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The International Capital Markets

New York University/ING Barings. The International Capital Markets. Prof. Ian Giddy New York University. Instruments and Markets. Corporate Bonds. Domestic. International. International Financial Markets. The Eurocurrency market Foreign exchange Covered interest arbitrage

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The International Capital Markets

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  1. New York University/ING Barings The International Capital Markets Prof. Ian Giddy New York University

  2. Instruments and Markets Corporate Bonds Domestic International

  3. International Financial Markets • The Eurocurrency market • Foreign exchange • Covered interest arbitrage • International portfolio investment returns • Hedging international portfolios • International diversification: passive vs active

  4. The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States” • Separation of currency, institution and jurisdiction • Why do people want Eurocurrency deposits and loans? • Why is LIBOR the world’s key benchmark rate?

  5. The Eurocurrency Market “A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States” • Separation of currency, institution and jurisdiction • Why do people want Eurocurrency deposits and loans? • Why is LIBOR the world’s key benchmark rate?

  6. 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

  7. The Global Bond Market • Domestic bonds • Foreign bond (Issued within country of currency, by non-resident issuers) • Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) • Global Bonds (Issued in the domestic and the Eurobond markets simultaneously)

  8. Characteristics of Eurobonds • Issued outside country of currency • Not subject to domestic registration or disclosure requirements • In most cases take form of private placements • Placed through syndicates in many countries who sell principally to nonresidents • Bonds are structured so as to be free of withholding tax • Bearer form But... • Eurobonds usually influenced de facto by government and banks of country of currency

  9. International Bond Markets are Linked • Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps Domestic US Domestic BOND Japanese MARKETS - Gov't WITHIN - Corporate - Gov't COUNTRY - Corporate OF Foreign CURRENCY Bonds Foreign "Yankee" Bonds "Samurai" Currency Swaps BOND MARKETS OUTSIDE Eurodollar Euroyen COUNTRY Bond Market Bond Market OF CURRENCY Long-dated Forward Exchange

  10. Exchange Rate Risk • Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies

  11. Policies and Exchange Rate Regimes • Exchange rate systems--fixed vs floating • Managed floating • EMU-type currency blocs • De facto blocs--the dollar

  12. The Euromarket vs the Euro “A Euro is a basket of individual European currencies” True or false? C

  13. Domestic Policies, Domestic Prices and Interest Rates, and Exchange Rates Country A Country B DOMESTIC DOMESTIC ECONOMIC ECONOMIC POLICIES POLICIES INFLATION INFLATION RATE RATE EXCHANGE RATE INTEREST INTEREST RATE RATE FORWARD RATE

  14. Foreign Exchange Mechanics and Calculations • “Money never leaves homes” • Funds transfer, chips, and timing • Relative interest rates 1. Forward premium or discount 2. Points 3. Spot and forward • Spot and forward 1. Points 2. Forward premium or discount 3. Relative interest rates

  15. Exchange Rates

  16. A Typical Forward Contract • We agree today to pay a certain price for a currency in the future JPY Sony B of A

  17. Foreign Exchange Quotations Spot Forward points

  18. Foreign Exchange Quotations Bid Offer Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward

  19. Foreign Exchange Quotations Bid Offer Spot Forward points Rule: add if bid<offer, subtract if bid>offer Outright forward 111.35 111.45 0.52 0.517 110.83 110.933

  20. The Forward Rate Tracks the Spot Rate

  21. Covered Interest Arbitrage

  22. In the 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 ExchangeDealing Money FUNDING EUROCURRENCY MarketDealing The Dealing Room

  23. 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 ExchangeDealing Money FUNDING EUROCURRENCY MarketDealing

  24. Interest-Rate Parity $1 (1 + / E$) = ($1/ S t )(1 + /EBP)Fnt where St is the spot exchange rate (dollars per British Pound) and Fnt is the forward rate. to a close approximation, (/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100 Interest-rate differential = forward premium or discount

  25. Example: Guidant’s Cash • Guidant, the medical instruments company, is seeking to invest 3-month US$ money. • Guidant can invest in the US CP market at 5.5% • Or in the Eurosterling market at 6.7% • The BP is: spot $1.5484, 3-mo forward $1.5454 • Which is better?

