1. The International Capital Markets Prof. Ian Giddy New York University New York University/ING Barings

2. Copyright ©1999 Ian H. Giddy Capital Markets 2 Instruments and Markets Corporate Bonds Domestic International

3. Copyright ©1999 Ian H. Giddy Capital Markets 3 International Financial Markets l The Eurocurrency market l Foreign exchange l Covered interest arbitrage l International portfolio investment returns l Hedging international portfolios l International diversification: passive vs active

4. Copyright ©1999 Ian H. Giddy Capital Markets 4 “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? The Eurocurrency Market

5. Copyright ©1999 Ian H. Giddy Capital Markets 5 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?

6. Copyright ©1999 Ian H. Giddy Capital Markets 6 US Domestic German Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Japanese Euro-Yen Domestic Market Market Where the Eurocurrency Market Fits In

7. Copyright ©1999 Ian H. Giddy Capital Markets 7 Where the Eurocurrency Market Fits In US Domestic German Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Foreign Exchange Market Japanese Euro-Yen Domestic Market Market Euro-CommercialEuro-Floating Rate Straight Paper Market Note Market Eurobond Market

8. Copyright ©1999 Ian H. Giddy Capital Markets 8 The Global Bond Market l Domestic bonds l Foreign bond (Issued within country of currency, by non- resident issuers) l Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) l Global Bonds (Issued in the domestic and the Eurobond markets simultaneously)

9. Copyright ©1999 Ian H. Giddy Capital Markets 9 Characteristics of Eurobonds l Issued outside country of currency l Not subject to domestic registration or disclosure requirements l In most cases take form of private placements l Placed through syndicates in many countries who sell principally to nonresidents l Bonds are structured so as to be free of withholding tax l Bearer form But... l Eurobonds usually influenced de facto by government and banks of country of currency

10. Copyright ©1999 Ian H. Giddy Capital Markets 10 International Bond Markets are Linked l Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps BOND MARKETS WITHIN COUNTRY OF CURRENCY BOND MARKETS OUTSIDE COUNTRY OF CURRENCY Currency Swaps Long-dated Forward Exchange Domestic US -Gov't -Corporate Foreign Bonds "Yankee" Domestic Japanese -Gov't -Corporate Foreign Bonds "Samurai" Eurodollar Bond Market Euroyen Bond Market

11. Copyright ©1999 Ian H. Giddy Capital Markets 11 Exchange Rate Risk l Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies

12. Copyright ©1999 Ian H. Giddy Capital Markets 12 Policies and Exchange Rate Regimes l Exchange rate systems--fixed vs floating l Managed floating l EMU-type currency blocs l De facto blocs--the dollar

13. Copyright ©1999 Ian H. Giddy Capital Markets 13 “A Euro is a basket of individual European currencies” True or false? The Euromarket vs the Euro C

14. Copyright ©1999 Ian H. Giddy Capital Markets 14 Domestic Policies, Domestic Prices and Interest Rates, and Exchange Rates Country ACountry BDOMESTICECONOMICPOLICIESINFLATION RATE RATE EXCHANGE RATEINTEREST RATE RATE FORWARD RATE

15. Copyright ©1999 Ian H. Giddy Capital Markets 15 Foreign Exchange Mechanics and Calculations l “Money never leaves homes” l Funds transfer, chips, and timing l Relative interest rates 1. Forward premium or discount 2. Points 3. Spot and forward l Spot and forward 1. Points 2. Forward premium or discount 3. Relative interest rates

16. Copyright ©1999 Ian H. Giddy Capital Markets 16 Exchange Rates

17. Copyright ©1999 Ian H. Giddy Capital Markets 17 A Typical Forward Contract l We agree today to pay a certain price for a currency in the future Sony B of A JPY

18. Copyright ©1999 Ian H. Giddy Capital Markets 18 Foreign Exchange Quotations SpotForward points

19. Copyright ©1999 Ian H. Giddy Capital Markets 19 Foreign Exchange Quotations Bid Offer Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward

20. Copyright ©1999 Ian H. Giddy Capital Markets 20 Foreign Exchange Quotations Bid Offer Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward 111.35 111.45 0.52 0.517 110.83 110.933

