The Eurocurrency Market and International Banking Noer Azam Achsani Moosa (2004)
2 The Eurocurrency Market The market is comprised of banks that accept short-term deposits and make short-term loans in currencies other than that of the country in which they are located. Eurocurrency – US dollar – Euro – Japanese yen – British pound – Swiss franc
3 Eurocurrency Centres Prerequisites – Political stability – Favourable environment for international finance – Good telecommunications system – Favourable time zone – High quality of life Important centres – European centres: London, Luxembourg, Paris, Zurich and Frankfurt – Centres outside developed countries: the Bahamas, Bahrain and Hong Kong – North America and Japan: International Banking Facilities (IBFs) and the Japan Offshore Market (JOM)
4 Evolution and Growth The market started in the 1950s. In 1957, the Bank of England introduced tight controls. In 1958, European currencies were made convertible. The rise of oil prices in the 1970s Efficiency
5 What Explains Efficiency? Eurobanks are not subject to regulations (e.g. Regulation Q, interest equalisation tax) No reserve requirements Economies of scale
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 6 Features of Eurobanking International banking encompasses Eurobanking. Liabilities are time or call deposits. Eurobanks cannot create deposits by writing claims against themselves. Eurobanks accept deposits and make loans in a variety of currencies. A Eurobank is often a branch of an international bank. There are no formal restrictions on entry.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 7 Features of Eurobanking (cont.) Transactions are large. The geographical spread is very wide. The market is not subject to the regulatory measures of the local authorities. The market is dominated by interbank operations. Participants include multinationals and central banks. Eurobanks do not have to hold reserves against deposits.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 8 Determination of the Bid-Offer Spread The bid rate is determined by “the demand by market makers and the supply of price takers”. The offer rate is determined by “the demand by price takers and the supply of market makers”.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 9 The Risk Premium Only borrowers of high quality can borrow at the offer rate quoted by market makers. Others have to pay a risk premium.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 10 International Banking International banking operations encompass those conducted with non-residents as well as those involving foreign currencies.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 11 Reasons for the Emergence of International Banking Meeting the needs of foreign subsidiaries Participation in the FX market Circumventing capital controls Provision of custodial services
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 12 Traditional Activities Export-import finance Buying and selling foreign exchange Provision of foreign loans
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 13 New Activities Dealing in Eurocurrencies Syndicated Eurocredit Investment banking
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 14 Innovative Activities Innovative financing Global money market Managing the loan portfolios of developing countries Private banking
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 15 The Organisational Set-up Correspondent banks Representative offices Bank agencies Foreign branches, subsidiaries and affiliates Consortium banks Global banks
Purchasing Power Parity
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 17 The Law of One Price (LOP) In the absence of frictions, the price of a commodity expressed in a common currency must be the same in every country:
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 18 From the LOP to PPP
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 19 PPP as a Comparative Statics Relationship
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 20 Deriving PPP from the S-D Model
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 21 Deriving PPP from the S-D Model (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 22 The PPP Exchange Rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 23 Derivation from PPP
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 24 PPP and the Real Exchange Rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 25 PPP and the Real Exchange Rate (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 26 PPP and the Real Exchange Rate (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 27 The Empirical Validity of PPP There is little empirical evidence to support the validity of PPP, particularly in the short run. There is some evidence for PPP under hyperinflation and over long periods of time.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 28 Actual and PPP Exchange Rates
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 29 Actual and PPP Exchange Rates (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 30 Actual and PPP Exchange Rates (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 31 Actual and PPP Exchange Rates (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 32 Nominal and Real Exchange Rates
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 33 Nominal and Real Exchange Rates (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 34 Nominal and Real Exchange Rates (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 35 Nominal and Real Exchange Rates (cont.)
