AJAFIN 6605-02

International Financial Markets

Financial markets are often designated as money
markets and capital markets.
*Money Markets are markets for short term financial assets
(Short-term instruments) e.g., T-Bills, CD's, Bankers
Acceptance(BAs), Commercial Papers(CP), Repurchase
Agreements (Repos)...
*Capital Markets are markets for long term financial assets
like Bonds, Stocks, Mortgages, etc.
We will emphasize two major components of International
Financial Markets:
i. The Foreign Exchange Market
ii. Eurocurrency, Eurocredit, & Eurobond Markets 1
Money Market (MM):
✦ In the MM, investors can buy S-T debts of governments,
banks, financial institutions, and corporations.
✦ Maturity varies from 1 day to 1 year
✦ Highly marketable
✦ Quickly convertible to cash (very liquid)
✦ Un-collateralized debt of issuers with high credit rating
✦ Quoted by using annualized discount yields
(negotiable CDs are exceptions)
Negotiable CDs:
✦ Denominations of over $100,000
✦ Depositor able to negotiate interest with bank
✦ Maturities range from 14 days to 1 year.
2
 T-Bills:
✦ U.S. Treasury Department sells T-Bills.
✦ The Federal Reserve Bank (FED) acts as fiscal agent and
conducts the yield auction.
Commercial Paper (CP):
✦ Unsecured IOUs of corporations with good credit.
✦ Maturities range from a few days to 270 days.
✦ Usually issued in denominations of $100,000 or more.
✦ About 1000 corporations issue CP in the U.S.

Banker’s Acceptances (BA):

✦ Denominations of over $100,000.
✦ Sold at discounts. 3
 Repurchase Agreement (REPO):
✦ In a REPO, buyer and seller of a security agree that seller
will repurchase security after a certain length of time or after
conditions are met.
✦ Seller repurchases security at a higher price.

Euronotes:
 Short-term promissory notes issued by a corporation and sold to
private or institutional investors
 Typical maturity is 3 to 6 months
 Sold originally at a discount from face value. Trade
in secondary markets
 Underwritten by international investment/commercial banks

4
Euro Medium Term Notes
 Similar to domestic medium term notes, with
maturities of 9 month to 10 years.
 Fill the gap between S-T and L-T euro debt
instruments

Eurocommercial Paper
 Unsecured short-term notes issued by corporations
and banks in the Eurocurrency Markets
 Typical maturities from 1 to 6 months
 Placed directly with investors through dealers.

5
Eurocredit (bank loans denominated in eurocurrencies and extended by
banks in countries other than in whose currency the loan is denominated)
 Loans of one year or longer extended by Eurobanks to
MNCs or governmental agencies.

Money Market Mutual Funds:

 Bring market for T-Bills, Commercial Papers, and
others to the small investor.

6
 The Foreign Exchange Market: An Outline
Organization: Functions, Participants, Size…
Spot market: Quotations
Bid/Ask Spreads
Cross rates
Location arbitrage
Triangular Arbitrage
Transaction costs.
Forward Market: Quotations
Maturities
Bid-Ask spreads
Premium/Discount
7
Use of the Fwd. Mkt. by MNCs
The Forward Swap: The Swap Price
Derivative Securities: The Forward Market
The Futures Market
The Options Market
The Swaps Market
The Eurocurrency Markets: Definitions
Eurodollars / Euro-currencies
Evolution of the Market
Deposit Creation
The Eurocredit Market: ……
The Eurobond Market: …….
8
✦ The Foreign Exchange Market is the world's
largest financial market.
The Bank for International Settlements estimates
daily trading volume of about $3.2 trillion. (WSJ 09/26/07)

✦ The Foreign Exchange Market is an over-the-

counter market.
That means there is no physical location where traders
get together to exchange currencies.
Rather they are located in the offices of major
commercial banks around the world and trading has
historically been done by telephone, telex, or the
SWIFT system.
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✦ The “Society for Worldwide Interbank Financial
Telecommunications”(SWIFT) is an international
bank communications network, that electronically
links brokers and traders.
✦ The network connects over 7000 banks and broker-
dealers in over 192 countries.
✦ SWIFT transports financial messages in a highly
secure way, but does not hold accounts for its
members and does not perform any form of clearing
or settlement.
SWIFT does not facilitate funds transfer.

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 An international payment system should provide:
✦ Security of value - instrument adequately transfers appropriate
value Security of medium - instrument hard to fake.
✦ Storage security – instrument can’t be easily stolen or its value
appropriated.
✦ Portability – instrument can be used to transport sufficient
value.
✦ Negotiability – others will accept the instrument.
✦ Convenience – low cost and speed of instrument transfer.
✦ Legal recognition and formalism – rules of the system
adequately regulated by state.

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 Global Settlement System
✦ CLS Bank International, a New York-based
settlement network, is supported by over 70 of the
world’s largest banking and financial institutions.
✦ CLS offers a unique real-time processing that
enables simultaneous FX settlement across the
globe thereby eliminating settlement risks caused
by delays arising from time-zone differences.

