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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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slide1

New York University/ING Barings

The International

Capital Markets

Prof. Ian Giddy

New York University

instruments and markets
Instruments and Markets

Corporate Bonds

Domestic

International

international financial markets
International Financial Markets
  • The Eurocurrency market
  • Foreign exchange
  • Covered interest arbitrage
  • International portfolio investment returns
  • Hedging international portfolios
  • International diversification: passive vs active
slide4

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?
slide5

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?
slide6

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

the global bond market
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)

characteristics of eurobonds
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
international bond markets are linked
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

exchange rate risk
Exchange Rate Risk
  • Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies
policies and exchange rate regimes
Policies and Exchange Rate Regimes
  • Exchange rate systems--fixed vs floating
  • Managed floating
  • EMU-type currency blocs
  • De facto blocs--the dollar
slide12

The Euromarket vs the Euro

“A Euro is a basket of individual European currencies” True or false?

C

domestic policies domestic prices and interest rates and exchange rates
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

foreign exchange mechanics and calculations
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

a typical forward contract
A Typical Forward Contract
  • We agree today to pay a certain price for a currency in the future

JPY

Sony

B of A

foreign exchange quotations
Foreign Exchange Quotations

Spot

Forward points

foreign exchange quotations1
Foreign Exchange Quotations

Bid Offer

Spot

Forward points

Rule:

add if bid<offer,

subtract if bid>offer

Outright forward

foreign exchange quotations2
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

slide22

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

slide23

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

slide24

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

slide25

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?
slide26

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
slide27

What if Guidant didn’t hedge?

EXCHANGE RATE

Spot

Forward

Actual

Today

In three

months

TIME

slide28

Unbiased Forward Rate Theory

Probability

EXCHANGE RATE

distribution

of actual

Spot

exchange rate

Forward

Actual

Today

In three

months

TIME

issues
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?
international equity investments
International Equity Investments
  • Equity returns in local currency
  • Exchange rate changes
  • Other factors?
equity returns domestic vs global
Equity Returns: Domestic vs Global

Yardeni.com

International charts

int l investment choices
Int’l Investment Choices
  • Direct Stock Purchases
  • ADRs
  • Mutual Funds
    • Open end
    • Closed end
  • Global companies
obstacles to international investment might include
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.
foreign exchnage risk in international investing
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
returns with fx
Returns with FX
  • Return in US is a function of two factors

1. Return in the foreign market

2. Return on the foreign exchange

returns with fx1
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

return example dollar appreciates
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%

return example dollar depreciates
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%

exchange rate risk1

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

turkey 1995
Turkey, 1995

Turkish Lira:

Down 33.5%

turkey 19951
Turkey, 1995

Turkish prices:

up 83.8%!

Turkish Lira:

Down 33.5%

hedging international equity investments
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

measuring benchmark returns
Measuring Benchmark Returns
  • Indexes
  • EAFE Index
  • Issues in Measuring Performance
    • Weighting
    • Cross-Holdings
  • Other Possibilities
    • Country and Region Funds
diversification benefits
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
the minimum variance frontier
The Minimum-Variance Frontier

E(r)

Efficient frontier

Individual assets

Global minimum-variance portfolio

international portfolio optimization passive vs active portfolios
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:

evidence suggests index funds are not for the international investor
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
slide52

Can globally mobile investors capture value & control?

Macro

Factors

  • Currency overvaluation
  • Capital restrictions
  • Acctg & disclosure requirements
  • IAS compliance
  • Bankruptcy regime
  • Creditor rights
  • Govt-corporate nexus
  • Trading infrastructure

Structural

Factors

  • Price-Value ratio, Sharpe ratio, EVA
  • D/E ratio
  • Currency & maturity mismatch
  • IAS conformity
  • Insider control
  • Objective research coverage
  • Trading liquidity

Firm-level

Factors

brady bonds
Brady Bonds
  • Origin?
  • Types?
  • Ecuador’s Bradies
    • Discount
    • Par
    • Past due interest
    • Interest equalization
  • What next?
correlations domestic vs global
Correlations: Domestic vs Global

creditmetrics.com

correlation engine

summary
Summary
  • The Eurocurrency market is most closely tied to the foreign exchange market
  • Covered interest arbitrage links spot-forward differential to interest rates
  • Foreign portfolio returns = equity + FX
  • International diversification pays
  • Hedging international portfolios is tricky
slide57

Ian H. Giddy

Ian Giddy

NYU Stern School of Business

Tel 212-998-0332; Fax 212-995-4233

ian.giddy@nyu.edu

http://giddy.org