1. 1 Offshore Market and its Evolution

2. 2 Classification of Financial Markets 2.Offshore markets:- –Offshore or external markets are those in which traded assets are denominated in a foreign currency OR located outside the geographical boundaries (country) of that particular currency in which assets are traded. –Offshore markets are not subject to many of the monitoring and regulatory provisions imposed by the state government nor of the country of the currency in which the asset is denominated.

3. 3 Offshore Market Illustration Suppose Microsoft wishes to place USD 25 million in a 91-day deposit. It obtains rate quotations from various banks in the US and in London. It finds the rate offered by Barclays Bank in London, 8% p.a., most attractive. It instructs CITI bank, New York, to transfer USD 25 million to Barclays. CITI informs Barclays London and asks where the funds should be credited. Barclays London maintains an account with Chase New York. CITI bank debits Microsoft’s account and credits Barclays account with Chase. Barclay creates a deposit account in the name of Microsoft in London and credits it with USD 25 million. An offshore dollar deposit has been created but ‘physically’, the dollars have not left the US. At maturity 91 days later, Barclays will calculate interest payable as: 25000000 x 0.08 x (91/360) = $505555.56

4. 4 Growth of Offshore Markets 1.In 1960 and 70’s American banks had to observe ceilings on the rate of interest they pay on deposits. 2.Reserve requirements and deposit insurance. 3.Importance of dollars as a vehicle currency in international trade therefore European corporations started to retain currencies denominated in dollars. 4.Time factor; European corporations prefer those banks which have similar working hours.

5. 5 Interest Rates in the Global Markets Short term money market rates in a domestic money market are linked to the so called risk free interest rate. In the offshore market the benchmark is the London Inter Bank Offer Rate (LIBOR). LIBOR is only an indicator of demand and supply. Another important term is London Inter Bank Bid Rate (LIBID). This is the rate which a bank is willing to pay for deposits accepted from another bank.

6. 6 Interest Rates in the Global Markets Financial press normally provides quotations for three and six months LIBOR. LIBOR also varies according to the currency in which the loan or deposit is denominated.

7. 7 Relationship b/w domestic and Offshore markets The rates are not identical why? 1.Differences in investors perception of risks associated with different banks and instruments. 2.Impact of regulation on banks cost of funds e.g. US banks are subject to reserve requirements as well as insurance.

8. 8 Why the interest rate is not far apart? In the US domestic markets, 90-day CD rates are ruling at 9.5%. There is a reserve requirement of 6% against funds raised with CDs and a deposit insurance premium of 0.04%. The effective cost of US bank will be: 9.50% + 0.04%= 10.15% 1 - 0.06 Suppose the bid rate for 90-day US dollar deposits in London is 11.5%. Banks with access to the US domestic money market can raise funds from US and place them in London for an arbitrage profit of 1.35%.

9. 9 Impact of regulations on banks cost of funds Suppose US and euro bank pay interest at 10% per annum. Assume that reserve requirements in the US are 5% and deposit insurance costs is 0.1% per annum for the US bank. The effective cost of funds for the US bank would be: 10 + 0.1 = 10.63% 1 - 0.05 While for the euro bank it is 10%. Therefore it is not possible for the US bank to pay interest at 10% If US bank wants to equalise their cost then they have to offer interest at 9.4%.

10. 10 Example 1.Assume that an investor after taking a loan in a foreign currency, converts it into rupees and uses the funds. To repay the loan with interest, he will need the foreign currency six months later. He enters into a forward contract with his bank in which the bank agrees to sell him the foreign currency at a rate specified now. In choosing between a pound sterling and a Yen loan, the depositor will compare the end-of-period rupee cash outflows from both for rupee inflow today. This comparison involves two factors, the interest rates to be paid and the forward exchange rate at which the currency of loan can be bought against rupees. Suppose on 20 March 2002, the following rates were available: Pound sterling 6-month LIBOR: 4.31 % p.a. Japanese yen 6-month LIBOR: 0.104% p.a. Spot Exchange Rate Rupees vs. Pound: Rs. 68.00 per pound 6- month Forward Exchange Rate Rupees vs. Pound: Rs. 69.35. Spot Exchange Rate Rupees vs. Yen: Rs. 0.3665 per Yen 6-month Forward Exchange Rupees vs. Yen: 0.3940 Suppose the fund requirement is Rs. 25 crore. Which currency you suggest ?

