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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 10 Topic: International Money Markets: The Eurocurrency Markets and International Banking Recall From Lecture 2: Defining the International Monetary System? It is the overall financial environment in which global businesses operate. It is represented by the following two sectors: Foreign Exchange Markets Currency markets (and foreign exchange regimes) International Money and Capital Markets Eurocurrency Markets (dominated by global banks) Traditional financial centers (London, New York, etc) and Offshore Financial Centers and Offshore Financial Markets (Cayman Islands, Singapore, etc). Bond markets Equity markets Financing Global Operations The global firm can finance its overseas activities through either: Internal sources of funds (i.e., within the corporate family). Funds from the parent or “sister subsidiaries.” External sources of funds (i.e., outside of the corporate family). Funds raised in the parent country’s financial markets. Funds raised in financial markets outside the parent country Can be either debt or equity funds. External Financing of the Global Firm Financing in Banks & other financial inst. parent country’s financial market Capital markets or money markets Funds (Debt and Equity) Sourced External Financing with Bank Loans: Local Currency Debt to Debt in Eurocurrency Financing: Banks foreign countries’ The financial markets and Direct Markets Global Long-term Bond Financing: Foreign and Offshore Bonds Firm Financing with Individual foreign shareholders Equity in foreign countries’ Joint venture with foreign partners financial markets International Money Markets The International Money Market represents the short and intermediate term borrowing and investment market. Global firms have access to the international money markets either through (1) intermediaries (commercial banks) or through the direct markets. The major international money markets are: Eurocurrency Loan (Euro-Lines of Credit) Markets Eurocredits (Syndicated) Market Euronotes Market Euro-Medium-Term Notes Market Eurocommercial Paper Market Sources of Debt in the International Money and Capital Markets Bank Loans Local Currency Bank Loans (Intermediary Market) Euro lines Offered by Banks (floating-rate, short-to-medium term) Syndicated Euro Credits Euronote/Paper Euro-Short Term Notes Market (Direct Market) Euro-Medium Term Notes (floating-rate, short-to-medium term) Euro-commercial Paper International Eurobonds (“Offshore” Currencies) Bond Market * straight fixed-rate debt (Direct Market) * floating-rate notes (FRN) (fixed & floating-rate, * equity-related issue medium-to-long term) Foreign Bonds (Domestic Currency) Creation of a Eurocurrency Deposit: Example Assume a German company sells a product to a US company and charges $1,000,000 for the sale. The US company pays by instructing its bank in New York to transfer $1,000,000 into the account of the German company (assume the German company has an account at the same New York bank). The German company then instructs its US bank to transfer the dollar deposit to a dollar time deposit at its bank in London. Note: Dollars do NOT leave the US, but instead the time deposit shifts from the US bank to a London bank. The London bank can now lend out these dollars to its clients. Brief History of the Eurocurrency Market Market originated in the 1950s, when communist governments (mainly the Soviet Union) needing dollars for international trade and concerned about the potential freeze of their dollar accounts in US banks, shifted their deposits to London The original bank in the London market accepting these deposits was the Banque Commercial pour I'Europe du Nord was best known by its cable code, EUROBANK; hence the term euromarket. By the 1960s, the practice of euro-deposits was extended to regular business customers. In 1964, the market size was estimated at $20 billion dollars, with the majority in the form of US dollar deposits. As the economies of Europe and Asia grew, the market was extended to additional currencies other than the US dollar. By 1995, the market had grown to $7 trillion, but the US dollar share was down to 44%. Market is growing about 25% per year! The Meaning of the “Euro” Prefix In the Eurocurrency Market, the prefix “euro” is used to denote the particular offshore currency in which the transaction is occurring, e.g., Euro-dollars, euro-yen, euro-pounds, euro-euros. Eurocurrencies are only the major currencies of the world. Although historically the market originated in Europe, today eurocurrency markets exist all over the world. Banks accepting euro deposits and making euro currency loans are commonly referred to as Eurobanks. Note: do not confuse this term with the single European currency, the “Euro.” Functions of the Eurocurrency Markets The Eurocurrency market serves two valuable functions for global firms: (1) Investment Market: Eurocurrency deposits are a