Internet resource: www.cls-group.com

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✦ Trading takes place somewhere in the world 24 hours a
day and frequently between individuals or institutions
located in different countries.
✦ Most trading activities take place in a few currencies like
the US Dollar, the Euro, the British Pound, the Japanese
Yen, the Canadian Dollar, and the Swiss Franc
✦ The foreign exchange market is not confined to any one
country but dispersed throughout the world’s leading
financial centers: London, New York, Tokyo, Paris,
Zurich, Amsterdam, Hong Kong, Frankfurt, Toronto,
Milan, Singapore, Berlin, Vienna, Chicago...
✦ Foreign Exchange traders not only buy and sell
currencies but, they create prices.
13
✦ Market Makers are those traders in the major money-
center banks around the world who are always ready
to buy or sell by quoting the bid/ask prices.
They create the market by creating bid/ask prices and
dealing at those prices.
✦ The difference between the two prices is called the
“spread."
✦ Participants in the FX market include importers,
exporters, portfolio managers, central banks, brokers,
commercial banks, arbitragers, speculators, tourists,
governments, etc.
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 The Foreign exchange market can be subdivided into:
✦ The Retail Market: permits the firms and individuals to obtain
foreign exchange for business or personal use.
✦ The Interbank Market: major participants are foreign
exchange traders employed by large banks.
Also large Multinational Corporations often maintain trading
departments that operate directly in this market. Traders in
the interbank market are called “dealers." They make the
market.
✦ Brokers: bring buyers and sellers together for a small
commission thereby helping to preserve the anonymity.
✦ Arbitragers: seek to profit from price differences in different
foreign exchange markets.
15
✦ Speculators: buy and sell in the hope that a price change
will result in a profit.
✦ Governments: Central Banks, Treasury Departments and
other Government Agencies sometimes participate in the
market in order to influence the exchange rate of a
particular currency.
For Example:
✦ FED buys dollars in foreign exchange market to
increase the value of the dollars.
✦ FED sells dollars in foreign exchange markets to
reduce the value of dollars.
Coordinated efforts among central banks are often used.
For example, the US FED bought the Mexican peso to
help prop up its value in early 1995. 16
 Other Participants (mainly in the forward markets)
✦ Traders: Use forward contracts to eliminate or cover the
risk of loss on export or import orders that are
denominated in foreign currencies.
✦ Hedgers: Hedgers, mostly Multinational corporations,
enter into forward contracts to protect domestic currency
value of foreign currency denominated asset and liabilities
on their balance sheets.
The increasing importance attached to exchange rates
results from the globalization or internationalization of
modern business, the continuing growth in world trade,
the trend towards economic integration and the rapid
pace of change in the technology of money transfer.
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✦ The Clearing System: Modern technology plays a central
role in the international transfer of funds or settling foreign
exchange transactions.
✦ In the U.S., electronic funds transfer takes place
through the “Clearing House Interbank Payment
System” (CHIPS).
This is a computerized network developed by the
New York Clearing House Association for transfer of
international dollar payments.
It links about 150 depository institutions that have
offices or affiliates in New York City.
✦ The New York Fed has established a settlement account for
member banks in which the account of a paying bank is
charged and the receiving banks account is credited.
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 Electronic Trading:
✦ In 1992, Reuters introduced a new service that added
automatic execution to the screen quotations used in
telephone trading thereby creating a genuine screen-
based market.
Other vendors like Telerate and Quotron, followed.
✦ Electronic trading systems offer automatic matching
in which traders enter buy and sell orders directly into
their terminals anonymously.
✦ These prices are visible to all market participants and any
trader anywhere in the world can execute a trade by hitting
two buttons!
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 Several questions are commonly asked in relation
to the foreign exchange rates. These include:
01) Why do exchange rates change
02) Why is it so difficult to forecast exchange rates
03) How can the Foreign exchange rates be forecasted
04) Why governments intervene in the exchange market
05) How to effectively hedge foreign exchange risks
06) How to speculate in the foreign exchange markets
07) How to evaluate the comments on exchange rates
found in the financial press
08) Government policy issues with respect to exchange

rates (e.g., fixed and floating regimes)

09) What we know and what we do not know yet about
exchange rate dynamics. 20
Functions of the Foreign Exchange Market:
Transfer of Purchasing Power:
✦ International trade and capital transaction usually
involve parties with different functional currencies.
✦ Trade and capital transactions can be invoiced in any
convenient currency.
✦ Therefore, one or more of the parties must transfer
purchasing power to or from own national currency.
✦ The Foreign exchange market facilitates this transfer
of purchasing power.

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 Provisions of credit:
✦ Movement of goods and services between countries
takes time. This gives rise to financing of inventory in
transit and sales inventory.
✦ The foreign exchange market provides a means of
transfer of credit.
Specialized instruments like Bankers' acceptances and
letters of credit, are made possible through the foreign
exchange market.

Minimizing Foreign Exchange Risk:

✦ The foreign exchange market provides "risk
transfer" facilities to third parties via forward,
futures, options, and swaps markets. 22
 Formal Definition:
✦ The Foreign exchange rate is the domestic currency
units per unit of a foreign currency.

