Int Fin Mkts

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

l Eurocurrency Markets and Lending
l International Bond Markets
l International Equity Markets
l Using the Global Capital Markets:
Investors’ and Issuers’ Perspectives
Copyright ©2002 Ian H. Giddy International Financial Markets 2

Policies and Exchange Rate Regimes
l Exchange rate systems--fixed vs

floating
l Managed floating
l EMS-type currency blocs
l De facto blocs--the dollar
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 world’s key benchmark
rate?

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 world’s key benchmark
rate?
Where the Eurocurrency Market Fits In
US Domestic German
Market EUR0CURRENCY MARKET Domestic
Market
Euro-Deutsche Mark
Eurodollar Market
Market Foreign
Exchange
Market Japanese
Euro-Yen Domestic
Market Market
Euro-Commercial Euro-Floating Rate Straight

Paper Market Note Market Eurobond Market

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 The Euromarkets Domestic Market B
Trea- Bank Euro Euro Bank Trea-

sury Deposit Deposit Deposit Deposit sury
Bill Market Market Bill
Trea- Corp - Euro Euro Corp - Trea-

sury orate Bond Bond orate sury
Bond Bond Market Market Bond 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)
l Capital controls and divided credit markets

Foreign Exchange
l Mechanics and calculations

l How banks make money
l How banks hedge
l Tasks of the corporate FX manager
Foreign Exchange Quotations
Spot Forward points

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

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

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

Currency Risk Exposure

(The Normal Distribution)
Probability
68%
95%
> 99% Return on

large company
–3 –2 –1 0 +1 +2 +3 stocks
– 48.2% – 27.9% – 7.6% 12.7% 33.0% 53.3% 73.6%
Covered Interest Arbitrage
Money Money
market 1 market 2
Spot Forward

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

CUS- FOR- Foreign
The DealingSPOT
TOMER Room WARD 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

CUS- FOR- Foreign
TOMER SPOT WARD Exchange
Dealing
Money
FUNDING EUROCURRENCY Market

Dealing

Funding a Eurokrona Loan
Three ways to fund:

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

l Take domestic krona
deposit E$ FX
3 MO
l Take EuroKrona deposit DEP SWAP
l Fund with dollars, hedged

E$ FX
into krona 3 MO
DEP SWAP
l Take E$ deposit
l Do FX swap: sell USD spot,
buy USD forward
Linkages Between Eurocurrency Rates
Interest
Interest rate
rate
differential
differential
Covered interest Uncovered interest
rate parity rate parity
Expected
Expected
Forward
Forward %
% change
change in
in
premium
premium exchange
exchange rate
rate
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

Example: Anglo’s 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?
Anglo’s Answer
It’s 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

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

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

months
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
Spot of actual
exchange rate
INTEREST
RATE
DIFFERENTIAL
Forward
Actual
TIME
Today In three
months

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
Law of One Price
p=Sp*
The Price of Tin
In New York On the Kuala On the
Lumpur London Metal
Market Metal
Exchange
273c per lb. 15.37 ringgit US$5830 per
= US$6.02 per kilogram tonne
per kilograma =US5.70 = US5.83
per kilogramb per kilogramc
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.
Purchasing Power Parity:

Theory and Evidence
S t=1-St = I-I*
St 1+I*
EXCHANGE-
RATE
CHANGE
n MEXICO 1994 RELATIVE

INFLATION
n JAPAN 1995

Deviations from
Purchasing Power Parity
140
REAL EXCHANGE RATE
130
120
JAPAN
110
100
90
80 UNITED STATES
70
60
1996Q1
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
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.
Deviations from
Purchasing Power Parity
140
REAL EXCHANGE RATE
130 JAPAN
120 GERMANY
110
100 FRANCE ITALY
90
80 UNITED STATES UK
70
60
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996Q1
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.

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
of the Exchange Rate
the Exchange Rate
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%)

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
2 3
RELATIVE 4 EXCHANGE
INTEREST RATE
RATES CHANGE
5 6
FORWARD
EXCHANGE
PREMIUM
OR DISCOUNT

A Framework
Country A Country B
DOMESTIC DOMESTIC
ECONOMIC ECONOMIC
POLICIES POLICIES
INFLATION INFLATION
RATE RATE
EXCHANGE
RATE
INTEREST INTEREST
RATE RATE
FORWARD
RATE
Turkey, 1995
Turkish Lira:
Down 33.5%

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

Prof. Ian Giddy

What are the Global Financial Markets?

l The Foreign Exchange Market

Copyright ©2002 Ian H. Giddy International Financial Markets 2

Policies and Exchange Rate Regimes

l Exchange rate systems--fixed vs

Copyright ©2002 Ian H. Giddy International Financial Markets 3

The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank

Copyright ©2002 Ian H. Giddy International Financial Markets 4

The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank

Copyright ©2002 Ian H. Giddy International Financial Markets 5

Where the Eurocurrency Market Fits In

Euro-Commercial Euro-Floating Rate Straight

Copyright ©2002 Ian H. Giddy International Financial Markets 7

Interest Rate Linkages in the

Domestic Market A The Euromarkets Domestic Market B

Trea- Bank Euro Euro Bank Trea-

Trea- Corp - Euro Euro Corp - Trea-

Copyright ©2002 Ian H. Giddy International Financial Markets 8

Domestic versus Euro

The Eurodollar Premium

Copyright ©2002 Ian H. Giddy International Financial Markets 9

l Mechanics and calculations

Copyright ©2002 Ian H. Giddy International Financial Markets 10

Foreign Exchange Quotations

Spot Forward points

Copyright ©2002 Ian H. Giddy International Financial Markets 12

Copyright ©2002 Ian H. Giddy International Financial Markets 13

Foreign Exchange Quotations

Copyright ©2002 Ian H. Giddy International Financial Markets 14

Copyright ©2002 Ian H. Giddy International Financial Markets 15

A Typical Forward Contract

l We agree today to pay a certain price

Copyright ©2002 Ian H. Giddy International Financial Markets 16

How Does the Bank Hedge a Forward

Copyright ©2002 Ian H. Giddy International Financial Markets 17

How Banks Hedge

Copyright ©2002 Ian H. Giddy International Financial Markets 18

Currency Risk Exposure

> 99% Return on

Copyright ©2002 Ian H. Giddy International Financial Markets 19

Covered Interest Arbitrage

Copyright ©2002 Ian H. Giddy International Financial Markets 20

Diagram of a Dealing Room

Foreign exchange and Eurocurrency dealing

The Dealing Room

FUNDING EUROCURRENCY Market

Copyright ©2002 Ian H. Giddy International Financial Markets 21

Diagram of a Dealing Room

Foreign exchange and Eurocurrency dealing

The Dealing Room

FUNDING EUROCURRENCY Market

Copyright ©2002 Ian H. Giddy International Financial Markets 22

Funding a Eurokrona Loan

Three ways to fund:

Copyright ©2002 Ian H. Giddy International Financial Markets 23

Funding a Eurokrona Loan

Three ways to fund:

l Fund with dollars, hedged

Linkages Between Eurocurrency Rates