Download MBA-IB (International Business) (Master of Business Administration) 4th Semester Global Financial Markets and Instruments Notes
UNIT - I
Lesson - 1
Globalization of Financial Markets
Objectives of the Lesson:
After studying this lesson you should able to:
Explain the Liberalized Foreign Investment Policy
Understand the International Financial Markets
Explain the Institutions involved in International Financial Markets
Know the Major Players in Financial Markets
Explain the Existing Types of Financial Market Structures
Structure of the Lesson:
1.0 Introduction
1.1 New Global Economic War
1.2 Liberalized Foreign Investment Policy
1.3 International Financial Markets
1.3.1 Basic Terms - Meaning
1.4 Financial Markets and Institutions
1.4.1 Major Players in Financial Markets
1.4.2 Existing Types of Financial Market Structures
1.5 Distinctions between Securities Markets
1.0 Introduction
Globalization of trade implies universalisation of the process of trade`. In 1990, increased
openness to international trade, under such headings as, outward orientation or trade
liberalization has been advocated as an engine of economic growth and a road to
development. The marginalization of Indian economy together with many other factors
resulted in a severe balance of payment crisis. The foreign exchange reserves fell rapidly to
less than three weeks of our imports needs. In order to overcome this situation, and boost up
exports, the Government initiated steps for the dismantling of restrictive policy instruments
through reforms m trade, tariff, and exchange rate policies.
After examining the list of imports and exports, the following corrections were made: gradual
withdrawal of many of the quantitative restrictions on imports and exports, shifting of a
significant number of items outside the purview of import licensing, considerable reduction
in the level of tariff rates, Exim scrip`s devaluation of rupee, partial and later on full
convertibility of rupee etc.
1.1 New Global Economic War
After the Second War and the IMF par value system came into existence, we became part of
the new world system. Countries had exchange control and various sorts of trade restrictions.
It was after the Seventies that gradually a scheme of flexible exchange rates came into
existence among leading developed countries. Gradually the developed countries started
freeing their exchange rates and also moved towards their system off free trade.
The World Trade Organization, of which we are a member, is now introducing all
over the world a free trade system. After the advent of Economic Reforms from 1991-1992,
we have moved over to currency, convertibility on current account. The importance of the
World Bank as financier has diminished considerably. The world is now dependant on private
capital imports. Even the role of the IMF has diminished with most countries adopting
currency convertibility. Capital flows are moving on a large scale dependent on incentives.
Most countries have lifted trade barriers and reduced import duties.
The WTO is introducing system in which domestic subsidies have to be removed and
uniform and low import duties have now to become the standard. There is no place for tariff
barriers and non-tariff barriers are also now getting lifted. The world`s industries are now
organized largely in terms of multinational corporations whose operations transcend many
countries. International demonstration effects are working powerfully in determining the
living styles in all countries.
1.2 Liberalized Foreign Investment Policy
In June 1991, Indian government initiated Programme of macro economic stabilization
and structural adjustment supported by IMF and the World Bank. As part of this Programme a
new industrial policy was announced on July 24, 1991 in the Parliament, which has started the
process of full-scale liberalization and intensified the process of integration of India with the global
economy.
A Foreign Investment Promotion Board (FIPB), authorized to provide a single
window clearance as been set up. India became a signatory to the convention of MIGA for
protection of foreign investments. Companies with more than 40 per cent of foreign equity
are now treated on par with fully Indian owned companies. New sectors such as mining,
banking, telecommunications, high-way construction, and management have been thrown
Open to private, including foreign owned companies.
1.3 International Financial Markets
1.3.1 Basic Terms - Meaning
An asset is anything of durable value, that is, anything that acts as a means to store value over
time. Real assets are assets in physical form (e.g., land, equipment, houses, etc.), including
"human capital" assets embodied in people (natural abilities, learned skills, knowledge).
Financial assets are claims against real assets, either directly (e.g., stock share equity claims)
or indirectly (e.g., money holdings, or claims to future income streams that originate
ultimately from real assets). Securities are financial assets exchanged in auction and over-
the-counter markets (see below) whose distribution is subject to legal requirements and
restrictions (e.g., information disclosure requirements).
Lenders are people who have available funds in excess of their desired expenditures that they
are attempting to loan out, and borrowers are people who have a shortage of funds relative to
their desired expenditures who are seeking to obtain loans. Borrowers attempt to obtain funds
from lenders by selling to lenders newly issued claims against the borrowers' real assets, i.e.,
by selling the lenders newly issued financial assets.
A financial market is a market in which financial assets are traded. In addition to enabling
exchange of previously issued financial assets, financial markets facilitate borrowing and
lending, by facilitating the sale by newly issued financial assets. A financial institution is an
institution whose primary source of profits is through financial asset transactions. Examples
of such financial institutions include discount brokers, banks, insurance companies, and
complex multi-function financial institutions.
1.4 Financial Markets and Institutions
Financial markets serve six basic functions. These functions are briefly listed below:
Borrowing and Lending: Financial markets permit the transfer of funds from one agent
to another for either investment or consumption purposes.
Price Determination: Financial markets provide vehicles by which prices are set both for
newly issued financial assets and for the existing stock of financial assets.
Information Aggregation and Coordination: Financial markets act as collectors and
aggregators of information about financial asset values and the flow of funds from
lenders to borrowers.
Risk Sharing: Financial markets allow a transfer of risk from those who undertake
investments to those who provide funds for those investments.
Liquidity: Financial markets provide the holders of financial assets with a chance to resell
or liquidate these assets.
Efficiency: Financial markets reduce transaction costs and information costs.
1.4.1 Major Players in Financial Markets
By definition, financial institutions are institutions that participate in financial markets, i.e., in
the creation and/or exchange of financial assets. The following are the major players of
financial markets:
Brokers
A broker is a commissioned agent of a buyer (or seller) who facilitates trade by locating a
seller (or buyer) to complete the desired transaction. A broker does not take a position in the
assets they trade. The profits of brokers are determined by the commissions they charge to the
users of their services (the buyers, the sellers, or both).
Diagrammatic Illustration of a Stock Broker
Dealers
Like brokers, dealers facilitate trade by matching buyers with sellers of assets; they do not
engage in asset transformation. Unlike brokers, however, a dealer can and does "take
positions" (i.e., maintain inventories) in the assets he or she trades that permit the dealer to
sell out of inventory rather than always having to locate sellers to match every offer to buy.
Also, unlike brokers, dealers do not receive sales commissions. Rather, dealers make profits
by buying assets at relatively low prices and reselling them at relatively high prices (buy low
- sell high). The price at which a dealer offers to sell an asset (the "asked price") minus the
price at which a dealer offers to buy an asset (the "bid price") is called the bid-ask spread and
represents the dealer's profit margin on the asset exchange.
Diagrammatic Illustration of a Bond Dealer
Investment Banks
An investment bank assists in the initial sale of newly issued securities (i.e., in IPOs = Initial
Public Offerings) by engaging in a number of different activities:
Advice: Advising corporate on whether they should issue bonds or stock, and, for
bond issues, on the particular types of payment schedules these securities should
offer;
Underwriting: Guaranteeing corporate a price on the securities they offer, either
individually or by having several different investment banks form a syndicate to
underwrite the issue jointly;
Sales Assistance: Assisting in the sale of these securities to the public.
Financial Intermediaries
Unlike brokers, dealers, and investment banks, financial intermediaries are financial
institutions that engage in financial asset transformation. That is, financial intermediaries
purchase one kind of financial asset from borrowers - generally some kind of long-term loan
contract whose terms are adapted to the specific circumstances of the borrower (e.g. a
mortgage) - and sell a different kind of financial asset to savers, generally some kind of
relatively liquid claim against the financial intermediary (e.g. a deposit account). In addition,
unlike brokers and dealers, financial intermediaries typically hold financial assets as part of
an investment portfolio rather than as an inventory for resale. In addition to making profits on
their investment portfolios, financial intermediaries make profits by charging relatively high
interest rates to borrowers and paying relatively low interest rates to savers.
Types of financial intermediaries include:
Depository Institutions (commercial banks, savings and loan associations, mutual savings
banks, credit unions); Contractual Savings Institutions (life insurance companies, fire and
casualty insurance companies, pension funds, government retirement funds); and Investment
Intermediaries (finance companies, stock and bond mutual funds, money market mutual
funds).
Diagrammatic Example of a Financial Intermediary: A Commercial Bank
1.4.2 Existing Types of Financial Market Structures
The costs of collecting and aggregating information determine, to a large extent, the types of
financial market structures that emerge. These structures take four basic forms:
Auction markets conducted through brokers;
Over-the-counter (OTC) markets conducted through dealers;
Organized Exchanges, such as the New York Stock Exchange, which combine
auction and OTC market features. Specifically, organized exchanges permit buyers
and sellers to trade with each other in a centralized location, like an auction. However,
securities are traded on the floor of the exchange with the help of specialist traders
who combine broker and dealer functions.
Intermediation financial markets conducted through financial intermediaries;
Financial markets taking the first three forms are generally referred to as securities
markets. Some financial markets combine features from more
than
one
of
these
categories, so the categories constitute only rough guidelines.
Auction Markets
An auction market is some form of centralized facility (or clearing house) by which buyers
and sellers, through their commissioned agents (brokers), execute trades in an open and
competitive bidding process. The "centralized facility" is not necessarily a place where
buyers and sellers physically meet. Rather, it is any institution that provides buyers and
sellers with a centralized access to the bidding process. All of the needed information about
offers to buy (bid prices) and offers to sell (asked prices) is centralized in one location which
is readily accessible to all would-be buyers and sellers, e.g., through a computer network. No
private exchanges between individual buyers and sellers are made outside of the centralized
facility. An auction market is typically a public market in the sense that it open to all agents
who wish to participate. Auction markets can either be call markets - such as art auctions -
for which bid and asked prices are all posted at one time, or continuous markets - such as
stock exchanges and real estate markets.
Over-the-Counter Markets
An over-the-counter market has no centralized mechanism or facility for trading. Instead, the
market is a public market consisting of a number of dealers spread across a region, a country,
or indeed the world, who make the market in some type of asset. That is, the dealers
themselves post bid and asked prices for this asset and then stand ready to buy or sell units of
this asset with anyone who chooses to trade at these posted prices. The dealers provide
customers more flexibility in trading than brokers, because dealers can offset imbalances in
the demand and supply of assets by trading out of their own accounts.
Intermediation Financial Markets
An intermediation financial market is a financial market in which financial intermediaries
help transfer funds from savers to borrowers by issuing certain types of financial assets to
savers and receiving other types of financial assets from borrowers. The financial assets
issued to savers are claims against the financial intermediaries, hence liabilities of the
financial intermediaries, whereas the financial assets received from borrowers are claims
against the borrowers, hence assets of the financial intermediaries
1.5 Distinctions between Securities Markets
Primary versus Secondary Markets:
Primary markets are securities markets in which newly issued securities are offered for sale to
buyers. Secondary markets are securities markets in which existing securities that have
previously been issued are resold. The initial issuer raises funds only through the primary
market.
Debt Versus Equity Markets:
Debt instruments are particular types of securities that require the issuer (the borrower) to pay
the holder (the lender) certain fixed dollar amounts at regularly scheduled intervals until a
specified time (the maturity date) is reached, regardless of the success or failure of any
investment projects for which the borrowed funds are used. A debt instrument holder only
participates in the management of the debt instrument issuer if the issuer goes bankrupt. An
example of a debt instrument is a 30-year mortgage. In contrast, equity is a security that
confers on the holder an ownership interest in the issuer. There are two general categories of
equities: "preferred stock" and "common stock." Common stock shares issued by a
corporation are claims to a share of the assets of a corporation as well as to a share of the
corporation's net income - i.e., the corporation's income after subtraction of taxes and other
expenses, including the payment of any debt obligations. This implies that the return that
holders of common stock receive depends on the economic performance of the issuing
corporation.
In contrast, preferred stock shares are usually issued with a par value and pay a fixed
dividend expressed as a percentage of par value. Preferred stock is a claim against a
corporation's cash flow that is prior to the claims of its common stock holders but is generally
subordinate to the claims of its debt holders. In addition, like debt holders but unlike common
stock holders, preferred stock holders generally do not participate in the management of
issuers through voting or other means unless the issuer is in extreme financial distress (e.g.,
insolvency). Consequently, preferred stock combines some of the basic attributes of both debt
and common stock and is often referred to as a hybrid security.
Money versus Capital Markets:
The money market is the market for shorter-term securities, generally those with one year or
less remaining to maturity.
The capital market is the market for longer-term securities, generally those with more than
one year to maturity.
Domestic Versus Global Financial Markets:
Euro-currencies are currencies deposited in banks outside the country of issue. For example,
euro-dollars, a major form of euro-currency, are U.S. dollars deposited in foreign banks
outside the U.S. or in foreign branches of U.S. banks. That is, euro-dollars are dollar-
denominated bank deposits held in banks outside the U.S. An international bond is a bond
available for sale outside the country of its issuer. A foreign bond is an international bond
issued by a country that is denominated in a foreign currency and that is for sale exclusively
in the country of that foreign currency. A Eurobond is an international bond denominated in a
currency other than that of the country in which it is sold.
Review Questions:
1. Discuss in detail the basic functions of financial markets
1. Outline in detail the major players in financial markets
1. Explain in detail the different types of existing financial market structures
1. Distinguish between Securities Markets
References:
1. Buckley, Adrian: Multinational Finance, Prentice Hall of India, New Delhi
2. Murice, Levi: International Finance, McGraw Hill, Int. Ed., New York.
3. Shaprio, A.C: Multinational Financial Management, Prentice Hall of India, New Delhi
Lesson - 2
The Bretton Woods System
Objectives of the Lesson:
After studying this lesson you should able to:
Know the Origins of the Bretton Woods System
Understand the International Financial Markets
Understand The Design of the Bretton Woods System
Explain Exchange Rate Stability
Explain the role of IMF and IBRD
Explain the Late Bretton Woods System
Structure of the Lesson:
2.0 Introduction
2.1 The Origins of the Bretton Woods System
2.1.1 The Experiences of the Great Depression
2.1.2 Economic Security
2.1.3 Governmental Intervention
2.1.4 U.S. Hegemony
2.1.5 The Atlantic Charter
2.1.6 U.S. hegemony and Europe
2.2 The Design of the Bretton Woods System
2.3 Exchange Rate Stability
2.3.1 The "Pegged Rate" or "Par Value" Currency Regime
2.3.2 The "reserve currency"
2.3.3 Formal Regimes
2.4 The International Monetary Fund
2.4.1 Designing the IMF
2.4.2 Subscriptions and Quotas
2.4.3 Financing Trade Deficits
2.4.4 Changing the Par Value
2.4.5 IMF Operations
2.5 The International Bank for Reconstruction and Development
2.6 Readjusting the Bretton Woods System
2.6.1 The Dollar Shortage and the Marshall Plan
2.6.2 Bretton Woods and the Cold War
2.7 The Late Bretton Woods System
2.0 Introduction
The Bretton Woods System of international economic management established the rules for
commercial and financial relations among the major industrial states. The Bretton Woods
System was the first example of a fully negotiated monetary order in world history intended
to govern monetary relations among independent nation-states. Preparing to rebuild global
capitalism as World War II was still raging, 730 delegates from all 44 Allied nations gathered
at the Mount Washington Hotel, situated in the New Hampshire resort town of Bretton
Woods, for the United Nations Monetary and Financial Conference. The delegates
deliberated upon and finally signed the Bretton Woods Agreement during the first three
weeks of July 1944.
Setting up a system of rules, institutions, and procedures to regulate the international political
economy, the planners at Bretton Woods established the International Bank for
Reconstruction and Development (later divided into the World Bank and Bank for
International Settlements) and the International Monetary Fund. These organizations became
operational in 1946 after a sufficient number of countries had ratified the agreement.
The chief features of the Bretton Woods System were, first, an obligation for each country to
maintain the exchange rate of its currency within a fixed value (plus or minus one percent) in
terms of gold; and, secondly, the provision by the IMF of finance to bridge temporary
payments imbalances. In face of increasing strain, the system eventually collapsed in 1971,
following the United States' suspension of convertibility from dollars to gold. Until the early-
1970s, the Bretton Woods System was effective in controlling conflict and in achieving the
common goals of the leading states that had created it, especially the United States.
2.1 The Origins of the Bretton Woods System
The political bases for the Bretton Woods System are to be found in the confluence of several
key conditions: the shared experiences of the Great Depression, the concentration of power in
a small number of states, and the presence of a dominant power willing and able to assume a
leadership role.
2.1.1 The Experiences of the Great Depression
A high level of agreement among the powerful on the goals and means of international
economic management facilitated the decisions reached by the Bretton Woods Conference.
The foundation of that agreement was a shared belief in capitalism. Although the developed
countries differed somewhat in the type of capitalism they preferred for their national
economies (France, for example, preferred greater planning and state intervention, whereas
the United States favoured relatively limited state intervention); all nevertheless relied
primarily on market mechanisms and on private ownership. Yet, it is their similarities rather
than their differences that appear most striking. All the participating governments at Bretton
Woods agreed that the monetary chaos of the interwar period had yielded several valuable
lessons.
The experience of the Great Depression, when proliferation of exchange controls and trade
barriers led to economic disaster, was fresh on the minds of public officials. The planners at
Bretton Woods hoped to avoid a repeat of the debacle of the 1930s, when exchange controls
undermined the international payments system that was the basis for world trade. The "beggar
thy neighbour" policies of 1930s governments (using currency devaluations to increase the
competitiveness of a country's export products in order to reduce balance of payments
deficits) worsened national deflationary spirals, which resulted in plummeting national
incomes, shrinking demand, mass unemployment, and a overall decline in world trade. Trade
in the 1930s became largely restricted to currency blocs (groups of nations that use an
equivalent currency, such as the "Pound Sterling Bloc" of the British Empire). These blocs
retarded the international flow of capital and foreign investment opportunities. Although this
strategy tended to increase government revenues in the short-run, it dramatically worsened
the situation in the medium and longer-run. Thus, for the international economy, planners at
Bretton Woods all favored a liberal system, one that relied primarily on the market with the
minimum of barriers to the flow of private trade and capital. Although they disagreed on the
specific implementation of this liberal system, all agreed on an open system.
2.1.2 Economic Security
Also based on experience of interwar years, U.S. planners developed a concept of economic
security that a liberal international economic system would enhance the possibilities of
postwar peace. One of those who saw such a security link was Cordell Hull, the U.S.
secretary of state from 1933 to 1944. Hull believed that the fundamental causes of the two
world wars lay in economic discrimination and trade warfare. Specifically, he had in mind,
the trade, and exchange controls (bilateral arrangements) of Nazi Germany and the imperial
preference system practiced by Britain (by which members or former members of the British
Empire were accorded special trade status).
2.1.3 Governmental Intervention
The developed countries also agreed that the liberal international economic system required
governmental intervention. In the aftermath of the Great Depression, public management of
the economy had emerged as a primary activity of governments in the developed states.
Employment, stability, and growth were now important subjects of public policy. In turn, the
role of government in the national economy had become associated with the assumption by
the state of the responsibility for assuring of its citizens a degree of economic well-being. The
welfare state grew out of the Great Depression, which created a popular demand for
governmental intervention in the economy, and out of the theoretical contributions of the
Keynesian school of economics, which asserted the need for governmental intervention to
maintain adequate levels of employment.
At the international level, these ideas also evolved from the experience of the 1930s. The
priority of national goals, independent national action in the interwar period, and the failure
to perceive that those national goals could not be realized without some form of international
collaboration resulted in "beggar-thy-neighbor" policies such as high tariffs and competitive
devaluations contributed to economic breakdown, domestic political instability, and
international war. The lesson learned was that, as New Dealer Harry Dexter White, the
principal architect of the Bretton Woods System put it:
"the absence of a high degree of economic collaboration among the leading nations will...
inevitably result in economic warfare that will be but the prelude and instigator of military
warfare on an even vaster scale."
