay for the BA if it has 150 days to maturity? What is the
effective annual rate on this investment?
Page 45
International Debt Crisis
• Governments issue bonds, just like companies
• If a foreign company defaults on a bond, what can you do
as a Canadian investor?
• At most you could
___________in that country and try
to sue the company managers. And you will probably
never buy that company’s bonds again.
Page 46
International Debt Crisis
• In 1970s major world banks wre accepting deposits
from the OPEC countries and Russia (oil dollars that
gave rise to the whole Eurodollar market)
• Large sums of money were invested in bonds or other
debt obligations issued by governments of less
developed countries LDCs
Page 47
International Debt Crisis
Ten Biggest American Bank Lenders to
Mexico
($bn, September 30th, 1987)
Page 48
Debt-for-Equity Swaps
• As part of debt ___________agreements among
the bank lending syndicates and the debtor
nations, creditor banks would sell their loans for
U.S. dollars at ___________from face value to
MNCs desiring to make equity investment in
subsidiaries or local firms in the LDCs.
• A LDC central bank would buy the ___________
from a MNC at a smaller discount than the MNC
paid, but in local currency.
• The MNC would use the ___________to make
pre-approved new investment in the LDC that was
economically or socially beneficial to the LDC.
Page 49
Debt-for-Equity Swap Illustration
International Bank
LDC firm or
MNC
subsidiary
Equity Investor
or MNC
LDC Central Bank
Page 50
Recent Banking Crises
• Japan. The collapse of the Japanese
___________set in
motion a downward spiral for the entire Japanese
economy and in particular Japanese banks.
• This put in jeopardy massive amounts of bank loans to
corporations.
• Asia. This crisis followed a period of economic expansion
in the region financed by record private capital inflows.
• Bankers from the G-10 countries actively sought to
finance the growth opportunities in Asia by providing
businesses with a full range of products and services.
___________in East Asia,
particularly in ______________________.
• This led to domestic price
Page 51
Financial Crises
• Factors Causing Financial Crises
1. Increase in interest rates
2. Increases in uncertainty
3. Asset market effects on balance sheets
• Stock market effects on net worth
• Unanticipated deflation
• Cash flow effects
4. Bank panics
Page 52