Chapter 3: Foreign Exchange & Eurocurrency Markets
the eurocurrency market: interest rates in domestic credit and eurocurrency markets
*Domestic lending rates are greater than LIBOR and deposit rate is less than LIBID* -Eurocurrency markets pays more interest on deposits and accepts less interest on loans than on comparable transactions in domestic credit markets *to make profit, banks purchase funds at low rates and lend them out at higher rates* (EX: a might pay 1.5% per year on the savings account of depositor and lend these funds out to a small business at 2.5% per year. The 1% spread is the source of the banks profit) Interest rates extended to corporate borrowers depend on the borrowers creditworthiness and size of loan -larger spreads are charged on smaller loans and on loans to customers with lower credit quality Interest spreads are often quoted in *basis points* where one basis point is 1/100th of 1% (or 1/100th of one cent) -*1% is equal to 100 basis points* The bank can afford to quote such small bid-ask spread for large transactions with a reputable counterpart -larger spreads would be quoted for smaller amounts, longer maturities, with banks of lower credit quality and in volatile market conditions
the eurocurrency market: floating rate pricing
*Euro currency lenders prefer to make short term, low risk loans* -they typically have maturities shorter than 5 years and interest rates tied to a variable rate base -short maturity keeps default risk to a minimum The variable interest rate lowers interest rate risk relative to a fixed rate contract of a comparable maturity -*LIBOR* is the most common variable base rate -the interbank market conducts most of its transactions in floating rate Eurocurrency contracts with maturities shorter than 5 years
the eurocurrency market: an absence of gov't interference
*Eurocurrency transactions fall outside of the jurisdiction of any single nation* -Results in the most distinctive feature: a near total absence of outside regulatory interference In most countries, Eurocurrency transactions have no withholding taxes, reserve requirements, interest rate regulations or caps, credit allocation regulations, or deposit insurance requirements -fewer disclosure requirements *But not entirely free from govt interference* -US SEC Rule 144A on private placements imposes a reserve requirement on dollars deposited from a foreign bank to a US bank -for deposits and loans that remain offshore, its essentially unregulated
financial markets characteristics: maturity
*Money markets*: market for financial assets and liabilities of short maturity, usually considered to be less than 1 year *capital markets*: markets for long term financial financial assets and liabilities, typically with maturities of 1 year or more
Most important function of the foreign exchange market
*To provide means to defend or hedge against exposures to currency risks* *foreign risk* or *currency risk*: the risk of unexpected changes in exchange rates The MNC is exposed to currency risk if unexpected changes in FX rates affect the value of the firms assets or liabilities -hedging can reduce adverse consequences of currency risk by creating currency exposures that offset the MNCs underlying exposures *FX market allows speculators to bet on changes in currency values* -currency speculation by international banks and hedge funds ensures that FX rates represent a consensus of market participants and provides additional liquidity to the FX markets
the foreign exchange market
*allows one currency to be exchanged for another* also referred to as the *currency market* or *FX market* -largely and interbank market that deals in spot and forward currency transactions In the *spot market* , trades are made for immediate delivery In the *forward market*, trades are made for future delivery, according to an agreed upon delivery date,exchange rate, and amount Further can be categorized into: -*outright forwards* transactions involving a single delivery -*currency swaps* involve multiple future delivery dates and are similar in form and function to portfolios of outright currency forward contracts most interbank transactions are settled through *Continuous linked settlement (CBS) group holdings AG*, with each counterparty receiving one currency and delivering the other -forward and swap transactions are settled on the agreed upon delivery date or dates Foreign exchange market is *the heart of international trade and finance*, because it *permits the transfer of purchasing power from one currency to another- either today or in the future*
Efficiency of the foreign exchange market: allocation efficiency
*due to efficient operations & information , interbank market in major currencies are the most allocated efficient market in the world* markets for less liquid currencies are less efficient in their allocation of capital -fixed exchange rate systems also are less efficient bc gov'ts intentionally disrupt the flow of capital int he pursuit if their policy objectives
the eurocurrency market