2.1.4 U.S. Hegemony
International economic management relied on the dominant power to lead the system. The
concentration of power facilitated management by confining the number of actors whose
agreement was necessary to establish rules, institutions, and procedures and to carry out
management within the agreed system. That leader was, of course, the United States. As the
world's foremost economic and political power, the United States was clearly in a position to
assume the responsibility of leadership.
The United States had emerged from the Second World War as the strongest economy in the
world, experiencing rapid industrial growth and capital accumulation. The U.S. had remained
untouched by the ravages of World War II and had built a thriving manufacturing industry
and grown wealthy selling weapons and lending money to the other combatants; in fact, U.S.
industrial production in 1945 was more than double that of annual production between the
prewar years of 1935 and 1939. In contrast, Europe and Japan were militarily and
economically shattered.
As the Bretton Woods Conference convened, the relative advantages of the U.S. economy
were undeniable and overwhelming. The U.S. held a majority of world investment capital,
manufacturing production and exports. In 1945, the U.S. produced half the world's coal, two-
thirds of the oil, and more than half of the electricity. The U.S. was able to produce great
quantities of ships, airplanes, land vehicles, armaments, machine tools, chemical products,
and so on. Reinforcing the initial advantage (and assuring the U.S. unmistakable leadership in
the capitalist world) the U.S. held 80 percent of the world's gold reserves and had not only a
powerful army but also the atomic bomb.
As the world's greatest industrial power, and one of the few nations not ravaged by the war,
the U.S. stood to gain more than any other country from the opening of the entire world to
unfettered trade. The United States would have a global market for its exports, and it would
have unrestricted access to vital raw materials.
The United States was not only able, it was also willing, to assume this leadership role.
Although the U.S. had more gold, more manufacturing capacity and more military power
than the rest of the world put together, U.S. capitalism could not survive without markets and
allies. William Clayton, the assistant secretary of state for economic affairs, was among
myriad U.S. policymakers who summed up this point: "We need markets, big markets around
the world in which to buy and sell."
There had been many predictions that peace would bring a return of depression and
unemployment, as war production ceased and returning soldiers flooded the labor market.
Compounding the economic difficulties was a sharp rise in labor unrest. Determined to avoid
another economic catastrophe like that of the 1930s, U.S. President Franklin D. Roosevelt
saw the creation of the postwar order as a way to ensure continuing U.S. prosperity.
2.1.5 The Atlantic Charter
Throughout the war, the United States envisaged a postwar economic order in which the U.S.
could penetrate markets that had been previously closed to other currency trading blocs, as
well as to open up opportunities for foreign investments for U.S. corporations by removing
restrictions on the international flow of capital. The Atlantic Charter, drafted during President
Roosevelt's August 1941 meeting with British Prime Minister Winston Churchill on a ship in
the North Atlantic was the most notable precursor to the Bretton Woods Conference. Like
Woodrow Wilson before him, whose "Fourteen Points" had outlined U.S. aims in the
aftermath of World War I; Roosevelt set forth a range of ambitious goals for the postwar
world even before the U.S. had entered the Second World War. The Atlantic Charter affirmed
the right of all nations to equal access to trade and raw materials. Moreover, the charter called
for freedom of the seas (a principal U.S. foreign policy aim since France and Britain had first
threatened U.S. shipping in the 1790s), the disarmament of aggressors, and the
"establishment of a wider and permanent system of general security."
As the war drew to a close, the Bretton Woods Conference was the culmination of some two
and a half years of planning for postwar reconstruction by the Treasuries of the U.S. and the
UK. U.S. representatives studied with their British counterparts the reconstitution of what had
been lacking between the two world wars: a system of international payments that would
allow trade to be conducted without fear of sudden currency depreciation or wild fluctuations
in exchange rates ailments that had nearly paralyzed world capitalism during the Great
Depression.
Without a strong European market for U.S. goods and services, most policymakers believed,
the U.S. economy would be unable to sustain the prosperity it had achieved during the war. In
addition, U.S. unions had only grudgingly accepted government-imposed restraints on their
demand during the war, but they were willing to wait no longer, particularly as inflation cut
into the existing wage scales with painful force. By the end of 1945, there had been major
strikes in the automobile, electrical, and steel industries. Financier and self-appointed adviser
to presidents and congressmen, Bernard Baruch, summed up the spirit of Bretton Wood in
early 1945: if we can "stop subsidization of labor and sweated competition in the export
markets," as well as prevent rebuilding of war machines, "oh boy, oh boy, what long term
prosperity we will have." Thus, the United States would use its predominant position to
restore an open world economy, unified under U.S. control, which gave the U.S. unhindered
access to markets and raw materials.
2.1.6 U.S. Hegemony and Europe
Furthermore, U.S. allies (economically exhausted by the war) accepted this leadership. They
needed U.S. assistance to rebuild their domestic production and to finance their international
trade; indeed, they needed it to survive. Before the war, the French and the British were
realizing that they could no longer compete with U.S. industry in an open marketplace.
During the 1930s, the British had created their own economic bloc to shut out U.S. goods.
Churchill did not believe that he could surrender that protection after the war, so he watered
down the Atlantic Charter's "free access" clause before agreeing to it. Combined, British and
U.S. trade accounted for well over half the world's exchange of goods. If the British bloc
could be split apart, the U.S. would be well on its way to opening the entire global
marketplace. But as the nineteenth century had been economically dominated by Britain, the
second half of the twentieth was to be one of U.S. hegemony.
A devastated Britain had little choice. Two world wars had destroyed the country's principal
industries that paid for the importation of half the nation's food and nearly all its raw
materials except coal. The British had no choice but to ask for aid. In 1945, the U.S. agreed to
a loan of 3.8 billion. In return, weary British officials promised to negotiate the agreement.
For nearly two centuries, French and U.S. interests had clashed in both the Old World and the
New World. During the war, French mistrust of the United States was embodied by General
Charles de Gaulle, president of the French provisional government. De Gaulle bitterly fought
U.S. officials as he tried to maintain his country's colonies and diplomatic freedom of action.
In turn, U.S. officials saw de Gaulle as a political extremist. But in 1945, de Gaulle the
leading voice of French nationalism was forced to grudgingly ask the U.S. for a billion dollar
loan. Most of the request was granted; in return France promised to curtail government
subsidies and currency manipulation that had given its exporters advantages in the world
market.
On a far more profound level, as the Bretton Woods conference was convening, the greater
part of the Third World remained politically and economically subordinate. Linked to the
developed countries of the West economically and politically formally and informally these
states had little choice but to acquiesce to the international economic system established for
them. In the East, Soviet hegemony in Eastern Europe provided the foundation for a separate
and stable international economic system.
In short, the confluence of these three favorable political conditions the concentration of
power, the cluster of shared interests and ideas, and the hegemony of the United States
provided the political capability to equal the tasks of managing the international economy.
2.2 The Design of the Bretton Woods System
Free trade relied on the free convertibility of currencies. Negotiators at the Bretton Woods
Conference, fresh from what they perceived as a disastrous experience with floating rates in
the 1930s, concluded that major monetary fluctuations could stall the free flow of trade.
The liberal economic system required an accepted vehicle for investment, trade, and
payments. Unlike national economies, however, the international economy lacks a central
government that can issue currency and manage its use. In the past this problem had been
solved through the use of gold and through the use of national currencies.
In the nineteenth and twentieth centuries gold played a key role in international monetary
transactions. The gold standard was used to back currencies; the international value of
currency was determined by its fixed relationship to gold; gold was used to settle
international accounts. The gold standard maintained fixed exchange rates that were seen as
desirable because they reduced the risk of trading with other countries.
Imbalances in international trade were theoretically rectified automatically by the gold
standard. A country with a deficit would have depleted gold reserves and would thus have to
reduce its money supply. The resulting fall in demand would reduce imports and the lowering
of prices would boost exports; thus the deficit would be rectified. Any country experiencing
inflation would lose gold and therefore would have a decrease in the amount of money
available to spend. This decrease in the amount of money would act to reduce the inflationary
pressure. Supplementing the use of gold in this period was the British pound. Based on the
dominant British economy, the pound became a reserve, transaction, and intervention
currency. But the pound was not up to the challenge of serving as the primary world
currency, given the weakness of the British economy after World War II.
The architects of Bretton Woods had conceived of a system wherein exchange rate stability
was a prime goal. Yet, in an era of more activist economic policy, governments did not
seriously consider permanently fixed rates on the model of the classical gold standard of the
nineteenth century. Gold production was not even sufficient to meet the demands of growing
international trade and investment. And a sizable share of the world's known gold reserves
were located in the Soviet Union, which would later emerge as a Cold War rival of the United
States and Western Europe.
The only currency strong enough to meet the rising demands for international liquidity was
the US dollar. The strength of the U.S. economy, the fixed relationship of the dollar to gold
($35 an ounce), and the commitment of the U.S. government to convert dollars into gold at
that price made the dollar as good as gold. In fact, the dollar was even better than gold: it
earned interest and it was more flexible than gold.
2.3 Exchange Rate Stability
The Bretton Woods system sought to secure the advantages of the gold standard without its
disadvantages. Thus, a compromise was sought between the polar alternatives of either
freely- floating or irrevocably fixed rates, an arrangement that might gain the advantages of
both without suffering the disadvantages of either while retaining the right to revise currency
values on occasion as circumstances warranted.
The rules of Bretton Woods, set forth in the articles of agreement, provided for a system of
fixed exchange rates. The rules further sought to encourage an open system by committing
members to the convertibility of their respective currencies into other currencies and to free
trade.
2.3.1 The "Pegged Rate" or "Par Value" Currency Regime
What emerged was the "pegged rate" currency regime. Members were obligated to establish a
parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates
within one percent, plus or minus, of parity (a "band") by intervening in their foreign
exchange markets (that is, buying or selling foreign money).
2.3.2 The "Reserve Currency"
In practice, however, since the principal "reserve currency" would be the U.S. dollar, this
meant that other countries would peg their currencies to the U.S. dollar, and - once
convertibility was restored - would buy and sell U.S. dollars to keep market exchange rates
within one percent, plus or minus, of parity. Thus, the U.S. dollar took over the role that gold
had played under the gold standard in the international financial system.
Meanwhile, in order to bolster faith in the dollar, the U.S. agreed separately to link the dollar
to gold at the rate of $35 per ounce of gold. At this rate, foreign governments and central
banks were able to exchange dollars for gold. Bretton Woods established a system of
payments based on the dollar, in which all currencies were defined in relation to the dollar,
itself convertible into gold, and above all, "as good as gold." The U.S. currency was now
effectively the world currency, the standard to which every other currency was pegged. As
the world's key currency, most international transactions were denominated in dollars.
The U.S. dollar was the currency with the most purchasing power and it was the only
currency that was backed by gold. Additionally, all European nations that had been involved
in World War II were highly in debt and transferred large amounts of gold into the United
States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was
strongly appreciated in the rest of the world and therefore became the key currency of the
Bretton Woods system.
Member countries could only change their par value with IMF approval, which was
contingent on IMF determination that its balance of payments was in a "fundamental
disequilibrium."
2.3.3 Formal Regimes
The Bretton Woods Conference led to the establishment of the International Monetary Fund
(IMF) and the International Bank for Reconstruction and Development (now known as the
World Bank), which still remain powerful forces in the world economy. As mentioned, a
major point of common ground at the Conference was the goal to avoid a recurrence of the
closed markets and economic warfare that had characterized the 1930s. Thus, negotiators at
Bretton Woods also agreed that there was a need for an institutional forum for international
cooperation on monetary matters. Already in 1944 the British economist John Maynard
Keynes emphasized "the importance of rule-based regimes to stabilize business
expectations, something he accepted in the Bretton Woods system of fixed exchanged rates.
Currency troubles in the interwar years, it was felt, had been greatly exacerbated by the
absence of any established procedure or machinery for inter-governmental consultation. As a
result of the establishment of agreed upon structures and rules of international economic
interaction, conflict over economic issues was minimized, and the significance of the
economic aspect of international relations seemed to recede.
2.4 The International Monetary Fund
Officially established on December 27, 1945, when the 29 participating countries at the
conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the keeper
of the rules and the main instrument of public international management. The Fund
commenced its financial operations on March 1, 1947. IMF approval was necessary for any
change in exchange rates. It advised countries on policies affecting the monetary system.
2.4.1 Designing the IMF
The big question at the Bretton Woods Conference with respect to the institution that would
emerge as the IMF was the issue of future access to international liquidity and whether that
source should be akin to a world central bank able to create new reserves at will or a more
limited borrowing mechanism. As the chief international economist at the U.S. Treasury in
1942-44, Harry Dexter White drafted the U.S. blueprint for international access to liquidity,
which competed with the plan drafted for the British Treasury by the eminent British
economist John Maynard Keynes. Overall, White's scheme tended to favor incentives
designed to create price stability within the world's economies, while Keynes' wanted a
system that encouraged economic growth. Although compromise was reached on some
points, because of the overwhelming economic and military power of the U.S., the
participants at Bretton Woods largely agreed on White's plan. As a result, the IMF was born
with an economic approach and political ideology that stressed controlling inflation and
introducing austerity plans over fighting poverty. This left the IMF severely detached from
the realities of Third World countries struggling with underdevelopment from the onset.
2.4.2 Subscriptions and Quotas
What emerged largely reflected U.S. preferences: a system of subscriptions and quotas
embedded in the IMF, which itself was to be no more than a fixed pool of national currencies
and gold subscribed by each country as opposed to a world central bank capable of creating
money. The Fund was charged with managing various nations' trade deficits so that they
would not produce currency devaluations that would trigger a decline in imports.
The IMF was provided with a fund, composed of contributions of member countries in gold
and their own currencies. The original quotas planned were to total $8.8 billion. When
joining the IMF, members were assigned "quotas" reflecting their relative economic power,
and, as a sort of credit deposit, were obliged to pay a "subscription" of an amount
commensurate to the quota. The subscription was to be paid 25 percent in gold or currency
convertible into gold (effectively the dollar, which was the only currency then still directly
gold convertible for central banks) and 75 percent in the member's own money.
Quota subscriptions were to form the largest source of money at the IMF's disposal. The IMF
set out to use this money to grant loans to member countries with financial difficulties. Each
member was then entitled to be able to immediately withdraw 25 percent of its quota in case
of payment problems. If this sum was insufficient, each nation that had the system was also
able to request loans for foreign currency.
2.4.3 Financing Trade Deficits
In the event of a deficit in the current account, Fund members, when short of reserves, would
be able to borrow needed foreign currency from this fund in amounts determined by the size
of its quota. In other words, the higher the country's contribution was, the higher the sum of
money it could borrow from the IMF.
Members were obliged to pay back debts within a period of eighteen months to five years. In
turn, the IMF embarked on setting up rules and procedures to keep a country from going too
deeply into debt, year after year. The Fund would exercise "surveillance" over other
economies for the U.S. Treasury, in return for its loans to prop up national currencies.
IMF loans were not comparable to loans issued by a conventional credit institution. Instead, it
was effectively a chance to purchase a foreign currency with gold or the member's national
currency.
2.4.4 Changing the Par Value
The IMF sought to provide for occasional discontinuous exchange-rate adjustments
(changing a member's par value) by international agreement with the IMF. Member nations
were permitted first to depreciate (or appreciate in opposite situations) their currencies by 10
percent. This tends to restore equilibrium in its trade by expanding its exports and contracting
imports. This would be allowed only if there was what was called a "fundamental
disequilibrium." A decrease in the value of the country's money was called "devaluation"
while an increase in the value of the country's money was called a "revaluation." It was
envisioned that these changes in exchange rates would be quite rare. Regrettably the notion of
fundamental disequilibrium, though key to the operation of the par value system, was never
spelled out in any detail; an omission that would eventually come back to haunt the regime in
later years.
2.4.5 IMF Operations
IMF was based in Washington, D.C., and staffed mainly by its economists. It regularly
exchanged personnel with the U.S. Treasury. When the IMF began operations in 1946,
President Harry S. Truman named White as its first U.S. Executive Director. Since no Deputy
Managing Director post had yet been created, White served occasionally as Acting Managing
Director and generally played a highly influential role during the IMF's first year.
2.5 The International Bank for Reconstruction and Development
No provision was made for international creation of reserves. New gold production was
assumed sufficient. In the event of structural disequilibria, it was expected that there would
be national solutions; a change in the value of the currency or an improvement by other
means of a country's competitive position. Few means were given to the IMF, however, to
encourage such national solutions. It had been recognized in 1944 that the new system could
come into being only after a return to normalcy following the disruption of World War II. It
was expected that after a brief transition period - expected to last no more than five years -
the international economy would recover and the system would enter into operation.
To promote the growth of world trade and to finance the postwar reconstruction of Europe,
the planners at Bretton Woods created another institution, the International Bank for
Reconstruction and Development (IBRD), now known as the World Bank. The IBRD had an
authorized capitalization of $10 billion and was expected to make loans of its own funds to
underwrite private loans and to issue securities to raise new funds to make possible a speedy
postwar recovery. The IBRD (World Bank) was to be a specialized agency of the United
Nations charged with making loans for economic development purposes.
2.6 Readjusting the Bretton Woods System
2.6.1 The Dollar Shortage and the Marshall Plan
The Bretton Wood arrangements were largely adhered to and ratified by the participating
governments. It was expected that national monetary reserves, supplemented with necessary
IMF credits, would finance any temporary balance of payments disequilibria. But this did not
however prove sufficient to get Europe out of the doldrums.
Marshall Plan (the European Recovery Program) was set up to provide U.S. finance to
rebuild Europe largely through grants rather than loans. The Marshall Plan was the program
of massive economic aid given by the United States to favoured countries in Western Europe
for the rebuilding of capitalism.
To encourage long-term adjustment, the United States promoted European and Japanese trade
competitiveness. Policies for economic controls on the defeated former Axis countries were
scrapped. Aid to Europe and Japan was designed to rebuild productive and export capacity. In
the long run it was expected that such European and Japanese recovery would benefit the
United States by widening markets for U.S. exports, and providing locations for U.S. capital
expansion. In 1958, the World Bank created the International Finance Corporation (IFC) and
the International Development Agency (IDA).
2.6.2 Bretton Woods and the Cold War
In 1945, Roosevelt and Churchill prepared the postwar era by negotiating with Joseph Stalin
at Yalta about respective zones of influence; this same year U.S. and Soviet troops joined
together in Germany and confronted one another in Korea. American power had to be used to
rebuild U.S.-friendly regimes and free market capitalism, especially in Europe. The fiscal
discipline imposed by Bretton Woods made the U.S. the only nation that could afford large-
scale foreign deployments within the Western alliance. Over the course of the late 1940s and
early 1950s, the United Kingdom and France were gradually forced to accept abandoning
colonial outposts, which would in the late 1950s and early 1960s, lead to revolt, and finally
independence for most of their empires.
The price paid for this position (especially in the Cold War climate) was the militarization of
the U.S. economy, what U.S. President Dwight D. Eisenhower called the "armament
industry" and "the military-industrial complex," and the related notion that the U.S. should
assume a protective role in what was referred to as "the free world."
2.7 The Late Bretton Woods System
The U.S. balance of Payments Crisis (1958-1968)
After the end of World War II, the U.S. held $26 billion in gold reserves, of an estimated total
of $40 billion (approx 60%). As world trade increased rapidly through the 1950s, the size of
the gold base increased by only a few percent. In 1958, the U.S. trade deficit swung negative.
The first U.S. response to the crisis was in the late 1950s when the Eisenhower administration
placed import quotas on oil and other restrictions on trade outflows. More drastic measures
were proposed, but not acted on. However, with a mounting recession that began in 1959, this
response alone was not sustainable. In 1960 with Kennedy's election a decade long effort to
maintain the Bretton Woods at the $35/ounce price was begun.
