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AJA4604.03 International Financial Markets Financial markets are often designated as money markets and capital markets. * Money Markets are markets for short term financial assets (short-term instruments) e.g., T-Bills, Certificates of Deposits (CDs), Bankers Acceptance (BA), Commercial Papers (CP), Repurchase Agreements (Repos) … * Capital Markets are markets for long term financial assets like Bonds, Stocks, Mortgages, etc. Two Major Components of International Financial Markets: i. The Foreign Exchange Market ii. Eurocurrency, Eurocredit, & Eurobond Markets 1 The Foreign Exchange Market is the world's largest financial market. The Bank for International Settlements estimates daily trading of about $4 trillion (WSJ 09-01-10) The Foreign Exchange Market is an over-the-counter market. That means there is no physical location where traders get together to exchange currencies. Traders located in the offices of major commercial banks around the world and communicate using the computer terminals, telephones, telexes, and other communication channels. 2 Most trading activities take place in a few currencies like the US dollar, The Euro, British Pounds, Yen, and Canadian Dollars. Foreign Exchange traders not only buy and sell currencies but, they create prices. Market Makers are those traders in major money-center banks around the world who are always ready to buy or sell by quoting the bid/ask prices. The difference between the two prices is called the “spread." They create the market by setting bid/ask prices and dealing at those prices. Participants include importers, exporters, portfolio managers, central banks, brokers, commercial banks, arbitragers, speculators, tourists, governments, etc. 3 The Foreign Exchange Market can be subdivided into: The Retail Market: Permits the firms and individuals to obtain foreign exchange for business or personal use. The Interbank Market: Major participants are foreign exchange traders employed by large banks. Also large Multinational Corporations often maintain trading departments that operate directly in this market. Traders in the interbank market are called "Dealers." They make the market. Brokers: Bring buyers and sellers together for a small commission thereby helping to preserve the anonymity. Arbitragers: Seek to earn riskless profit from price differences in different foreign exchange markets. 4 Speculators: Buy and sell in the hope that a price change will result in a profit. Governments: Central Banks, Treasury Departments and other Government Agencies sometimes participate in the market in order to influence the exchange rate of a particular currency. For Example: FED buys dollars in the foreign exchange market to increase the value of the dollar. FED sells dollars in the foreign exchange market to reduce the value of the dollar. Coordinated efforts among central banks are often used. Example: The Federal Reserve Bank bought Mexican pesos to help prop up the value of the currency in 1995. 5 Other Participants : Traders: Use forward contracts to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currencies. Hedgers: Hedgers, mostly Multinational corporations, enter into forward contracts to protect domestic currency value of foreign currency denominated asset and liabilities on their balance sheet. The increasing importance attached to exchange rates results from the globalization or internationalization of modern business, the continuing growth in world trade, the trend towards economic integration, and the rapid pace of change in the technology of money transfer. 6 Functions of Foreign Exchange Markets Transfer of Purchasing Power: International trade and capital transaction usually involve parties with different functional currencies. Trade and capital transactions can be invoiced in any convenient currency. Therefore, one or more of the parties must transfer purchasing power to or from own national currency. The Foreign exchange market facilitates this transfer of purchasing power. Provisions of credit: Movement of goods and services between countries takes time. This gives rise to financing of inventory in transit and sales inventory. The foreign exchange market provides a means of transfer of credit. Specialized instruments like Bankers' Acceptances and Letters of Credit, are made possible through the foreign exchange market. 7 Minimizing Foreign Exchange Risk: The foreign exchange market provides "risk transfer" facilities to third parties through Forward, Futures, Options, and Swaps markets. During the past decade the foreign exchange market has served as the invisible hand guiding the purchase and sale of goods, services, raw materials, and flow of investments in every corner of the globe. The market directly affects every country’s bonds, equities, private property, manufacturing, and all assets that are accessible to foreign investors. It plays a major role in determining who finances government deficits, who buys equity in companies, who owns real estates, who buys companies, and who hires and fires employees. 