Giddy
International Financial Markets/1
International
Financial Markets
Prof. Ian Giddy
Stern School of Business,
New York University
What are the Global Financial Markets?
l
The Foreign Exchange Market
l
Eurocurrency Markets and Lending
International Bond Markets
l International Equity Markets
l Using the Global Capital Markets:
Investors’ and Issuers’ Perspectives
l
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Policies and Exchange Rate Regimes
Exchange rate systems--fixed vs
floating
l Managed floating
l EMS-type currency blocs
l De facto blocs--the dollar
l
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The Eurocurrency Market
“A Eurodollar is a dollar deposited in a bank
within a jurisdication outside the United
States”
l Separation of currency, institution and
jurisdiction
l Why do people want Eurocurrency deposits
and loans?
l Why is LIBOR the world’s key benchmark
rate?
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The Eurocurrency Market
“A Eurodollar is a dollar deposited in a bank
within a jurisdication outside the United
States”
l Separation of currency, institution and
jurisdiction
l Why do people want Eurocurrency deposits
and loans?
l Why is LIBOR the world’s key benchmark
rate?
International Financial Markets 5
Copyright ©2002 Ian H. Giddy
Where the Eurocurrency Market Fits In
US Domestic
Market
Eurodollar
Market
Euro-Commercial
Paper Market
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German
Domestic
Market
EUR0CURRENCY MARKET
Euro-Deutsche Mark
Market
Foreign
Exchange
Market
Euro-Yen
Market
Euro-Floating Rate
Note Market
Japanese
Domestic
Market
Straight
Eurobond Market
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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
Treasury
The Euromarkets
Bank
Deposit
Euro
Deposit
Euro
Deposit
Market
Market
Corp -
Euro
Euro
Corp -
orate
Bond
Bond
Market
Bond
Market
orate
Bond
Bill
Treasury
Bond
Domestic Market B
Bank
Deposit
Treasury
Bill
Treasury
Bond
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Copyright ©2002 Ian H. Giddy
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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Foreign Exchange
Mechanics and calculations
l How banks make money
l How banks hedge
l Tasks of the corporate FX manager
l
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Copyright ©2002 Ian H. Giddy
Foreign Exchange Quotations
Spot
Copyright ©2002 Ian H. Giddy
Forward points
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Exchange Rates
Spot
How
(2 business Forward
Currency quoted days)
(90 days)
British
US$
1.632
1.617
pounds per
(GBP)
GBP
Japanese Yen per 117.5
116.3
yen (JPY) US$
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Foreign Exchange Quotations
Bid
Offer
Spot
Forward points
Rule:
add if bid<offer,
subtract if bid>offer
Outright forward
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Exchange Rates
Spot
How
(2 business Forward
Currency quoted days)
(90 days)
British
US$
1.632
1.617
pounds per
(GBP)
GBP
Japanese Yen per 117.5
116.3
yen (JPY) US$
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A Typical Forward Contract
l
We agree today to pay a certain price
for a currency in the future
JPY
Sony
Sony
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BBof
ofAA
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How Does the Bank Hedge a Forward
Contract?
Hedging approaches:
uOpen
uForward
uSpot plus swap
uRollover
uMoney
market
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How Banks Hedge
SHORT
LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward
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Currency Risk Exposure
(The Normal Distribution)
Probability
68%
95%
Return on
large company
stocks
> 99%
–3
– 48.2%
–2
– 27.9%
–1
– 7.6%
0
12.7%
+1
33.0%
+2
53.3%
+3
73.6%
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Covered Interest Arbitrage
Money
market 1
Money
market 2
Spot
Forward
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Diagram of a Dealing Room
Foreign exchange and Eurocurrency dealing
are interrelated activities and so are done on
the same trading floor.
The Dealing Room
CUSFORThe
DealingSPOT
Room WARD
TOMER
Foreign
Exchange
Dealing
Money
FUNDING
EUROCURRENCY
Market
Dealing
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Copyright ©2002 Ian H. Giddy
Diagram of a Dealing Room
Foreign exchange and Eurocurrency dealing
are interrelated activities and so are done on
the same trading floor.
The Dealing Room
CUSTOMER
SPOT
FORWARD
Foreign
Exchange
Dealing
Money
FUNDING
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EUROCURRENCY
Market
Dealing
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Funding a Eurokrona Loan
Three ways to fund:
l Take
domestic krona deposit
l Take EuroKrona deposit
3 MO
NKR
DEP
3 MO
NKR
DEP
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Copyright ©2002 Ian H. Giddy
Funding a Eurokrona Loan
Three ways to fund:
l Take
domestic krona
deposit
l Take EuroKrona deposit
l Fund with dollars, hedged
into krona
3 MO
E$
FX
DEP SWAP
3 MO
E$
FX
DEP SWAP
l Take
E$ deposit
l Do FX swap: sell USD spot,
buy USD forward
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Linkages Between Eurocurrency Rates
Interest
Interest rate
rate
differential
differential
Covered interest
rate parity
Uncovered interest
rate parity
Expected
Expected
%
% change
change in
in
exchange
exchange rate
rate
Forward
Forward
premium
premium
Unbiased
forward rate
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Interest-Rate Parity
$1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt
where S t is the spot exchange rate (dollars per British
Pound) and Fnt is the forward rate.
to a close approximation,
(/ E$ - / EBP) = [(Ft n - St)/S t] (365/n) 100
Interest-rate differential = forward
premium or
discount
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Example: Anglo’s Funding
l
Anglo-American, the natural resources
conglomerate, is seeking 3-month US$
funding.
uAnglo
can fund in the US CP market at
5.5%
uOr in the Eurosterling market at 6.7%
uThe BP is:
spot $1.5484, 3-mo forward $1.5454
uWhich is cheaper?