The design of the Bretton Woods System was that only nations could enforce gold
convertibility on the anchor currency - the United States. Gold convertibility enforcement
was not required, but instead, allowed. Nations could forgo converting dollars to gold, and
instead hold dollars. Rather than full convertibility, it provided a fixed price for sales between
central banks. However, there was still an open gold market, 80% of which was traded
through London, which issued a morning "gold fix," which was the price of gold on the open
market. For the Bretton Woods system to remain workable, it would either have to alter the
peg of the dollar to gold, or it would have to maintain the free market price for gold near the
$35 per ounce official price. The greater the gap between free market gold prices and central
bank gold prices, the greater the temptation to deal with internal economic issues by buying
gold at the Bretton Woods price and selling it on the open market.
The first effort was the creation of the "London Gold Pool." The theory of the pool was that
spikes in the free market price of gold, set by the "morning gold fix" in London, could be
controlled by having a pool of gold to sell on the open market, which would then be
recovered when the price of gold dropped. Gold price spiked in response to events such as the
Cuban Missile Crisis, and other smaller events, to as high as $40/ounce. The Kennedy
administration began drafting a radical change of the tax system in order to spur more
productive capacity, and thus encourage exports. This would culminate with his tax cut
program of 1963, designed to maintain the $35 peg.
In 1967 there was an attack on the pound, and a run on gold in the "sterling area," and on
November 17, 1967, the British government was forced to devalue the pound. While West
Germany agreed not to purchase gold from the U.S., and agreed to hold dollars instead, the
pressure on both the Dollar and the Pound Sterling continued. In January 1968 Johnson
imposed a series of measures designed to end gold outflow, and to increase American
exports. However, to no avail: on March 17, 1968, there was a run on gold, the London Gold
Pool was dissolved, and a series of meetings began to rescue or reform the system as it
existed. The attempt to maintain that peg collapsed in November 1968, and a new policy
program was attempted: to convert Bretton Woods to a system where the enforcement
mechanism floated by some means, which would be set by either fiat, or by a restriction to
honor foreign accounts.
"Floating" Bretton Woods 1968-1972
By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the
Eisenhower, Kennedy and Johnson administrations, had become increasingly perishable.
Gold outflows from the United States accelerated, and despite gaining assurances from
Germany and other nations to hold gold, the "dollar shortage" of the 1940s and 1950s had
become a dollar glut. In 1967, the IMF agreed in Rio de Janeiro to replace the tranche
division set up in 1946. Special Drawing Rights were set as equal to one U.S. dollar, but were
not usable for transactions other than between banks and the IMF. Nations were required to
accept holding SDRs equal to three times their allotment, and interest would be charged, or
credited, to each nation based on their SDR holding. The original interest rate was set at
1.5%.
The intent of the SDR system was to prevent nations from buying pegged dollars and selling
them at the higher free market price, and give nations a reason to hold dollars, by crediting
interest, at the same time, set a clear limit to the amount of dollars which could be held. The
use of SDRs as "paper gold" seemed to offer a way to balance the system, turning the IMF,
rather than the U.S., into the world's central banker. The US tightened controls over foreign
investment and currency, including mandatory investment controls in 1968. In 1970, U.S.
President Richard Nixon lifted import quotas on oil in an attempt to reduce energy costs;
instead, however, this exacerbated dollar flight, and created pressure from petro-dollars.
The "Nixon Shock"
By the early 1970s, as the Vietnam War accelerated inflation, the United States was running
not just a balance of payments deficit but also a trade deficit (for the first time in the
twentieth century). The crucial turning point was 1970, which saw U.S. gold coverage
deteriorate from 55% to 22%. This, in the view of neoclassical economists, represented the
point where holders of the dollar had lost faith in the U.S. ability to cut its budget and trade
deficits. In 1971 more and more dollars were being printed in Washington, then being
pumped overseas, to pay for the nation's military expenditures and private investments. In the
first six months of 1971, assets for $22 billion fled the United States. In response, on August
15, 1971, Nixon unilaterally imposed 90-day wage and price controls, a 10% import
surcharge, and most importantly "closed(ing) the gold window," making the dollar
inconvertible to gold directly, except on the open market. Unusually, this decision was made
without consulting members of the international monetary system or even with his own State
Department, and was soon dubbed the Nixon shock.
The surcharge was dropped in December 1971 as part of a general revaluation of major
currencies, which were henceforth allowed 2.25 percent devaluations from the agreed
exchange rate. But even the more flexible official rates could not be defended against the
speculators. By March 1976, all the world's major currencies were floating; in other words,
exchange rates were no longer the principal target used by governments to administer
monetary policy.
The Smithsonian Agreement
The shock of August 15 was followed by efforts under U.S. leadership to develop a new
system of international monetary management. Throughout the fall of 1971, there was a
series of multilateral and bilateral negotiations of the Group of Ten seeking to develop a new
multilateral monetary system. In December of 1971, on the 17th and 18th, the Group of Ten,
meeting in the Smithsonian Institute in Washington, created the Smithsonian Agreement
which devalued the dollar to $38 dollars an ounce, with 2.25% trading bands, and attempted
to balance the world financial system using SDRs alone. It failed to impose discipline on the
US government, and with no other credibility mechanism in place, the pressure against the
dollar in gold continued. This resulted in gold becoming a floating asset, and in 1971 it
reached $44.20/ounce, in 1972 $70.30/ounce and still climbing. By 1972, currencies began
abandoning even this devalued peg against the dollar, though it would take a decade for all of
the industrialized nations to do so. In February of 1973, the Bretton Woods currency
exchange markets would close, after a last gasp devaluation of the dollar to $44/ounce, and
only would reopen in March in a floating currency regime. The collapse of the Bretton
Woods system is a subject of intense debate. Review Questions:
1. What is Bretton Woods System? Explain its objectives.
2. Explain the design of the Bretton Woods System
3. Narrate the circumstances leading to the creation of Bretton Woods Monetary System.
4. Analyze the features of Bretton Woods System and discuss the causes for its breakdown.
5. Explain the devaluation of the dollar twice and the failure of Smithsonian Agreement.
References:
1. Buckley, Adrian: Multinational Finance, Prentice Hall of India, New Delhi
2. Murice, Levi: International Finance, McGraw Hill, Int. Ed., New York.
3. Shaprio, A.C: Multinational Financial Management, Prentice Hall of India, New Delhi
Lesson - 3
The Gold Standard
Objectives of the Lesson:
After studying this lesson you should able to:
Know the History of the Modern Gold Standard
Understand the International Financial Markets
Define the Differing Definitions of "Gold Standard"
Explain Effects of Gold Backed Currency
Know the Advocates of a renewed Gold Standard
Explain the Gold as a Reserve Today
Structure of the Lesson:
3.0 Introduction
3.1 Early coinage
3.2 History of the Modern Gold Standard
3.2.1 The Crisis of Silver Currency and Bank Notes (1750-1870)
3.2.1 The Crisis of Silver Currency and Bank Notes (1750-1870)
3.2.2 Establishment of the International Gold Standard (1871-1900)
3.2.3 Gold Standard from peak to crisis (1901-1932)
3.2.4 The Depression and Second World War (1933-1945)
3.2.5 Post-war International Gold Standard (1946-1971)
3.3 Differing Definitions of "Gold Standard"
3.4 Effects of Gold Backed Currency
3.5 Advocates of a renewed Gold Standard
3.6 Gold as a Reserve Today
3.0 Introduction
The gold standard is a monetary system in which the standard economic unit of account is a
fixed weight of gold. When several nations are using such fixed unit of account then the rates
of exchange between national currencies effectively becomes fixed. The gold standard may
also be viewed as a monetary system in which changes in the supply and demand of gold
determine the value of goods and services in relation to their supply and demand. Because of
its rarity and durability gold has long been used as a means of payment. The exact nature of
the evolution of money varies significantly across time and place, though it is believed by
historians that gold's high value for its utility, density, resistance to corrosion, uniformity and
easy divisibility made it useful as both a store of value, and a unit of account for stored value
of other kinds - in Babylon a bushel of wheat was the unit of account, and a weight in gold
used as the token to transport value. Early monetary systems based on grain would use gold
to represent the stored value. Banking began when gold deposited in a bank could be
transferred from one bank account to another by what is called a Giro system, or lent at
interest.
When used as part of a hard money system, the function of paper currency is to reduce the
danger of transporting gold, reduce the possibility of debasement of coins, and avoid the
reduction in circulating medium to hoarding and losses. The early development of paper
money was spurred originally by the unreliability of transportation and the dangers of long
voyages, as well as the desire of governments to control or regulate the flow of commerce
within their control. Money backed by specie is sometimes called representative money, and
the notes issued are often called certificates, to differentiate them from other forms of paper
money.
3.1 Early Coinage
The first metal used as currency was silver, before 2000 BC, when silver ingots were used in
trade, and it was not until 1500 years later that the first coinage of pure gold was introduced.
However, long before this time gold had been the basis of trade contracts in Accadia, and
later in Egypt. Silver would remain the most common monetary metal used in ordinary
transactions through the 19th century.
The Persian Empire collected taxes in gold, and when conquered by Alexander the Great, this
gold became the basis for the gold coinage of his empire. The paying of mercenaries and
armies in gold solidified its importance: gold would become synonymous with paying for
military operations, as mentioned by Niccolo Machiavelli in The Prince two thousand years
later. The Roman Empire would mint two important gold coins: aureus, which was
approximately 7 grams of gold alloyed with silver and the smaller solidus which weighed 4.4
grams, of which 4.2 was gold. The Roman mints were fantastically active -- the Romans
minted, and circulated, millions of coins during the course of the Republic and the Empire.
After the collapse of the Western Roman Empire and the exhaustion of the gold mines in
Europe, the Byzantine Empire continued to mint successor coins to the solidus called the
nomisma or bezant. They were forced to mix more and more base metal with the gold until
by the turn of the millennium the coinage in circulation was only 25% gold by weight. This
represented a tremendous drop in real value from the old 95% pure Roman coins. Thus, trade
was increasingly conducted via the coinage in use in the Arabic world, produced from
African gold: the dinar.
The dinar and dirham were gold and silver coins, respectively, originally minted by the
Persians. The Caliphates in the Islamic world adopted these coins, but it is with Caliph Abd
al-Malik (685-705) who reformed the currency that the history of the dinar is usually thought
to begin. He removed depictions from coins, and established standard references to Allah on
the coins, and fixed ratios of silver to gold. The growth of Islamic power and trade made the
dinar the dominant coin from the Western coast of Africa to northern India until the late
1200s, and it continued to be one of the predominant coins for hundreds of years afterwards.
In 1284 the Republic of Venice coined their first solid gold coin, the ducat, which was to
become the standard of European coinage for the next 600 years. Other coins, the florin,
nobel, grosh, zloty and guinea, were also introduced at this time by other European states to
facilitate growing trade. The ducat, because of Venice's pre-eminent role in trade with the
Islamic world, and its ability to secure fresh stocks of gold, would remain the standard
against which other coins were measured.
3.2 History of the Modern Gold Standard
The adoption of gold standards proceeded gradually. This has led to conflicts between
different economic historians as to when the "real" gold standard began. Sir Isaac Newton
included a ratio of gold to silver in his assay of coinage in 1717 which created a relationship
between gold coins and the silver penny which was to be the standard unit of account in the
Law of Queen Anne; for some historians this marks the beginning of the "gold standard" in
England. However, more generally accepted is that a full gold standard requires that there be
one source of notes and legal tender, and that this source is backed by convertibility to gold.
Since this was not the case throughout the 18th century, the generally accepted view is that
England was not on a gold standard at this time.
3.2.1 The Crisis of Silver Currency and Bank Notes (1750-1870)
To understand the adoption of the international gold standard in the late 19th century, it is
important to follow the events of the late 1700s and early 1800s. In the late 18th century,
wars and trade with China, which sold to Europe, but had little use for European goods,
drained silver from the economies of Western Europe and the United States. Coins were
struck in smaller and smaller amounts, and there was a proliferation of bank and stock notes
used as money.
In the 1790s England suffered a massive shortage of silver coinage, and ceased to mint larger
silver coins, issued "token" silver coins and over-struck foreign coins. With the end of the
Napoleonic Wars, England began a massive re-coinage program that created standard gold
sovereigns and circulating crowns and half-crowns, and eventually copper farthings in 1821.
The re-coinage of silver in England after a long drought produced a burst of coins: England
struck nearly 40 million shillings between 1816 and 1820, 17 million half crowns and 1.3
million silver crowns. The 1819 Act for the Resumption of Cash Payments set 1823 as the
date for resumption of convertibility, reached instead by 1821. Throughout the 1820s small
notes were issued by regional banks, which were finally restricted in 1826, while the Bank of
England was allowed to set up regional branches. In 1833, however, the Bank of England
notes were made legal tender, and redemption by other banks was discouraged. In 1844 the
Bank Charter Act established that Bank of England Notes, fully backed by gold, were the
legal standard. According to the strict interpretation of the gold standard, this 1844 act marks
the establishment of a full gold standard for British money.
The USA adopted a silver standard based on the "Spanish milled dollar" in 1785. This was
codified in the 1792 Mint and Coinage Act, and by the use by the Federal Government of the
"Bank of the United States" to hold its reserves, as well as establishing a fixed ratio of gold to
the US dollar. This was, in effect, a derivative silver standard, since the bank was not
required to keep silver to back all of its currency. This began a long series of attempts for
America to create a bimetallic standard for the US Dollar, which would continue until the
1920s. Gold and silver coins were legal tender, including the Spanish real, a silver coin struck
in the Western Hemisphere. Because of the huge debt taken on by the United States Federal
government to pay for the Revolutionary War, silver coins struck by the government left
circulation, and in 1806 President Jefferson suspended the minting of silver coins. Through
the period from 1860 to 1871, various attempts to resurrect bi-metallic standards were made,
including one based on the gold and silver franc, however, with the rapid influx of silver from
new deposits, the expectation of scarcity of silver ended.
The interaction between central banking and currency basis formed the primary source of
monetary instability during this period. The combination that produced economic stability
was restriction of supply of new notes, a government monopoly on the issuance of notes
directly and indirectly, a central bank and a single unit of value. Attempts to evade these
conditions produced periodic monetary crisis - as notes devalued, or silver ceased to circulate
as a store of value, or there was a depression as governments, demanding specie as payment,
drained the circulating medium out of the economy. At the same time there was a
dramatically expanded need for credit, and large banks were being chartered in various states,
including, by 1872, Japan. The need for a solid basis in monetary affairs would produce a
rapid acceptance of the gold standard in the period that followed.
3.2.2 Establishment of the International Gold Standard (1871-1900)
Germany was created as a unified country following the Franco-Prussian War; it established
the Reichsmark, went on to a strict gold standard, and used gold mined in South Africa to
expand the money supply. Rapidly most other nations followed suit, since gold became a
transportable, universal, and stable unit of valuation.
Dates of Adoption of a Gold Standard:
Germany 1871
Latin Monetary Union 1873 (Belgium, Italy, Switzerland, France)
United States 1873 (de facto)
Scandinavia 1875 by monetary Union: Denmark, Norway and Sweden
Netherlands 1875
France (internally) 1876
Spain 1876
Austria 1879
Russia 1893
Japan 1897
India 1898
United States 1900 (de jure)
Throughout the decade of the 1870s deflationary and depression-driven economics created
periodic demands for silver currency. However, such attempts generally failed, and continued
the general pressure towards a gold standard. By 1879, only gold coins were accepted
through the Latin Monetary Union, composed of France, Italy, Belgium, Switzerland and
later Greece, even though silver was, in theory, a circulating medium.
By creating a standard unit of account which was easily redeemable, relatively stable in
quantity, and verifiable in its purity, the gold standard ushered in a period of dramatically
expanded trade between industrializing nations, and "periphery" nations which produced
agricultural goods -- the so called "bread baskets". This "First Era of Globalization" was not,
however, without its costs. One of the most dramatic was the Irish Potato Famine, where even
as people began to starve it was more profitable to export food to Britain. The result turned a
blight of the potato crop into a humanitarian disaster. Amartya Sen in his work on famines
theorized that famines are caused by an increase in the price of food, not by food shortage
itself, and hence the root cause of trade-based famines is an imbalance in wealth between the
food exporter and the food importer.
At the same time it caused a dramatic fall in aggregate demand, and a series of long
Depressions in the United States and the United Kingdom. This should not be confused with
the failure to industrialize or a slowing of total output of goods. Thus the attempts to produce
alternate currencies include the introduction of Postal Money Orders in Britain in 1881, later
made legal tender during World War I, and the "Greenback" party in the US, which
advocated the slowing of the retirement of paper currency not backed by gold.
By encouraging industrial specialization, industrializing countries grew rapidly in population,
and therefore needed sources of agricultural goods. The need for cheap agricultural imports,
in turn, further pressured states to reduce tariffs and other trade barriers, so as to be able to
exchange with the industrial nations for capital goods, such as factory machinery, which were
needed to industrialize in turn. Eventually this pressured taxation systems, and pushed nations
towards income and sales taxes, and away from tariffs. It also produced a constant downward
pressure on wages, which contributed to the "agony of industrialization". The role of the gold
standard in this process remains hotly debated, with new articles being published attempting
to trace the interconnections between monetary bases, wages and living standards.
By the 1890s in the United States, a reaction against the gold standard had emerged centered
in the Southwest and Great Plains. Many farmers began to view the scarcity of gold,
especially outside the banking centers of the East, as an instrument to allow Eastern bankers
to instigate credit squeezes that would force western farmers into widespread debt, leading to
a consolidation of western property into the hands of the centralized banks. The formation of
the Populist Party in Lampasas, Texas specifically centered around the use of "easy money"
that was not backed by gold and which could flow more easily through regional and rural
banks, providing farmers access to needed credit. Opposition to the gold standard during this
era reached its climax with the presidential campaign of Democrat William Jennings Bryan
of Nebraska. Bryan argued against the gold standard in his Cross of gold speech in 1896,
comparing the gold standard (and specifically its effects on western farmers) to the crown of
thorns worn by Jesus at his crucifixion. Bryan ran and lost three times, each time carrying
mostly Southern and Great Plains states.
3.2.3 Gold Standard from Peak to Crisis (1901-1932)
By 1900 the need for a lender of last resort had become clear to most major industrialized
nations. The importance central banking to the financial system was proven largely by
examples such as the 1890 bail out of Barings Bank by the Bank of England. Barings had
been threatened by imminent bankruptcy. Only the United States still lacked a central
banking system.
There had been occasional panics since the end of the depressions of the 1880s and 1890s
which some attributed to the centralization of production and banking. The increased rate of
industrialization and imperial colonization, however, had also served to push living standards
higher. Peace and prosperity reigned through most of Europe, albeit with growing agitation in
favor of socialism and communism because of the extremely harsh conditions of early
industrialization.
This came to an abrupt halt with the outbreak of World War I. Britain was almost
immediately forced to gradually end its gold standard, ending convertibility to Bank of
England notes starting in 1914. By the end of the war England was on a series of fiat
currency regulations, which monetized Postal Money Orders and Treasury Notes. The need
for larger and larger engines of war, including battleships and munitions, created inflation.
Nations responded by printing more money than could be redeemed in gold, effectively
betting on winning the war and redeeming out of reparations, as Germany had in the Franco-
Prussian War. The United States and the United Kingdom both instituted a variety of
measures to control the movement of gold, and to reform the banking system, but both were
forced to suspend use of the gold standard by the costs of the war. The Treaty of Versailles
instituted punitive reparations on Germany and the defeated Central Powers, and France
hoped to use these to rebuild her shattered economy, as much of the war had been fought on
French soil. Germany, facing the prospect of yielding much of her gold in reparations, could
no longer coin gold Reichsmarks, and moved to paper currency. The series of arrangements
to prop up the gold standard in the 1920s would constitute a book length study unto
themselves, with the Dawes Plan superseded by the Morgenthau Plan. In effect the US, as the
most persistent positive balance-of-trade nation, loaned the money to Germany to pay off
France, so that France could pay off the United States. After the war, the Weimar Republic
suffered from hyperinflation and introduced Rentenmarks, an asset currency, to halt it. These
were withdrawn from circulation in favor of a restored gold Reichsmark in 1942.
