EUROCURRENCY MARKETS

Gagan Deep Sharma (Dr)

University School of Management Studies
 Eurocurrency Market
 Eurocurrency is a time deposit of money in an international bank located in a
country different from the country that issued the currency (Eurosterling are
deposits of British pound sterling in banks outside of the United Kingdom,
and Euroyen are deposits of Japanese yen in banks outside of Japan)
 Banks accepting Eurocurrency deposits are called Eurobanks
 Eurocurrency market is an external banking system that runs parallel to the
domestic banking system of the country that issued the currency
 The Eurocurrency market operates at the interbank and/or wholesale level as
majority of Eurocurrency transactions are interbank transactions
 Eurobanks with surplus funds and no retail customers to lend to will lend to
Eurobanks that have borrowers but need loanable funds
 The rate charged by banks with excess funds is referred to as the interbank
offered rate; they will accept interbank deposits at the interbank bid rate
 The spread is generally 1/8 of 1 percent for most major Eurocurrencies
 Eurocredits
 Eurocredits are short- to medium-term loans of Eurocurrency
extended by Eurobanks to corporations, sovereign
governments, nonprime banks, or international organizations
 The loans are denominated in currencies other than the home
currency of the Eurobank
 Because these loans are frequently too large for a single bank
to handle, Eurobanks will band together to form a bank
lending syndicate to share the risk
 The credit risk on these loans is greater than on loans to other
banks in the interbank market. Thus, the interest rate on
Eurocredits must compensate the bank, or banking syndicate,
for the added credit risk
Interest rates and rollovers in Eurocredits
 Interest rate on Eurocredits must compensate the bank, or banking
syndicate, for the added credit risk
 On Eurocredits originating in London the base lending rate is LIBOR
 The lending rate on these credits is stated as LIBOR X percent, where X
is the lending margin charged depending upon the creditworthiness of
the borrower
 Eurocredit may be viewed as a series of shorter-term loans, where at
the end of each time period (generally three or six months), the loan is
rolled over and the base lending rate is repriced to current LIBOR over
the next time interval of the loan
 Rollover Pricing: An example

 Teltrex International can borrow $3,000,000 at LIBOR plus a lending

margin of .75 percent per annum on a three-month rollover basis from
Barclays in London. Suppose that three-month LIBOR is currently
5.53125 percent. Further suppose that over the second three-month
interval LIBOR falls to 5.125 percent. How much will Teltrex pay in
interest to Barclays over the six-month period for the Eurodollar loan?
 Forward rate agreement
 A forward rate agreement (FRA) is an interbank contract that allows
the Eurobank to hedge the interest rate risk in mismatched deposits
and credits
 FRAs are structured to capture the maturity mismatch in standard-
length Eurodeposits and credits
 An FRA involves two parties, a buyer and a seller, where:
 the buyer agrees to pay the seller the increased interest cost on a notional
amount if interest rates fall below an agreement rate, or
 the seller agrees to pay the buyer the increased interest cost if interest rates
increase above the agreement rate
 FRA might be on a six-month interest rate for a six month period
beginning three months from today and ending nine months from
today; this would be a “three against nine” FRA
 Forward rate agreement - Example

 As an example, consider a bank that has made a three-month Eurodollar loan of

$3,000,000 against an offsetting six-month Eurodollar deposit. The bank’s concern is
that three-month LIBOR will fall below expectations and the Eurocredit is rolled over
at the new lower base rate, making the six-month deposit unprofitable. To protect itself,
the bank could sell a $3,000,000 “three against six” FRA. The FRA will be priced such
that the agreement rate is the expected three-month dollar LIBOR in three months.
Assume AR is 6 percent and the actual number of days in the three-month FRA period
is 91. SR is 5.125 percent
 Euronotes

 Euronotes are short-term notes underwritten by a group of

international investment or commercial banks called a “facility”
 A client-borrower makes an agreement with a facility to issue
Euronotes in its own name for a period of time, generally 3 to 10 years
 Euronotes are sold at a discount from face value and pay back the full
face value at maturity
 Euronotes typically have maturities of from three to six months
 Borrowers find Euronotes attractive because the interest expense is
usually slightly less—typically LIBOR plus 1⁄8 percent—in comparison
to syndicated Eurobank loans
 The banks find them attractive to issue because they earn a small fee
from the underwriting or supply the funds and earn the interest return
 Eurocommercial paper
 Eurocommercial paper, like domestic commercial paper, is
an unsecured short-term promissory note issued by a
corporation or a bank and placed directly with the
investment public through a dealer. Like Euronotes,
Eurocommercial paper is sold at a discount from face value
 Maturities typically range from one to six months
 The vast majority of Eurocommercial paper is U.S. dollar-
denominated
 Questions

gagan@ipu.ac.in