8 The market affects every aspect of our daily personal or corporate lives and influences the economic and political destiny of every nation. The foreign exchange market is a stabilizing factor in global system of monetary exchange. 9 Formal Definition: The Foreign exchange rate can be defined as units of domestic currency per unit of a foreign currency. This is a “direct quote” for the foreign currency. Example: Let the U.S. be "domestic" 1. If you need $1.75 to purchase 1 unit of the British Pound Sterling, then $/£ = 1.75 (d/f) Dollars per pound , the dollar price of one pound, is a “direct quote” for the pound in the U.S. It means units of the home currency, in this case the $, (or domestic currency) needed to acquire one unit of a foreign currency, in this case the pound. 10 Alternatively: The foreign exchange rate can be defined as units of a foreign currency per unit of domestic currency. This is an “indirect quote” for the foreign currency. 2. If 105 units of the Japanese Yen are needed to purchase one unit of the U.S. Dollar, then ¥/$ = 105 (f/d). This is an indirect quote for the Yen in the US. 11 Since the direct and the indirect quotations are alternative means of stating exchange rates, the two methods are related. One is the inverse of the other. Thus: $ = 1 £ £/$ and, ¥ = 1 $ $/¥ Examples: If $/£ = 1.4435, obtain £/$ If SF/$ = 7.3848, obtain $/SF If R/$ = 2.2019, obtain $/R 12 Most interbank quotes around the world are stated in “European terms” which means foreign currency price of one dollar, e.g. Won/$ = 1225.50, ¥/$ = 95.25, Peso/$ = 12.1045 The alternate way, dollar price of one unit of foreign currency, is called “American terms” e.g. $/£ = 1.6235, and $/€ = 1.4155 13 Spot Rates: A spot transaction is the purchase of foreign exchange for immediate delivery (usually, delivery is within the following two business days). Forward Rates: A forward exchange rate or forward rate, is the price agreed upon today for purchase or sale of foreign currency for future delivery (transfer/settlement) and payment. The rate is agreed upon at the time the contract is made, but payment and delivery are not required until maturity. 14 Forward maturities are normally 30, 60, 90, 180, 360 days in the future. Maturities of one or two weeks are also common. Odd maturities may be negotiated even up to 5 years. 15 Cross Rates: Frequently, the need arises to obtain the relationship (price) between two currencies from their relationship with (quotation in) a third currency. Formally, given two currencies A & B, If $/A and $/B are given, then The value of A in terms of B (or B per unit of A) is given by : $/A = $ * B = B $/B A $ A This is the cross rate. 16 Example: Given $/£ and $/SF, then: $/£ = $ * SF = SF $/SF £ $ £ Given: $/£ = 1.4155 and SF/£ = 3.1318, then SF = SF/£ = 3.1318 = 2.2125 $ $/ £ 1.4155 Given: $/£ = 1.8632, $/ ¥ = .008013, then: ¥ = $/£ = 1.8632 = 232.52 £ $/ ¥ .008013 17 Exercise: 1. Given P/$ = 12.4250, C$/$ = 1.1607, Obtain C$/P 2. Given Y/$ = 95.53, SF/$ = 1.1566, Compute Y/SF 3. You have just received a gift of 600,000 Yen that you wish to convert to Euros. You are given that $/€=1.2865 and Y/$=83.63. How many Euros would you get ? 18 The Bid-ask Spread: Bid Price: price at which a dealer will buy a currency. Ask price: price at which the dealer will sell a currency (= offer price). Dealers do not normally charge a commission on their currency transactions but profit from the bid/ask spread. Computing the bid/ask spread in percentage terms: Bid/Ask spread = Ask Rate - Bid Rate * 100 Ask Rate 1 This expresses the spread in terms of the "discount" obtained by the dealer. 19 Alternatively, Bid/Ask spread = Ask Rate - Bid Rate * 100 Bid Rate 1 This expresses the spread in terms of the markup established by the dealer. In practice, the £ may be quoted at $1.7019-36. This means a bid price of 1.7019 and an ask price of 1.7036. In practice, this quotation may simply be given as 19-36 as the dealers are sufficiently up to date to know the preceding numbers. A point is the last digit in a quotation, and convention dictates the numbers of decimal points in each quotations. 20 Premium or Discount on Forward Rate: If the forward rate exceeds the existing spot rate (direct quotes) that forward rate contains a premium. If the forward rate is less than the spot rate, that forward rate contains a discount. To compute the Premium (Discount): Let, F = Forward rate e.g., $/£ = d/f S = spot rate n = time to maturity Then given a direct quote of the £: F- S * 360 = premium (discount) on the £. S n 21 For an indirect quote, (e.g. £ quoted as £/$ = .6564) the premium (discount) on the £ is given by: S-F * 360 = premium (discount) F n A premium means that the direct price in the forward market is higher than the direct price in the spot market. A discount is the reverse. Exercise: Given that spot C$/$ = 1.1596 and 6- month fwd C$/$ = 1.1618, obtain: i). P(d) on US dollar. ii). P(d) on Canadian dollar. 