International Financial Markets Prof. Ian GIDDY Stern School of Business New York University

Copyright ©2003 Ian H. Giddy International Financial Markets 2 What are the Global Financial Markets? l The Foreign Exchange Market l Eurocurrency Markets and Lending l International Bond Markets l International Equity Markets l 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” 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?

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” 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?

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: l Domestic vs. Euro l 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 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

Copyright ©2003 Ian H. Giddy International Financial Markets 9 Foreign Exchange l Mechanics and calculations l How banks make money l How banks hedge l Tasks of the corporate FX manager

Copyright ©2003 Ian H. Giddy International Financial Markets 10 Foreign Exchange Quotations SpotForward points

Copyright ©2003 Ian H. Giddy International Financial Markets 11 Exchange Rates Currency How quoted Spot (2 business days) Forward (90 days) British pounds (GBP) US$ per GBP Japanese yen (JPY) Yen per US$

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 Offer Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward

Copyright ©2003 Ian H. Giddy International Financial Markets 14 Exchange Rates Currency How quoted Spot (2 business days) Forward (90 days) British pounds (GBP) US$ per GBP Japanese yen (JPY) Yen per US$

Copyright ©2003 Ian H. Giddy International Financial Markets 15 A Typical Forward Contract l We agree today to pay a certain price for a currency in the future Sony B of A JPY

Copyright ©2003 Ian H. Giddy International Financial Markets 16 How Does the Bank Hedge a Forward Contract? Hedging approaches:  Open  Forward  Spot plus swap  Rollover  Money 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 on large company stocks 68% 95% > 99% – 3 – 48.2% – 2 – 27.9% – 1 – 7.6% % % % %

Copyright ©2003 Ian H. Giddy International Financial Markets 19 Covered Interest Arbitrage

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 Room CUS- 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 Room CUS- 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: l Take domestic krona deposit l Take EuroKrona deposit 3 MO NKR DEP 3 MO NKR DEP

Copyright ©2003 Ian H. Giddy International Financial Markets 23 Funding a Eurokrona Loan Three ways to fund: l Take domestic krona deposit l Take EuroKrona deposit l Fund with dollars, hedged into krona l Take E$ deposit l Do FX swap: sell USD spot, buy USD forward 3 MO E$ DEP FX SWAP 3 MO E$ 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 $1 (1 + / E$ ) = ($1/ S t )(1 + / EBP ) F n t where S t is the spot exchange rate (dollars per British Pound) and F n t is the forward rate. to a close approximation, (/ E$ - / EBP ) = [(Ft n - S t )/S t ] (365/n) 100 Interest-rate differential = forward premium or discount

Copyright ©2003 Ian H. Giddy International Financial Markets 29 Example: Anglo’s Funding l 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 $  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 q Cost: $1(1+5.5%/4) =  UK: borrow British pounds, change into dollars at spot rate, cover by buying sterling at 3-mo forward rate to repay the pounds q Cost: ($1/1.5484)(1+6.7%/4) =

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 Source: ecobank.xls

Copyright ©2003 Ian H. Giddy International Financial Markets 33 Ecobank l Cost of GBP: 3 19/32 = % l Cost of EUR, hedged into GBP: [1.4282(1+2 17/32 /400)/ ]4 =

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 Probability distribution of actual exchange 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 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

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 l 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 l Switch funding to pesos, despite the slightly higher cost l Borrow in dollars, but hedge the exchange risk in the forward market.

Copyright ©2003 Ian H. Giddy International Financial Markets 44 Ivoire Rubber

Copyright ©2003 Ian H. Giddy International Financial Markets 45 Ivoire Rubber

Copyright ©2003 Ian H. Giddy International Financial Markets 46 Cost of Hedging

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 l Foreign-exchange intervention l Money-market intervention (consider interaction with monetary policy) l Fiscal policy--the demand side l Tariffs and subsidies l 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.” n What is the probability of a devaluation? n How much? n What should GTI-Dakar do?

Copyright ©2003 Ian H. Giddy International Financial Markets 52 Cap des Biches: Choices for GTI-Dakar n Renegotiate the $30 million loan, replacing it with a loan denominated in Euros n Keep the USD loan in place, but enter into a 6-year currency swap to effectively convert GTI's payments into Euros. n Hedge the dollar-Euro risk by buying dollars forward, with rolling 3-month forward contracts n Hedge against a possible devaluation of the CFA franc, by selling francs in the 3-month forward market. n Leave the dollar loan unhedged, and pass the cost of any foreign exchange losses on to Senelac, the buyer of GTI's power n 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

Copyright ©2003 Ian H. Giddy International Financial Markets 54 Contact Info Ian H. Giddy NYU Stern School of Business Tel ; Fax