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Anglo’s Answer
It’s cheaper for Anglo-American to borrow
in the US CP market. Reason:
uUS:
simply borrow for 3 months
q Cost:
$1(1+5.5%/4) = 1.01375
uUK:
borrow British pounds, change into
dollars at spot rate, cover by buying
sterling at 3-mo forward rate to repay the
pounds
q Cost:
Copyright ©2002 Ian H. Giddy
($1/1.5484)(1+6.7%/4)1.5454 = 1.01478
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Unbiased Forward Rate Theory
EXCHANGE
RATE
Spot
Forward
Actual
Today
In three
months
TIME
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Copyright ©2002 Ian H. Giddy
Unbiased Forward Rate Theory
EXCHANGE
RATE
Probability
distribution
of actual
exchange rate
Spot
Forward
Actual
Today
Copyright ©2002 Ian H. Giddy
TIME
In three
months
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Unbiased Forward Rate
Forward premium or discount
= Expected annual rate of change
of the exchange rate
That is,
P$/DM
=
E(R$/DM )
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International Fisher Effect
EXCHANGE RATE
Probability
distribution
of actual
exchange rate
Spot
INTEREST
RATE
DIFFERENTIAL
Forward
Actual
TIME
Today
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In three
months
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International Fisher Effect
/E$ = /EDM + E(R$/DM )
That is,
Interest-rate differential
equals
Expected annual rate of change of
exchange rate
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Cost of Hedging
Type of Hedge
Cost of Hedging
Forward
Forward premium
Money Market Hedge Interest rate
(Borrow to match
differential
assets)
Do nothing
Expected rate of
change of
exchange rate
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Law of One Price
p=Sp*
The Price of Tin
In New York
On the Kuala
Lumpur
Market
273c per lb.
= US$6.02
per kilograma
15.37 ringgit
per kilogram
=US5.70
per kilogramb
a1 avoirdupois pound = 0.45359 kilograms
bUS$1 = 2.6965 Malaysian ringgit on the date of calculation
c 1 tonne = 1000 kilogram.
All data taken from the Commodities section
of the London Financial Times.
On the
London Metal
Metal
Exchange
US$5830 per
tonne
= US5.83
per kilogramc
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Purchasing Power Parity:
Theory and Evidence
S t=1-St
St
=
I-I*
1+I*
EXCHANGERATE
CHANGE
n
MEXICO 1994
RELATIVE
INFLATION
n
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JAPAN 1995
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REAL EXCHANGE RATE
Deviations from
Purchasing Power Parity
140
130
JAPAN
120
110
100
90
UNITED STATES
80
70
1996Q1
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
60
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 index
indicates improved international competitiveness.
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Copyright ©2002 Ian H. Giddy
REAL EXCHANGE RATE
Deviations from
Purchasing Power Parity
140
JAPAN
130
GERMANY
120
110
FRANCE
100
ITALY
90
UK
UNITED STATES
80
70
1996Q1
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
60
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 index
indicates improved international competitiveness.
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Inflation & Interest Rates
US
US Expected
Expected Inflation
Inflation Rate
Rate 2%
2%
Canadian
Canadian Expected
Expected Inflation
Inflation Rate
Rate 7%
7%
US
US Interest
Interest Rate
Rate 5%
5%
Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
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Copyright ©2002 Ian H. Giddy
Inflation & Interest Rates
US
US Expected
Expected Inflation
Inflation Rate
Rate 2%
2%
Canadian
Canadian Expected
Expected Inflation
Inflation Rate
Rate 7%
7%
US
US Interest
Interest Rate
Rate 5%
5%
Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Expected
Expected Rate
Rate of
of Change
Change
of
the
Exchange
of the Exchange Rate
Rate
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Inflation & Interest Rates
Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
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Inflation & Interest Rates
Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Buy
Buy Canadian
Canadian Dollars
Dollars Forward
Forward
(at
(at discount
discount of
of 5%)
5%)
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Inflation & Interest Rates
Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Buy
Buy Canadian
Canadian Dollars
Dollars Forward
Forward
(at
discount
of
5%)
(at discount of 5%)
Buy
Buy Canadian
Canadian Dollar
Dollar Futures
Futures
(at
(at discount
discount of
of 5%)
5%)
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The Linkages Again
RELATIVE
EXCESS
MONEY
SUPPLY
1
RELATIVE
INFLATION
RATES
2
3
4
RELATIVE
EXCHANGE
INTEREST
RATE
RATES
CHANGE
5
6
FORWARD
EXCHANGE
PREMIUM
OR DISCOUNT
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A Framework
Country A
Country B
DOMESTIC
ECONOMIC
POLICIES
DOMESTIC
ECONOMIC
POLICIES
INFLATION
RATE
INFLATION
RATE
EXCHANGE
RATE
INTEREST
RATE
INTEREST
RATE
FORWARD
RATE
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Turkey, 1995
Turkish Lira:
Down 33.5%
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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
Copyright ©2002 Ian H. Giddy
International Financial Markets 58