International Financial Management P G Apte

CHAPTER - 6 Global Financial Markets and Interest Rates International Financial Management P G Apte

6.1 The Global Financial Market • The last two decades have witnessed the emergence of a vast global financial market enabling massive cross-border capital flows • Geographical integration and functional integration of financial markets • The early part of eighties saw the process of disintermediation get under way • The process of liberalization and integration continued into the 1990s with many of the developing countries carrying out substantive reforms and opening up their financial markets

6.1 The Global Financial Market • Domestic and offshore markets • Eurocurrencies Market • Differences between offshore and domestic markets • Are domestic and offshore markets really two distinct markets or should we view the entire global financial market as a single market ? • Arbitrage will ensure that they will be closely linked together in terms of costs of funding and returns on assets • They do differ significantly on the regulatory dimension

6.3 Euromarkets • It is mainly an interbank market trading in time deposits and various debt instruments • A "Eurocurrency Deposit" deposit is a deposit in the relevant currency with a bank outside the home country of that currency • Similarly a Eurodollar Loan • The prefix "Euro" is now outdated • These markets have evolved a variety of instruments • The key difference between Euromarkets and their domestic counterparts is one of regulation

6.3 Euromarkets • Eurodollar market originated in 1950’s • Growth of the eurodollar market was due to a number of other factors • Supply side • US restrictions on domestic banks and capital markets throughout the 60's and 70's (Regulation Q, Int.Equlization tax) • The importance of the dollar as a vehicle currency in international trade and finance • European companies’ preference for dealing with European banks • Demand side • Demand for Eurodollar loans by non-US entities and by US multinationals to finance their foreign operations

6.3 Euromarkets • Like any other fractional reserve banking system, eurobanks can generate multiple expansion of eurodeposits on receiving a fresh injection of cash • The "modern" approach rejects the idea of a fixed reserve ratio and emphasizes the fact that supply of Eurodeposits on one hand and the demand for Euroloans on the other are both dependent upon the rate of interest • Also relevant are risks – mainly political – as perceived by depositors and borrowers.

6.3 Euromarkets (contd.) • Concerns about Euro and offshore markets • The market facilitates short term speculative capital flows - the so called "hot money" • National monetary authorities lose effective control over monetary policy since domestic residents can frustrate their efforts by borrowing or lending abroad • The market is based on a tremendously large volume of interbank lending

6.3 Euromarkets (contd.) • Euromarkets create “private international liquidity” • The markets allow central banks of deficit countries to borrow for balance of payments purposes thus enabling them to put off needed adjustment measures

6.3 Euromarkets (contd.) • The advantages of Euro and offshore markets • More efficient allocation of capital worldwide • Smoothing out the effects of sudden shifts in balance of payments imbalances • The spate of financial innovations that have been created by the market which have vastly enhanced the ability of companies and governments to better manage their financial risks

6.4 Interest Rates in the Global Money Markets • The linkages between interest rates in the domestic and offshore markets and between interest rates for different currencies in the offshore market • The spectrum of interest rates existing in an economy at any point of time is the result of the complex interaction between several forces as shown in figure 6.1

6.4 Interest Rates in the Global Money Markets (contd.) Figure 6.1 Determinants of Interest Rates

6.4 Interest Rates in the Global Money Markets (contd.) • Interbank deposit market, the benchmark is provided by the interbank borrowing and lending rates in the Eurocurrency market e.g. LONDON INTER-BANK OFFER RATE abbreviated LIBOR • The relationship between interest rates in the domestic and euro segments of the money market

6.4 Interest Rates in the Global Money Markets (contd.) • Arbitrage by borrowers and investors with access to both the markets should serve to keep the rates close together • Why are the rates not identical? • Demand side and supply side factors • Linkages between interest rates for different currencies in the euromarket • Forward contract: Under this contract, a depositor agrees to deliver a particular currency six months later in return for another currency, at an exchange rate specified now. This is the forward exchange rate.