11. 11 Solution Spot rate Rs/£ 68Forward Rs/£ 69.35 Rs/Rs/£ = 250,000,000/68 = £ 3,676,471 £ 3,676,471 x 0.0431 x 180/360 = £ 79,228 Total amount due in £= £ 3,755,699 £ 3,755,699 x Rs/£ 69.35=Rs. 260,457,726 Spot rate Rs/¥ 0.3665Forward Rs/¥ 0.3940 Rs/Rs/¥ = 250,000,000/0.3665 = ¥ 682,128,240 ¥ 682,128,240 x 0.00104 x 180/360 = ¥ 354,707 Total amount due in £= ¥ 682,482,947 ¥ 682,482,947 x Rs/¥ 0.3940=Rs. 268,898,281 Therefore £ is loan is better the ¥.

12. 12 Example 2.An investor in Singapore is examining bank deposits in various currencies as a short term investment for 6- months. –Pound (£) sterling 6-month LIBOR: 6.64 % p.a. –Swiss Franc (CHF) 6-month LIBOR: 2.06% p.a. Spot Exchange Rate SGD per CHF: 1.100, 6- month Forward Exchange Rate SGD per CHF:1.1107. Spot Exchange Rate SGD per £: 2.8000, 6-month Forward Exchange SGD per £: 2.7475 Which option will be better? need the answers in percentage.

13. 13 3.One year ago, a Canadian investor converted CAD to yen and purchased 100 shares of stock in a Japanese company at a price of 3,150 yen per share. The stock's total purchase cost was 315,000 yen. At the time of purchase, 1 yen equalled 0.009574 CAD. Today, the stock is selling at a price of 3,465 yen per share, and in the currency market 1 CAD equals 124.527 yen. The stock does not pay a dividend. If the investor were to sell the stock today and convert the proceeds back to CAD. what would be his realized rate of return on his initial CAD investment from holding the stock? What would be the realized rate of return in Japanese yen?

14. 14 4.The following exchange rates are quoted in the spot market: $1 U.S. = 113.835 Japanese yen. 1 Canadian dollar = $1.09354 U.S. Crane Cola is a U.S. company with worldwide operations. The company can produce a liter of cola in Canada at a cost of 0.45 Canadian dollars. The cola can be sold in Japan for 120 Japanese yen. How much operating profit (measured in U.S. dollars) does the company make on each liter of cola sold in the Japanese market?

15. 15 5.Roughly 16 months ago I had £14000. I had a plan to visit Germany so I converted £’s in €’s at an exchange rate of £1/1.2€. I spent the 8000 €’s in Germany in 3 months time and then decided to visit Japan for rest of the days so I exchanged the rest of the €’s in my pocket with Japanese ¥ at exchanged rate of 1£/420 ¥. During my stay in Japan I spent 2,500,000 ¥. After 16-months I came to back to England and converted the remaining ¥’s to £’s. Required: Assuming, the currency exchange rate remains constant over the last sixteen months, how much £’s you would have in your pocket at return.

16. 16 6. Suppose the spot rate between euro and USD is 0.8700 USD per euro. Further, 90-day forward is 0.8500. Dollars can be lent or borrowed at a rate of 5% p.a. while the rate for euro deposits or loans is 8% p.a. Is there an opportunity to make a risk-less profit from a European point of view?

17. 17 7. Three investors, an American, a German and a British are valuing the stock of ABC Inc, an American firm currently priced at say $100. All the three agree that in US dollar terms, the stock will fetch a return of 10% p.a. (ignoring dividends). –The expected inflation rates are 5%, 3% and 7% p.a. in the US, Germany and UK respectively. The exchange rates are €1.0850/$ and $1.5000/£ at the start of the year. –The German investor expects the exchange rate to be €1.0500/$ and the British investor expects the rate to go to $1.40/£ by the year-end. –What are their expected real, i.e. inflation-adjusted returns measured in their respective home currencies?