22 Using The Forward Contract: Example: A U.S. importer of German BMW receives a bill of €2 million for the 700 series. The Bill is due in 90 days. Assume that Spot $/ € = 1.4775 and 90-day forward $/ € = 1.4856. The spot $/€ in 90 days is unknown. What should the importer do? The Forward contract is a means of locking in the price at which Euros will be acquired in 90 days. The importer can enter into a fwd contract to purchase Euros for delivery in 90 days at the fwd rate of $/€ = 1.4856. 23 Percentage Change in Exchange Rates The percentage change in exchange rates can be obtained as follows: % = Ending Rate - Beginning Rate * 100 Beginning Rate 1 The percentage change in exchange rate indicates an upward or downward movement in the value of a currency against other currencies over time. 24 Example: o t Let et = $/£ |--------------------------------| S0 St at t = 0, $/£ = 1.7557 t = 1, $/£ = 1.9567 %= 1.9567 - 1.7557 * 100 = 0.11448 1.7557 1 The BP has appreciated in value against the dollar by about 11% during this period. 25 Common Terms Depreciation -- Devaluation -- Weakening Appreciation -- Revaluation -- Strengthening Soft Currency -- Expected to decrease in value Hard Currency -- Expected to maintain its value or increase in value “The Dollar is Mixed” indicates that the $ did not move in one direction against major currencies. It is up against some, and down against others. 26 The Eurocurrency Markets Definitions A Eurodollar is a U.S.-dollar denominated bank deposit held outside the U.S. More generally, a Eurocurrency deposit is a domestic-currency denominated bank deposit held outside the domestic geographical area. In other words, Eurocurrencies are typically time deposits denominated in currencies other than those of the countries in which they are located. 27 Other important Eurocurrencies are: Euro-Canadian dollar, Euro-Swiss franc, Euro-Sterling, Euro-yen and now Euro- Euro!. Smaller offshore banking centers which participate in the eurocurrency market include such locations as the Cayman Islands, Bahamas, Bahrain, Luxembourg. The Singapore market is often called: "Asian Dollar Market.” 28 The Evolution of the Market: The development and expansion of the Eurocurrency markets have their roots in overt and covert events. 1) In the late 1950s British-owned banks utilized foreign currency deposits (in the UK) as a lending medium in order to save the business that was at that time endangered by exchange controls (in the UK) on transactions in pounds sterling. 29 2) The Soviet Union: provided impetus for the early growth of the market. As the cold war heated up, the Soviet Union began to worry about the U.S. Government freezing its deposits in New York. The Soviets needed to maintain dollar accounts for international trade and investment. The dollar was then virtually the only currency acceptable worldwide. The Soviet Union responded to this problem by placing its dollar-denominated deposits in banks outside the U.S. jurisdiction. British banks were the primary recipients of these deposits. 30 3) Changes in U.S. Balance of Payment Situation: From 1945-50 the U.S. had persistent surpluses. These were replaced by deficits in 1957. Deficits resulted in increased foreign holding of US dollars. (What is the percentage of $s in circulation held outside the US?) By mid 1958 the European market in dollar deposits and loans had become established. 4) The Interbank Market and Global Financial Innovations. 31 5) Regulatory Developments in the US: (i) "Regulation Q": Interest rate ceilings existed in the U.S. during the 1960s and 1970s. With higher interest on dollars deposited in the eurodollar market, funds moved to banks in Europe. Many U.S. banks opened European offices to receive these funds. (ii) Federal Reserve "Regulation M": This regulation requires the keeping of reserves against deposits. Since reserves constitute idle funds, the cost of operating in the Eurocurrency market is relatively less since there are no reserve requirements in the eurocurrency market. Many American banks moved some of their operations to the relatively unregulated eurocurrency market. 32 (iii) Controls and Restrictions on Borrowing Funds in the U.S. for Reinvestment Abroad: (voluntary in 1965, mandatory in 1968) Forced many borrowers to seek sources of loans in Europe, thereby increasing the demand for funds deposited in the eurocurrency markets. (iv) The U.S. Interest Equalization Tax (1963): Imposed a tax on U.S. residents' earnings on foreign securities. This increased the interest foreign borrowers were forced to pay on funds borrowed directly from the U.S. market. By channeling funds through the eurocurrency market, this tax is avoided. 33 6) The Role of Narrow Spreads: The desire of depositors to receive highest possible yields and of borrowers to pay lowest possible costs are met in the Eurocurrency market. Absence of regulation permits higher yields to depositors and lower costs to borrowers. 7) Desire of British Banks - to maintain their leading position in international finance plus the favorable regulatory environment in the United Kingdom. 34 8) The Role of OPEC: OPEC countries use the Eurocurrency market to invest part of their petrodollars, so that the eurocurrency market provides a medium for what is commonly called "Petrodollar Recycling.