In the United Kingdom the pound was returned to the gold standard in 1925, by the
somewhat reluctant Chancellor of the Exchequer Winston Churchill, on the advice of
conservative economists at the time. Although a higher gold price and significant inflation
had followed the WWI ending of the gold standard, Churchill returned to the standard at the
pre-war gold price. For five years prior to 1925 the gold price was managed downward to the
pre-war level, meaning a significant deflation was forced onto the economy.
John Maynard Keynes was one economist who argued against the adoption of the pre-war
gold price believing that the rate of conversion was far too high and that the monetary basis
would collapse. He called the gold standard "that barbarous relic". This deflation reached
across the remnants of the British Empire everywhere the Pound Sterling was still used as the
primary unit of account. In the United Kingdom the standard was again abandoned in 1931.
Sweden abandoned the gold standard in 1929, the US in 1933, and other nations were, to one
degree or another, forced off the gold standard.
As part of this process, many nations, including the US, banned private ownership of large
gold stocks. Instead, citizens were required to hold only legal tender in the form of central
bank notes. While this move was argued for under national emergency, it was controversial at
the time, and there are still those who regard it as an illegal and unconstitutional usurpation of
private property. While this is not a mainstream view, many of the people who hold it are
influential out of proportion to their numbers.
3.2.4 The Depression and Second World War (1933-1945)
In 1933 the London Conference marked the death of the international gold standard as it had
developed to that point in time. While the United Kingdom and the United States desired an
eventual return to the Gold Standard, with President Franklin Delano Roosevelt saying that a
return to international stability "must be based on gold" -- neither was willing to do so
immediately. France and Italy both sent delegations insisting on an immediate return to a
fully convertible international gold standard. A proposal was floated to stabilize exchange
rates between France, Britain, and the United States based on a system of drawing rights, but
this too collapsed. The central point at issue was what value the gold standard should take. In
the years that followed nations pursued bilateral trading agreements, and by 1935, the
economic policies of most Western nations were increasingly dominated by the growing
realization that a global conflict was highly likely, or even inevitable. During the 1920s the
austerity measures taken to re-stabilize the world financial system had cut military
expenditures drastically, but with the arming of the Axis powers, war in Asia, and fears of the
USSR exporting communist revolution, the priority shifted toward armament, and away from
re-establishing a gold standard. The last gasp of the 19th century gold standard came when
the attempt to balance the United States Budget in 1937 lead to the "Roosevelt Recession".
Even such gold advocates as Roosevelt's budget director conceded that until it was possible to
balance the budget, a gold standard would be impossible.
During the period from 1939 to 1942, Britain depleted much of its gold stock in purchases of
munitions and weaponry on a "cash and carry" basis from the US and other nations. This
depletion of Britain's reserve signalled to Winston Churchill that returning to a pre-war style
gold standard was impractical; instead, John Maynard Keynes, who had argued against such a
gold standard, became increasingly influential: his proposals, a more wide-ranging version of
the "stability pact" style gold standard, would find expression in the Bretton Woods
Agreement.
3.2.5 Post-war International Gold Standard (1946-1971)
The essential features of the gold standard in theory rest on the idea that inflation is caused by
an increase in the quantity of money, an idea advocated by David Hume, and that uncertainty
over the future purchasing power of money depresses business confidence and leads to
reduced trade and capital investment. The central thesis of the gold standard is that removing
uncertainty, friction between kinds of currency, and possible limitations in future trading
partners will dramatically benefit an economy, by expanding both the market for its own
goods, the solidity of its credit, and the markets from which its consumers may purchase
goods. In much of gold standard theory, the benefits of enforcing monetary and fiscal
discipline on the government are central to the benefits obtained, advocates of the gold
standard often believe that governments are almost entirely destructive of economic activity,
and that a gold standard, by reducing their ability to intervene in markets, will increase
personal liberty and economic vitality.
3.3 Differing Definitions of "Gold Standard"
If the monetary authority holds sufficient gold to convert all circulating money, then this is
known as a 100% reserve gold standard, or a full gold standard. Some believe there is no
other form of gold standard, since on any "partial" gold standard the value of circulating
representative paper in a free economy will always reflect the faith that the market has in that
note being redeemable for gold. Others, such as some modern advocates of supply-side
economics contest that so long as gold is the accepted unit of account then it is a true gold
standard.
In an internal gold-standard system, gold coins circulate as legal tender or paper money is
freely convertible into gold at a fixed price.
In an international gold-standard system, which may exist in the absence of any internal gold
standard, gold or a currency that is convertible into gold at a fixed price is used as a means of
making international payments. Under such a system, when exchange rates rise above or fall
below the fixed mint rate by more than the cost of shipping gold from one country to another,
large inflows or outflows occur until the rates return to the official level. International gold
standards often limit which entities have the right to redeem currency for gold. Under the
Bretton Woods system, these were called "SDRs" for Special Drawing Rights.
3.4 Effects of Gold Backed Currency
The commitment to maintain gold convertibility tightly restrains credit creation. Credit
creation by banking entities under a gold standard threatens the convertibility of the notes
they have issued, and consequently leads to undesirable gold outflows from that bank. The
result of a failure of confidence produces a run on the specie basis, which is generally
responded to by the bankers suspending specie payments. Hence, notes circulating in any
"partial" gold standard will either be redeemed for their face value of gold (which would be
higher than its actual value) - this constitutes a bank "run"; or the market value of such notes
will be viewed as less than a gold coin representing the same amount.
In the international gold standard imbalances in international trade were rectified by requiring
nations to pay accounts in gold. A country in deficit would have to pay its debts in gold thus
depleting gold reserves and would therefore have to reduce its money supply. This would
cause prices to deflate, reducing economic activity and, consequently, demand would fall.
The resulting fall in demand would reduce imports; thus theoretically the deficit would be
rectified when the nation was again importing less than it exported. This lead to a constant
pressure to close economies in the face of currency drains in what critics called "beggar thy
neighbor" policies. Such zero-sum gold standard systems showed periodic imbalances which
had to be corrected by rapid falls in output.
The gold standard, in theory, limits the power of governments to cause price inflation by
excessive issue of paper currency, although there is evidence that before World War I
monetary authorities did not expand or contract the supply of money when the country
incurred a gold outflow. It is also supposed to create certainty in international trade by
providing a fixed pattern of exchange rates. The gold standard in fact is deflationary, as the
rate of growth of economies generally outpaces the growth in gold reserves. This, after the
inflationary silver standards of the 1700s was regarded as a welcome relief, and an
inducement to trade. However by the late 19th century, agitation against the gold standard
drove political movements in most industrialized nations for some form of silver, or even
paper based, currency.
3.5 Advocates of a renewed Gold Standard
The internal gold standard is supported by anti-government economists, including extreme
monetarists, Objectivists, followers of the Austrian School of Economics and even many
proponents of libertarianism. Much of the support for a gold standard is related to a distrust
of central banks and governments, as a gold standard removes the ability of a government to
manage the value of money, even though, historically, the establishment of a gold standard
was part of establishing a national banking system, and generally a central bank. The
international gold standard still has advocates who wish to return to a Bretton Woods-style
system, in order to reduce the volatility of currencies, but the unworkable nature of Bretton
Woods, due to its government-ordained exchange ratio, has allowed the followers of Austrian
economists Ludwig von Mises, Friedrich Hayek and Murray Rothbard to foster the idea of a
total emancipation of the gold price from a state-decreed rate of exchange and an end to
government monopoly on the issuance of gold currency.
Many nations back their currencies in part with gold reserves, using these not to redeem
notes, but as a store of value to sell in case their currency is attacked or rapidly devalues.
Gold advocates claim that this extra step would no longer be necessary since the currency
itself would have its own intrinsic store of value. A Gold Standard then is generally promoted
by those who regard a stable store of value as the most important element to business
confidence.
It is generally opposed by the vast majority of governments and economists, because the gold
standard has frequently been shown to provide insufficient flexibility in the supply of money
and in fiscal policy, because the supply of newly mined gold is finite and must be carefully
husbanded and accounted for.
A single country may also not be able to isolate its economy from depression or inflation in
the rest of the world. In addition, the process of adjustment for a country with a payments
deficit can be long and painful whenever an increase in unemployment or decline in the rate
of economic expansion occurs.
One of the foremost opponents of the gold standard was John Maynard Keynes who scorned
basing the money supply on "dead metal". Keynesians argue that the gold standard creates
deflation which intensifies recessions as people are unwilling to spend money as prices fall,
thus creating a downward spiral of economic activity. They also argue that the gold standard
also removes the ability of governments to fight recessions by increasing the money supply to
boost economic growth. Much of this thought has been reversed when stagflation hit the
United States in the early '70s in contradiction to Keynes' General Theory of Employment
Interest and Money.
Gold standard proponents point to the era of industrialization and globalization of the 19th
century as the proof of the viability and supremacy of the gold standard, and point to Britain's
rise to being an imperial power, conquering nearly one quarter of the world's population and
forming a trading empire which would eventually become the Commonwealth of Nations as
imperial provinces gained independence.
Gold standard advocates have a strong following among commodity traders and hedge funds
with a bearish orientation. The expectation of a global fiscal meltdown and the return to a
hard gold standard has been central to many hedge financial theories. More moderate gold
bugs point to gold as a hedge against commodity inflation, and a representation of resource
extraction, in their view gold is a play against monetary policy follies of central banks, and a
means of hedging against currency fluctuations, since gold can be sold in any currency, on a
highly liquid world market, in nearly any country in the world. For this reason they believe
that eventually there will be a return to a gold standard, since this is the only "stable" unit of
value. That monetary gold would soar to $5,000 an ounce, over 10 times its current value,
may well have something to do with some of the advocacy of a renewed gold standard,
holders of gold would stand to make an enormous profit.
Few economists today advocate a return to the gold standard. Notable exceptions are some
proponents of Supply-side economics and some proponents of Austrian Economics.
However, many prominent economists, while they do not advocate a return to gold, are
sympathetic with hard currency basis, and argue against fiat money. This school of thought
includes US central banker Alan Greenspan and macro-economist Robert Barros. The current
monetary system relies on the US Dollar as an "anchor currency" which major transactions,
such as the price of gold itself, are measured in. Currency instabilities, inconvertibility and
credit access restriction are a few reasons why the current system has been criticized, with a
host of alternatives suggested, including energy based currencies, market baskets of
currencies or commodities. Gold is merely one of these alternatives.
The reason these visions are not practically pursued is based on the same reasons that the
gold standard fell apart in the first place: a fixed rate of exchange decreed by governments
have no organic relationship between the supply and demand of gold and the supply and
demand of goods.
Thus gold standards have a tendency to fall apart as soon as it becomes advantageous for
governments to overlook them. By itself, the gold standard does not prevent nations from
switching to a fiat currency when there is a war or other exigency, even though paradoxically
gold gains in value through such circumstances as people use it to preserve value since fiat
currency is typically introduced to cause inflation.
The practical matter that gold is not currently distributed according to economic strength is
also a factor: Japan, while one of the world's largest economies, depending on which
measure, it has gold reserves far less than could support that economy. Finally, the quantity
of gold available for reserves, even if all of it were confiscated and used as the unit of
account, would put the value of gold upwards of 5,000 dollars an ounce on a purchasing
parity basis. If the current holders of gold imagine that this is the price that they will be paid
for giving up their gold, they are quite likely to be disappointed. For these practical reasons
-- inefficiency, misallocation, instability, and insufficiency of supply -- the gold standard is
likely to be more honoured in literature than practiced in fact.
3.6 Gold as a Reserve Today
During the 1990s Russia liquidated much of the former USSR's gold reserves, while several
other nations accumulated gold in preparation for the Economic and Monetary Union. The
Swiss Franc left a full gold convertible backing. However, gold reserves are held in
significant quantity by many nations as a means of defending their currency, and hedging
against the US Dollar, which forms the bulk of liquid currency reserves. Weakness in the
dollar tends to be offset by strengthen of gold prices. Gold remains a principal financial asset
of almost all central banks along side foreign currencies and government bonds. It is also held
by central banks as a way of hedging against loans to their own governments as an "internal
reserve".
In addition to other precious metals, it has several competitors as store of value: the US dollar
itself and real estate. As with all stores of value, the basic confidence in property rights
determines the selection of which one is chosen, as all of these have been confiscated or
heavily taxed by governments. In the view of gold investors, none of these has the stability
that gold had, thus there are occasionally calls to restore the gold standard. Occasionally
politicians emerge who call for a restoration of the gold standard, particularly from the
libertarian right and the anti-government left. Mainstream conservative economists such as
Barros and Greenspan have admitted a preference for some tangibly backed monetary
standard, and have stated that a gold standard is among the possible range of choices. Some
privately issued modern notes (such as e-gold) are backed by gold bullion, and gold. Both
coins and bullion are widely traded in deeply liquid markets, and therefore still serve as a
private store of wealth.
In 1999, to protect the value of gold as a reserve, European Central Bankers signed the
"Washington Agreement", which stated they would not allow gold leasing for speculative
purposes, nor would they "enter the market as sellers" except for sales that had already been
agreed upon. A selling band was set. This was intended to prevent further deterioration in the
price of gold. In 2001, Malaysian Prime Minister Mahathir Mohamad proposed a new
currency that would be used initially for international trade between Muslim nations. The
currency he proposed was called the gold dinar and it was defined as 4.25 grams of 24-
carat gold. Mahathir Mohamad promoted the concept on the basis of its economic merits as a
stable unit of account and also as a political symbol to create greater unity between Islamic
nations.
Review Questions:
1. What is Paper Gold?
2. Give the differing definitions of "Gold Standard"
3. Explain the eeffects of Gold Backed Currency
References:
Bordo, M.D. and Eichengreen, B. (eds.) (1993) A Retrospective on the Bretton Woods
System: Lessons for International Monetary Reform, Chicago: University of Chicago Press.
Diverse perspectives on the post-war monetary regime by ranking economists and political
scientists, written to mark the fiftieth anniversary of the Bretton Woods Conference
Edward S. Mason and Robert E. Asher, The World Bank Since Bretton Woods (Washington,
D.C.: The Brookings Institution, 1973), pp. 105-107, 124-135.
Eichengreen, B. (1996) Globalizing Capital: A History of the International Monetary System,
Princeton, NJ: Princeton University Press. An insightful review of the life and death of the
Bretton Woods System by a prominent international economist; set in a broader interpretation
of the evolving international monetary system.
Lesson - 4
The European Monetary System
Objectives of the Lesson:
After studying this lesson you should able to:
explain European Exchange Rate Mechanism (or ERM)
know the history of the EMU
Know about the countries using the euro
Know Non-EU Currencies Pegged to the Euro
Structure of the Lesson:
4.0 Introduction
4.1 The European Exchange Rate Mechanism (or ERM)
4.2 History of the EMU
4.3 Participation in the Economic and Monetary Union
4.3.1 Countries using the euro
4.4 EU Members outside the Euro-Zone
4.5 Effects of a Single Currency
4.6 The euro and oil
4.7 Euro Exchange rate against the U.S. Dollar
4.8 Currencies Pegged to Euro
4.9 Countries with the Euro as currency
4.10 Non-EU Currencies Pegged to the Euro
4.11 Fiscal policy
4.12 Convergence Criteria
4.0 Introduction
The European Monetary System (EMS) was an arrangement established in 1979 where
most nations of the European Economic Community (EEC) linked their currencies to prevent
large fluctuations relative to one another. After the collapse of the Bretton Woods system in
1971, the EEC countries agreed to maintain stable exchange rates by preventing exchange
fluctuations of more than 2.25%. By March 1979, the EEC established European Monetary
System, and created the European Currency Unit (ECU).
The basic elements of the arrangement were:
1. The ECU: a basket of currencies, preventing movements above 2.25% (6% for Italy)
around parity in bilateral exchange rates with other member countries.
2. An Exchange Rate Mechanism (ERM)
3. An extension of European credit facilities.
4. The European Monetary Cooperation Fund: created in October 1972, it allocated
ECUs to members' central banks in exchange for gold and US dollar deposits.
Periodic adjustments raised the values of strong currencies and lowered those of weaker ones,
but after 1986 changes in national interest rates were used to keep the currencies within a
narrow range. In the early 1990s the European Monetary System was strained by the differing
economic policies and conditions of its members, especially the newly reunified Germany,
and Britain permanently withdrew from the system. This led to the so-called Brussels
Compromise in August 1993, which established a new fluctuation band of +15%.
The European Currency Unit (ECU) was a basket of the currencies of the European
Community member states, used as the unit of account of the European Community, before
being replaced by the euro. The European Exchange Rate Mechanism attempted to minimize
fluctuations between member state currencies and the ECU. The ECU was also used in some
international financial transactions. The ECU was conceived on 13 March 1979 as an internal
accounting unit. It had the ISO 4217 currency code XEU. On January 1, 1999, the euro (with
the code EUR) replaced the ECU, at the value EUR 1 = XEU 1. Unlike the ECU, the euro is a
real currency, although not all member states participate in its use (for details on euro
membership see Euro-zone). Until 1999, all member states that participated in the ERM, also
participated in the ECU. Due to the ECU being used in some international financial
transactions, there was a concern that foreign courts might not recognize the euro as the legal
successor to the ECU. This was unlikely to be a problem, since it is a generally accepted
principle of private international law that states determine their currencies, and that therefore
states would accept the European Union legislation to that effect. However, for abundant
caution, several foreign jurisdictions adopted legislation to ensure a smooth transition. Of
particular importance here were the U.S. states of Illinois and New York, under whose laws a
large proportion of international financial contracts are made. Both these states passed
legislation to ensure that the euro was recognized as successor to the ECU.
Although the acronym ECU is formed from English words, at the same time the word ecu
was a reference to an ancient French coin of the same name. That was one (perhaps the main)
reason that a new name was devised for its successor currency, euro, which was felt to not
favour any single language. The currency's symbol comprises an interlaced C and E, which
are the initial letters of the phrase: 'European Community' in many European languages.
However, this symbol was not widely used: few systems at the time could render it and in any
case banks preferred (as with all currencies) to use the ISO code XEU.
4.1 The European Exchange Rate Mechanism (or ERM)
The European Exchange Rate Mechanism (or ERM) was a system introduced by the
European Community in March 1979, as part of the European Monetary System (EMS), to
reduce exchange rate variability and achieve monetary stability in Europe, in preparation for
Economic and Monetary Union and the introduction of a single currency, the euro, which
took place on 1 January 1999.
The ERM is based on the concept of fixed currency exchange rate margins, but with
exchange rates variable within those margins. Before the introduction of the euro, exchange
rates were based on the ECU, the European unit of account, whose value was determined as a
weighted average of the participating currencies.
A grid (known as the Parity Grid) of bilateral rates was calculated on the basis of these
central rates expressed in ECUs, and currency fluctuations had to be contained within a
margin of 2.25% on either side of the bilateral rates (with the exception of the Italian lira,
which was allowed a margin of 6%). Determined intervention and loan arrangements
protected the participating currencies from greater exchange rates fluctuations. Ireland's
participation in the ERM resulted in the Irish pound breaking parity with the Pound Sterling
in 1979, as very shortly after the launch of the ERM the Pound Sterling, not at the time an
ERM currency, appreciated against all ERM currencies and continued parity would have
taken the Irish pound outside of its agreed band.
In 1990, the United Kingdom participated but was forced to exit the programme after the
Pound Sterling came under major pressure from currency speculators led by George Soros.
The ensuing crash of 16 September 1992 was subsequently dubbed "Black Wednesday". In
1993, the margin had to be expanded to 15% to accommodate monetary problems with the
Italian lira and the Pound Sterling.
