Markets

Giddy
International Financial Markets/1
International
Financial Markets
Prof. Ian Giddy
Stern School of Business,
New York University
What are the Global Financial Markets?

l
The Foreign Exchange Market
Eurocurrency Markets and Lending
International Bond Markets

l International Equity Markets
l Using the Global Capital Markets:
Investors and Issuers Perspectives
l
Copyright 2002 Ian H. Giddy
International Financial Markets 2
Giddy
Policies and Exchange Rate Regimes

Exchange rate systems--fixed vs
floating
l Managed floating
l EMS-type currency blocs
l De facto blocs--the dollar
l
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 worlds key benchmark
rate?
Giddy
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 worlds key benchmark
rate?
Where the Eurocurrency Market Fits In
US Domestic
Market
Eurodollar
Market
Euro-Commercial
Paper Market
German
Domestic
Market
EUR0CURRENCY MARKET
Euro-Deutsche Mark
Market
Foreign
Exchange
Market
Euro-Yen
Market
Euro-Floating Rate
Note Market
Japanese
Domestic
Market
Straight
Eurobond Market
Giddy
Interest Rate Linkages in the

International Money Market
Two stories to tell:
l Domestic vs. Euro
l Eurocurrency A vs. Eurocurrency B
Domestic Market A
Treasury
The Euromarkets
Bank
Deposit
Euro
Deposit
Euro
Deposit
Market
Market
Corp -
Euro
Euro
Corp -
orate
Bond
Bond
Market
Bond
Market
orate
Bond
Bill
Treasury
Bond
Domestic Market B
Bank
Deposit
Treasury
Bill
Treasury
Bond
Domestic versus Euro

The Eurodollar Premium
Market price of risk
versus
Cost of regulation
l
Eurodollar vs. U.S. Interest Rate
Effective cost of domestic deposit

=
(interest rate + FDIC fees)

(1 - reserve requirement)
Capital controls and divided credit markets
Giddy
Foreign Exchange
Mechanics and calculations

l How banks make money
l How banks hedge
l Tasks of the corporate FX manager
l
Foreign Exchange Quotations
Spot
Forward points
Giddy
Exchange Rates
Spot
How
(2 business Forward
Currency quoted days)
(90 days)
British
US$
1.632
1.617
pounds per
(GBP)
GBP
Japanese Yen per 117.5
116.3
yen (JPY) US$
Foreign Exchange Quotations
Bid
Offer
Spot
Forward points
Rule:
add if bid<offer,
subtract if bid>offer
Outright forward
Giddy
Exchange Rates
Spot
How
(2 business Forward
Currency quoted days)
(90 days)
British
US$
1.632
1.617
pounds per
(GBP)
GBP
Japanese Yen per 117.5
116.3
yen (JPY) US$
A Typical Forward Contract

l
We agree today to pay a certain price

for a currency in the future
JPY
Sony
Sony
BBof
ofAA
Giddy
How Does the Bank Hedge a Forward

Contract?
Hedging approaches:
uOpen
uForward
uSpot plus swap
uRollover
uMoney
market
How Banks Hedge

SHORT
LONG
Today
T+2
T+90
Methods:
- Spot + swap
- Spot + rollover swap
- Money market
- Outright forward
Giddy
Currency Risk Exposure

(The Normal Distribution)
Probability
68%
95%
Return on
large company
stocks
> 99%
3
48.2%
2
27.9%
1
7.6%
0
12.7%
+1
33.0%
+2
53.3%
+3
73.6%
Covered Interest Arbitrage
Money
market 1
Money
market 2
Spot
Forward
Giddy
Diagram of a Dealing Room

Foreign exchange and Eurocurrency dealing
are interrelated activities and so are done on
the same trading floor.
The Dealing Room
CUSFORThe
DealingSPOT
Room WARD
TOMER
Foreign
Exchange
Dealing
Money
FUNDING
EUROCURRENCY
Market
Dealing
Diagram of a Dealing Room

