1. International Financial Markets and Instruments: An Introduction
Chapter 3
International Financial Markets and Instruments: An Introduction

2. Learning Objectives
Summarize the fundamental components of international financial markets.
Illustrate how global money markets, interest rates, and foreign exchange markets are interdependent.
Describe the types and roles of international currency and monetary derivatives.

3. International Bank Lending
Banks’ balance sheets commonly have loans and deposits that are international in origin.
As of 2008, gross international bank lending was $37.5 trillion!

4. Gross international bank lending can be divided into three components:
domestic bank loans in domestic currency to foreigners,
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domestic bank loans in foreign currency to foreigners,
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domestic bank loans in foreign currency to domestic residents.
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5. The first is called “traditional foreign bank lending.”
The second and third represent the euro-currency market.

6. The Eurodollar Market
Eurodollar deposits arise when a U.S. exporter wishes to sell goods to a foreigner, is paid in dollars, and wishes to leave the dollars in an account in a foreign bank.
The Eurodollar market began to be important in the 1950s, as the USSR chose to put dollar-denominated deposits in British (rather than American) banks.
Other factors, such as the oil shocks in the 1970s, increased Eurodollar holdings.

7. The Significance of Eurodollar Markets
The rise of Eurodollar markets has significantly increased the international mobility of financial capital.
This means that interest rates have been increasingly linked across countries, and have moved toward each other.
One drawback is that financial problems quickly spread worldwide, such as happened in 2008.

8. The International Bond Market (Debt Securities)
Government and corporations can borrow money by issuing bonds.
Bonds have a face value – this is the amount that will be paid to the lender when the bond matures.
Foreign bond markets and eurobond markets together comprise the international bond market.

9. The stock of this sort of debt was $23.9 trillion as of 2008.

10. Significance of the International Bond Market
As with the Eurodollar markets, the increasing importance of international bond markets has increased the international mobility of financial capital, and countries’ interest rates have moved toward each other.
This increased interdependence also helps spread financial problems.

11. International Stock Markets
Ownership in companies (common stock) is another asset that is traded internationally.
Exact figures on the volume of international stock transactions are difficult to obtain, but most believe these have increased.
This may create a tendency for movements of stock prices across countries to become more similar to each other.

12. Significance of the Rise of International Stock Markets
The increasing importance of international stock markets has facilitated the flow of financial capital to its most productive use.
This increased interdependence can also allow financial problems to spread quickly, as was demonstrated in 2008.

13. Basic International Financial Linkages: Review
As we learned in Chapter 20, investors will be indifferent between domestic and foreign investment when
(ihome – iforeign) ≈ p = xa – RP, where
p is the forward exchange rate premium.

14. Basic International Financial Linkages: An Example
How does the Eurodollar market change our understanding of financial linkages?
Suppose
Lending iNY 7%
Lending iLondon 8%
Lending iEuro$ London
6.5%
Lending iEurosterling NY
7.5%
Deposit iNY 5%
Deposit iLondon 6%
Deposit iEuro$ London
5.5%
Deposit iEurosterling NY
Spot e$/£
1.691
3-months forward e$/£
1.687

15. Basic International Financial Linkages
If covered interest arbitrage parity holds, after dividing the annual interest rate difference by 4 to approximate a 3-month rate we get
(ihome – iforeign) ≈ p
( )/4 ≈ (1.687 – 1.691)/1.691 ≈

16. Basic International Financial Linkages
What happens if the Federal Reserve raises U.S. interest rates by ½ of a percentage point? Now, the eurodollar deposit rate will rise to 6% and the eurodollar lending rate will rise to 7%.
We’d also expect the forward rate to rise (the dollar depreciates) and the spot rate to fall (the dollar appreciates).

17. International Financial and Exchange Rate Adjustments
NY money market i' i D€ $

18. International Financial and Exchange Rate Adjustments
The higher interest rate in New York increases demand for eurodollars.
This will put upward pressure on the eurodollar rate.

19. International Financial and Exchange Rate Adjustments
London money market
(eurodollars) i' i0 D$
D‘$ $

20. International Financial and Exchange Rate Adjustments
The higher U.S. interest rate leads to an increased supply of pounds on the spot market; this additional supply is hedged in the forward market.

21. International Financial and Exchange Rate Adjustments
Spot market
e$/£
e'$/£ D£

22. International Financial and Exchange Rate Adjustments
Forward market
e'$/£
e$/£
D'£ D£ €

23. Further adjustments might occur in the U. K
Further adjustments might occur in the U.K.’s money market and the eurosterling market that would lead to higher interest rates there, but the Bank of England may intervene to prevent this.

24. Hedging Eurodollar Interest Rate Risk
New instruments, called derivatives, have emerged to hedge interest rate risk.
Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, etc.

25. Commonly Used Derivatives
Maturity mismatching
Future rate agreements
Eurodollar interest rate swaps
Eurodollar cross-currency interest rate swaps
Eurodollar interest rate futures
Eurodollar interest rate options
Options on swaps

26. The Current Global Derivatives Market
Futures have been traded on metals and agricultural commodities for more than a century, so the idea of derivatives isn’t new.
However, in the past 25 years there has been an explosion in the use of global derivatives.
Annual growth rates have been in the range of 20%-30%.

27. Values of Selected Global Derivatives, 1987-2008
(in billions of dollars)
1987
2008
A. Exchange-traded instruments
$730
$59,797
Interest rate futures
488
19,271
Interest rate options
123
35,161
Currency futures 15
102
Currency options 60
126
Stock mkt index futures 18
729
Stock mkt index options 28
4,409
B. Over-the-counter instruments
866
683,725
Interest rate swaps
683
356,772
Currency swaps
183
16,307
62,162

28. The Current Global Derivatives Market$ $ $ $
Why have derivatives become so important?

29. Participants in the international financial markets have discovered that derivatives can
increase their returns
lower their risk

30. Derivatives allow for an unbundling of exposure to foreign exchange risk, interest rate risk, and price risk.

31. The Current Global Derivatives Market
However, as the global financial crisis of has shown, derivatives cannot eliminate risk.

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