convenient way for global firms to earn a return on their short term excess (“idle”) funds. Eurodollar time deposits normally have maturities from overnight to six months, but may be as long as five years; they are not insured. Minimum investment of $100,000; and are not marketable. For an example see: http://www.wachovia.com/corp_inst/page/0,,7_26_252_923,00 .html (2) Borrowing Market: Eurocurrency loans are a major source of short-term and intermediate term loans for global firms to finance their working capital needs. Eurocurrency Market Structure The Eurocurrency market is two tiered: Wholesale (interbank) market where large global banks trade euro-currencies among themselves ($1,000,000 minimum). Represents about 50% of the market. Gross data (next slide) includes wholesale market Retail market: where global banks accept euro- deposits from clients and make euro-currency loans to clients. Represents about 50% of the market. Net data (next slide) includes only retail market. Major clients include global firms and governments. Size of Eurocurrency Deposit Market (Billion of Dollars), 1964-1995 Interest Rates in the Eurocurrency Market Within the interbank Eurocurrency market, there are two important interest rates: Interbank Offer Rate: The rate charged by banks with excess currency deposits to lend to other banks (“borrowing rate”). Major market is in London, hence LIBOR. Interbank Bid Rate: The rate at which a bank will accept deposits from another bank (“deposit rate”). Again, the major market is London, hence LIBID. Offer rates will be higher than bid rates by about 1/8% The LIBOR rate is often used to scale loan rates to clients in the retail market. LIBOR, March 29, 2007 Fixed by the British Bankers Association, 11:00 London time Source: http://www.marketprices.ft.com/markets/currencies/money Importance of LIBOR Rates (1) Used by foreign exchange market maker banks to calculate forward rates on currencies. Recall: Under the interest rate parity the forward rate must offset market interest rate differentials. In equilibrium, the forward rate offsets the LIBOR differential between currencies. (2) Used by global banks in “scaling” retail market lending rates to corporate and sovereign entity borrowers: Lending rate = LIBOR + “X” basis points Where “X” basis points is the lender’s estimation of the unique risk associated with a particular borrower. LIBOR, LIBID and Domestic Rates LIBOR and LIBID rates will generally parallel the rates on equivalent borrowing and deposit opportunities in each country’s domestic financial market. However, lending rates will generally be lower than equivalent domestic market rates, and deposit rates will generally be higher than equivalent domestic market rates. This interest rate structure reflects: Smaller spreads (between deposit rates and lending rates) in the offshore markets than in the domestic markets due to cost advantages in the market. Typical Spreads in Domestic and Eurocurrency Credit Markets LIBOR and Domestic Borrowing Interest Rates, March 29, 2007 12 Month LIBOR Prime Lending Rate US 5.20% 8.25% Euro 4.17% 4.58% Yen 0.78% 1.63% Eurodollar Deposit Rates and CD Rates, April 3, 2007 CDs (secondary market) United States 1-month 5.29 3-month 5.30 6-month 5.29 Eurodollar deposits (London) 1-month 5.32 3-month 5.34 6-month 5.32 Source: http://www.federalreserve.gov/Releases/H15/update/ Eurocurrency Loans (Euro-Lines) Eurocurrency loans (also called euro lines): These are short term lines of credit against eurocurrencies offered by banks. Specifically these are arrangements between a Eurobank and a customer allowing the customer to borrow up to a pre-specified amount of a designated euro-currency. There is a fee for the line of credit itself (about 1/4 to 1/2 of 1% per annum on the unused portion of the line) and then an interest rate applied against any borrowed amount. Interest rate on borrowing is scaled to LIBOR Eurocredits Eurocredits are short- to medium-term euro- currency loans made by Eurobanks. Often these loans are too large for one bank to underwrite, thus A number of banks will form a syndicate to share the size and risk of the loan (hence, syndicated eurocredits). Eurocredits feature a “roll over provision.” The loan’s maturity can be extended by mutual agreement between lender and borrower. At roll over, the interest rate is re-scaled to the new LIBOR. Example of a Roll Over Eurocredit Example: Roll Over of a 6 Month Euro-Credit years Today 1 2 3 4 5 6 etc. etc. etc. Loan is re-scaled at new LIBOR every six months, with interest payments made on those roll-over dates 23 Euronotes Euronotes are short term promissory notes issued by a corporation and sold to institutional or private investors. Maturity is typically three to six months. Euro-notes are underwritten by international investment banks or international commercial banks through “Euronote Programs.” The program identifies the dealer(s) who will act on behalf of the borrower in placing issues with