Page 1 International Finance Lecture 4

Page 2 International Finance Course topics –Foundations of International Financial Management –World Financial Markets and Institutions –Foreign Exchange Exposure –Financial Management for a Multinational Firm

Page 3 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 4 International Banking and Money Market _____________ Banking International Money Market International Debt Crises

Page 5 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 6 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.Canadian Bankers Association webpage

Page 7 The big six Bank of Montreal – The Bank of Nova Scotia – CIBC – National Bank of Canada – Royal Bank of Canada – Toronto-Dominion Bank –

Page 8 International focus of the Big Six

Page 9 Schedule II Banks in Canada

Page 10 Ten Largest U.S. Banks

Page 11 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 12 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 13 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 14 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 15 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. The IMF recognizes as major _______ banking centers: –the Bahamas –Bahrain –the Cayman Islands –Hong Kong –the Netherlands Antilles –Panama –Singapore

Page 16 Cost of Banking Crises in Other Countries

Page 17 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.Lack of knowledge or ability to closely monitor bank operations in other countries 2.Hard to identify which agency is responsible Trend: cooperation and standardization of regulatory ___________ (i.e. Basel Accord)

Page 18 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.

Page 19 Calculating capital requirements

Page 20 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 21 Calculating capital requirements 1 st category: zero weight, reserves and government securities in OECD countries 2 nd category: 20% weight, claims on banks in OECD countries 3 rd category: 50% weight, municipal bonds and residential mortgages 4 th 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 risk- weighted assets.

Page 22 Calculating capital requirements Is First Bank well-capitalized according to Risk- based capital requirements?

Page 23 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. We will deal with VaR later in the course. Idea of using value at risk: compare VaR with bank capital

Page 24 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 25 Money Market Instruments Treasury ___________ ___________Funds Repurchase ___________ ___________Certificates of Deposit Commercial Paper Banker’s ___________ International Money Market Instruments

Page 26 International Money Market Eurocurrency Market ___________ Forward Rate Agreement ___________ Eurocommercial paper

Page 27 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. dollar- denominated 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 28 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 Reservethe Federal Reserve

Page 29 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 30 Eurocredits Comparison of US lending and borrowing rates with Eurodollar rates on August 19, 2002

Page 31 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 32 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 33 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, R fix. 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 34 Forward Rate Agreements Time line Interest Rate

Page 35 Forward Rate Agreements In theory ___________could be made at time T 2. At that time, based on the notional amount L and number of days T 2 - T 1 : –If R T1  T2 < R fixed, Bank 1 could pay to Bank 2 the agreed ___________rate R fixed, and receive from Bank 2 the variable rate R T1  T2. –This never happens; instead Bank 1 just pays the __________ (R fixed - R T1  T2 ) to Bank 2. –If R T1  T2 > R fixed, Bank 2 could pay to Bank 1 the agreed fixed rate R fixed, and receive from Bank 2 the variable rate R T1  T2. –This never happens; instead Bank 2 just pays the difference (R T1  T2 - R fixed ) to Bank 1.

Page 36 Forward Rate Agreements In practice Payment L*|R fixed - R T1  T2 |*(T 2 - T 1 )/360 is _________ to time T 1 and paid at time T 1, since the rate is known at T 1 and no real need to wait until T 2, unless the contract allows for reference rate variability between T 1 and T 2 Payment under standard FRA is calculated as follows

Page 37 Forward Rate Agreements The reference rate R fixed is normally set at today’s level of forward rate F T1  T2. Continuously compounded Forward rate, ___________ F T1  T2 = (R T2 *T 2 -R T1 *T 1 )/(T 2 -T 1 ) For example, you observe 6-month LIBOR=5.39% and 3- month 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 F 91  182 =

Page 38 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 39 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 40 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 R fixed F T1  T2 to detrmine profit/loss for long/short position in the FRA.

Page 41 Forward Rate Agreements Example. Now it is day 0 and the FRA specifies that R fixed =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 42 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 43 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 44 Discount basis Discount securities are quoted on bank discount basis. r BD = quoted rate D – discount, D = ___________ t – days to maturity F – face value P - current price

Page 45 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 46 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 47 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 48 International Debt Crisis Ten Biggest American Bank Lenders to Mexico ($bn, September 30 th, 1987)

Page 49 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 50 Debt-for-Equity Swap Illustration International Bank Equity Investor or MNC LDC Central Bank LDC firm or MNC subsidiary

Page 51 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. This led to domestic price ___________ in East Asia, particularly in ______________________.

Page 52 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