“ 9) Another factor explaining Eurocurrency development is the improvement in clearing operations. In October 1981, the Clearing House Interbank Payment System (CHIPS) shifted from next-day to same-day settlement. To better compete with domestic market in the US, CHIPS had to match the Fed Wire's immediate availability of funds service. 35 10) Other Features of the Eurocurrency Market: Low costs per transaction because of relatively large size of transactions. Costs of complying with regulations are low since there are no deposit insurance assessments. Borrowers' credit worthiness is well known so that the need for credit investigation is low. No taxes are withheld from interest payments to Eurocurrency depositors. Taxes and fees levied on euro-banking operations are generally lower than those applied to domestic banking. 36 Eurocurrency markets need not be located in Europe, though they originate in Europe. For example, in the U.S., domestic banks are (since 1981) permitted to open International Banking Facilities (IBF) which are computerized account records kept separate from U.S. banks' domestic accounts. They must be domiciled inside U.S. territory and focus on international commerce. They accept foreign currency denominated deposits. 37 These "onshore/offshore" bank accounts are permitted in an effort to regain deposits lost to offshore banking operations. IBF accounts are free from reserve requirements and assessment for deposit insurance; are also exempt from federal taxes, becoming taxable only when transferred to the banks' regular accounts. 38 The primary participants in the Eurocurrency market are large banks called Eurobanks. Transactions are predominantly interbank, hence the market is frequently called "interbank market." In addition, large scale or "wholesale" transactions take place between banks and non-bank customers. Transactions are typically priced off the London Interbank Offer Rate (LIBOR) which is a floating rate commonly charged for loans between Eurobanks. LIBOR is the world's most widely used benchmark for short-term interest rates. It is the rate at which the world’s most credit worthy borrowers are able to borrow money. 39 The Eurocredit Market: Loans of 1 year or longer extended by Eurobanks are called Eurocredit Loans. These loans are popular with corporations and government agencies. Since Eurobanks accept short-term deposits, there exists the problem of maturity mismatch between deposits and loans. To avoid the risk Eurobanks commonly use Floating Rate Eurocredit Loans. Loan rates float in accordance with movement of some market interest, such as the LIBOR. Syndicated Eurocredit Loans are provided to large corporate or government borrowers by a group of banks participating in the syndicate. 40 The Eurobond Market: Eurocurrency and Eurocredit loans help to accommodate short and medium term borrowers. The Eurobond was created to accommodate long-term borrowers. Partially the result of Interest Equalization Tax (IET) imposed in the U.S. in 1963 to discourage U.S. investors from investing in foreign securities. Foreign borrowers are thus forced to look elsewhere for funds and the Eurobond market fills the void. The Eurobond market facilitates the transfer of long-term funds from surplus spending units to deficit spending units around the world. This market helps to link investors with borrowers around the world, and thereby helps to integrate the world's financial system. 41 International Stock Markets Major Stock Exchanges and Indexes ….. Emerging Stock Market Exchanges and Indexes... Morgan Stanley Capital International (MSCI) World Index … Stock Market Capitalizations Around the World... Investing Internationally: Avenues. -- Direct Purchase of Foreign Shares -- Purchase of MNC stocks -- American Depository Receipts (ADRs) -- World Equity Benchmark Shares: I-shares, ETFs -- International Mutual Funds 42 The US stock market is a Continuous Market. Securities are available for trading throughout trading session. Other markets use a system of Call Market. Each security is called for trading at a specific time and can be traded only at that time. Rules for listing stocks on exchanges differ markedly worldwide. Some stocks are listed on multiple exchanges. US listing requirements are among the most restrictive. 43 Recall: What is FX/Forex/Foreign Exchange/Currency Exchange? Who are the participants in the FX market? What is the margin?: Collateral (cash, or security) that an investor is required to keep on deposit to cover potential losses. Typically 5% in FX. What is the bid price? / ask (offer) price? What is the “pip”: The smallest price movement available in an instrument. 1 pip is equivalent to 1 basis point. What is a “long” or “short” position? Explain “market” and “limit” orders: Market orders are executed immediately at current market price. Limit orders are executed when market price reached a specified price trigger. What is a “round trip” transaction? Speculative currency trading is designated “round trip” because positions are settled within the same account and same currency from which trade originated 44
"International Financial Markets Dealer"