✦ Example: Let the U.S. be "domestic"

1. If you need $1.95 to purchase 1 unit of the British
Pound Sterling, then
$/£ = 1.95 (d/f)

✦ Dollars per pound is a direct quote for the pound in the

U.S. It means the home currency, in this case the $, (or
domestic currency) needed to acquire one unit of a
foreign currency, in this case the pound.
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Alternatively:
✦ The foreign exchange rate can be defined as units of
a foreign currency per unit of domestic currency.
This is an indirect quote.

2. If 125 units of the Japanese Yen are needed to

purchase one unit of the U.S. Dollar, then:
¥/$ = 125 (f/d).

This is an indirect quotation for the Yen in the US.

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✦ Since the direct and the indirect quotations are alternative
means of stating exchange rates, the two methods are
related. One is the inverse of the other. Thus
$ = 1
£ £/$
or,
¥ = 1
$ $/¥
✦ Most interbank quotes are quoted around the world are
stated in "European" terms which means the foreign
currency price of one dollar, e.g., SF/$ = 1.2378, ¥/
$ = 132, etc.
✦ The alternate way, dollar price of one unit of foreign
currency, is called "American" Terms e.g. $/£ = 1.7535.25
 Spot Rates:
✦ A spot transaction is the purchase of foreign exchange
for immediate delivery (usually, delivery within the
following 2 business days).
 Forward Rates:
✦ A forward exchange rate or forward rate, is the price
agreed on today for purchase or sale of foreign currency
for future delivery (transfer/settlement) and payment.
The
rate is agreed on at the time the contract is made, but
normally payment and delivery are not required until
maturity.
✦ Forward maturities normally are 30, 60, 90, 180, 360 days
in to the future. Odd maturities may be negotiated for26one
to two weeks or even up to 5 years.
 Cross Rates:
✦ Frequently, the need arises to obtain the
relationship (price) between two currencies from
their relationship with (quotation in) a third
currency.
✦ Formally, given two currencies A & B.
If $/A and $/B are given, then the value of A in
terms of B (or B per unit of A) is given by:
$/A = $ *
B = B
$/B A $ A
This is the cross rate. 27
Examples: Given $/£ and $/SF, then
$/£ = $ * SF = SF
$/SF £ $ £

Given: $/£ = 1.4155 and SF/£ = 3.1318, then

SF = SF/£ = 3.1318 = 2.2125
$ $/£ 1.4155

Given: $/£ = 1.8632; $/ ¥ = .008013, then

¥ = $/£ = 1.8632 = 232.52

£ $/ ¥ .008013
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The Bid-Ask Spread:
Bid Price: price at which a dealer will buy a currency.
Ask price: price at which the dealer will sell a currency
(offer price).
Dealers do not normally charge a commission on their
currency transactions but profit from the bid/ask spread.

Computing the bid/ask spread in percentage terms:

Bid/Ask spread = Ask Rate - Bid Rate *

100
Ask Rate 1
This expresses the spread in terms of the "discount"
obtained by the dealer. 29
Alternatively,
Bid/Ask spread = Ask Rate - Bid Rate *
100
Bid Rate 1
This expresses the spread in terms of the markup
established by the dealer.

Outright and Points Quotations:

✦ In outright quotations the full price is given to all
its decimal points.
✦ In points quotation abbreviations are used.
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 For example, the £ may be quoted at $1.9819-36.

This means a bid price of 1.9819 and an ask price

of 1.9836.
 In practice, this quotation may simply be given as
19-36 as the dealers are sufficiently up to date to
know the preceding numbers.
 The last digit in a quotation represents point(s), and
convention dictates the numbers of decimal points in
each quotation.
For example:
$/£ = 1.9825 (4 digits)
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$/Y = .008799 (6 digits)
Forward Quotes With Bid/Ask Spreads:
✦ Interbank quotations are expressed as a bid (buy) and an
offer (sell or ask).
✦ Bid and Ask quotations may appear complicated because

the bid for one currency is also the ask of another currency.
✦ In outright quotations the full price is given to all its
decimal points.
✦ In points quotations abbreviations are used.

When quotations in European terms (indirect) are rendered

in American terms (direct) the bid and the ask reverse.
The reciprocal of the bid becomes the ask and the
reciprocal of the ask becomes the bid
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✦ In the Interbank market, dealers usually quote the
forward rate as a discount from or a premium on, the
spot rate.
✦ This forward differential is called the "Swap Rate".
Example: Given that:
£: spot $/£ = 1.7860 ¥: spot $/¥ = .007949
90-day Fwd = 1.7580 90-day fwd = .007929
✦ The "Swap Rate" (forward differential) for the £ was
quoted as a 280-point discount (from the spot).
✦ The "Swap Rate" for the 90-day forward Yen was
quoted as a 20-point discount from the spot.
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✦ A "Swap Rate" can be converted into an outright rate
by adding the premium (in points) to or subtracting the
discount (in points) from the spot rate.
✦ When the forward bid (in points) is smaller than the Ask
rate (in points) the forward rate is at a premium and the
points should be added to the spot price to compute the
outright quote.
✦ Conversely, if the bid (in points) exceeds the ask
(in points), the forward rate is at a discount and the points
must be subtracted from the spot price to obtain the
outright quotes.

Note that the buying rate, spot or the forward, is always

less than the selling rate and forward bid/ask spread
always exceeds spot bid/ask spread. 34
Example:
The following quotes are given for the respective
maturities for the £ and the SF.

