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Lecture 4


									  International Finance

             Lecture 4

Page 1
International Finance
• Course topics
  – Foundations of International Financial
  – World Financial Markets and Institutions
  – Foreign Exchange Exposure
  – Financial Management for a Multinational

 Page 2
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 3
International Banking and
Money Market
 • _____________ Banking
 • International Money Market
 • International Debt Crises

  Page 4
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
• 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 5
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
• More details at Canadian Bankers Association webpage,
  including how Schedule I, II, and III banks differ from
  each other.

  Page 6
The big six
• Bank of Montreal
•    The Bank of Nova Scotia
•    CIBC
•    National Bank of Canada
•    Royal Bank of Canada
•    Toronto-Dominion Bank

    Page 7
International focus of the Big Six

  Page 8
Schedule II Banks in Canada

 Page 9
Ten Largest U.S. Banks

 Page 10
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 11
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 12
       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 13
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
• 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 14
       Offshore Banking Centers
• An offshore banking         • The IMF recognizes as
  center is a country whose     major _______
  banking system is             banking centers:
  organized to permit            – the Bahamas
  external accounts beyond       – Bahrain
  the ___________scope of        – the Cayman Islands
  local economic activity.       – Hong Kong
• The host country usually       – the Netherlands
  grants complete freedom          Antilles
  from host-country              – Panama
  governmental banking           – Singapore
  Page 15
Cost of Banking Crises in Other Countries

   Page 16
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 17
Capital Adequacy Standards
• Bank capital adequacy refers to the amount of equity
  ___________and other securities a bank holds as
• 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 18
Calculating capital requirements

                        First Bank
            Assets                       Liabilities
Reserves                 $3 m   Chequable deposits     $20 m
Canada securities       $10 m   Nontransactions        $60 m
Loans to other banks     $7 m   Borrowings             $11 m
Municipal bonds         $10 m   Loan loss reserves      $2 m
Residential mortgages   $10 m   Bank capital            $7 m
Commercial loans        $20 m
Consumer loans          $35 m
Fixed assets             $5 m

  Page 19
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
  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 20
Calculating capital requirements
1st category: zero weight, reserves and government
securities in OECD countries
2nd category: 20% weight, claims on banks in OECD
3rd category: 50% weight, municipal bonds and residential
4th category: 100% weight, debts of consumers and
Off-balance-sheet activities are treated in a similar manner
Banks must hold as capital at least 8% of their risk-
weighted assets.

  Page 21
Calculating capital requirements
 • Is First Bank well-capitalized according to Risk-
   based capital requirements?

  Page 22
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 23
International Money Markets
•    Money Markets Defined
    1. Money market ___________are usually sold in large
    2. They have ___________default risk
    3. They mature in one year ___________from their issue
•    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 24
Money Market Instruments
• Treasury ___________
• ___________Funds
• Repurchase ___________
• ___________Certificates of Deposit
• Commercial Paper
• Banker’s ___________
• International Money Market Instruments

 Page 25
International Money Market
 • Eurocurrency Market
 • ___________
 • Forward Rate Agreement
 • ___________
 • Eurocommercial paper

  Page 26
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

  Page 27
     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
• View Eurodollar deposit rates the Federal Reserve

 Page 28
• 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 29
    Comparison of US lending and borrowing rates with
    Eurodollar rates on August 19, 2002

Page 30
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 31
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 32
      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.,
•   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 33
                    Forward Rate Agreements
Interest Rate

                                        Time line
                Page 34
Forward Rate Agreements
• In theory ___________could be made at time T2. At that
  time, based on the notional amount L and number of days
  T2 - T1:
   – If RT1T2 < Rfixed, Bank 1 could pay to Bank 2 the
     agreed ___________rate Rfixed, and receive from Bank
     2 the variable rate RT1T2.
   – This never happens; instead Bank 1 just pays the
     __________ (Rfixed - RT1T2) to Bank 2.
   – If RT1T2 > Rfixed, Bank 2 could pay to Bank 1 the
     agreed fixed rate Rfixed, and receive from Bank 2 the
     variable rate RT1T2.
   – This never happens; instead Bank 2 just pays the
     difference (RT1T2 - Rfixed) to Bank 1.
   Page 35
Forward Rate Agreements
• In practice
• Payment L*|Rfixed - RT1T2|*(T2 - T1)/360 is _________
  to time T1 and paid at time T1, since the rate is known
  at T1 and no real need to wait until T2, unless the
  contract allows for reference rate variability between
  T1 and T2
• Payment under standard FRA is calculated as follows

                  L  Rfixed  RT 1T 2  (T2  T1 ) / 360
                       1  RT 1T 2  (T2  T1 ) / 360

 Page 36
Forward Rate Agreements
• The reference rate Rfixed is normally set at today’s level of
  forward rate FT1T2.
• Continuously compounded Forward rate, ___________
       FT1T2 = (RT2*T2-RT1*T1)/(T2-T1)
• 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
      F91182 =

  Page 37
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 38
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 39
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 < or > FT1T2 to
  detrmine profit/loss for long/short position in the FRA.
              L  Rfixed  FT 1T 2  (T2  T1 ) / 360
       VFRA 
                       1  RT 2  (T2 / 360)

  Page 40
Forward Rate Agreements
• Example. Now it is day 0 and the FRA specifies that

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 41
• 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
   – Euro-MTNs is partially sold on a continuous basis –this
     allows the borrower to raise funds as they are needed.
   Page 42
     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 43
Discount basis
• Discount securities are quoted on bank discount basis.

                       D 360
                rBD    
                       F  t
• rBD= quoted rate
• D – discount, D =   ___________
• t – days to maturity
• F – face value
• P - current price

   Page 44
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 45
       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 46
      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 47
    International Debt Crisis
    Ten Biggest American Bank Lenders to
    ($bn, September 30th, 1987)

Page 48
     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 49
           Debt-for-Equity Swap Illustration

                    International Bank

LDC firm or
                     Equity Investor
                        or MNC

                   LDC Central Bank

       Page 50
             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
• 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.
                           ___________in East Asia,
• This led to domestic price
  particularly in ______________________.

   Page 51
              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

 Page 52

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