  26. Guidants’s Answer It’s better for Guidant to invest in the GBP instrument and hedge. Reason: • US: simply invest for 3 months • Result: $1(1+5.5%/4) = 1.01375 • UK: take the US dollars, change into British pounds at spot rate, cover by selling sterling at 3-mo forward rate to convert the money back into dollars • Result: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478

  27. What if Guidant didn’t hedge? EXCHANGE RATE Spot Forward Actual Today In three months TIME

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

  29. Issues • What are the risks involved in investment in foreign securities? • How do you measure benchmark returns on foreign investments? • Are there benefits to diversification in foreign securities?

  30. International Equity Investments • Equity returns in local currency • Exchange rate changes • Other factors?

  31. Equity Returns: Domestic vs Global Yardeni.com International charts

  32. Int’l Investment Choices • Direct Stock Purchases • ADRs • Mutual Funds • Open end • Closed end • Global companies

  33. Obstacles to International Investment Might Include: • Information barriers. • Political and capital control risks. • Foreign exchange risks. • Restrictions on foreign investment and control. • Taxation. • Higher costs.

  34. Foreign Exchnage Risk in International Investing Foreign Exchange Risk • Variation in return related to changes in the relative value of the domestic and foreign currency • Total Return = Investment return plus return on foreign exchange • Not possible to completely hedge a foreign investment

  35. Returns with FX • Return in US is a function of two factors 1. Return in the foreign market 2. Return on the foreign exchange

  36. Returns with FX (1 + rUS) = (1 + rFM) (1 + rFX) rUS = return on the foreign investment in US Dollars rFM = return on the foreign market in local currency rFX = return on the foreign exchange

  37. Return Example: Dollar Appreciates Initial Investment : $100,000 Initial Exchange: $2.00/ Pound Sterling Final Exchange:$2.10/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (1.05) = (1.155) rUS = 15.5%

  38. Return Example: Dollar Depreciates Initial Investment : $100,000 Initial Exchange: $2/ Pound Sterling Final Exchange: $1.85/ Pound Sterling Return in British Security: 10% Return in US Dollars (1 + rUS) = (1.10) (.9250) = (1.0175) rUS = 1.75%

  39. Relative monetary and fiscal policies Relative inflation Exchange Rate Risk • Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and hence to nominal equity returns. Exchange rate change

  40. Turkey, 1995 Turkish Lira: Down 33.5%

  41. Turkey, 1995 Turkish prices: up 83.8%! Turkish Lira: Down 33.5%

  42. Hedging International Equity Investments • Buy foreign equity and hedge the anticipated future value, P+E(r)? • Use short-term, value-adjusted, roll-over hedges? • Do nothing, because equities bear no currency sign? Anticipated Initial Actual

  43. Measuring Benchmark Returns • Indexes • EAFE Index • Issues in Measuring Performance • Weighting • Cross-Holdings • Other Possibilities • Country and Region Funds

  44. Diversification Benefits Evidence shows international diversification is beneficial • Possible to expand the efficient frontier above domestic only frontier • Possible to reduce the systematic risk level below the domestic only level

  45. Systematic Risk Level with International Diversification Risk Dom Int’l Securities

  46. The Minimum-Variance Frontier E(r) Efficient frontier Individual assets Global minimum-variance portfolio

  47. Efficient Frontier with International Diversification Int’l Return Dom * * * * * * * * Risk

  48. The Global Efficient Frontier

  49. International Portfolio Optimization: Passive vs Active Portfolios (Let the proportions of all possible assets vary until the optimal proportions are found.) The results of letting the computer find the best proportions for various levels of return:

  50. Evidence Suggests Index Funds are Not for the International Investor • For the international investor the capitalization-weighted portfolio may not be the optimal one. The reason is market segmentation. The world stock market is not efficient yet, the evidence suggests, at least not in the "mean-variance efficiency" sense that is required by the CAPM. • Because of real exchange risk (deviations from PPP), what is the optimal portfolio for an investor in one country may not be the optimal portfolio for an investor in another, even if there were a single risk-free asset acceptable to both. • Studies confirm these propositions

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