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Chapter 3

International Financial Markets and Instruments: An Introduction

Learning Objectives

Summarize the fundamental components of international financial markets.

Illustrate how global money markets, interest rates, and foreign exchange markets are interdependent.

Describe the types and roles of international currency and monetary derivatives.

International Bank Lending

Banks’ balance

sheets commonly

have loans and

deposits that are

international in

origin.

As of 2008, gross international bank lending was $37.5 trillion!

Gross international bank lending can be divided into three components:

domestic bank

loans in

domestic

currency to

foreigners,

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domestic bank

loans in foreign

currency to

foreigners,

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domestic bank

loans in foreign

currency to

domestic

residents.

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The first is called “traditional foreign bank lending.”

The second and third represent the euro-currency market.

The Eurodollar Market

Eurodollar deposits arise when a U.S. exporter wishes to sell goods to a foreigner, is paid in dollars, and wishes to leave the dollars in an account in a foreign bank.

The Eurodollar market began to be important in the 1950s, as the USSR chose to put dollar-denominated deposits in British (rather than American) banks.

Other factors, such as the oil shocks in the 1970s, increased Eurodollar holdings.

The Significance of Eurodollar Markets

The rise of Eurodollar markets has significantly increased the international mobility of financial capital.

This means that interest rates have been increasingly linked across countries, and have moved toward each other.

One drawback is that financial problems quickly spread worldwide, such as happened in 2008.

The International Bond Market (Debt

Securities)Government and corporations can borrow money by issuing bonds.

Bonds have a face value – this is the amount that will be paid to the lender when the bond matures.

Foreign bond markets and eurobond markets together comprise the international bond market.

The stock of this sort of debt was $23.9 trillion as of 2008.

Significance of the International Bond Market

As with the Eurodollar markets, the increasing importance of international bond markets has increased the international mobility of financial capital, and countries’ interest rates have moved toward each other.

This increased interdependence also helps spread financial problems.

International Stock MarketsOwnership in companies (common stock) is another asset that is traded internationally.

Exact figures on the volume of international stock transactions are difficult to obtain, but most believe these have increased.

This may create a tendency for movements of stock prices across countries to become more similar to each other.

The increasing importance of international stock markets has facilitated the flow of financial capital to its most productive use.

This increased interdependence can also allow financial problems to spread quickly, as was demonstrated in 2008.

Significance of the Rise of International Stock Markets

Basic International Financial Linkages: Review

As we learned in Chapter 20, investors will be indifferent between domestic and foreign investment when

(ihome – iforeign) ≈ p = xa – RP, where

p is the forward exchange rate premium.

Basic International Financial Linkages: An

ExampleHow does the Eurodollar market

change our understanding of financial linkages?

Suppose

Lending iNY 7% Lending iLondon 8%

Lending iEuro$ London 6.5% Lending iEurosterling NY 7.5%

Deposit iNY 5% Deposit iLondon 6%

Deposit iEuro$ London 5.5% Deposit iEurosterling NY 6.5%

Spot e$/£ 1.691 3-months forward e$/£ 1.687

Basic International Financial Linkages

If covered interest arbitrage parity holds, after dividing the annual interest rate difference by 4 to approximate a 3-month rate we get

(ihome – iforeign) ≈ p

(0.07 -0.08)/4 ≈ (1.687 – 1.691)/1.691

-0.0025 ≈ -0.0025.

Basic International Financial Linkages

What happens if the Federal Reserve raises U.S. interest rates by ½ of a percentage point? Now, the eurodollar deposit rate will rise to 6% and the eurodollar lending rate will rise to 7%.

We’d also expect the forward rate to rise (the dollar depreciates) and the spot rate to fall (the dollar appreciates).

International Financial and Exchange Rate Adjustments

i

$

S$

D€

i

S'$

i'NY money market

International Financial and Exchange Rate Adjustments

The higher interest rate in New York increases demand for eurodollars.

This will put upward pressure on the eurodollar rate.

International Financial and Exchange Rate Adjustments

i

$

S$

D$

i'

D‘$

i0

London money market (eurodollars)

International Financial and Exchange Rate Adjustments

The higher U.S. interest rate leads to an increased supply of pounds on the spot market; this additional supply is hedged in the forward market.

e$/£

£

S£

D£

Spot market

S'£

e$/£

e'$/£

International Financial and Exchange Rate Adjustments

e$/£

€

St€

D£

e'$/£

D'£

Forward markete$/£

International Financial and Exchange Rate Adjustments

Further adjustments might occur in the U.K.’s money market and the eurosterling market that would lead to higher interest rates there, but the Bank of England may intervene to prevent this.

Hedging Eurodollar Interest Rate Risk

New instruments, called derivatives, have emerged to hedge interest rate risk.

Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, etc.

Commonly Used Derivatives

Future rate agreements

Eurodollar interest rate swaps

Eurodollar cross-currency interest rate swaps

Eurodollar interest rate futures

Eurodollar interest rate options

Maturity mismatching

Options on swaps

The Current Global Derivatives Market

Futures have been traded on metals and agricultural commodities for more than a century, so the idea of derivatives isn’t new.

However, in the past 25 years there has been an explosion in the use of global derivatives.

Annual growth rates have been in the range of 20%-30%.

Values of Selected Global Derivatives, 1987-2008

(in billions of dollars) 1987 2008

A. Exchange-traded instruments $730 $59,797

Interest rate futures 488 19,271

Interest rate options 123 35,161

Currency futures 15 102

Currency options 60 126

Stock mkt index futures 18 729

Stock mkt index options 28 4,409

B. Over-the-counter instruments 866 683,725

Interest rate swaps 683 356,772

Currency swaps 183 16,307

Interest rate swaps 0 62,162

The Current Global Derivatives Market

Why have derivatives become so important?

Participants in the international financial markets have discovered

that derivatives can

increase their

returns

lower their

risk

Derivatives allow for an unbundling of exposure to foreign exchange risk, interest rate risk, and price risk.

The Current Global Derivatives Market

However, as the global financial crisis of 2007-08 has shown, derivatives cannot eliminate risk.

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