WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Objectives: Eurocurrency Market Eurobond Market Asian Dollar Market SDR (1 SDR = x1$ + x2DM + x3FF + x4 £ + x5¥) ECU / Euro

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Eurodollar Market (cont.) c. Operation: - type: CD (overnight - 10-15 Yrs.) - Marketable or Negotiable Instruments Secondary Markets (ICDMA) - Tap CD Tranche CD SDR CD - Rate:

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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 Financial markets Goswami FNGB 7451 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 A: The advantage to a customer in favor of borrowing in the external market A External Market Lending Rate (Fed Fund Rate): The rate charged on banks loans in the external market B: LENDING SPREAD The spread paid by the customer over LIBOR on external market loans B LIBOR: The rate at which a Euromarket bank is willing to place a deposit at another Euromarket bank C: INTERBANK SPREAD The difference between a bank’s bid and offer rate for deposits in the external market (usually 1/8%) LIMEAN (London Interbank Mean Rate): The average of LIBOR and LIBID C LIBID (London Interbank Bid Rate): The rate that a Euromarket bank is willing to pay to attract a deposit from another Euromarket bank D: The advantage to a depositor for placing a deposit in the external market D Domestic Deposit Rate: The rate that a bank pays for a deposit in the domestic market

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Eurodollar Market (cont.) e. Participants: Supply: Swiss Banks Central Banks Institutional Investors Demand: Governments MNC’s Speculators

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Eurodollar Market (cont.) 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Eurodollar Market (cont.) f. Disadvantages: No lender of last resort No FDIC Domestic Monetary Policy Petrodollar Recycling Overexposure Extensive Speculation Volatile FE Rate Additional Risk a. Sovereign or Country Risk b. Foreign Exchange Risk

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Foreign Bond: (cont.) 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Foreign Bond: (cont.) 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Eurobond Vs. Eurocurrency Loan

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS 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 Financial markets Goswami FNGB 7451 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% Non-bank & Interbank Depositors Borrower Rev. Credit Banks Principal & Interest Payment Ref. Agent Agent Bank

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Eurocurrency - Revisited: (cont.) 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

WORLD FINANCIAL MARKETS Financial markets Goswami FNGB 7451 WORLD FINANCIAL MARKETS Eurocurrency - Revisited: (cont.) 7. Terms of Eurocurrency Borrowing: - Type of Credit: a. Term Credit b. Revolving Credit - Commitment Clause - Maturity - Currency - Repayment Clauses & Prepayment Clauses