investors. Euro-notes are originally sold at a discount from their face value and pay back the full face value at maturity and can trade in secondary markets. Eurocommercial Paper Unsecured short-term notes issued by corporations and banks in the Eurocurrency markets. Maturities typically range from one month to 6 months. Historically, U.S. dollar denominated (about 75%); but euro is becoming more important. Placed directly with investors through a dealer. Through a “Eurocommercial Program” with a dealer who places the issues with potential investors. Euro-Medium-Term Notes (MTNs) MTNs are fixed or floating rate notes issued by a corporation or government to investors. Maturities of 9 months to 10 years (but most under 5 years) MTNs are offered on an on-going basis rather than all at once like a bond. Issued through a “Euro-MTN Program.” With this type of program, the issuer can vary the amount of notes to be issued at any one time depending upon its needs and “windows” of opportunity. Thus, a Euro- MTN-program offers issuers flexibility in the raising of medium and longer-term funds. MTNs are placed by dealers and they can trade in secondary markets (many do on the London Stock Exchange). These instruments generally bridge the maturity gap between Eurocommercial paper and Eurobonds. Who Uses the Eurocurrency Markets? Rise of the Offshore Financial Center Offshore financial centers are best defined as those money centers that attract a high level of non-resident financial activity. Offshore financial centers are not new. In the 1920, wealthy American, UK and Canadian citizens established offshore trusts in the Bahamas and the Cayman Islands (to minimize their taxes). In the 1960s and 1970s, US banks established offshore branches to escape US regulations and to book euro-currency loans. Characteristics of Offshore Financial Centers Many (but not all) offshore financial centers are sparsely populated small island states (Switzerland is an exception). These locations provide some or all of the following advantages: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity. Since the 1980s, the number of offshore financial centers (as identified by the IMF) has risen from about 30 to just under 70. Offshore Financial Centers (1999) Africa Asia and Pacific Europe Middle East Western Hemisphere Djibouti Cook Islands Andorra Bahrain Anguilla Liberia Guam Campione (Italy) Israel Antigua Mauritius Hong Kong Cyprus Lebanon Aruba Seychelles Japan Dublin, Ireland Bahamas Tangier Malaysia Gibraltar Barbados Macao Guernsey Belize Marianas Isle of Man Bermuda Marshall Islands Jersey British Virgin Islands Micronesia Liechtenstein Cayman Islands Nauru London, U.K. Costa Rica Niue Luxembourg Dominica Philippines Madeira Grenada Singapore Malta Montserrat Tahiti Monaco Netherlands Antilles Thailand Netherlands Panama Vanuatu Switzerland Puerto Rico Western Samoa St. Kitts and Nevis St. Lucia St. Vincent and Grenadines Turks and Caicos United States Uruguay West Indies Web Sites: Offshore Financial Centers For a good discussion of Offshore Financial Centers visit the following IMF web site: http://www.imf.org/external/np/mae/oshore/2000/eng/back.htm To view one offshore financial center, the Cayman Islands, visit the following web site: http://www.ecayonline.com/cayman-offshore-financial.html Link to Offshore Banking and Investments International (Global) Banks Critical to the functioning of the eurcurrency markets are global commercial banks. Why? Global banks accept euro-deposits and make euro- loans. And they do so within both in the interbank and retail markets. International (i.e., global) banks can be distinguished from domestic banks by the: The types of services they offer The deposits they are willing to accept The loans they are willing to make For a discussion of why banks establish a global presence, please see Appendix 2 International Banks: Services Managing Euro-Programs for borrowers. Financing of cross border trade (exports) Letters of credit; bankers’ acceptances Offering foreign exchange services Market maker banks. Buying and selling foreign exchange for clients Offering hedging contracts (forwards and options). Offering interest rate and currency swap financing. Consulting services to global firms Hedging strategies; international cash management. Underwriting eurobonds, foreign bonds, and equity issues for global firms. International Banking: Deposits International banks may or may not be involved in accepting domestic (i.e., local currency) deposits in the various foreign markets in which they operate. All global banks, however, participate in eurocurrency deposit market. Accepting a wide range of foreign currency deposits. International Banking: Loans International banks are lenders of eurocurrency deposits To one another (in the interbank markets) And to retail customers. Also, participation in syndicated eurocurrency loans to large multinational firms and sovereign entities. Many banks involved in these loan agreements. Some