Spot 1 Month 3 Months 6 Months

£: $2.0015-30 19-17 26-22 42-35
SF: $0.6963-68 4-6 9-14 25-38
✦ Compute the outright quotes.

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 £ ($/£) SF ($/SF)

Maturity Bid Ask Spread% Bid Ask Spread%

Spot 2.0015 2.0030 0.075 0.6963 0.6968 0.072

1 Month 1.9996 2.0013 0.085 0.6967 0.6974 0.100

3 Months 1.9989 2.0008 0.095 0.6972 0.6982 0.143

6 Months 1.9973 1.9995 0.110 0.6988 0.7006 0.257

This example shows that the SF is selling at a premium

while the £ is at a discount against the $.
• Note the slightly wider spread between outright bid and
Ask on the Swiss Franc compared to the spread on the
pound. The difference is due to the broader market in
pounds. Also the widening of spreads over time for both
currencies is caused by the greater uncertainty surrounding
future exchange rates. 36
 The Bid/Ask Spreads in Cross Rates:
Consider the following quotes:
$/£ = $ 1.7109-36
$/SF = $ 0.6250-67

Find the direct quote for the £ in terms of the SF

(with B/A spread). i.e. find SF/£ in b/a quotes.
The bid and ask quotes for SF/£ are:

BID: SF = SF *
$ = 1 *
1.7109 = 2.7300
£ $ £ .6267 1
37
ASK: SF = SF *
$ = 1 *
1.7136 = 2.7418
£ $ £ .6250 1
Hence the cross rates with B/A spreads are:
SF/£ = 2.7300 - 2.7418
or = 2.7300 – 418

✦ Sometimes a forward transaction is called an "outright

forward" to emphasize that no spot transaction is involved
and to distinguish it from a "swap transaction"

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 A "swap transaction" involves the sale of a foreign
currency with a simultaneous agreement to repurchase at
some later date in the future; OR
 The purchase of the foreign currency with an agreement to
resell at sometime in the future.
Generally a forward swap is an arrangement in which two
parties agree to exchange specific amounts of currencies on
one date and to reverse the exchange, usually at a different
exchange rate, on a later date. The arrangement can be a
spot-forward or forward-forward swap.
These forward swaps differ from currency swaps in that
there are no exchanges of interest payments and are
usually for shorter time periods.
• Spot - fwd swap: Spot now with fwd later;
39
• Fwd - fwd swap: fwd at t with fwd at t+30.
Example:
City Bank buys SF5 million from the Swiss Bank for $2
million (spot) and simultaneously agrees to sell the SF
back in 6 months for $ 2.1 million.

✦ The difference between the sale price and the

repurchase price is called the “swap rate”
✦ This “swap” is a way to borrow one currency for a
limited time while giving up the use of another
currency for the same time, i.e., a short-term
borrowing of one currency combined with a short-
term loan of an equivalent amount of another
currency. 40
Note:
According to the Bank for International Settlements
(BIS), in 2001, spot transactions account for 33% of
the market, forward transactions 11%, and swap
transactions, (involve a package of spot and
forward contracts), 56% of the market.

41
 Exercises:
✦ 1. A trader quotes the SF against the $ at a Bid/Ask
(buy/sell) price of:
SF/$ = 2.3697 - 2.3725.
The principle of buy low and sell high applies.
The smaller number 2.3697 is the bid price and
the larger number 2.3725 is the ask price.
Obtain the bid/ask prices for $/SF.

✦ 2. If a bank quotes bid/ask prices SF/£ = 4.085-4.090.

What should be the bid/ask prices for £/SF?

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3. A bank is currently quoting the following rates:
i) SF/$ = 2.3697-2.3725
$/£ = 1.5525-1.5535
What SF/£ cross rates bid/ask would the bank quote?

ii) SF/$ = 2.5110-2.5140

¥/$ = 245-246
Find ¥/SF Bid/Ask rates.
iii) DK/$ = 5.5279-5.5289 (DK = Denmark krone)

SK/$ = 6.8681-6.8691 (SK = Sweden krona)

Obtain SK/DK bid/ask rates.

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Premium or Discount on Forward Rate:
✦If the forward rate exceeds the existing spot rate (direct
quotes) it contains a premium.
If the forward rate is less than the spot rate, that
forward rate contains a discount.
To compute the Premium (Discount)
Let: F = Forward rate e.g., $/£ = d/f
S = spot rate
n = time to maturity
then:
For a direct quote of the £ (e.g. £ quoted as $/£ = 1.5235):
F-S * 360 gives premium (discount) on the £.
S n
44
For an indirect quote, (e.g. £ quoted as £/$ = .6564)

S-F * 360 gives premium (discount) on the pound.

F n

✦ A premium means that the direct price in the forward

market is higher than the direct price in the spot market.
A discount is the reverse.

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Examples:

Spot ($/SF) .4520

30-day Forward .4541
90-day Forward .4585
180-day Forward .4654
a. Obtain the p (d) on the Swiss franc in each case.
b. Compute the p (d) on the dollar in each case.