21. Copyright ©1999 Ian H. Giddy Capital Markets 21 The Forward Rate Tracks the Spot Rate

22. Copyright ©1999 Ian H. Giddy Capital Markets 22 Covered Interest Arbitrage

23. Copyright ©1999 Ian H. Giddy Capital Markets 23 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 In the Dealing Room The Dealing Room

24. Copyright ©1999 Ian H. Giddy Capital Markets 24 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

25. Copyright ©1999 Ian H. Giddy Capital Markets 25 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

26. Copyright ©1999 Ian H. Giddy Capital Markets 26 Example: Guidant’s Cash l Guidant, the medical instruments company, is seeking to invest 3-month US$ money.  Guidant can invest 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 $1.5454  Which is better?

27. Copyright ©1999 Ian H. Giddy Capital Markets 27 Guidants’s Answer It’s better for Guidant to invest in the GBP instrument and hedge. Reason:  US: simply invest for 3 months q Result: $1(1+5.5%/4) = 1.01375  UK: take the US dollars, change into British pounds at spot rate, cover by selling sterling at 3-mo forward rate to convert the money back into dollars q Result: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478

28. Copyright ©1999 Ian H. Giddy Capital Markets 28 TIME EXCHANGE RATE Spot Forward Actual Today In three months What if Guidant didn’t hedge?

29. Copyright ©1999 Ian H. Giddy Capital Markets 29 TIME EXCHANGE RATE Spot Forward Actual Probability distribution of actual exchange rate Today In three months Unbiased Forward Rate Theory

30. Copyright ©1999 Ian H. Giddy Capital Markets 30 Issues l What are the risks involved in investment in foreign securities? l How do you measure benchmark returns on foreign investments? l Are there benefits to diversification in foreign securities?

31. Copyright ©1999 Ian H. Giddy Capital Markets 31 International Equity Investments l Equity returns in local currency l Exchange rate changes l Other factors?

32. Copyright ©1999 Ian H. Giddy Capital Markets 32 Equity Returns: Domestic vs Global Yardeni.com International charts

33. Copyright ©1999 Ian H. Giddy Capital Markets 33 Int’l Investment Choices l Direct Stock Purchases l ADRs l Mutual Funds  Open end  Closed end l Global companies

34. Copyright ©1999 Ian H. Giddy Capital Markets 34 Obstacles to International Investment Might Include: l Information barriers. l Political and capital control risks. l Foreign exchange risks. l Restrictions on foreign investment and control. l Taxation. l Higher costs.

35. Copyright ©1999 Ian H. Giddy Capital Markets 35 Foreign Exchnage Risk in International Investing Foreign Exchange Risk l Variation in return related to changes in the relative value of the domestic and foreign currency l Total Return = Investment return plus return on foreign exchange l Not possible to completely hedge a foreign investment

36. Copyright ©1999 Ian H. Giddy Capital Markets 36 Returns with FX l Return in US is a function of two factors 1. Return in the foreign market 2.Return on the foreign exchange

37. Copyright ©1999 Ian H. Giddy Capital Markets 37 Returns with FX (1 + r US ) = (1 + r FM ) (1 + r FX ) r US = return on the foreign investment in US Dollars r FM = return on the foreign market in local currency r FX = return on the foreign exchange

38. Copyright ©1999 Ian H. Giddy Capital Markets 38 Return Example: Dollar Appreciates Initial Investment : $100,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange:$2.10/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + r US ) = (1.10) (1.05) = (1.155) r US = 15.5%

39. Copyright ©1999 Ian H. Giddy Capital Markets 39 Return Example: Dollar Depreciates Initial Investment : $100,000 Initial Exchange: $2/ Pound Sterling Final Exchange: $1.85/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + r US ) = (1.10) (.9250) = (1.0175) r US = 1.75%

40. Copyright ©1999 Ian H. Giddy Capital Markets 40 Exchange Rate Risk l Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and hence to nominal equity returns. Relative monetary and fiscal policies Relative monetary and fiscal policies Relative inflation Relative inflation Exchange rate change Exchange rate change