Foreign exchange and Eurocurrency dealing
are interrelated activities and so are done on
the same trading floor.
The Dealing Room
CUSTOMER
SPOT
FORWARD
Foreign
Exchange
Dealing
Money
FUNDING
EUROCURRENCY
Market
Dealing
Giddy
Funding a Eurokrona Loan
Three ways to fund:

l Take
domestic krona deposit

l Take EuroKrona deposit
3 MO
NKR
DEP
3 MO
NKR
DEP
Funding a Eurokrona Loan
Three ways to fund:

l Take
domestic krona
deposit
l Take EuroKrona deposit
l Fund with dollars, hedged
into krona
3 MO
E$
FX
DEP SWAP
3 MO
E$
FX
DEP SWAP
l Take
E$ deposit
l Do FX swap: sell USD spot,
buy USD forward
Giddy
Linkages Between Eurocurrency Rates
Interest
Interest rate
rate
differential
differential
Covered interest
rate parity
Uncovered interest
rate parity
Expected
Expected
%
% change
change in
in
exchange
exchange rate
rate
Forward
Forward
premium
premium
Unbiased
forward rate
Interest-Rate Parity
$1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt

where S t is the spot exchange rate (dollars per British
Pound) and Fnt is the forward rate.
to a close approximation,
(/ E$ - / EBP) = [(Ft n - St)/S t] (365/n) 100
Interest-rate differential = forward
premium or
discount
Giddy
Example: Anglos Funding

l
Anglo-American, the natural resources

conglomerate, is seeking 3-month US$
funding.
uAnglo
can fund in the US CP market at
5.5%
uOr in the Eurosterling market at 6.7%
uThe BP is:
spot $1.5484, 3-mo forward $1.5454
uWhich is cheaper?
Anglos Answer
Its cheaper for Anglo-American to borrow
in the US CP market. Reason:
uUS:
simply borrow for 3 months
q Cost:
$1(1+5.5%/4) = 1.01375
uUK:
borrow British pounds, change into

dollars at spot rate, cover by buying
sterling at 3-mo forward rate to repay the
pounds
q Cost:
($1/1.5484)(1+6.7%/4)1.5454 = 1.01478
Giddy
Unbiased Forward Rate Theory

EXCHANGE
RATE
Spot
Forward
Actual
Today
In three
months
TIME
Unbiased Forward Rate Theory

EXCHANGE
RATE
Probability
distribution
of actual
exchange rate
Spot
Forward
Actual
Today
TIME
In three
months
Giddy
Unbiased Forward Rate

Forward premium or discount
= Expected annual rate of change
of the exchange rate
That is,
P$/DM
E(R$/DM )
International Fisher Effect

EXCHANGE RATE
Probability
distribution
of actual
exchange rate
Spot
INTEREST
RATE
DIFFERENTIAL
Forward
Actual
TIME
Today
In three
months
Giddy
International Fisher Effect

/E$ = /EDM + E(R$/DM )
That is,
Interest-rate differential
equals
Expected annual rate of change of
exchange rate
Cost of Hedging
Type of Hedge
Cost of Hedging
Forward
Forward premium
Money Market Hedge Interest rate

(Borrow to match
differential
assets)
Do nothing
Expected rate of
change of
exchange rate
Giddy
Law of One Price

p=Sp*
The Price of Tin
In New York
On the Kuala
Lumpur
Market
273c per lb.

= US$6.02
per kilograma
15.37 ringgit
per kilogram
=US5.70
per kilogramb
a1 avoirdupois pound = 0.45359 kilograms
bUS$1 = 2.6965 Malaysian ringgit on the date of calculation
c 1 tonne = 1000 kilogram.
All data taken from the Commodities section
of the London Financial Times.
On the
London Metal
Metal
Exchange
US$5830 per
tonne
= US5.83
per kilogramc
Purchasing Power Parity:

Theory and Evidence
S t=1-St
St
I-I*
1+I*
EXCHANGERATE
CHANGE
MEXICO 1994
RELATIVE
INFLATION
n
JAPAN 1995
Giddy
REAL EXCHANGE RATE
Deviations from
Purchasing Power Parity
140
130
JAPAN
120
110
100
90
UNITED STATES
80
70
1996Q1
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
60
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,
adjusted for change in relative wholesale price of domestic manufactures. A fall in the index
indicates improved international competitiveness.
REAL EXCHANGE RATE
Deviations from
Purchasing Power Parity
140
JAPAN
130
GERMANY
120
110
FRANCE
100
ITALY
90
UK
UNITED STATES
80
70
1996Q1
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
60
Source: JP Morgan. Index of real effective exchange rate versus 18 industrial country currencies,
adjusted for change in relative wholesale price of domestic manufactures. A fall in the index
indicates improved international competitiveness.
Giddy
Inflation & Interest Rates