On 31 December 1998, the ECU exchange rates of the Euro-zone countries were frozen and
the value of the euro, which then superseded the ECU on a 1:1 basis, was thus established. In
1999, ERM 2 replaced the original ERM. The Greek and Danish currencies were part of the
system, but as Greece joined the euro in 2001, the Danish krone was left as the only
participant member. Currencies in ERM 2 are allowed to float within a range of ?15% with
respect to a central rate against the euro. In the case of the krone, the Danish Central Bank
keeps the exchange rate within the narrower range of ? 2.25% against the central rate of EUR
1 = DKK 7.460 38. As of 1 May 2004, the ten National Central Banks (NCBs) of the new
member countries became party to the ERM 2 Central Bank Agreement. The national
currencies themselves will become part of the ERM 2 at different dates, as mutually agreed.
The Estonian kroon, Lithuanian litas, and Slovenian tolar were included in the ERM 2 on 28
June 2004; the Cypriot pound, the Latvian lat and the Maltese lira on 2 May 2005; the Slovak
koruna on 25 November 2005. The currencies of the three largest countries which joined the
European Union on 1 May 2004 (the Polish zloty, the Czech koruna, and the Hungarian
forint) are expected to follow eventually. EU countries that have not adopted the euro must
participate for at least two years in the ERM 2 before joining the Euro-zone.
The European Monetary System 2 or EMS-2 was launched on January 1, 1999. In EMS 2
the ECU basket is being discarded and the new single currency euro has become an anchor
for the other currencies participating in the ERM 2. Participation in the ERM 2 is voluntary
and the fluctuation bands remain the same as in the original ERM, i.e. +15 %, once again
with the possibility of individually setting a narrower band with respect to the euro. New
members became Denmark and Greece. The EMS-2 is seen as a means to eventually join the
European Monetary Union.
In economics, a monetary union is a situation where several countries have agreed to share a
single currency among them. The European Economic and Monetary Union (EMU)
consists of three stages coordinating economic policy and culminating with the adoption of
the euro, the EU's single currency. All member states of the European Union participate in
the EMU. Twelve member states of the European Union have entered the third stage and
have adopted the euro as their currency. The United Kingdom and Denmark have opt-outs
exempting them from the transition to the third stage of the EMU. The remaining eleven
member states are required to enter the third stage and adopt the euro. Under the Copenhagen
criteria, it is a condition of entry for states acceding to the EU that they be able to fulfil the
requirements for monetary union within a given period of time. The 10 new countries that
acceded to the European Union in 2004 all intend to join third stage of the EMU in the next
ten years, though the precise timing depends on various economic factors. Similarly, those
countries who are currently negotiating for entry will also take the euro as their currency in
the years following their accession.
Prior to adopting the euro, a member state has to have its currency in the European Exchange
Rate Mechanism (ERM 2) for two years. Cyprus, Denmark, Estonia, Latvia, Lithuania,
Malta, Slovenia and Slovakia are the current participants in the exchange rate mechanism.
EMU is sometimes misinterpreted to mean European Monetary Union.
4.2 History of the EMU
The Delors Report of 1989 (named after Jacques Delors, then President of the Commission)
set out a plan to introduce the EMU in three stages and it included the creation of institutions
like the European System of Central Banks (ESCB), which would become responsible for
formulating and implementing monetary policy. The three stages for the implementation of
the EMU were the following.
Stage One: 1 July 1990 to 31 December 1993
On 1 July 1990, exchange controls were abolished, thus capital movements were
completely liberalised in the EEC.
The Treaty of Maastricht in 1992 established the completion of the EMU as a formal
objective and set a number of economic convergence criteria, concerning the inflation
rate, public finances, interest rates and exchange rate stability.
The treaty entered into force on the 1 November 1993.
Stage Two: 1 January 1994 to 31 December 1998
The European Monetary Institute was established as the forerunner of the European
Central Bank, with the task of strengthening monetary cooperation between the member
states and their national banks, as well as supervising ECU banknotes.
On 16 December 1995, details such as the name of the new currency (the euro) as well as
the duration of the transition periods were decided.
On 16-17 June 1997, the European Council decided in Amsterdam to adopt the Stability
and Growth Pact, designed to ensure budgetary discipline after creation of the euro, and a
new exchange rate mechanism (ERM 2) was set up to provide stability between the euro
and the national currencies of countries that had not yet entered the euro-zone.
On 3 May 1998, at the European Council meeting in Brussels, the 11 initial countries that
were to participate in the third stage from 1 January 1999 were selected.
On 1 June 1998, the European Central Bank (ECB) was created, and in 31 December
1998, the conversion rates between the 11 participating national currencies and the euro
were established.
Stage Three: 1 January 1999 and continuing
From the start of 1999, the euro has been a real currency, and a single monetary policy
has been introduced under the authority of the ECB. A three-year transition period began
before the introduction of actual euro notes and coins, but legally the national currencies
already ceased to exist.
On 1 January 2001, Greece joined the third stage of EMU.
The euro notes and coins are finally introduced in January 2002.
Presently, the euro (symbol: ; banking code: EUR) is the currency of twelve European
Union member states: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy,
Luxembourg, the Netherlands, Portugal, and Spain, collectively known as the Euro-zone.
The euro is the result of the most significant monetary reform in Europe since the Roman
Empire. Although the euro can be seen simply as a mechanism for perfecting the Single
European Market, facilitating free trade among the members of the Euro-zone, it is also
regarded by its founders as a key part of the project of European political integration.
Monaco, San Marino, and the Vatican City, which formerly used the French franc or the
Italian lira as their currency, now use the euro as their currency and are licensed to mint their
own euro coins in small amounts, even though they are not EU states. The euro is also used
for payment of debt in other European non-EU jurisdictions such as Montenegro, Kosovo and
Andorra.
The euro is administered by the European System of Central Banks (ESCB), composed of the
European Central Bank (ECB) and the Euro-zone central banks operating in member states.
The ECB (headquartered in Frankfurt am Main, Germany) has sole authority to set monetary
policy; the other members of the ESCB participate in the printing, minting and distribution of
notes and coins, and the operation of the Euro-zone payment system.
Characteristics
The euro is divided into 100 cents. In the English language, the form "cent" is officially
required to be used in legislation in the singular and in the plural, though the natural plural
cents is recommended for use in material aimed at the general public. All euro coins have a
common side showing the denomination (value) and a national side showing an image
specifically chosen by the country that issued it; the monarchies often have a picture of their
reigning monarch; other countries usually have their national symbols. All different coins can
be used in all the participating member states: for example, a euro coin bearing an image of
the Spanish king is legal tender not only in Spain, but also in all the other nations where the
euro is in use. There are 2, 1, 50c, 20c, 10c, 5c, 2c and 1c coins, though the latter two are
not generally used in Finland or the Netherlands (but are still legal tender). Euro banknotes
have a common design for each denomination on both sides. Notes are issued in the
following amounts: 500, 200, 100, 50, 20, 10, and 5. Some higher denominations are
not issued in some countries, though again, are legal tender.
There is a Europe-wide clearing system for large transactions, set up prior to the launch of the
euro called TARGET. For retail payments, several arrangements are used and the general rule
is that an intra-euro-zone transfer shall cost the same as a domestic one. Credit card charging
and ATM withdrawals within the euro-zone also are charged as if they were domestic. Paper-
based payment orders, such as cheques, are still domestic based.
Transition
The euro was established by the provisions in the 1992 Maastricht Treaty on European Union
that was used to establish an economic and monetary union. In order to participate in the new
currency, member states had to meet strict criteria such as a budget deficit of less than three
per cent of GDP, a national debt ratio of less than sixty per cent of GDP, combined with low
inflation and interest rates close to the EU average. Due to differences in national
conventions for rounding and significant digits, all conversion between the national
currencies had to be carried out using the process of triangulation via the euro. The definitive
values in euro of these subdivisions (which represent the exchange rates at which the
currency entered the euro) are as follows:
13.7603 Austrian schillings (ATS)
40.3399 Belgian francs (BEF)
2.20371 Dutch gulden (NLG)
5.94573 Finnish markka (FIM)
6.55957 French francs (FRF)
1.95583 German Mark (DEM)
0.787564 Irish pounds (IEP)
1936.27 Italian lire (ITL)
40.3399 Luxembourg francs (LUF)
200.482 Portuguese escudos (PTE)
166.386 Spanish pesetas (ESP)
The above rates were determined by the Council of the European Union, based on a
recommendation from the European Commission based on the market rates on 31 December
1998, so that one ECU (European Currency Unit) would equal one euro. (The European
Currency Unit was an accounting unit used by the EU, based on the currencies of the member
states; it was not a currency in its own right.) These rates were set by Council Regulation
2866/98 (EC), of 31 December 1998. They could not be set earlier, because the ECU
depended on the closing exchange rate of the non-euro currencies (principally the pound
sterling) that day. Greece failed to meet the criteria for joining initially, so it did not join the
common currency on 1 January 1999. It was admitted two years later, on 1 January 2001, at
the following exchange rate:
340.750 Greek drachmas (GRD)
The procedure used to fix the irrevocable conversion rate between the drachma and the euro
was different, since the euro by then was already two years old. While the conversion rates
for the initial eleven currencies were determined only hours before the euro was introduced,
the conversion rate for the Greek drachma was fixed several months beforehand, in Council
Regulation 1478/2000 (EC), of 19 June 2000.
The currency was introduced in non-physical form (travellers' cheques, electronic transfers,
banking, etc.) at midnight on 1 January 1999, when the national currencies of participating
countries (the Euro-zone) ceased to exist independently in that their exchange rates were
locked at fixed rates against each other, effectively making them mere non-decimal
subdivisions of the euro. The euro thus became the successor to the European Currency Unit
(ECU).
4.3 Participation in the Economic and Monetary Union
4.3.1 Countries using the Euro
At present the member states officially using the euro are Austria, Belgium, Finland, France
(except Pacific territories using the CFP franc), Germany, Greece, Ireland, Italy,
Luxembourg, Netherlands, Portugal and Spain. Overseas territories of some Euro-zone
countries, such as French Guiana, R?union, Saint-Pierre et Miquelon, and Martinique, also
use the euro. These countries together are frequently referred to as the "Euro-zone", "Euro-
land" or more rarely as "Euro-group".
Many of the foreign currencies that were pegged to European currencies are now pegged to
the euro. For example, the Cape Verdean escudo used to be pegged to the Portuguese escudo,
but is now pegged to the euro. Bosnia-Herzegovina uses a convertible mark which was
pegged to the Deutsche mark but is now pegged to the euro. Similarly the CFP franc, CFA
franc and Comorian franc, all once pegged to the French franc, are now pegged to the euro.
The euro is widely accepted in Cape Verde already on an informal basis, and in November
2004, during a meeting in Portugal, the prime minister of Cape Verde considered formally
adopting the euro as his country's currency. Also East Timor resumed using the Portuguese
Escudo as legal tender in 1999, when the escudo was already a subdivision of the euro. There
was no changeover as the USD was later introduced as sole legal tender in the territory. Since
December 2002, North Korea has switched from the dollar as its official currency for all
foreign transactions to the euro. The euro has since then also replaced the dollar in large parts
of the black market and in shops where the dollar was used earlier.
In total, the euro is the official currency in 31 states and territories. Also, 27 states and
territories that have a national currency are also pegged to the euro including fourteen West
African countries including Senegal and Cameroon, three French overseas territories
including French Polynesia and New Caledonia, two African island countries where the
currency was formerly pegged to the Portuguese or French currency, three former
Communist countries where the currency was pegged to the German mark including
Macedonia. Morocco, Cyprus, Denmark, Estonia and Hungary are also pegged to the euro.
4.4 EU Members outside the Euro-Zone
The ten newest European Union members are required by their treaties of accession to
eventually use the euro, as eventual adoption of the euro was part of their accession
agreements. Cyprus, Estonia, Latvia, Lithuania, Malta, Slovenia and Slovakia have already
joined Denmark in the European Exchange Rate Mechanism, ERM 2. The United Kingdom
and Sweden have no plans at present to adopt the euro; however Sweden, unlike the UK and
Denmark, does not have a formal opt-out from the monetary union (the third stage of EMU)
and therefore must, in theory at least, convert to the euro at some point. Notwithstanding this,
on 14 September 2003, a Swedish referendum was held on the euro, the result of which was a
rejection of the common currency. The Swedish government had argued that such a line of
action was possible since one of the requirements for Euro-zone membership is a prior two-
year membership of the ERM 2. By simply choosing to stay outside the exchange rate
mechanism, the Swedish government is provided a formal loophole avoiding the theoretical
requirement of adopting the euro. Sweden's major parties continue to believe that it would be
in the national interest to join.
UK euro-sceptics believe that the single currency is merely a stepping stone to the formation
of a unified European super state, and that removing Britain's ability to set its own interest
rates will have detrimental effects on its economy. The contrary view is that, since intra-
European exports make up 60% of the UK's total, it eases the Single Market by removing
currency risk. An interesting parallel can be seen in the 19th century discussions concerning
the possibility of the UK joining the Latin Monetary Union. The UK government has set five
economic tests that must be passed before it can recommend that the UK join the euro. It
assessed these tests in October 1997 and June 2003, and decided on both occasions that they
had not all been passed. All three main political parties in the UK have promised to hold a
referendum before joining the euro, and opinion polls consistently report a majority of the
public to be opposed to joining the euro.
4.5 Effects of a Single Currency
The introduction of a single currency for many separate countries presents a number of
advantages and disadvantages for the participating nations. Opinions differ on the actual
effects of the euro so far, as most of them will take years to understand.
Removal of Exchange Rate Risk
One of the most important benefits of the euro will be lowered exchange rate risks, which
will make it easier to invest across borders. The risks of changes in the value of respective
currencies have always made it risky for companies or individuals to invest or even
import/export outside their own currency zone. Profits could be quickly eliminated as a result
of exchange rate fluctuations. As a result, most investors and importers/exporters have to
either accept the risk or "hedge" their bets, resulting in further costs on the financial markets.
Consequently, it is less appealing to invest outside one`s own currency zone. The Euro-zone
greatly increases the potentially "exchange-risk free" investment area. Since Europe`s
economy is heavily dependent on intra-European exports, the benefits of this effect can
hardly be overstated. This is particularly important for countries whose currencies have
traditionally fluctuated a great deal such as the Mediterranean nations.
Removal of Conversion Fees
A benefit is the removal of bank transaction charges that previously were a cost to both
individuals and businesses when exchanging from one national currency to another. Although
not an enormous cost, multiplied thousands of times, the savings add up across the entire
economy.
Deeper Financial Markets
Another significant advantage of switching to the euro is the creation of deeper financial
markets. Financial markets on the continent are expected to be far more liquid and flexible
than they were in the past. There will be more competition for and availability of financial
products across the union. This will reduce the financial servicing costs to businesses and
possibly even individual consumers across the continent. The costs associated with national
debt will also decrease. It is expected that the broader, deeper markets will lead to increased
stock market capitalisation and investment. Larger, more internationally competitive financial
and business institutions may arise.
Price Parity
Another effect of the common European currency is that differences in prices - in particular
in price levels - should decrease. Differences in prices can trigger arbitrage, e.g. artificial
trade in a commodity between countries purely to exploit the price differential, which will
tend to equalise prices across the euro area. This should also result in increased competition
between companies, which should help to contain inflation and which therefore will be
beneficial to consumers. Similarly, price transparency across borders should benefit
consumers find lower cost goods or services.
Macroeconomic Stability
An important side-effect of the euro will be greater macroeconomic stability for the entire
continent. Much of Europe has been susceptible to economic problems such as inflation
throughout the last 50 years. Inflation is a very damaging phenomenon from most of society`s
perspective. It discourages investment, can cause social unrest, and causes problems for
taxation. However, many countries are unable or unwilling to deal with serious inflationary
pressures. They often have other priorities that compromise their ability to deal with inflation.
Sometimes their economic clout is simply insufficient. However, there have been models,
particularly with largely independent central banks, that have successfully countered
inflation. One such bank was the Bundesbank in Germany; since the European Central Bank
is modelled off of the Bundesbank, is independent of the pressures of national governments,
and has a mandate to keep inflationary pressures low. Many economists foresee a period of
increasing price stability in Europe after the euro`s introduction.
Less-specific Monetary Policy
Some economists are concerned about the possible dangers of adopting a single currency for
a large and diverse area. Because the Euro-zone has a single monetary policy, and so a single
interest rate, set by the ECB, it cannot be fine-tuned for the economic situation in each
individual country (however, prior to the introduction of the euro, exchange rates were
already very much in sync after the latest European currency crisis in the early 1990s). Public
investment and fiscal policy in each country is thus the only way in which government-led
economic stimulus can be introduced specific to each region or nation. This inflexible interest
rate might stifle growth in some areas, while over-promoting it in others. The result could be
extended periods of economic depression in some areas of the continent, disadvantaged by
the central interest rate. Given such a situation resentment and friction within the community,
and toward the bank, might well increase. Others point out that in today's globalised economy
individual countries do not have power to effectively manage their monetary policy, as it
creates other imbalances. This effect was already visible in the last European currency crises
of 1992, when the Bundesbank was effectively coordinating monetary policy for the whole
continent.
Some proponents of the euro point out that the Euro-zone is similar in size and population to
the United States, which has a single currency and a single monetary policy set by the Federal
Reserve. However, the individual states that make up the USA have less regional autonomy
and a more homogeneous economy than the nations of the EU.
If the euro were to become either a hegemonic currency replacing the dollar or a co-
hegemonic currency equal in reserve status to the dollar, some of the subsidy the USA gains
would be transferred to the EU and help balance out some of the problems of the present
heterogeneous economic structure still in place.
The euro will probably become one of two, or perhaps three, major global reserve currencies.
Currently, international currency exchange is dominated by the American dollar. The dollar is
used by banks as a stable reserve on which to ensure their liquidity and international
transactions and investments are often made in dollars.
What makes a currency attractive for foreign transactions? Primarily, a proven track record of
stability, a broad, well developed financial market to dispose of the currency in, and proven
acceptability to others. The Euro will almost certainly be able to match these criteria at least
as well as the U.S. dollar, so given some time to become accepted, it will likely begin to take
its place alongside the dollar as one of the world`s major international currencies. There are
several benefits to reserve currencies of being such an internationally acceptable currency. If
the euro were to become a reserve currency it would benefit member countries by lowering
the service charges on their debts. Since the currency would be so broadly acceptable it
would make the premiums paid to debt holders lower, since the risk to the borrower is lower.
4.6 The Euro and Oil
The Euro-zone consumes more imported petroleum than the United States. This would mean
that more euros than US dollars would flow into the OPEC nations, but oil is priced by those
nations in US dollars only. There have been frequent discussions at OPEC about pricing oil in
euros, which would have various effects, among them, requiring nations to hold stores of
euros to buy oil, rather than the US dollars that they hold now. Venezuela under the
presidency of Hugo Ch?vez has been a vocal proponent of this scheme, despite selling most
of its own oil to the United States. If the exchange rate and the oil price move in different
directions, oil price changes are magnified. Pricing oil in euros would nullify this dependency
of European oil prices on the USD/EUR exchange rate.
4.7 Euro Exchange rate against the U.S. Dollar
After the introduction of the euro, its exchange rate against other currencies, especially the
US dollar, declined heavily. At its introduction in 1999, the euro was traded at USD1.18; on
26 October 2000, it fell to an all time low of $0.8228 per euro. It then began what at the time
was thought to be a recovery; by the beginning of 2001 it had risen to nearly $0.96. It
declined again, although less than previously, reaching a low of $0.8344 on 6 July 2001
before commencing a steady appreciation. In the wake of U.S. corporate scandals, the two
currencies reached parity on 15 July 2002, and by the end of 2002 the euro had reached $1.04
as it climbed further.