41. Copyright ©1999 Ian H. Giddy Capital Markets 41 Turkey, 1995 Turkish Lira: Down 33.5%

42. Copyright ©1999 Ian H. Giddy Capital Markets 42 Turkey, 1995 Turkish Lira: Down 33.5% Turkish prices: up 83.8%!

43. Copyright ©1999 Ian H. Giddy Capital Markets 43 Hedging International Equity Investments l Buy foreign equity and hedge the anticipated future value, P+E(r)? l Use short-term, value-adjusted, roll-over hedges? l Do nothing, because equities bear no currency sign? Anticipated Actual Initial

44. Copyright ©1999 Ian H. Giddy Capital Markets 44 Measuring Benchmark Returns l Indexes l EAFE Index l Issues in Measuring Performance  Weighting  Cross-Holdings l Other Possibilities  Country and Region Funds

45. Copyright ©1999 Ian H. Giddy Capital Markets 45 Diversification Benefits Evidence shows international diversification is beneficial l Possible to expand the efficient frontier above domestic only frontier l Possible to reduce the systematic risk level below the domestic only level

46. Copyright ©1999 Ian H. Giddy Capital Markets 46 Systematic Risk Level with International Diversification Risk Securities Int’l Dom

47. Copyright ©1999 Ian H. Giddy Capital Markets 47 The Minimum-Variance Frontier Efficient frontier Individual assets Global minimum- variance portfolio E(r)

48. Copyright ©1999 Ian H. Giddy Capital Markets 48 Efficient Frontier with International Diversification Return Risk * * * * * * * * Dom Int’l

49. Copyright ©1999 Ian H. Giddy Capital Markets 49 The Global Efficient Frontier

50. Copyright ©1999 Ian H. Giddy Capital Markets 50 International Portfolio Optimization: Passive vs Active Portfolios (Let the proportions of all possible assets vary until the optimal proportions are found.) The results of letting the computer find the best proportions for various levels of return:

51. Copyright ©1999 Ian H. Giddy Capital Markets 51 Evidence Suggests Index Funds are Not for the International Investor l For the international investor the capitalization- weighted portfolio may not be the optimal one. The reason is market segmentation. The world stock market is not efficient yet, the evidence suggests, at least not in the "mean-variance efficiency" sense that is required by the CAPM. l Because of real exchange risk (deviations from PPP), what is the optimal portfolio for an investor in one country may not be the optimal portfolio for an investor in another, even if there were a single risk- free asset acceptable to both. l Studies confirm these propositions

52. Copyright ©1999 Ian H. Giddy Capital Markets 52 Emerging Equity Markets

53. Copyright ©1999 Ian H. Giddy Capital Markets 53 Can globally mobile investors capture value & control? Macro Factors Currency overvaluation Capital restrictions Structural Factors Acctg & disclosure requirements IAS compliance Bankruptcy regime Creditor rights Govt-corporate nexus Trading infrastructure Price-Value ratio, Sharpe ratio, EVA D/E ratio Currency & maturity mismatch IAS conformity Insider control Objective research coverage Trading liquidity Firm-level Factors

54. Copyright ©1999 Ian H. Giddy Capital Markets 54 www.bankofny.com/adr adr.com

55. Copyright ©1999 Ian H. Giddy Capital Markets 55 Brady Bonds l Origin? l Types? l Ecuador’s Bradies  Discount  Par  Past due interest  Interest equalization l What next?

56. Copyright ©1999 Ian H. Giddy Capital Markets 56 Correlations: Domestic vs Global creditmetrics.com correlation engine

57. Copyright ©1999 Ian H. Giddy Capital Markets 57 Summary l The Eurocurrency market is most closely tied to the foreign exchange market l Covered interest arbitrage links spot- forward differential to interest rates l Foreign portfolio returns = equity + FX l International diversification pays l Hedging international portfolios is tricky

58. Copyright ©1999 Ian H. Giddy Capital Markets 58

59. Copyright ©1999 Ian H. Giddy Capital Markets 59 www.giddy.org

60. Copyright ©1999 Ian H. Giddy Capital Markets 60

61. Copyright ©1999 Ian H. Giddy Capital Markets 61 Ian H. Giddy Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://giddy.org