46
 Using The Forward Contract: an Example
✦ A U.S. importer of German BMW receives a bill of € 2m
for the 700 series. The Bill is payable in 90 days.
Spot $/ € = 1. 3467. The 90-day forward $/ € = 1.3495.
The Forward contract is a means of locking in the price at
which euros will be acquired in 90 days. Discuss.

✦ Percentage Change in Exchange Rates:

The percentage change in exchange rates can be obtained
as follows:

% change = Ending Rate - Beginning Rate * 100

Beginning Rate 1
47
Example:
|----------------------------|
Given that: 0 1
at t = 0 : $/£ = 1.7895
t = 1 : $/£ = 1.9795

%Δ = 1.9795 - 1.7895 * 100 = 10.62

1.7895 1

The pound has appreciated in value against the dollar by

10.62% during the given period.

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Some Common Terms:
Depreciation -- Devaluation -- Weakening
Appreciation -- Revaluation -- Strengthening
Soft Currency -- Expected to decrease in value
Hard Currency -- Expected to maintain its value

to increase in value.
Dollar is Mixed -- The $ did not move in one

direction against the major currencies - up with

some, down with some.
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 Arbitrage in Foreign Exchange Market:
✦ Arbitrage is one of the most powerful forces at work in a
market economy.
It is the simultaneous purchase and sale of the
same (or essentially similar) good or security in two
different markets for advantageously different prices -
provided that the price spread more than offsets
transaction costs.
✦ Arbitrage plays a critical role in the analyses of security
markets because its effect is to bring prices to their
fundamental values and keep markets efficient.
The effect of arbitrage is to reduce/eliminate price
differentials on identical products by arbitragers buying
low and selling high to realize riskless profit. 50
 Locational Arbitrage:
✦ The prices charged by different banks for foreign
exchange cannot vary significantly.
Prices are kept more or less in line with each other
through a process called “Locational Arbitrage”
✦ If the price of a foreign exchange varies from one bank
to another, an arbitrager will be able to "buy low" and
"sell high."
Such an activity should lead to an increase in
the rate at the low-priced bank and decrease in the rate at
the high-priced bank.
✦ Arbitrage activity will continue as long as the difference
in prices is large enough to generate a profit. 51
 EXAMPLE: Bank A Bank B
Bid price for X $ .50 $ .52
Ask price for X $ .51 $ .53
In this example profitable arbitrage opportunity exists.
Given that the arbitrager has $1m.
✦ Buy X from bank A at .51 and simultaneously sell them to
Bank B at .52. If $ 1,000,000 are available then,
$1,000,000 will buy X = 1,000,000/.51 = 1,960,784.
Sell to Bank B for 1,960,784 * $.52 = $ 1,019,608 for a
profit of $19,608.
✦ The high demand for X in Bank A leads to an increase in price
and increased supply of X in Bank B leads to a decrease in price.
✦ Such a situation usually disappears before most firms even
become aware of it. 52
✦ As an example of how arbitrage works, consider a large
bank in London. The Chief of the FOREX department,
Dollar($) section, observes over the telex that the $ prices
of Pound ($/£) spurts up in New York.
Here is a chance to make some money! To exploit the
situation, the arbitrager does two things:

✦ First he/she contacts a broker or a correspondent bank

in New York and sells, say £1m (sells high).

✦ At almost the same time he/she buys the same amount of

£s in London.
If the arbitrager does not buy and sell at almost the
same instant the spread appears, there is a risk of missing
the opportunity. 53
✦ The sale of pounds in New York where the price is
high and the repurchase in London, where the price is
low, contributes to eliminating the price deferential.
✦ As other market participants take similar actions, the
price differences appears.

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Triangular Arbitrage:
Example 1:
Consider the following quotes in New York, Frankfurt,
and London. (Assume no transaction costs)
FRANKFURT ($/€ = 1.2471)
LONDON (€/£ = 1.4544)
NEW YORK ($/£ = 1.8590)
✦ Is Triangular Arbitrage feasible? Show why/why not.
✦ Describe a strategy to profit from triangular arbitrage.
✦ What percentage profit is possible?

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 Solution:

FRANKFURT NEW YORK

$/€ = 1.2471 $/£ = 1.8590

London
€/£ = 1.4544

On the Bases of New York and Frankfurt quotes:

€ = € * $ = 1 . 1.859 = 1.4907
£ $ £ 1.2471
The € is worth more in London (fewer € required to buy £
in London)
Hence acquire € elsewhere and sell it in London. 56
e.g. € → £ → $ → €
Given €1m:
1000000 * 1 * 1.8590 * 1 = 1,024,930
1.4544 1.2471
Profit = € 24,930 ≈ 2.5 % .

✦ Arbitrage activity causes £ to appreciate against € in

London, the $ to appreciate against the £ in New York
and the € against the $ in Frankfort.

57
Example 2:
Assume no transaction cost. Suppose £1 = $1.8095 in NY,
$1 = C$1.3215 in Toronto and C$1 = £ 0.4342 in London.
Show whether or not triangular arbitrage opportunities exist
How could a trader profit from triangular arbitrage?
Compute the percentage profit possible.
Solution:

NY Toronto
$/£=1.8095 C$/$=1.3215

London
£/C$= 0.4342
58
Given New York and Toronto quotes:
£ = £. $ = 1 * 1 = 0.4182
C$ $ C$ 1.8095 1.3215
The C$ is worth more in London than implied by cross rates
from NY and Toronto.
It will be profitable to acquire C$ and sell it for £ in London.

