WORLD FINANCIAL MARKETS

WORLD FINANCIAL MARKETS

Objectives:

• Eurocurrency Market

• Eurobond Market

• Asian Dollar Market

• SDR (1 SDR = x1$ + x2DM + x3FF + x4 £ + x5¥)

• ECU / Euro


• Eurocurrency Market a. Offshore

b. Time Deposit

c. $, DM, FF, ¥,

SF,, £

• Eurodollar Market

a. Largest component of Eurocurrency Market

b. Evolution - Marshall Plan

- Cold War

- Higher Yield

- £ Crisis of 1957

- US B/P Deficit in ‘60s


• Eurodollar Market (cont.)

- Interest Equalization Tax (63 -74)

- Voluntary Restrictions (65 - 74)

- Mandatory Restrictions (68 - 74) OFDI (Office of Foreign Direct Investment)

- Restrictions on Capital Outflow

- Regulation Q (60 - 73) / M

- Petrodollar Deposit by Arab Countries

(1973 - 1974) Recycling LDC Debt Problem

F.C.R.P Foreign Credit Restraint Program



c.Operation:

- type: CD (overnight - 10-15 Yrs.)

- Marketable or Negotiable Instruments

Secondary Markets (ICDMA)

- Tap CD

Tranche CD

SDR CD

- Rate:


• Interest Rate Structure in the Eurocurrency Market:

LIBOR = London Interbank Offer Rate

LIBID = London Interbank Bid Rate

Interbank, or Funding Spread

Lending Spread: short term loans in the Eurocurrency market are typically priced at LIBOR plus a spread. The bank can fund the loan at LIBID, earn a 1/8% funding spread, and also earn the lending spread

WORLD FINANCIAL MARKETS• Interest Rate Structure in the Eurocurrency Market:

Domestic Lending Rate (PRIME): The rate charged by banks for loans in the domestic market

External Market Lending Rate (Fed Fund Rate): The rate charged on banks loans in the external market

LIBOR: The rate at which a Euromarket bank is willing to place a deposit at another Euromarket bank

LIMEAN (London Interbank Mean Rate): The average of LIBOR and LIBID

LIBID (London Interbank Bid Rate): The rate that a Euromarket bank is willing to pay to attract a deposit from another Euromarket bank

Domestic Deposit Rate: The rate that a bank pays for a deposit in the domestic market

A

B

C

D

A: The advantage to a customer in favor of borrowing in the external market

B: LENDING SPREAD The spread paid by the customer over LIBOR on external market loans

C: INTERBANK SPREAD The difference between a bank’s bid and offer rate for deposits in the external market (usually 1/8%)

D: The advantage to a depositor for placing a deposit in the external market


• Interest Rate Structure in the Eurocurrency Market:

LIBOR Spread is lower:

- Lack of reserve requirement

- Regulatory expenses

- No governmental intervention at concessionary rates

- Most borrowers are well known

- High volumes / lower margins

- Some tax profits


e.Participants:

Supply: Swiss Banks

Central Banks

Institutional Investors

Demand: Governments

MNC’s

Speculators



e.Advantages: Narrower Interest Rate Spread

Lower Loan Rates: Wholesale Nature

Borrower’s Credit

Higher Deposit Rates: No Reserve Requirement

No Interest Ceiling

No SEC or FDIC



f. Disadvantages:

No lender of last resort

No FDIC

Domestic Monetary Policy

Petrodollar RecyclingOverexposure

Extensive Speculation Volatile FE Rate

Additional Risk

a. Sovereign or Country Risk

b. Foreign Exchange Risk


• Eurobond Market

A market for dollar denominated securities offered by a syndicate of international banks to investors in two or more nations where their distribution is legal



• Foreign Bond:

Evolution:

- Capital outflow restrictions by US (1960’s) e.g. 1963 interest equalization tax:

Yankee Bonds / Samurai / Bulldog / Rembrandt

- Opening of non-dollar sectors (Euro-FF or Euro- £)

- Distribution technique

- Secondary Market or Liquidity

a. Euroclear (1968: Brussels)

b. CEDEL (1971: Luxembourg)

c. Association of International Bond Dealers: A self- regulatory agency


• Foreign Bond: (cont.)

Types of Instruments:

- Fixed Rate Bonds: Fixed coupon bid annually. Bullet

- Floating Rate Notes: Floating coupon, 6/3 months, base rate LIBOR floor rate

- Convertible Bonds: Bonds can be converted to equity

- Bonds with Equity Warrants

- Zero Coupon Bonds

- Zero Coupon Perpetual Bonds



Operations:

- Straight Debt

- Convertible Debt

- Currency Option Bond

- FRN (Floating Rate Bond)

Participants:

- Invisible Market Bearer Form No record of ownership

- Secondary Market Free of governmental restrictions No disclosures



Advantages:

- Bearer form No withheld taxes

- Flexible Rates: Fixed or Floating

- Numerous currencies are available liquid international market

Disadvantages:

- Issuing costs and distribution costs are higher

- If mismatched, FE risk is higher

- Assessment of credit risk is difficult


• Eurobond Vs. Eurocurrency Loan

Eurobonds Eurocurrency

1. Cost of Borrowing Fixed Vs. Floating Rate Floating Nature

2. Maturity Long-term Short-term

3. Size Small - FC higher Large - FC lower

4. Flexibility Less flexible Very flexible (multicurrency)

5. Spread Higher Lower


• Eurocurrency - Revisited:

1. Syndicated Lending in External Markets:

- Size: 1987 1988 1989 1990 (in US$

billion) 80.3 116.2 114.5 120

- By Origin: (1987-1990) US$ billion

US 81.6

UK 74.4

Italy 28.1

France 21.3

Australia 17.7

Canada 13.6


• Eurocurrency - Revisited: (cont.)

2. Interest Rate Risk: Floating Rate Pricing

- Effects: Long term commitment of funds

Loans can be funded with short term deposits

Interest rate risk passed on to borrowers

3. Size of Funding: Syndication of Loans

Large volume of funds available to single customers

Need for cooperation among major banks


• Eurocurrency - Revisited: (cont.)

4. Syndication:

- Mandated Banks: Put the deal together

- Managing Banks: Give an underwriting commitment

Lead Manager Manager Co-Manager

- Participating Banks: Provision of funds

- Agent Banks: Manages borrowing and repayment of funds

- Reference Agent: LIBOR rates

WORLD FINANCIAL MARKETS• Eurocurrency - Revisited: (cont.)

5. Floating Rate Pricing:

Period LIBOR SPREAD Lending Rate

7/1 - 12-31/89 9.50 1.0 10.50%

1/1 - 6-30/89 9.25 1.0 10.25%

7/1 - 12-31/90 8.50 1.0 9.50%

1/1 - 6-30/90 8.25 1.0 9.25%

Borrower Rev. Credit Banks

Ref. Agent

Agent Bank

Principal & Interest

Payment

Non-bank & Interbank Depositors


6. Cost Structure of a Syndicated Credit:

- Periodic Costs: a. Interest Rates (LIBOR) + Spread

b. Commitment Fee

c. Agency Costs

- Up-front Costs: a. Management Fees: to Mandated Bank, Underwriting fee to managing banks, participation fee

b. Out of Pocket Expenses


7. Terms of Eurocurrency Borrowing:

- Type of Credit: a. Term Credit

b. Revolving Credit

- Commitment Clause

- Maturity

- Currency

- Repayment Clauses & Prepayment Clauses

WORLD FINANCIAL MARKETS

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