US
US Expected
Expected Inflation
Inflation Rate
Rate 2%
2%
Canadian
Canadian Expected
Expected Inflation
Inflation Rate
Rate 7%
7%
US
US Interest
Interest Rate
Rate 5%
5%
Canadian
Canadian Interest
Interest Rate
Rate 10%
10%

US
US Expected
Expected Inflation
Inflation Rate
Rate 2%
2%
Canadian
Canadian Expected
Expected Inflation
Inflation Rate
Rate 7%
7%
US
US Interest
Interest Rate
Rate 5%
5%
Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Expected
Expected Rate
Rate of
of Change
Change
of
the
Exchange
of the Exchange Rate
Rate
Giddy

Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%

Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Buy
Buy Canadian
Canadian Dollars
Dollars Forward
Forward
(at
(at discount
discount of
of 5%)
5%)
Giddy

Borrow
Borrow at
at US
US Interest
Interest Rate
Rate 5%
5%
Invest
Invest at
at Canadian
Canadian Interest
Interest Rate
Rate 10%
10%
Buy
Buy Canadian
Canadian Dollars
Dollars Forward
Forward
(at
discount
of
5%)
(at discount of 5%)
Buy
Buy Canadian
Canadian Dollar
Dollar Futures
Futures
(at
(at discount
discount of
of 5%)
5%)
The Linkages Again

RELATIVE
EXCESS
MONEY
SUPPLY
1
RELATIVE
INFLATION
RATES
3
4
RELATIVE
EXCHANGE
INTEREST
RATE
RATES
CHANGE
FORWARD
EXCHANGE
PREMIUM
OR DISCOUNT
Giddy
A Framework
Country A
Country B
DOMESTIC
ECONOMIC
POLICIES
DOMESTIC
ECONOMIC
POLICIES
INFLATION
RATE
INFLATION
RATE
EXCHANGE
RATE
INTEREST
RATE
INTEREST
RATE
FORWARD
RATE
Turkey, 1995
Turkish Lira:
Down 33.5%
Giddy
Contact Info
Ian H. Giddy
NYU Stern School of Business
Tel 212-998-0426; Fax 212-995-4233
Ian.giddy@nyu.edu
http://giddy.org

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Giddy

International Financial Markets/1

New York University

What are the Global Financial Markets?

The Foreign Exchange Market

Eurocurrency Markets and Lending

International Bond Markets

Copyright 2002 Ian H. Giddy

International Financial Markets 2

International Financial Markets/2

Policies and Exchange Rate Regimes

Copyright 2002 Ian H. Giddy

International Financial Markets 3

The Eurocurrency Market

Copyright 2002 Ian H. Giddy

International Financial Markets 4

International Financial Markets/3

The Eurocurrency Market

International Financial Markets 5

Copyright 2002 Ian H. Giddy

Where the Eurocurrency Market Fits In

International Financial Markets/4

Interest Rate Linkages in the

International Financial Markets 8

Copyright 2002 Ian H. Giddy

Domestic versus Euro

Eurodollar vs. U.S. Interest Rate

Effective cost of domestic deposit

(interest rate + FDIC fees)

Capital controls and divided credit markets

Copyright 2002 Ian H. Giddy

International Financial Markets 9

International Financial Markets/5

Mechanics and calculations

International Financial Markets 10

Copyright 2002 Ian H. Giddy

Foreign Exchange Quotations

Copyright 2002 Ian H. Giddy

International Financial Markets 12

International Financial Markets/6

International Financial Markets 13

Copyright 2002 Ian H. Giddy

Foreign Exchange Quotations

International Financial Markets 14

International Financial Markets/7

International Financial Markets 15

Copyright 2002 Ian H. Giddy

A Typical Forward Contract

We agree today to pay a certain price

Copyright 2002 Ian H. Giddy

International Financial Markets 16

International Financial Markets/8

How Does the Bank Hedge a Forward

International Financial Markets 17

Copyright 2002 Ian H. Giddy

How Banks Hedge

International Financial Markets 18

International Financial Markets/9

Currency Risk Exposure

International Financial Markets 19

Copyright 2002 Ian H. Giddy

Covered Interest Arbitrage

Copyright 2002 Ian H. Giddy

International Financial Markets 20