4.8 Currencies Pegged to Euro
Part of the euro's strength in the period 2001-2004 was thought to be due to more attractive
interest rates in Europe than in the United States. The US Federal Reserve had maintained
lower rates than the European Central Bank for these years, despite key European economies,
notably Germany, growing relatively slowly or not at all. This is attributed in part to the
ECB's duty to check inflation across the Euro-zone, which in high-performing countries such
as Republic of Ireland is above the ECB's target.
A key factor is that a number of Asian currencies are rising less against the dollar than is the
euro. In the case of China, the renminbi was until recently pegged against the dollar, whilst
the Japanese yen is supported by intervention (and the threat of it) by the Bank of Japan. This
means much of the pressure from a falling dollar is translated into a rising euro.
The euro's climb from its lows began shortly after it was introduced as a cash currency. In the
time between 1999 and 2002, euro-sceptics believed that the weak euro was a sign that the
euro experiment was doomed to fail. It may be that its weakness in this period was due to low
confidence in a currency that did not exist in "real" form. While the overt conversion to notes
and coins had not yet occurred, it remained possible that the project could fail. Once the euro
became "real" in the sense of existing in the form of cash confidence in the euro rose and the
increasing perception that it was here to stay helped increase its value. This effect was
probably significant in the euro's decline and recovery between 1999 and 2002, but other
factors are more significant since then.
Another factor in the early decline of the euro was that many investors and central banks sold
large portions of their legacy (national) currency holdings once the irrevocable exchange
rates were set, as the goal of holding multiple currencies is to dampen losses when one
currency falls. Once the exchange rates between Euro-zone countries were pegged against
each other, holdings in German marks and French francs (for example) became identical.
There is also some reason to believe that significant sums of illegally held monies were sold
for dollars to avoid an official and public exchange for euros. Despite the euro's rise in value,
as well as the value of other major and minor currencies, the US trade deficits continue to
rise.
There is speculation that the strength of the euro relative to the dollar might encourage the
use of the euro as an alternative reserve currency. Moves by central banks with major reserve
currency holdings such as those of India or China to switch some of their reserves from
dollars to euros, or even of OPEC countries to switch the currency they trade in from dollars
to euros, will further reinforce the dollar's decline. In 2004, the Bank for International
Settlements reported the proportion of bank deposits held in euros rising to 20%, from 12% in
2001, and it is continuously rising. The falling dollar also raises returns for US investors from
investing in foreign stocks, encouraging a switch which further depresses the dollar. The rise
in the euro should dampen Euro-zone exports, but there is little sign of this happening yet.
The main reason is that the currencies of Euro-land's major world-wide customers are also
seeing their currencies rise relative to the dollar.
4.9 Countries with the Euro as currency
There are 12 members in the Euro-zone: Austria, Belgium, Finland, France (except pacific
territories using CFP franc), Germany, Greece, Ireland, Italy, Luxembourg, Netherlands,
Portugal, and Spain. The European Central Bank is responsible for the monetary policy
within the Euro-zone.
Nations with formal agreements with the EU
Monaco, San Marino, and Vatican City also use the euro, although they are not officially euro
members or members of the EU. (They previously used currencies that were replaced by the
euro.) They now mint their own coins, with their own national symbols on the reverse. These
countries use the euro by virtue of agreements concluded with EU member states (Italy in the
case of San Marino and Vatican City, France in the case of Monaco), on behalf of the
European Community.
Nations without formal agreements with the EU
Andorra does not have an official currency and hence no specific euro coins. It previously
used the French franc and Spanish peseta as de facto legal tender currency. There has never
been a monetary arrangement with either Spain or France; however, the EU and Andorra are
currently in negotiations regarding the official status of the Euro in Andorra. As of 1
December 2002, North Korea has replaced the US dollar with the euro as its official currency
for international trading. The euro also enjoys popularity domestically, especially among
resident foreigners.
Non-euro-zone EU countries
The other 13 countries of the European Union that do not use the euro are: Denmark,
Sweden, the United Kingdom, and the ten member states that joined the Union on 1 May
2004; namely Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta,
Poland, Slovakia, and Slovenia. Denmark and the United Kingdom got special derogations in
the original Maastricht Treaty of the European Union.
4.10 Non-EU Currencies Pegged to the Euro
In 1999 the Bulgarian currency was redenominated (1 new lev = 1000 old levs) and the
value of the lev was fixed to one German mark, therefore its value has since been fixed in
relation to the euro.
Cape Verde's currency was pegged to the Portuguese escudo, and now the euro.
Bosnia and Herzegovina's currency, the Convertible Mark, was pegged to the German
mark (and now the Euro).
The CFA, Comorian and CFP francs, used in former French colonies, were pegged to the
French franc, and now the euro.
4.11 Fiscal policy
For their mutual assurance and stability of the currency, members of the Euro-zone have to
respect the Stability and Growth Pact, which sets agreed limits on deficits and national debt,
with associated sanctions for deviation. The European System of Central Banks (ESCB) is
composed of the European Central Bank (ECB) and the national central banks (NCBs) of all
25 EU Member States. The Stability and Growth Pact is an agreement by European Union
member states related to their conduct of fiscal policy, to facilitate and maintain Economic
and Monetary Union of the European Union.
4.12 Convergence Criteria
Convergence criteria, also known as the Maastricht criteria, is the criteria for European
Union member states to enter the third stage of European Economic and Monetary Union
(EMU) and adopt the euro. The 4 main criteria are based on Article 121(1) of the European
Community Treaty. Those member countries that are to adopt the euro need to meet certain
criteria which include:
1. Inflation rate: No more than 1? % higher than the 3 best-performing member states.
2. Government finance:
Annual government deficit:
The ratio of the annual government deficit to gross domestic product (GDP) must not exceed
3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to
3%. Only exceptional and temporary excesses would be granted for exceptional cases.
National debt:
The ratio of gross national debt to GDP must not exceed 60% at the end of the preceding
fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must
have sufficiently diminished and must be approaching the reference value at a satisfactory
pace.
3. Exchange rate: Applicant countries should have joined the exchange-rate mechanism
(ERM 2) under the European Monetary System (EMS) for 2 consecutive years and should not
have devaluated its currency during the period.
4. Long-term interest rate: The nominal long-term interest rate must not be more than 2%
higher than the 3 best-performing member states. The purpose of setting the criteria is to
maintain the price stability within the Euro-zone even with the inclusion of new member
states.
Review Questions
1. Explain European Exchange Rate Mechanism (or ERM)
2. Outline the history of the EMU
3. Outline the countries using the euro and EU Members outside the Euro-Zone
References:
The Gold Standard in Theory and History, Barry Eichengreen (Editor), Marc Flandreau,
1997
The Gold Standard and Related Regimes: Collected Essays (Studies in Macroeconomic
History), Michael D. Bordo (Editor), Forrest Capie (Editor), Angela Redish
A Retrospective on the Classical Gold Standard, 1821-1931 (National Bureau of Economic
Research Conference Report), Michael D. Bordo (Editor), Anna J. Schwartz (Editor), 1984
UNIT ? II
Lesson ? I
AN OVER VIEW
Lesson Outline:
Creation of Euro ? currency Markets
Creation of Euro Dollar.
Emergence of Global currency Markets.
Size and structure European Markets.
Regulatory Systems and
Major Instruments.
Learning Objectives
Understand the nature of European money market.
Define Euro ? Currency market.
Understand the nature of Euro ? Dollar.
Understand the regulatory systems.
Understand the popular and major instruments of and governing the common International
money market.
Introduction
A cursory glauce of of the World Map will show that EURASIA is one of the big
continents. In this continent if we cut across ? South to North ? at the point of the SUEZ
CANAL we get 2 parts. The one on our right is ASIA` and the other on the left is
EUROPE.
Our current study is about the Europe, now comprising of 25 countries as on
1.5.2004. This includes the countries already enjoying membership in the European Union
and some, which propose to join before the end of 2007.
Objectives:-
1.
To trace the creation and growth of Euro ? currency markets.
2.
To discuss the composition of instruments death with in Euro markets.
3.
To explain the determinants of interest rates in Euro Markets.
4.
To discuss the evolution, components, and institutions in the International Bond
Market and finally.
5.
To provide an overview of the foreign bonds.
CREATION OF EURO ? CURRENCY MARKETS
To have a clear understanding of the functioning the Euro-Currency, it is imperative to know
the meaning and concept of Euro-Dollar, because all transactions up to 1960 were in Euro-
Dollar only. A strict line of demarcation will only be artificial .
An American Dollar, outside America is called as Euro-Dollar. But presently the non-dollar
denominated deposits have a widespread existence in the Euro-Currency markets. Also much
of the market is new located outside Europe.
The term Euro-Dollar refers to all such financial assets and liabilities denominated in U.S.
Dollars, but which are transacted outside the territory of the U.S.A. It was precisely to
overcome the difficulties arising out of the monetary regulations which did not become
applicable on such markets outside the geographical transitory of U.S.A. that these markets
have come into existence and are making tremendous growth since then 1960.
There were many restrictions imposed by the Federal Reserve Board of U.S.A. on the U.S.
commercial Banks on payment of interest takes on deposits received from individuals. Such
instructions could, no longer, be imposed on the Euro-Dollar deposits.
Another regulation which got amended in 1969 was responsible for a rapid growth of
Euro-Dollar market. The regulation (Similar to the concept of cash Reserve Ratio in the
Indian contest) required that only U.S. banks situated in its territory required to maintain a
Reserve against deposits whereas their foreign branches as well as foreign banks deposits
in U.S. banks need not keep any such reserve.
The policy to tighten the domestic availability of credit with the Banks, made the
position of U.S.`S domestic bank to find them selves in a difficult situation.
Added to this, a nearly double the interest ? rate prevailing abroad in the foreign
branches of U.S. Banks encouraged the depositors to move away from the banks ? domestic
to foreign branches. Due to the non-availability of adequate credit domestically, the banks in
U.S.A. were forced to borrow from the other European Banks, to meet their domestic demand
from their customers, such increased demand pushed up the interest ? rates in Euro Banks.
The other restrictions aimed at (a) controlling the capital outflows from U.S. and (b)
improving the BOP situation were equally responsible for the rapid growth of Euro ? Dollar
market.
The Financial institutions operating the Euro-Currency markets may be identified as under.
(i)
The U.S. Banks
After the second world ? war (1939 ? 45) the American Banks wanted to participate
directly to help their multi-national corporations abroad. This job was assigned earliest to the
foreign banks.
(ii)
The consortia Movement:
This involves in some kind of a Joint venture with other Banks with the objective of
Euro-Financing business. These ventures were known as Consortium Banks. These are
intended to provide medium term loans to the international borrowers.
(iii) European Banking Response
Most of the major European Banks did not consider the establishment of American
Banks` foreign branches simply as an operationally convenient move but a kind of strategy
since they witnessed a break ? down of the earlier Correspondent branching system.
The Euro ? Currency market acts as an inter-bank money bank at international level. It
provides an adequate credit to private and public companies.
EURO ? CURRENCY INSTRUMENTS
(A)
EURO ? DOLLAR DEPOSITS:
The deposits in Euro-Dollar markets have 2 types of options (1) Regular time deposits
involving very limited period (i.e. overnight, call money or other accounts) and (2)
Certificates of Deposits (CDs) involving large amounts (Usually above $1,00,000) and with
longer maturities (Between 3 to 6 months). A cable or telex message transfers the amounts
from the Bank`s account in U.S. to the borrowers account anywhere. Confirmation of
transaction is only paper work. The flow time is very short so as to prevent the owner from
losing large sums of interest.
(B)
EURO ? DOLLAR LOANS
The normal range in which these loans vary, is found to be between $ 5,00,000 upto $
100 millions or even more. The maturity period ranges between 30 days upto 5 to 7 years.
However the loan amount as well as the re ? payment period depends on the relationship and
goodwill between the borrower and lender.
The Interest rates on the Euro ? Dollar loans are floating ? rates rather than fixed
rates, particularly for medium and longer maturities of about 3 years and beyond, generally
the Interest Rate will be the LIBOR rates plus 1.5% The payment of interest is fixed at 6
monthly intervals, until maturity. The Euro ? Dollar loans protect the Euro ? Bank`s project
also (LIBO Rates means London inter Bank Offer Rates).
Composition of the Euro ? Currency Markets
The Bank for International Settlements (BIS) gives the details of the Euro ?
currencies transacted between the countries of the Euro ? Currency area.
There are 2 categories of countries involved with the Euro ? Currency area (1)
Countries of Inside area and those of Outside area This classification is done on the basis
of reporting of figures done by only 8 countries especially in the inside area. They are ?
Belgium, Finance, Germany, Italy, Netherlands, Sweden, Switzerland & U.K.
The outside area Countries are ? west ? European countries, East European
countries, Canada, Japan, Latin America, Middle ? East, U.S.A. and others.
Determinants of Euro ? currency Rates
There is a basis for the lenders of Dollars into the Euro ? market, namely, the money
market rates, they would obtain in the U.S.A. Generally the interest rates would be revised in
response to a rise in the demand in domestic market or domestic country. The ultimate
borrowers would rather prefer borrowing from the euro market, since the need not require to
keep minimum compensating balances. Normally, the borrower would be willing to offer a
slightly higher interest on such Euro ? Loans. The Banks will not bother paying higher
interest on their Dollar deposits than their U.S. Counter parts.
If we make a comparison between the interest rates on 60 to 89 days Certificates of
Deposits (CDS) in the U.S. Visa ? Vis the Euro Dollar rates for Similar maturity, it may be
observed that the Euro ? Dollar interest rate would be above its counter part of the CD rate in
U.S.
What determines the fluctuations in the size of the spread of Euro ? Dollar rates over
the U.S. rates? There are 2 important causes (1) The U.S. Regulations of Banking System on
the international Capital outflows and (2) the fear of possible collapse in the Euro ? Dollar
markets.
This market has gained strength due to 2 reasons (1) The U.S. regulation policies
announced during 1969 in U.S. and (2) The credit squeeze policy. Free convertibility of Euro
? Currencies into U.S. Dollars have helped the development of Euro ? Dollar market.
Relationship between Domestic and Euro Currency Markets
The interest rates in the national and Euro ? currency markets cannot be independently
determined. The extent to which there are additional costs, taxes, or risks involved in moving
dollars between the New York and London markets will have a proportionate effect on the
interest differential. Suppose such is not the case, then, naturally, the arbitrageurs would
obtain funds in the low cost markets and lend the same in the higher ? return ? market. There
is a very minimal cost of shifting funds from the U.S. domestic market to the Euro markets.
The difference is due to the currency controls or the risk involved in such movement.
EURO ? CURRENCY SPREADS
The term Spreads represents the margin between lending and deposit rates During the past
3 decades, the lending rates have been lowest mainly because of the following factors.
1.
Lack of reserve requirements.
2.
Regulatory expenses are either non ? existent or very minimal.
3.
No compulsory lending to some priority borrowers at concessional rates.
4.
Information collection and processing is done quickly and with least cost since
most of the borrowers are well ? known.
Maturity Analysis
The Bank for International Settlements started publishing information bi ? annually since
1978, entitled. The maturity Distribution of International Bank lending. There were 2
fundamental reasons (1) The less developed countries were facing outstanding debts to the
international banks and (2). The information published by the world bank and the
organisation for Economic cooperation and Development (O.E.C.D.) on external debt
position of various countries is relatively out ? dated and less comprehensive when compared
with the Bank for International Settlements (BIS) data.
The Maturity Period` refers to the residual time period remaining of the bank claims
but not their original maturities. The claims for maturity period are classified into 3
categories.
1.
Less than and including one year.
2.
Above one year and upto and including 3 years and
3.
Above three years.
International Bond Market
This is defined as a market for bonds which are sold anywhere in the world but not in
the geographical territory of the country of currency in which it is denominated. Mostly
the funds raised by the borrowers in such market consist of foreign currencies i.e., other
than the borrowers own currency for example, a U.S. company borrowing Euro ? Dollars,
outside U.S.
Classification of International Bond Market
1. Euro Bond market and
2. Foreign Bond market.
A bond issued is said to be a Euro ? Bond issue if such bonds are mainly sold in
other countries than the country of origin.
A foreign bond is one which is placed by a domestic syndicate, on the market of a
single country and is denominated in that countries currency.
QUALIFICATIONS OF A Non ? resident
1.
Government or government Agencies or political sub ? divisions which are not
located in the country of issue.
2.
International organisations like the International Monetary Fund and the
International Bank for Re-construction and Development.
3.
Officially sponsored international enterprises except when their registered office
is in the concerned country.
The Bond Issues were started in New York. Some of the attractions for
borrowers in New York included,
1.
Quick and efficient system of under ? writing.
2.
Lower interest rates thus reduce the cost of borrowing and.
3.
Large and adequate supply.
The interest rate disparity between the U.S. domestic market and the Euro Dollar market
was due to (1) the presence of investors willing to arbitrage between these 2 markets and
(2) because of the discontinuation of the discriminatory poling by the U.S. wherein it used
to impose withholding taxes only on the foreign investors.
The
placement
of
Euro
?
Bond
issue
was
done
through
on
under-writing group and there was a growing popularity for privilege placed issues due to
merits like quickness, simplicity etc.
During the sixties and first half of seventies, approximately 75% of the Euro ? Bonds
were dollar ? denominated. Later, there has been a fall in the share of dollar denominated
issues following a decrease in the dollar value. Consequently, non ? dollar issues mainly in
Japanese yen and the Deutsche Mark have increased.
TYPE OF EURO ? BONDS
Classification of Euro ? Bonds.
1.
Straight Euro ? Bonds
2.
Euro ? Bonds with more currencies.
(a) Multiple Currency bonds
(b) EMV Bonds
(c) Unit of Account bonds
(d) Parallel Bonds
Though the pre ? fix Euro gives an impression that such bonds are confined to the
European countries, the Euro Bond Market is truly international as those bonds are sold to
investors around the world and such issues need not comply with the national regulations and
controls.
Straight Euro ? Bonds represent a substantial part of the Euro Bond market in which
the Bonds are issued with a single currency. However, later, the bonds involving more than
one currency have started occupying on important position in the Euro ? Bond Market.
Sometimes, the creditor loses, if and only if all the currencies included in the multiple
currency contract depreciate simultaneously against others which are not included. As an
example, consider a Japanese leader - bank buying such multiple currency bond and opting
payment in the form of U.S. Dollars, or British pounds or Italian liras. If all these three
currencies depreciate against, say, the Yen, than it loses and Vice versa. Anyhow the gains
are maximized and losses minimized in the event of any exchange rate variations.
European Monetary Union (EMU) bonds, also referred to as the European Currency
Union Bonds are also multiple Currency Bonds . The difference being there are 6 major
reference currencies. For the borrower the basic advantage is that these EMU bonds bear a
lower interest rate than the previous type of bonds. The main disadvantage is an obligation to
compensate the creditor for the difference in exchange rate appreciation of these 6 currencies.
For the lender, there is enough protection since in the event of devaluation, he is
entitled to obtain repayment in the least devalued currency and similarly he demands in case
of appreciation repayment in the form of the most unvalued currency.
SECONDARY MARKETS FOR EURO BONDS
Secondary markets refer to the sale of bonds or any other security, which is already bought
for the first time in a primary market and has been present only for name`s sake in Euro ?
Bond market. But, because of the price quotations both buying and selling prices for various
Euro ? Bonds being made by the commercial banks, security firms and Bond brokers the
secondary trading has become easiest and gaining more popularity.
There is a 3 tier structure in the issue of Euro bonds, consisting of
(1).
Issue Managers (2) Under writers and (3) sellers. In the case of U.S.A., the under ?
writers must purchase or Swallow the unsold portion of the issue, while in Eurobond,
under writing, the underwrites make their best efforts to sell. They have wider options in
the event of portions of the bond issue remaining unsold, including the cancellation of the
unsold part if the under writers are reluctant to purchase.