C$ → £ → $ → C$
Given C$ 1000
1000* 0.4342 * 1.8095 * 1.3215 = C$1,038.28
Profit = 3.828% 59
Example 3: Assume zero transaction costs:
A: ¥/U$ = 106.50, B: C$/U$ = 1.3215 , C: ¥/C$ = 82.905
✦ Determine if triangular arbitrage is feasible.
✦ State what you would do to profit from arbitrage.
✦ Obtain the percentage profit possible.

Solution:

A B
¥/U$ = 106.50 C$/U$ = 1.3215

C
¥/C$ = 82.905
60
By cross rates from A & B,
¥ = ¥ . U$ = 106.50 . 1 = 80.590
C$ U$ C$ 1.3215
The C$ is more valuable at C:
Borrow C$ and sell it for ¥ at C, Sell ¥ for U$ at A and
the U$ for C$ at B.
e.g. C$ → ¥ → U$ → C$
Given 1C$:
1 * 82.905 * 1 * 1.3215 = C$1.02772
106.50
Profit ≈ 2.8%

61
 Transaction Costs:
Assume transaction cost is .6% (.25%, .35%).
With a .60% Trans. cost, each stage the arbitrager
receives 99.4% of what he previously received.
There are three transactions in this example and
these can be incorporated as follows:

--- insert equation here ---

62
 Derivative Securities Markets: An Overview
These are forwards, futures, options, and swaps.

✦ Forward Contracts are "private" contracts

offered by banks that provide for the purchase or
sale of units of a currency at a specified exchange
rate for future delivery and settlement.

63
✦ Currency Futures Contract:
Permits the exchange/trading (purchase or sale) of
a specified number of contracts of a currency at
specified exchange rate for future delivery.
Prices are determined by an auction process on the
floor of an organized futures exchange.
Unlike the forward contracts, the futures contract
entails daily settlements (marking to the market)
and the posting of a margin.
Currency futures contracts contain standard units
of the underlying currencies. 64
✦ Currency Options Contract:
Is an exchange traded contract which grants the
buyer (holder or owner) the right, but not the
obligation, to purchase or sell a specified number
of contracts of the underlying currency at a
prescribed price (the strike price or exercise price)
within a given period of time.
The buyer pays a premium to acquire this right.
Contract sizes are standardized.

65
✦ A Swap contract is a contractual agreement evidenced
by a single document in which two parties, called
counterparties, agree to make period payments to
each other.
The agreement spells out the instrument to be
exchanged (which may or may not be the same), the
applicable interest rate on each instrument (which
may be fixed or floating), the timetable for making
payments, and other provisions.
Swap contracts are tailor-made to meet the needs of
the counterparties with the aid of swap specialists
who serve as brokers and/or market makers.
Swaps trade in the OTC market.
66
 The Eurocurrency Markets
Definitions:
✦ A Eurodollar is a U.S.-dollar denominated bank deposit
held outside the U.S. More generally, a Eurocurrency
deposit is a domestic-currency denominated bank deposit
held outside the domestic geographical area.
✦ Eurocurrencies are typically time deposits denominated in
currencies other than those of the countries in which they
are located.
✦ Therefore, the eurodollar (eurocurrency) market is an
international money market focused on short-tern credit
flows while the eurobond market is an international capital
market focused on long-term bonds.
67
✦ The most important Eurocurrencies are the Euro-
Canadian dollar, Euro-Euro, Euro-Swiss franc,
Euro-sterling, and Euro-yen.

✦ Smaller offshore banking centers which

participate in the Eurocurrency market include
such locations as the Cayman Islands, Bahamas,
Bahrain, Luxembourg ….

✦ The Singapore market is often called “Asian dollar

market.”

68
✦ The Eurocurrency market therefore consists of
those banks, called Eurobanks, that accept
deposits and make loans in foreign currencies.

✦ The Eurocurrency market enables investors to

hold short-term claims on commercial banks,
which then act as intermediaries to transform these
deposits into claims on final borrowers.

69
 The Evolution of the Market:
The development and expansion of the Eurocurrency
markets have their roots in overt and covert events.

1) In the late 1950s British-owned banks utilized

foreign currency deposits (in the UK) as a lending
medium in order to save business that was at that time
endangered by exchange controls (by the UK) on
transactions in pounds sterling.
In turn this lead to active solicitation of dollar deposits
by banks in Western Europe.

70
2) The Soviet Union: provided impetus for the early
growth of the market. As the cold war heated up,
the Soviet Union began to worry about the U.S.
Government freezing its deposits in New York.
The Soviets needed to maintain dollar accounts for
international trade and investment.
The dollar was then virtually the only currency
acceptable worldwide.

The Soviet Union responded to this problem by

placing its dollar-denominated deposits in banks
outside the U.S. jurisdiction.
British and French banks were the primary
recipients of these deposits. 71
3) Changes in U.S. Balance of Payment Situation:
The 1945-50 period saw persistent surpluses.
These were replaced by deficits in
1957. Deficits resulted in increased
foreign holding of dollars. By mid 1958 European
market in dollar deposits and loans had become established.