*external credit markets trade deposits and loans that are denominated in a single currency but are traded outside the borders of the country issuing that currency* -external credit markets grew up in Europe *Eurodollar*: dollar denominated deposits held in a country other than the US *Eurosterling*: credit market resides outside the UK *Euroyen*: market resides outside Japan Eurocurrency market remains relatively unencumbered by gov't regulation, b/c the gov't issuing the currency has no direct jurisdiction over the deposit, the depositor, or the Euromarket bank banks making a market in Eurocurrencies quote *bid rates* at which they will take deposits and *offer rates* or *ask rates* at which they will make loans to other Eurocurrency banks -the difference between the bank offer and bud rates is called *the bid-ask spread* *London Interbank Bid Rate (LIBID)*: *London Interbank Offer Rate (LIBOR)*: benchmark offer rate for interbank deposits
financial markets characteristics: regulation
*internal market contracts*: financial contracts issued in the currency of a host country, placed within that country, and regulated by authorities in that country *external market contracts*: financial contracts issued outside the borders of any single country and can be regulated by more than one country or by none at all
financial markets characteristics
*markets for financial assets and liabilities* most important characteristic is its liquidity *liquidity*: the ease with which you can capture an assets value -assets can be quickly converted into their cash value interbank currency and Euro currency markets enjoy high liquidity
financial markets characteristics: operational, informational and allocational efficiency
*operational efficiency*: how large an influence transaction costs have on a markets operation *informational efficiency*: refers to whether market prices reflect information and thus the "true" or intrinsic value of the underlying asset *allocational efficiency:* refers to how well a financial market channels capital toward its most productive uses
Efficiency of the foreign exchange market: operational efficiency
*refers to the influence of market frictions* the interbank wholesale is the worlds most efficient -very low % costs for large transactions between major banks *% fees on retail transactions can be large* -tourists face bid-ask spreads of 2-10% at international airports -fees charged by local vendors outside of airports can be even higher *One way to reduce these charges is to use a ATM card from your local bank* -a range of fees may apply to internt'l cash withdrawals depending on the policies of your financial institution, but often around 2% of the transaction amount
Efficiency of the foreign exchange market: international efficiency
*refers to whether prices reflect value* international commercial banks ensure that currency values represent a consensus of informed opinions -also provide a forum in which market participants can speculate on the direction of the change in currency values -speculative activity promotes efficiency
the eurocurrency market: clearing and settlement for international transactions
Transfers between international financial institutions are cleared and settled through the *Society for Worldwide Interbank Financial Telecommunications (Swift)* An industry owned cooperative with thousands of members from the commercial banking, asset management, securities and insurance industries -ensures low cost, secure transmission of electronic messages between member institutions
two rules for dealings w/ foreign exchange: think of buying or selling currency in the *denominator* of an exchange rate
buying or selling currency is like buying and selling any other asset -the currency in the *denominator* as the asset being traded currency values are then just like any other asset
Foreign exchange market participants
commercial banks serve as *dealers* r * market makers* in the FX market by -quoting *bid* and *offer (ask) prices* -earn profit by buying at their bid price and selling at a slightly higher offer price -*Bid-ask spreads* (ask price-bid price) depend on the size of the transaction, liquidity, and volatility of the currencies -for forward transactions: the credit worthiness of the counterparty The bank has a long position in a particular currency when it has purchased that currency in the spot or fwd mkt -short position when it has sold that currency dealers take a position but -FX *brokers* serve as matchmakers and do not put their own money at risk -they monitor the quotes of major internt'l banks thru computerized quotation systems such as Reuters and identify the banks offering the best rates More than 85% of all FX transactions are conducted thru commercial banks, credit card companies, or other financial institutions
European and american quotes for the US dollar
interbank quotations that include the US dollar are given in the *European Terms*, which states the foreign currency price of one US dollar *EX*: SF1.7120/$ for the Swiss franc the US dollar is the most frequently traded currency and this convention is used for all interbank dollar quotes -except those involving the British pound or currencies of few former colonies of the British commonwealth
two rules for dealings w/ foreign exchange: keep track of your currency units
refernces to currency values invariably have the value of a single currency in mind -the statement "the dollar fell against the yen" refers to the dollar -"the yen rose against the dollar", refers to the yen *currency of reference* or *referent currency*: The currency being referred to