Large sums can be raised at a stroke and the funds can be easily re ? distributed across
the countries it intends. A second option which is relatively risky and less preferable, could
be that separate issues may be made in the needed countries.
Euro Bond and Euro Currency ? A Comparison
A borrower has two options between the Euro Bonds and Euro currencies. There are certain
merits and demerits of processing loans in the form of Euro currencies as well as Euro bonds,
depending upon certain prevailing conditions.
Eurobonds issues have the choice of fixed as well as floating rates. The Fixed Rate Bonds
have their own advantages since the currency inflows and outflows can be offset with a
calculated rate. The interest rate on Euro Currency loans is variable. It benefits the
borrower, if interest declines and vice versa.
The Euro ? currency loans have to be repaid in a relatively smaller time ? periods less than
loans from Euro Bond market. Euro Currency loans with multiple currencies provide on
easier opportunity to change over from one currency to another at stipulated dates, while it
involves some complications in the case of Euro Bonds. The Euro Currency loans can be
raised quickly while it involves a relatively longer time for raising loans thr0ough the Euro
Bonds.
FUNCTIONS OF EURO CURRENCY MARKETS.
1.Cheap resource of working capital.
Euro currency loans attract lesser interest than the loans of the domestic economy.
Interest rates are lowest because overhead costs are lower. Since the dealings are between
banks with good credit ? rating, the costs of credit checking and processing are less. The
lending rates can ? thus, be fixed lower than the domestic market. Similarly, it is possible to
fix deposit rates higher than in the domestic markets.
2. Liquidity
The financial institutions find it highly profitable to hold their idle resources in
Euromarkets. Since there are lesser restrictions in the markets, the investors can make
investments in bearer securities. It has an added advantage in the form of absence of tax
withholding on interest, Most of these deposits have maturities ranging from less than one
day to a few months. On an average, about 80% of these deposits have the maturity of 6
months.
3. Facilities of International Trade.
They provide easy loans which facilitate International Trade. Most of the Banks
prefer this form of financing to the traditional forms like the letter of credit (LC). Much of the
preference for Euro Currencies arise from the lower interest rates and the absence of
emphasis on procedural formalities. Considering the attractiveness of these funds, there has
been a sizable increase in the volume of transactions in these markets.
4. Euro Debt Markets
These markets can be studied under 2 broad classifications (a) Euro Dollar loans and
(b) Euro bond markets.
4(a). Euro Dollar Loans
The demand for Euro ? Dollar loans was pushed up during 1960, indirectly by the
restriction imposed in obtaining loans within the U.S. These restrictions were the result of a
voluntary restraint programme adopted in 1965. It was followed by certain mandatory
controls in 1968. These structures controlled the creation of loans within the U.S. Borrowers
are, therefore, forced to look for funds outside the U.S. The Euro ? Dollar loans provided the
much needed alternate source of funds.
From 1963 to 1974, The U.S. Interest ? Equalization Tax was in vogue. The tax
was a levy on U.S. residents earnings on foreign securities. To equalize the expenditure to a
U.S. resident lender on account of the levy, the foreign borrowers were forced to offer higher
interest. Euro ? Dollar loans did not attract the interest ? equilisation as a result the interest
rates offered were much lower.
Euro currency loans, irrespective of the currency in which it is denominated, are
easier to obtain as compared to the loans denominated in home currencies since it is also
possible to obtain a loan of any currency within a country (e,g, Pound, Mark, Yen etc.,) in
New York itself, it is easier for the borrowers to borrow locally than to approach the home
market of a currency individually (i.e., Pounds in London, Marks in Germany, Yen in Tokyo
etc.,)
4(b). Euro Bonds.
These bonds are of more recent origin. They are unsecured bearer debt instruments with
maturity of 5 years or more. The bond is sold in the markets other than those in the country
in whose currency it is issued.
Since Euro Bonds are not regulated strictly, their issue ? costs are lower than those of
domestic issues. As such they had become an excellent source of raising long term capital.
The issue of the bonds is generally made simultaneously in several markets on behalf of
international borrowers by syndicates.
OTHER TYPES OF EURO CURRENCY INSTRUMENTS
a).Bank Deposits
These are conventional deposits of Euro ? currencies in Banks. Usually the period of
maturity is either 30 days or 90 days. They are seldom made for periods longer than 90 days.
Interest rates are pre ? fixed on the basis of the duration of the deposit.
5. SDR denominated Deposits.
Euro ? Currency deposits may be denominated in Special Drawing Rights (SDR) of
the International Monetary Fund. They are non ? negotiable deposits with specific maturity
dates. They are, however, not as popular as Euro currency Deposits.
6. Certificates of Deposits (CDs)
They are negotiable instruments, actively traded in the secondary markets. They are
not term ? deposits, they offer a highest rate of liquidity.
7).
International Banking Facility
These are separate set of accounts with a Bank. They can accept foreign currency
deposits. If used to make loans to foreigners, they do not require insurance covers. In such
cases, the reserve requirements too are waived. Withdrawals can be made offer giving 2
days notice.
8). Euro ? Dollar Futures
When the assets and liabilities of Euro banks are not equal in terms of volume and
maturity, they are subject to risks of exchange rate fluctuations. Euro Dollar Futures market
helps Euro Banks to avoid much risks by making a future sales.
CURRENCY OPTIONS
A currency option is an arrangement between an option holder and an Option
writer The option holder is the buyer and the option writer is the seller of an option. A
currency option gives the buyer the right, but not the obligation, to either buy or sell a
specified quantity of one currency in exchange for another at a pre ? determined exchange
rate, known as the strike price.
However, the option to buy or sell must be exercised on or before a specified expiry
date. Though the holder has no obligation to increase an option, the writer of the option must
comply with its terms and should be prepared to buy or sell the underlying currency when a
holder decides to exercise and option. Now, in what follows, a brief description is provided
on the salient features of the currency option.
FEATURES OF CURRENCY OPTION
Currency options are of 2 types, viz, (1) Over The Counter (OTC) options and (2) Exchange
Traded Options, (OTC) options can be arranged individually with a Bank, whereas the
Exchange Traded option can be purchased through a broker on options exchange such as The
philedelphia stock Exchange (PHLX), Chicago Mercantile Exchange (CME) etc.,
CALL OPTION Vs PUT OPTION
A call option gives its holder the right but not the obligation, to buy the specified amount or
quantity of a currency usually against the U.S.$ at the strike price. On the other hand, a put
option given its holder the right to U.S.$
QUANTITY OF CURRENCY
The option agreement specifies the Quantity of currency an option buyer can purchase or sell.
In the case of Exchange Trade options, the quantity is a standard amount. For example, on
PHLX, the currency options traded are, currently restricted to the following against the
U.S.Dollars.
Option
Quantity
Pound Sterling
31,250
Australian Dollar
A$50,000
Canadian Dollar
C$50,000
Japanese Yen
6,250,000
ECU`s
ECVS 65,500
Deutsche Mark
DM 62,500
Swiss Frane
SFr 62,500
Rench Frane
FFr 250,000
Strike Price of the Currency.
The Exchange Rate at which the holder has the right, but not the obligation, to
exchange the currencies. When an option is the strike price must be higher, or lower or
exactly the same as the current spot rate. Thus a strike price could be (1) at ? the ? money (2)
in the money and (3) out of the money.
At ? the - money - option
An option whose strikes price is the same as the current market exchange rate. An at
the money option would be used by a customer who wants to guarantee today`s rate while
allowing himself some profit potential, if the exchange rates were to move in his favour.
In ? the ? money - option
A currency option whose strike ? rate is more favourable than the current spot ? rate.
Normally this type of option would attract a high premium, as the holder can make an
immediate exchange profit. By exercising his right.
Expiry Date
The date on which the right to exercise the option ends.
SUMMARY
There has been an introduction which traced the resource behind the evolution o the
Euro Dollar market, its growth, its popularity etc., The Euro Dollar deposits and loans and the
Corresponding constituents in each of them were noted.
A list of countries which were traditionally involved with the Euro currency market
was presented. They were classified into the inside area and outside area.
Later, how the U.S. Money market interest rates influence the Euro ? market interest
? rates was observed. Euro Currency spreads and maturities have been discussed. The
concept of international bond market was explained and its constituents, namely, the Euro
Bonds Market and the foreign Bond market were discussed at length within the Euro ? Bond
market, the various types of bonds involving a single and multiple currencies, their
characteristics and advantages were noted. The functioning institutions which deal with them
has been explained.
Also, a comparative analysis of obtaining loans from bonds and from Euro Currency
has been made. Finally, the topic was would up with some aspects like who are the major
borrowers of loans from the Euro ? Bond market, which sectors got financed with such loans,
in which currencies, majority of bond issues have been made and which countries formed a
major share in marketing the Euro ? Bonds etc.,
In general, a fairly good idea was given about the 2 institutions such as the Euro ?
Bond market as well as the Euro ? Currency market.
KEY WORDS
Euro ? Currency Market
A market where Euro ? Economics are deposited and but with involvement of the
Euro ? Banks.
Euro ? Currencies
Such currencies like the U.S. Dollar, Deutseche mark, Swiss Francs, Italian Lira,
Japanese Yen etc., in which the deposits and loans are made, are known as Euro ?
currencies
Maturity Period
The remaining period of Bank claims at a particular date.
OECD (ORGANISATION FOR ECONOMIC COOPERATION AND
DEVELOPMENT)
It consists of Australia, Austria, Belgium, Canada, Denmark, Finland, France,
Germany, Greece, Iceland, Ireland, Italy, Japan, Luxembourg, Netherlands, New Zealand,
Norway, Portugal, Spain, Sweden, Switzerland, Turkey, United Kingdom and the United
States of America. The OCED has been the Chief Source of data relating to International
bonds.
IBF (International Banking Facilities)
London became the centre of international banking activities. It was due to the
restrictions imposed by the U.S. to bring back the Eurodollar business back to U.S. in 1981,
the IBF was announced, It is a set of institutions having very few regulations, which accept
foreign deposits and provide loans above $1,00,000/- to foreigners.
These IBFs have been prohibited from issuing negotiable instruments. They
Succeeded in bringing back the International Banking activities into U.S. But they themselves
have been lagging behind in international bagging.
NIF ( Note Insurance Facilities)
To withstand competition from the Euro Bond market, the Euro banks have created
NIF which allows the borrower to issue his own short ? term notes that are later distributed
by some financial institutions. Usually large and reputed companies use NIF to raise loans.
The NIF are unsecured loans and sometimes also called as a Euro commercial Paper (due to
similarities with the Commercial paper of the U.S. Money market).
Asia Currency Market
It was formed in 1968 with its head quarters in Singapore. Singapore has the most
liberal financial environment compared to its any other Asian counter part. In the recent past,
it has started growing very rapidly, though compared to the Euro currency market, it is still
very insignificant. It functions basically to chanalise the Euro Dollas into Asia, particularly
the South ? East Asia. It also facilitates the Euro Dollar deposits for the Asian investors.
QUESTIONS
1.
What do you understand by the Euro ? Currency market? What are inside and
outside areas?.
2.
Explain the Euro ? Currency spreads and maturity.
3.
What are Euro and Foreign Bonds? What has been the position of Dollar
denominated bonds in the Euro Bonds in the recent past?
4.
Briefly discuss the Euro Bonds involving more than one single currency.
5.
Explain the utility of Euro ? Currency Market.
BOOKS FOR FURTHER REFERENCE
1.
Dennis, Geoffrey E.J ? International financial flows: Statistical hand Book ?
Grahms and Trotman. Sussex. U.K. 198.
2.
Rita M.Rodriges ? International Financial Management, practice ? Hall, New
Jersy 1976.
3.
Allan C.Shapiro ? Multi National Financial Management ? Practice hall, New
Delhi 1995.
4.
Francisco L.Rivera ? Batiz & Luis Rivera Bakz ? International Finance and open
economy; Macro Economics, MAC Millan N.Y.1989.
5.
quriun Brain Scott. The New Euro Markets. Mac Millan Press. London 1975.
6.
Jeevanandam C. Foreign Exchange ? Sultan Chand & Sons, Daryagaj, New
Delhi ? 1998.
7.
Dewett K.K. and Verma J.D. ? Refresher course in Economic Theory ?
S.Chand and company Ltd., Ram Nagar, New Delhi 1997.
8.
Ahuja. H.L. Macro Economics, Theory and practice, S.Chand & Sons, Ram
Nagar, New Delhi. 2002.
LESSON ? 2
CREATION OF EURO DOLLAR
INTRODUCTION
In order to understand the creation of Euro ? Dollar it is necessary to trace the
history of the economic scenario from 1944, because, before the establishment of Dollar
Standards, there were some efforts made by the world community to standardize the
exchange rate as Euro Dollar
The background was that for a long time, say since 1930, the U.S. Dollar was ruling
the international money market. In Europe, originally there were 12 countries which had a lot
of international business. The U.S. dollar has been considered as the generally recognized
currency number one, because, after 1930, the U.S. Dollar has not been devalued. Even now,
in the international business, the countries quote the prices of their exportable products only
in terms of U.S. Dollar.
SOME INTERNATIONAL INSTITUTIONS
1).
The International Monetary Fund (I.M.F).
2).
The International Bank for Reconstruction and Development, (I.B.R.D) or world
Bank.
These were the outcome of the historical and significant international conference held
in 1944 at a place called Bretton woods, Bretton woods conference to charter a new
international financial system, to replace the than prevailing gold standard.
This famous conference saw the birth of the I.M.F. and W.B. The purpose of I.N.F.
has been to lend money for its poor members to pay for the deficit Balance of Payment.
Similarly the world Bank (W.B.) was established with the prime objective of restructuring
and rehabilitating the war ? ravaged economies of the world, through financial acid.
A significant outcome of the Bretton woods conference was the adoption of Gold
Exchange and Dollar Standards.
Under the gold Exchange standard of 1944, the currencies of all other countries were
priced or pegged in terms of the U.S. Dollar and the U.S.Dolar was in turn priced in terms of
gold. The U.S. was required to maintain gold reserves, while other countries were required
to maintained gold reserves, while other countries were required to have a reserve of united
states Dollar (USD)
After 1968 until 1973, it was possible to convert the foreign currencies only into
Dollars, the whole system was suitably termed as the Dollar standard.
Under the Dollar Standard, whenever there was an increase in demand for any
currency, the central bank was required to supply the currency. The strength of U.S. Dollar
was on account of its increased demand for making payment for imports by countries.
Another notable factor in the history of the creation of Euro Dollar was that the
organisation of Petrolium exporting Countries (OPEC) had large scale receipts of USD The
U.S. was able to attract much of these dollars and hence, these Dollars were popularly termed
as Petro Dollars.
There was the establishment of a lending institution in Europe, called The Emergency
Fund. The share capital of this fund was contributed by all countries. As usual, the U.S. has
taken the major park of the share capital, by sending U.S.Dollar to Europe.
The U.S. Dollar which goes out of U.S. to Europe for this Emergency Fund was
called as Euro Dollar
This is how the so ? called Euro Dollar was created.
Following this nomenclature, other countries followed. For example Euro ? Yen
of Japan, Euro ? Lira of Italy, Euro ? Marks of Germany etc., These different currencies
in these new names formed the capital of the famous lending institutions like The
International Monetary Fund and The International bank for Reconstruction and
Development (now called as world Bank)
In a similar manner, other Countries belonging to the Group of Ten also followed.
They are (1) Belgium (2) Canada (3) France (4) West Germany (5) Italy (6) Japan (7)
Netherlands (8) Sweden (9) U.K.and (10) Switzerland.
In all their share of the capital of the European Emergency Fund they have attributed
the adjective Euro for their Currency.
Moreover, Since 1st January 1986, the Value of one Special Drawing Right (SDR)
was based on a basket of currencies, viz, US Dollar, German Mark Japanese yen, U.K. Pound
and the French Franc whenever any member country of I.M.F. goes in for a borrowal, they
are using common name Euro Dollar, which will be converted into their national currency
later.
The world Bank also follows the nomenclature Euro Dollar for giving loans to
member countries to reconstruct their economies, which were in a bad condition as a
consequence of II world war. (Most of these countries are still in European Union).
Later on, in the History of the creation of Euro Dollar we find a lot of Improvement,
like The Group of Seven. This is the group of countries wheich were lending and
borrowing in terms of Euro Dollar. The are the richest and industrialised nations. They are
(1) Japan (2) West Germany (3) France (4) U.K. (5) Italy (6) Canada and (7) U.S.A.
This group of seven had proposed to build up a U.S. Dollar 50 Billion emergency
bail out fund which would be used to help countries facing acute financial problems. For
such lending the term Euro ? Dollar was used.
EURO DOLLAR MARKETS.
This market is spread over Europe, Middle East and Asia. Short term Euro markets
are called as Euro Dollar Markets. Any currency, held outside its home country is referred to
as Euro ? Dollar ? Currency. For example U.S.Dollar, outside U.S.A. is always called as
Euro Dollar of course, this is based on their share in the capital of the European
Emergency Fund.
Americans prefer to hold their Dollars outside the U.S. This may be attributed
sometimes, to the numerous financial service, provided by foreign (especially European)
Banks as compared with American Banks as well as the regulations and restrictions on capital
out flow by the U.S. Similarly, at times, the U.S. may force restrictions on the Americans
refraining them from depositing in foreign securities.
In such cases, it would be advantages for the Americans to have their dollar deposits
outside the U.S. and they can use their Euro ? Dollar deposits, whenever they require it
without any fear of any restrictions, laid down by the U.S. Government.
These Euro ? Dollar Deposits gainded popularity with most of the American
corporations outside U.S. also, especially when the exchange restrictions were imposed on
residence in the 1960s. Between the 1960s and 1970s, the U.S. Banks and other financial
institutions had to abide by the restrictions placed on the maximum rate of interest that they
could pay on the deposits. Particular interest are the Q and M regulations placed bythe
U.S. Federal Reserve Board.
The Q regulations restricted the interest rates on deposits. But the U.S. Banks,
outside U.S. were not subject to such restrictions. This had attracted large volumes of Dollar
deposits outside the U.S.
The M regulation stipulated, holding of reserves against deposits. These
regulations were not applicable to deposits with overseas branches of U.S. Banks.
Yet another reason for Dollar deposits in other countries was the absence of deposit
insurance. The Dollar deposits inside the U.S. were required to be covered by deposit
insurance.
THE EURO ? DOLLAR LOANS
The demand for the Euro ? Dollar loans was pushed up during 1960s, indirectly by
the restrictions imposed in obtaining loans within the U.S. The restrictions were the result of
a voluntary restraint programme adopted in 1965. It was followed by certain mandatory
controls in 1968. Borrowers are forced to look for funds outside the U.S. consequently the
Euro Dollar Loans provided the much needed alternate source of Funds.
From 1963 to 1974, there was a levy of the interest equalization Tax within the U.S.
for the local U.S.Dollar deposits. But the Euro ? Dollar loans did not attract this tax and
therefore the interest rates offered were lower.
EURO DOLLAR BONDS
These are of more recent origin after 1974. They are the unsecured bearer
instruments with a maturity of 5 years and more. Since these Euro Dollar Bonds are not
regulated strictly, their issue costs are lower than those of domestic issues. Hence they had
become an excellent source of issues for raising the long term capital.
EURO DOLLAR FUTURES
When the assets and liabilities of Euro ? Banks are not equal in terms of volume and
maturity, they are subject to the risk of Exchange rate fluctuations. The Euro dollar
Futures markets help Euro Banks to avoid much risks by making a future` sales.
FOREIGN EXCHANGE MARKETS FOR EURO DOLLARS
These markets have shot up into prominence as a natural response to the growing
volume of International Trade. These markets facilitate the conversion of one currency into
another, especially in Europe area, for various purposes like trade, payments for services,
developmentsl projects, speculation etc., Estimates put the total volume of trade done in a day
to nearly over a trillion. This was a larger or bigger figure than the stock markets of the
world. Besides the conversion of various countries into Euro Dollar, the foreign exchange
markets provide services like the extension of credit and holding of other facilities also.