4) The Market as a Source of Short-term Funds:

Supports trade financing activities of international banks.
It facilitates foreign exchange transactions by banks
and provides short-tern money market trading opportunities.
International banks use the market as an outlet for placing
surplus funds temporarily at attractive yields.
Eurocurrency interbank market has become the central
mechanism to channel flow of international funds among
banks and this gave birth to the LIBOR as an important
international interest rate
72
5) Regulatory Developments in the U.S.
(i) "Regulation Q": Interest rate ceilings existed in the
U.S. during the 1960s and 1970s.
With higher interest on dollars deposited in the
eurodollar market, funds moved to banks in Europe.
Many U.S. banks opened European offices to receive
these funds.
(ii) Federal Reserve "Regulation M": This regulation
requires the keeping of reserves against deposits.
Since reserves constitute idle funds, the cost of
operating in the Eurocurrency market is relatively
less since there are no reserve requirements in the
eurocurrency market.
Many American banks moved some of their operations to
the relatively unregulated eurocurrency market.
73
(iii) The Controls and Restrictions on Borrowing
Funds in the U.S. for Reinvestment Abroad:
(voluntary in 1965, mandatory in 1968) forced many
borrowers to seek sources of loans in Europe, thereby
increasing the demand for funds deposited in the
eurocurrency markets.

(iv) The U.S. Interest Equalization Tax (1963):

Imposed a tax on U.S. residents' earnings on foreign
securities.
This increased the interest foreign borrowers
were forced to pay on funds borrowed directly from
the U.S. market.
By channeling funds through the eurocurrency
market, this tax is avoided. 74
6) The Role of Narrow Spreads: The desire of depositors
to receive highest possible yields and of borrowers to
pay lowest possible costs are met in the eurocurrency
market. Absence of regulation permits higher yields to
depositors and lower costs to borrowers.

7) Desire of British Banks to maintain their position in

international finance plus the favorable regulatory
environment in the United Kingdom.
8) Confidence in Vehicle Currencies especially the dollar

9) The Role of OPEC: OPEC countries invest part of

their petrodollars in the Eurocurrency Market so that
the market provides a medium for the so called
"Petrodollar Recycling”. 75
10) Other Features of the Market:
◆ Costs of complying with regulations are low since

there are no deposit insurance assessments.

◆ Borrowers' credit worthiness is well known so that

the need for credit investigation is low.

◆ No taxes are withheld from interest payments to

eurocurrency depositors.
◆ Taxes and fees levied on euro banking operations

are generally lower than those applied to domestic

banking.
◆ Low costs per transaction because of relatively

large size of transactions.

76
Eurocurrency markets need not be located in Europe,
though they originate in Europe.

For example, in the U.S., domestic banks are (since 1981)

permitted to open International Banking Facilities (IBF)
which are computerized account records kept separate from
U.S. banks' domestic accounts.
They must be domiciled inside U.S. territory and focus on
international commerce.
They accept foreign currency denominated deposits.
These "onshore/offshore" bank accounts are permitted in
an effort to regain deposits lost to offshore banking
operations.
IBF accounts are free from reserve requirements and assessment
for deposit insurance. They are also exempt from federal taxes,
77
✦ The primary participants in the Eurocurrency market are
large banks called Eurobanks.
Transactions are predominantly interbank, hence the
market is frequently called the "interbank market."
In addition, large scale or "wholesale" transactions take
place between banks and non-bank customers.
✦ Transactions are typically priced off the London
Interbank Offered Rate (LIBOR) which is a floating rate
at which London banks lend to one another.
✦ Interest rates on Euroloans to governments and their
agencies, corporations, and non-prime banks are set at a
fixed margin above LIBOR for the period and currency
chosen.
78
✦ At the end of each period the interest for the next
period is calculated at the same fixed margin over the
new LIBOR.
✦ The drawdown, the period over which the borrower
may take down the loan, and the repayment period
vary with borrower’s needs.
A commitment fee of about 0.5% per annum is
charged on the unused balance.
✦ Eurodollar loans have multi-currency clauses giving
borrowers the right, subject to availability, to switch
from one currency to another on any rollover/reset date.
This feature
provides a potentially valuable exposure management
for borrowers. 79
 Reference Rates of Interest:
✦ A reference rate of interest, for example U.S. dollar
LIBOR, is the rate of interest used in a standardized
quotation, loan agreement, or financial derivative
valuation.
✦ LIBOR, London interbank offered rate, is by far the
most widely used and quoted.
It is an interest rate charged by
banks for S-T loans to one another. It is an important
benchmark for mortgages, corporate financing, etc.
It is officially defined by the British Bankers
Association (BBA).
✦ The BBA also calculates Yen LIBOR, Euro LIBOR,
and other currency LIBOR rates. 80
✦ Most major financial centers also construct
their own interbank offered rates for local loan
agreement purposes.

These include:
✦ FIBOR: Frankfurt interbank offered rate
✦ PIBOR: Paris interbank offered rate
✦ SIBOR: Singapore interbank offered rate
✦ MIBOR: Madrid interbank offered rate
✦ EIBOR: Emirate interbank offered rate (interest rate charged
by banks in the United Arab Emirates for interbank transactions)
81
 Eurodeposit Creation:
✦ Eurocurrency deposits are subject to the same
multiple expansion feature of a domestic banking
system.
✦ Funds are deposited in a Eurobank which lends
them to deficit spending units and, in effect,
creates new deposits.