6.4 Interest Rates in the Global Money Markets (contd.) • Effective interest rate • Covered Interest Arbitrage • The relationship between the domestic and offshore market interest rates for a currency are governed by risk premia, reserve requirements and other regulations that apply to domestic deposits and the presence of capital controls

6.4 Interest Rates in the Global Money Markets (contd.) • The differences in interest rates between currencies in the euromarket are explained by the differences in the spot-forward margins. • In equilibrium, effective returns on all currencies would be equal

6.5 An Overview of Money Market Instruments • During the decade of the eighties the markets have evolved a wide array of funding instruments • Commercial Paper • Commercial paper is a corporate short-term, unsecured promissory note issued on a discount to yield basis • It can be regarded as a corporate equivalent of CD (Certificate of Deposit) which is an interbank instrument

6.5 An Overview of Money Market Instruments (contd.) • Certificates of Deposit • A Certificate of Deposit (CD) is a negotiable instrument evidencing a deposit with a bank • Unlike a traditional bank deposit which is non-transferable, a CD is a marketable instrument so that the investor can dispose it off in the secondary market when cash is needed • Banker’s Acceptance • This is an instrument widely used in the US money market to finance domestic as well as international trade

6.5 An Overview of Money Market Instruments (contd.) • In a typical international trade transaction, the seller(exporter) draws a time or “usance” draft on the buyer's (importer's) bank. On completing the shipment, the exporter hands over the shipping document and the letter of credit issued by the importer's bank to its bank. The exporter gets paid the discounted value of the draft. The exporter's bank presents the draft to the importer's bank which stamps it as "accepted“.

MEDIUM TO LONG TERM INSTRUMENTS • Syndicated Credits • Foreign and Offshore Bonds (Eurobonds) • Buyer’s and Supplier’s Credits • Forfaiting • International Equity Issues - GDRs/ADRs ; Foreign • Listing • Project Finance • NIFs, RUFs and other Underwritten Facilities – Gone out of fashion

Borrowing on International Capital Markets (US$ Billion) 2007 2008 2009(Q1+Q2) 1 Syndicated Credit Facilities 2770 1682 449 Borrowers from (i) Developed Countries 2257 1304 368 (ii) Developing Countries 442 316 69 2 Debt Securities 2977 2436 1505 (Net Issues) Issuers from (i) Developed Countries 2763 2345 1397 (ii) Developing Countries 155 28 17 2a Money Market Instruments* 199 82 -138 2b Bonds and Notes 2778 2355 1643

ANNOUNCED INTERNATIONAL EQUITY ISSUES (US $ BILLION) ISSUERS FROM 2006 2007 2008 2009 2009 Q1 Q2 All Countries 371 499 392 57 255 Developed Countries 225 256 306 43 225 Developing Countries 124 216 79 9.5 26 China 52 62.4 15.6 6.4 12.5 India 10.3 22.9 12.0 0.0 3.8 S.Korea 7.4 5.3 1.2 1.0 0.9

Dragon Bond A bond that is issued in Asia but denominated in U.S. dollars. Yankee Bond A bond denominated in U.S. dollars that is publicly issued in the U.S. by foreign banks and corporations. According to the Securities Act of 1933, these bonds must first be registered with the Securities and Exchange Commission (SEC) before they can be sold. Yankee bonds are often issued in tranches and each offering can be as large as $1 billion. Bulldog Bond A sterling denominated bond that is issued in London by a company that is not British. Matilda Bond An bond denominated in the Australian dollar and issued on the Australian market by a foreign entity.

Maple Bond A bond denominated in Canadian dollars that is sold in Canada by foreign financial institutions and companies. Samurai Bond A yen-denominated bond issued in Tokyo by a non-Japanese company and subject to Japanese regulations. Shogun Bond A type of foreign-currency denominated bond that is issued in Japan by foreign entities. Organizations such as the World Bank have issued such debt instruments in the past. Geisha Bond Similar to Shogun bonds but privately placed.

6.6 Summary • Examine the interest rate linkages between the different segments of the global money markets • Close link between interest rates in the domestic and offshore markets in a particular currency • Brief survey of common short-term funding instruments in global money markets

International Financial Management P G Apte