syndicates have involved up to 200 banks. Allows for the pooling of resources and the sharing of risk! International Banks Ranked by Asset Size, 2006 1 UBS (Switzerland) 2 Citigroup (United States) 3 Mizuho Holdings* (Japan) 4 HSBC (U.K.) 5 Credit Agricole Groupe (France) 6 PNB Paribus (France) 7 JP Morgan Chase (United States) 8 Deutsche Bank (Germany) 9 Royal Bank of Scotland (U.K.) 10 Bank of America (United States) *Formed by the 2002 merger of Dai-Ichi Kangyo, Fuji Bank and The Industrial Bank of Japan. Appendix 1: Example of a Corporate Borrower in the Eurocurrency Market CWB, is a Canadian company, that sells western Canadian wheat and barley throughout the world. The company raises money in Canada, the United States and in various eurocurrency markets through a Eurocommercial Paper Program and a Euro Medium Term Notes Program. CWB’s Web Site Visit CWB’s web site (as noted below) to see their recent eurocurrency borrowing activities. From this site, link to “funding programs,” then go to eurocommercial paper program and euro medium term note program. http://www.cwb.ca/public/en/about/investor/#f unding Appendix 2: Why Do Banks Establish a Global Presence and What Organizational Structures do they Use? Why do Banks Establish International Operations? Possible Low Marginal Costs in going global. Apply home knowledge to foreign market. Knowledge Advantage in global market Overseas operations can utilize the parent’s knowledge to compete successfully in foreign market Home (Headquartered) Information Source Providing local firms (in foreign countries) with information about parent’s home market Growth Home market may be saturated or experiencing slow growth. Why do Banks Establish International Operations? Regulation Advantage Global banks may not face the same regulations as do their domestic banks (e.g., reserve requirements on eurocurrency deposits). Defensive Strategy Following corporate clients overseas Providing retail customer overseas services Risk Reduction Greater stability of consolidated earnings. Prestige Example of Global Bank: Citigroup Financial services firm combining banking, insurance, and investments under one global organization. “Universal or full service bank” Currently located in over 100 countries Began international operations in 1912! Go to home page and view countries and product lines http://www.citigroup.com/citigroup/homepage/ Services Offered by International Banks The particular services offered by a global bank is a function of: The regulatory environment. What will foreign (host) governments allow? Developing countries still somewhat restrictive regarding foreign banks. The type of banking office established. Organizational structure will determine type of servies to be offered. See next 4 slides on global banking structures. Correspondent Banking Structure Correspondent Banking Structure is characterized by: Having no physical presence overseas Headquarters maintains “correspondent relationships” with other banks in foreign markets Results in “correspondent” balances held at overseas correspondent banks. Allows a bank to service core clients overseas through correspondent banks with little cost. Facilities foreign exchange conversion for clients Facilities trade financing (clearing bankers acceptances) for clients. Representative Office Structure Representative Office is characterized by: A small overseas service facility staffed by parent bank personnel. The office cannot make loans or accept deposits, but: Office is there to assist core clients in that country with: Country and economic information Introductions to government/business contacts Credit evaluations of local firms This is a potentially useful (and relatively low cost) strategy if a global bank has many important clients in foreign country and they wish to maintain contact with these firms. Foreign Branch Office Structure Foreign Branch Office is characterized by: Since, legally the branch office is part of the parent bank: The branch office is subject to regulations both at home and in foreign country. Branch lending limits are based upon parent capital (not branch office “capital’). Thus, a branch can provide larger loans to overseas clients. This structure allows for fast global clearing of checks within the bank’s organization: Branch to branch and to parent clearing. This has been the most popular form of U.S. bank expansion abroad. Subsidiary Bank Structure Subsidiary Bank is characterized by: A bank locally incorporated (in foreign country). Bank is either wholly owned by parent, or joint venture with local partner. An affiliate bank is a non-controlled subsidiary (i.e., arising out of a joint venture). These banks operate under the banking laws of the country in which it is incorporated. Arrangement was particularly desirable before the abolition of U.S. Glass Steagell Act. U.S. banks incorporated overseas so as to engage in investment banking activities.
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