Covered Interest Parity
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 37 Definition The CIP hypothesis describes the relationship between the spot rate, the forward rate and interest rates. It is an application of LOP to financial markets.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 38 Reasons for interest in CIP It can be used as a measure of capital mobility. It links the term structure of interest rates with the term structure of forward spreads. It implies optimal resource allocation in a market economy. It has implications for financing and investment decisions
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 39 The CIP Equilibrium Condition
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 40 Return on Investments Converting at spot rate Investing in foreign assets Reconverting at forward rate Domestic investment Foreign investment Investor (K)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 41 Covered Interest Arbitrage Covered margin Investing at domestic rate Domestic foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign domestic Borrowing foreign currency Converting at spot rate S 1 unit Reconverting at forward rate Loan repayment Covered margin 1 unit Reconverting at forward rate S
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 42 Profit from Covered Arbitrage (Domestic→Foreign)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 43 Covered Arbitrage with Bid-Offer Spreads (Domestic→Foreign)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 44 Covered Arbitrage with Bid-Offer Spreads (Foreign→Domestic)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 45 Arbitrage with Bid-Offer Spreads Covered margin Investing at domestic bid rate Domestic foreign Borrowing domestic currency Converting at spot offer rate Investing at foreign bid rate Foreign domestic Borrowing foreign currency Converting at spot bid rate S 1 unit Reconverting at forward bid rate Loan repayment Covered margin 1 unit Reconverting at forward offer rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 46 Deviations from CIP Deviations from CIP are indicated by a non- zero covered margin.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 47 Covered Margins in Percentage Points (Short Australian Dollar)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 48 Covered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 49 Covered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 50 Covered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 51 The Effect of Transaction Costs
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 52 Political Risk This refers to the uncertainty that while funds are invested abroad they may be frozen, become inconvertible or be confiscated. A minimum covered margin is required before indulging in covered arbitrage.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 53 Tax Differentials The covered margin is reduced in the presence of taxes.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 54 Liquidity Differences The more uncertainty there is concerning future needs and alternative sources of financing, the higher the premium to be received before indulging in covered arbitrage.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 55 Other Factors Other factors cause deviations from CIP because they hinder the movement of arbitrage funds. These include inelastic supply, capital market imperfections and capital controls.
Market Efficiency, Uncovered Interest Parity and Real Interest Parity
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 57 The Concept of Market Efficiency In an efficient market, prices reflect all available information. Implication It is not possible to predict price movements from available information. It is not possible to earn abnormal returns via active trading.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 58 Weak Efficiency Prices reflect all the information contained in the past behaviour of prices.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 59 Semi-Strong Efficiency Prices reflect all the information contained in their past behaviour, as well as all public information.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 60 Strong Efficiency Prices reflect all available information, including private and insider information.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 61 Spot-Market Efficiency The spot exchange rate moves in a random and unpredictable way, reflecting the random arrival of new information:
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 62 Forward Market Efficiency The market reflects all available information where the information is contained in the forward rate.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 63 Forward Market Efficiency (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 64 The Forward Rate as Predictor of the Spot Rate (AUD/GBP)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 65 The Forecasting Error of the Forward Rate (AUD/GBP)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 66 Uncovered Interest Parity UIP is a condition that precludes profitable uncovered arbitrage. It is ‘uncovered’ because the long currency position is left open. It can be derived by combining CIP and unbiased efficiency.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 67 Return on Domestic Investment and Foreign Investment (with Uncovered Position) Converting at spot rate Investing in foreign assets Reconverting at expected spot rate Domestic Investment Foreign Investment Investor (K)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 68 The UIP Condition
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 69 The Effect of Uncovered Arbitrage UIP can be derived from arbitrage. A violation of the UIP condition triggers uncovered arbitrage.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 70 Uncovered Interest Arbitrage Covered margin Investing at domestic rate Domestic foreign Borrowing domestic currency Converting at spot rate Investing at foreign rate Foreign domestic Borrowing foreign currency Converting at spot rate S 1 unit Reconverting at spot rate Loan repayment Covered margin 1 unit Reconverting at spot rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 71 Uncovered Arbitrage with Bid- Offer Spreads Covered margin Investing at domestic bid rate Domestic foreign Borrowing domestic currency Converting at spot offer rate Investing at foreign bid rate Foreign domestic Borrowing foreign currency Converting at spot bid rate S 1 unit Reconverting at spot bid rate Loan repayment Covered margin 1 unit Reconverting at spot offer rate
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 72 The Empirical Validity of UIP For UIP to be valid, the uncovered margin must fluctuate around a mean value of zero.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 73 Uncovered Margins in Percentage Points (Short Australian Dollar)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 74 Uncovered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 75 Uncovered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 76 Uncovered Margins in Percentage Points (Short Australian Dollar) (cont.)
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 77 Real Interest Parity The real interest rate is the nominal rate adjusted for inflation
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a International Finance: An Analytical Approach 2e by Imad A. Moosa Slides prepared by Afaf Moosa 78 Real Interest Parity RIP can be derived by combining UIP and PPP.