82
Example:
Stage A:
Assume that IBM purchases computer components from a
UK supplier, COMPUK, for $1m and pays with a check
drawn on its Chase Manhattan Bank in New York.
Assume also that COMPUK deposits the check in
Westminster Bank, London.

A Eurodollar deposit is now created since COMPUK has a

dollar-denominated account outside the U.S.
Typically, money center banks maintain accounts with one
another. So, Westminster Bank deposits the check at
Chase which now shows a change of ownership on the
$1m deposit from IBM to Westminster.
83
Stage B:
Now, suppose Volvo of Sweden obtains a loan of
$900,000 from Westminster and uses the proceeds to
pay for purchases from a another Swedish company,
Stockhm 1.

Stockhm 1 deposits the proceeds in the Bank of Sweden,

thus creating another eurodollar deposit.
When the Bank of Sweden initiates collection, $900,000
of Westminster deposit at Chase change ownership to the
Bank of Sweden.

84
Eurodollar Deposit Expansion: Main Features
Stage A
Chase, NY Westminster, London
Deposits of IBM Deposit at Chase Deposits of COMUK

-$1,000,000 +$1,000,000 +$1,000,000

Deposits of Westminster
+$1,000,000
Stage B
Chase, NY Bank of Sweden
Deposits of Westminster Deposit at Chase Deposits of Stockhm1
-$900,000 +$900,000 +$900,000
Deposits of Bank of Sweden
85
+$900,000
✦ At this point, the level of Eurodollar deposit is $1,900,000
The process of expansion continues geometrically.
The expansion is limited by the level of voluntary
(discretionary) reserve held by each Eurobank.
✦ With a zero discretionary reserve, the expansion continues
without limit unless the dollars are used to purchase
products or services in the U.S. at which point the
expansion process stops.
✦ The Asian dollar market grew to accommodate the needs
of businesses that need U.S. dollars as a medium of
exchange for international trade/investment.
✦ Favorable tax advantages in Singapore and Hong Kong,
(e.g., low withholding taxes, reduced tax on offshore
loans) encourage growth of the Asian market.
86
 The Eurocredit Market:
✦ Loans of 1 to 5 years (medium term) extended by
Eurobanks are called Eurocredit Loans.
These loans are popular with corporations/governments.
✦ Since Eurobanks accept short-term deposits, there exists
the problem of maturity mismatch between deposits and
loans. To avoid the risk Eurobanks commonly offer
floating rate Eurocredit Loans.
✦ Loan rates float in accordance with movement of some
market interest, such as the LIBOR - the rate commonly
charged for loans among Eurobanks.
• Syndicated Eurocredit Loans are provided to large
corporate or government borrowers by a group of banks
participating in the syndicate. 87
 The Eurobond Market
✦ Eurocurrency and Eurocredit loans help to accommodate
short and medium term borrowers respectively.
✦ The Eurobond was created to accommodate long-term
borrowers.
✦ Partially the result of Interest Equalization Tax imposed
in the U.S. in 1963 to discourage U.S. investors from
investing in foreign securities.
Foreign borrowers were thus forced to look elsewhere for
funds and enter the Eurobond market.
✦ The Eurobond market facilitates the transfer of long-
term funds from surplus spending units to deficit
spending units around the world.
✦ Issued by MNCs, large domestic corps., governments,
governmental enterprises, and intern’l institutions.88
✦ The market helps to link investors with borrowers around
the world, and thus help to integrate the world's financial
system.
✦ The Eurobond market, unlike the domestic bond market,
is almost entirely free of official regulation.
It is self-regulated by the Association of International
Bond Dealers .

✦ The bonds are sold outside the countries in whose

currencies they are denominated and underwritten by an
international syndicate of banks.
✦ Offered simultaneously in a number of major capital
markets
89
✦ Eurobonds feature different types of issues ..
including straight fixed-rate, floating rate note, and
equity related/convertible.

Foreign Bonds
 Underwritten by a syndicate and sold within the
country of the denominated currency.
 Borrower/issuer is from another country
 These include Yankee, Samurai, and Bulldogs bonds.

90
 Note Issuance Facilities and Euronotes:
✦ Eurobanks have responded to the competition from
the Eurobond market by creating a new instrument
called the “Note Issuance Facility” (NIF) which is
a low-cost substitute for syndicated credits.

✦ It allows borrowers to issue their own short-term

Euronotes which are then distributed by financial
institutions providing the NIF

NIF, sometimes called “short-term note issuance

facility”, has some features of the U.S. commercial
paper market and some features of the U.S
commercial lines of credit. 91
 Internet Resources:
1. www.imf.org/external/fin.html IMF website.
Contains exchange rate quotes for selected
currencies
2. www.ny.frb.org/pihome/ststistics/forex12.shtml
NY Fed site with noon forex rates.
3. www.bis.org/publ/index.html BIS site contains
annual reports, external debts, foreign exchange
market activities etc.

92