When we speak of International Trade, we know that a country would prefer to import
goods for which it does not have a Comparative cost advantage, while exporting those
goods for which it has a comparative advantage over others. Normally\, there is a time gap
between the dispatch of goods and receipt of money. Therefore the Euro Dollar credit
servicing and the conversion of Currencies within Europe is facilitated by the Euro dollar
foreign exchange markets.
CONSTITUTENTS OF EURO DOLLAR EXCHANGE MARKETS
These markets have no physical structure. This is because there is no common place
where people can assemble to buy and sell the Euro Dollars. Most of the transactions are
done over the counter (OTC), via Telephone, Telex or cable. There is also no fixed trading
time. Trading is done 24 hours a day all the days of the year. By and large, London, New
York, Singapore and Tokyo are the largest foreign exchange trading centres for Euro Dollar.
The Market Makers for Euro Dollar
1.
Banks which are engaged in the conversion of currencies on behalf of this customer.
2.
Non ? Banking institutions that are engaged in exchanging currencies for certain
specific purposes.
3.
Speculators who are engaged in buying and selling currencies to take advantage of the
exchange rate fluctuation and
4.
Arbitragers engaged in arbitrage activities to take advantage of the price differentials
in various exchange markets.
OPERATIONS OF MARKET MAKERS FOR EURO DOLLAR
Foreign Exchange Banks operate in 2 levels. In the first i.e the retail level the banks
deal with individuals and corporations, The transactions for purchase and sale of currencies
are between the banks and its customers.
In the second level, the transactions are wholesale in nature. This is done in the inter
? bank market. Most of the operations are done directly by banks. However, at times, the
services of the Foreign Exchange Brokers are taken.
THE EURO ? CURRENCY INSTRUMENTS
(A) EURO DOLLAR DEPOSITS
The depositors in the Euro ? Dollar markets have basically 2 types of options.
1.
Regular time ? deposits involving very limited periods i.e., over ? right call money or
other accounts and.
2.
The Certificates of Deposits (CDs) involving larger amounts (usually above 1,00,000
Euro ? Dollars) and with longer maturities between 3 to 6 months.
The flow ? time for such transfers of funds is expected to be very short so as to
prevent the owner from losing larger sums of interest.
(B).
Euro ? Dollar Loans
Based upon the past transactions over a few decades, the normal range in which these
loans vary, is found to be between $ 5,00,000 upto $ 100 Million and or even more. The
maturity period ranges between 30 days to 5 to 7 years. However there are flexibilities in the
duration and modes of advancing loans and it all depends upon the nature of relationship the
borrower has with the Euro - Banks.
With regard to the aspects of interest ? rates an the Euro ? Dollar loans, these are
floating rates rather than fixed. It is so, particularly for medium and longer maturities of
about 3 years and beyond. Since these Euro ? Banks themselves borrow substantial funds
between them at the London Inter Bank offer Rates (LIBOR), they, I inturn, offer the loans to
their borrowers at typically 1.5% over the LIBOR rate, established at six ? monthly intervals,
until maturity. It protects the Euro ? Banks profits.
(C). EURO ? DOLLAR SPREADS
The term Spread represents the margin between lending and deposit rates. During
the past 3 decades, it has been observed that the lending rates have been lower mainly
because of the following factors.
(a). Lack of reserve requirements
(b). Regulatory expanses are either non ? existent or very minimal.
(c). No compulsory lending to some priority borrowers at concessional rates.
(d).
Information collection and processing is done quickly and with least cost since most
of the borrowers are well ? known.
Similarly the deposit rates of Euro ? Dollars tend to be higher than the rates provided
in the domestic markets for the following reasons.
a.
The Euro ? Banks are in a better position to offer higher rates as a consequence of
lower regulatory costs.
b.
The Euro ? Banks are not conditioned with interest rates ceilings, unlike in the case
with most of the national markets.
c.
In order to attract deposits that too on a large scale, the Euro Banks have been
compelled to offer more interest rates on deposits which would otherwise be
deposited in the domestic banks.
The International Euro ? Dollar Bond Markets
The International Euro ? Dollar Bond Market may be defined as a market for Bonds
which are sold anywhere in the world but not in the geographical territory of the country of
currency in which it is denominated. Mostly the funds raised by the borrowers in such
market consists of foreign currency (i.e. other than the borrowers home currency) but on
some occasions, the borrower can borrow from such international markets in his home
currency (like a U.S. Company borrowing Euro Dollars.
The International Euro ? Dollar market can be classified into 2 categories namely.
(a).
Euro Bond Market and
(b).
Foreign Bond Market
A Euro ? Dollar Bond issued is said to be a Euro ? Dollar Bond issue if such bonds
are mainly sold in other counties than the country in whose currency the issue is
denominated. The organisation for Economic cooperation and Development (OECD) which
has been a prominent source of data regarding the international bonds has been defined as
under.
A Euro ? Dollar foreign bond is one which is placed (on behalf of a non ? resident)
by a domestic syndicate, on the market of a single country and is denominated in that
country`s Currency.
To be a non ? resident, a borrower must come from one of the following categories.
a.
Government or government Agency or political sub ? divisions which are not located
in the country in which the issue is made.
b.
International Organisation (like I.M.F. I.B.R.D etc.,)
c.
Officially sponsored international enterprises except when their registered office is in
the country concerned.
Countries government as well as private firms started floating bond issues in New York and
not among the Europeon countries. Some of the attractions for the borrowers in New York
included:
1.
Quick and efficient system of under ? Writing.
2.
Lower interest rates and thus reduce the cost of borrowing and
3.
Large and adequate supply
TYPES OF EURO ? DOLLAR BONDS
These bonds have not been homogeneous in nature. They can be classified into the
following categories.
1.
Straight Euro ? Dollar Bonds.
2.
Euro ? Dollar Bonds with more Currencies
a.
Multiple currency Bonds.
b.
EMU Bonds (European Monetary Union)
?.
Unit of Accounts Bonds and
(d).
Parallel Bonds.
The Euro ? Dollar Bond market is truly international as these Bonds are sold to
investors around the world and such issues need not comply with the national regulations and
controls.
Straight Euro ? Dollar Bonds represent a substantial part of the Euro - Dollar Bond market in
which Bonds are issued with a single currency. Hence, bonds involving in more than one
currency have started occupying an important position in the Euro Dollar Bond market.
The multiple currency Bonds provide an entitlement to the creditor for opting the
payment of interest as well as the principal amount of the Bond in any pre ? determined
options of currencies. As for example, Consider a Japanese leader buying Such multiple
currency bond and opting payment in the form of U.S. Dollars or British Pounds or Italian
Liras, If all these 3 currencies are depreciable against, say, the yen, then he loses. If the
appoint happens, he gains.
In case, all currencies depreciate, he accepts payment in the form of the least
depreciated one, and if all currencies appreciate, he selects the payment in the most
appreciated one. This way, the gains are maximized and the losses minimized in the event of
any exchange rate variation.
The European Monetary Union (EMU) Bonds, sometimes also referred to as the
European currency Union Bonds are also multiple currency bonds For the borrower, the basic
advantage is that these EMU Bonds bear a lower interest rates (thus less consider) than the
previous type of bonds.
For the lender, there is enough protection since in the event of devaluation he is
entitled to obtain repayment in the least devalued currency and similarly he demands in case
of appreciation repayment in the form of the most unvalued currency.
The unit of Account is neither a means of payment nor an instruments of exchange,
although it may become so under special circumstances, as for example, when a transfer is
made from one account to another an the books of a bank. The European Monetary
Agreement has been following the unit of Account as the base currency unit.
SECONDARY MARKET FOR EURO ? DOLLAR BONDS
Secondary market refers to the sale of Bonds or any other securities already bought for the
first time in a primary market has been present only for name`s sake in Euro ? Dollar Bond
market. After mid ? 1980s, because of price quotations (both buying and selling prices) for
various Euro Bonds being made by the commercial banks, securities firms and bond brokers,
the secondary trading has become easier and gaining more popularity.
There is a 3 tier structure in the issuance of the Euro ? Dollar Bonds, consisting of (1)
Managers (2) underwriters and (3) sellers In case of U.S.A. the underwriters must purchase or
swallow the unsold portion of the issue, while in Euro ? Dollar Bond underwriting, the
underwriters make their best efforts to sell they have wider options in the event of portions of
the Bond issue remaining unsold, including the cancellation of the unsold part, if the
underwriters are reluctant to purchase.
COMPARISON BETWEEN EURO ? CURRENCY AND
EURO ? DOLLAR BOND LOANS
There are certain merits and demerits of processing loans in the form of Euro
Currencies and Euro ? Dollar Bonds, depending upon certain conditions.
Euro ? Dollar Bonds have the choice of fixed as well as floating rates. Fixed rate
bonds have their own advantages since currency inflows and outflows can be offset with a
calculated rate. The interest rate on Euro Dollar Currency loans is variable. It benefits the
borrower if interest declines and vice versa.
The Euro currency loans have to be repaid in a relatively smaller time periods than
loans from the Euro Bank market. The Euro currency loans provide an easier opportunity to
change over from one currency to another at stipulated dates, while it involves some
complications in the case of Euro Bonds. Euro ? currency loans can be raised quickly while
it involves relatively longer time for raising loans through Euro ? Dollar Bonds.
KEY WORDS
Euro ? Dollar Market
A market where the Euro ? Dollars are deposited and but with the involvement of the
Euro Banks.
Euro ? Dollars.
Such currencies as the U.S. Dollar Deutsche mark, French francs, Italian Lira,
Japanese yen etc., in which deposits and loans are made as converted Euro ? Dollars.
Maturity Period
The remaining period of bank claims a particular date.
OECD
Organisation for Economic Cooperation and Development 24 member members ?
countries.
IBF
International Baking Facilities ? London is the Centre
NIF
Note issue Facilities
Asia Currency Market
It was formed in 1968. keeping Singapore as Head Quarters. It functions basically to
chanalise the Euro ? Dollar deposits for Asian investors.
LESSON ? 3
INTRODUCTION
Emergence of Global currency Markets:
A significant development in the European Economic Communities (EEC) Financial
secenario was the emergence a new fixed Exchange rate mechanism. It is also called as the
Emergence of Global currency market.
This system emerged from 1972 under this system the EEC countries Exchange rates
were maintained within a named band i.e., within 1 1/8% of the pre ? determined par values.
The movement of currencies was restricted to either side of the parity. The band for other
exchange rates was wider. It was popularly termed as Snake in the Tunnel. This
technology came into use, keeping in mind the time path followed by the EEC exchange rate.
However, the rising inflation differentials and current account in balances of
European countries resulting from the oil crisis of 1973 purview of the snake In 1979 some
refinements were made to the European Monetary System (EMS) which was the base for the
global currency market.
Under it the Parity Grid determines the lower and higher limits of Exchange rates,
between each pair of the member countries currency. The band has a width of 21.4% above
and below the pair rates. Thus, the Central Banks of both the countries would be required to
buy and sell the currencies unconditionally. For e.g, if the German Mark is at lower support
point of the permissible range when compared with the British pound, the German Central
Bank would be required to buy the Marks and the British Central Bank would be required to
buy the Marks and the British Central Bank has to sell pounds un conditionally under the
EMS. The effective limits of the literal band are determined by the strong and week
currencies in the grid. The automatic adjustment incorporated in the system makes it
effective.
THE EUROPEON CURRENCY UNIT
It represents a basket of currencies of the member countries, the weight assigned to
the European Communities currency depends an the proportion of the country`s Gross
National Product in the European community`s gross product, and its share of trade within
the community the basket is reviewed once in 5 years. All the European community`s
Currencies are represented in the Basket. Only a few participated in the Exchange Rare
mechanism.
THE GROUP OF SEVEN
The group of seven consists of Seven richest and industrialized nations viz, (1) Japan
(2) West Germany (3) France (4) United Kingdom (5) Italy (6) Canada and (7) U.S.A. The
purpose was to bring down the unnatural external to value of U.S. Dollar to statilise the
Exchange Rates.
The Group of Seven meet regularly to coordinate intervention by the government to
prevent unwarranted fluctuations in Exchange Rates. This is in the interest of facilitating
smooth international trade.
The Group of Seven has a proposal to build up a $ 50 Billion Emergency Fund
which would be used to help countries facing acute financial problems. It also proposed to
make regulations necessitating greater disclosure so as to enable greater flow of information
to the markets.
EURO MARKETS
They are unregulated money and Capital markets. These markets are spread over
Europe, Middle East and Asia. Shot ? term Euro markets are called as Euro ? currency
Markets. Any currency held outside to home country is referred to as Euro ? currency. For
example when a Dollar is held as a deposit outside the U.S. is refered to as Euro ? Dollar,
Similarly a deposit in Marks, outside Germany is called as a Euro ? Mark deposit.
DEVELOPMENT OF EURO ? CURRENCY MARKET
The Dollar was and still is widely used to settle the international payments. Although
there is an increase in European Deposits, denominated in Canadian Dollars, the pound
sterling, Franc, Marks, Yen etc., by far the U.S. Dollar still remains the most popular Euro ?
currency.
The preference for Dollars can be attributed to the relative political stability and the
absence of severe restrictions in the U.S. It thus facilitates high liquidity to Dollar ?
denominated deposits.
There are many reasons which have helped to popularize Euro Dollar deposits. Some
of these are discussed in detail here.
Americans could prefer to hold their Dollars outside the U.S. This may be attributed
sometimes to the numerous financial services provided by foreign banks as compared to
American Banks. Further, at regulations and restrictions are capital outflow by the U.S.
Similarly, at times the U.S. may lay restrictions an the Americans restraining them from
depositing in foreign securities. In such cases it would be advantageous dfor the Americans to
have Dollar Deposits outside the U.S. as they can use their Euro Dollar deposit whenever
they require it, without fear of any restrictions being laid.
During the 1960s, the U.S. banks and financial institutions had to abide by the
restrictions placed an the maximum rate of interest that they could pay an the deposits placed
with them of particular interest are the Q and M regulations placed by the U.S. Federal
Reserve Board. The Q regulations restricted the interest rates on deposits. The U.S. Banks,
outside the U.S. were subject to such restriction. Many U.S. Banks outside the U.S. were not
subject to such restrictions.
This fact has attracted large volumes of Dollar Deposits outside the U.S. A large part
of dollar deposits had flown out of the Country prior to de regulation and continued to remain
there through the tenure of the deposit, some of these deposits on maturity, were reinvested
in the U.S. since interest differentials ceased to exist.
Another contributory to the movement of dollar deposits outside the U.S. was the M
regulations. It stipulated holding of reserves against deposits. These regulations were not
applicable to deposits with overseas branches of U.S. Banks. On account of reserves, which
are idle funds, the cost of operation in U.S. was naturally much higher than abroad. The U.S.
Banks preferred to shift some of their dollar deposits outside the U.S. to less regulated or
unregulated markets.
Yet another reason for the dollar deposits outside the U.S. being more attractive was
the absence of the need to pay for Deposit Insurance. The Dollar deposits inside the U.S.
were required to be covered by deposit insurance.
Euro Dollar markets also grew as a measure to avoid interest equalization tax levied
on U.S. lenders earnings abroad. Foreigners in U.S. have also in U.S. Have also shown
greater interest in Euro ? markets, since 1979 when Iranian assets were frozen by the U.S.
Between 1975 and 1988, the Euro Dollar market had recorded an annual average growth of
17% Euro deposits had steadily increased over the years, in spite of the removal of
restrictions initially placed by the Federal Reserve.
EURO ? CURRENCY MARKET INTEREST RATES
These are wholesale markets facilitating inter ? bank transactions. Purchases and
sales of currency are transacted by Banks regularly. The interest rate for the transactions in
London Inter Bank offer Rate (LIBOR). The interest rate in such cases is LIBOR plus a mark
up. The mark up varies between ? to 2 ? percent.
FUNCTIONS OF EURO CURRENCY MARKETS
Cheap source of working capital.
The Euro ? currency loans attract lesser interest than the loans of the domestic
economy. Interest rates are lower because overhead costs are lower. Since dealings are
between bank with good credit rating, the cost of credit checking and processing are less.
Lending rates can be fixed lower than the domestic market. Similarly, it is possible to fix the
deposit interest rates higher than in the domestic markets.
Liquidity
Financial institutions find it highly profitable to hold their idle sources in Euro ?
Markets. Since there are less restrictions in the markets, the investors can make investments
in bearer securities. It has an added advantage in the form of in the form of absence of tax
withholding an interest. Most of these deposits have maturities ranging from less than one
day to a few months. On an average about 80% of these deposits have maturity of 6 months.
Facilitates International Trade
They provide easy loans which facilitate International Trade. Most banks prefer this
form of financing to traditional forms like the letter of Credit. Much of the preference for
Euro ? currencies arise from lower intrest rates and absence of emphasis an procedural
formalities. Considering the attractiveness of these funds, there has been a sizable increase in
the volume of transactions in these markets.
Euro ? Debt Markets.
These can be studied under 2 broad classifications (1) Euro ? Dollar Loans and (2)
Euro ? Bond Markets.
Euro ? Dollar Loans.
The demand for Euro ? Dollar loans was pushed up during 1960 in directly by the
restrictions imposed in obtaining loans within the U.S. The restrictions were the result of a
voluntary restraint programme adopted in 1965. It was followed by mandatory controls in
1968. These strictures controlled the creation of loans within the U.S. Borrowers are,
therefore, forced to look for funds outside the U.S. Euro Dollars loans provided the much
needed alternate source of funds.
From 1963 to 1974. The U.S. interest equalization tax was in vogue. The tax was a
levy an U.S. residents. Earnings on foreign securities. To equalize the expenditure to a U.S.
resident lender, an account of the tax levy, foreign borrowers were forced to offer higher
interest. Euro ? Dollar loans did not attract interest equalization tax, as a result, the interest
rates offered were much lower.
Euro Bonds
These are of more recent origin They are un ? secured bearer debt instruments with
maturity of 5 years and more. The Bond is sold in the markets other than those in the county
in whose currency it is issued.
Since Euro ? Bonds are not regulated strictly, their issue costs are lower than those of
domestic issues. As such they had become an excellent source for raising long ? term capital
the issue of the Bonds is generally made simultaneously in several markets on behalf of
international borrowers by syndicate.
OTHER TYPES OF EURO ? CURRENCY INSTRUMENTS
Bank Deposits: These are conventional deposits of Euro ? currencies in Banks.
Usually the period of maturity is either 30 days or 90 days. They are seldom made for periods
longer than 90 days. Interest rates are pre fixed on the basis of the duration of the deposit.
SDR Dominated Deposits
These are negotiable instruments actively traded in the secondary markets. These
are not term deposits. They offer a high rate of liquidity.
International Banking Facility
They are separate set of accounts with a Bank. They can accept foreign currency
deposits. If used to make loans to foreigners they do not require insurance covers. In such
cases, the reserve requirements to are waived. Withdrawals can be made after giving 2 days
notice.
Euro ?Dollar Futures
When the assets and liabilities of Euro Banks are not equal in terms of volume and
maturity, they are subject to risks of exchange rate fluctuations. Euro ? Dollar futures
markets helps Euro ? Banks to avoid much risks by making a futures sales.
To understand clearly of the global currency markets, we have to know the meaning
and concept of global currency market, It is mainly because these markets did largely, if not
entirely function upto date upto 1980s, is Dollars.
At present, the non ? dollar denominated deposits have a wide spread existence, in
such global currency markets. Also much of this market is new located outside Europe. The
term global currency markets refers to all such financial assets and liabilities denominated in
U.S. Dollars but which are transacted outside the territory of U.S.A.
It should be remembered that such transactions cannot take place independently but
they will be in contact with their country of origin (U.S.A.) and some banks in the U.S. keep
associated with the transactions outside the country for Euro ? currency transactions. In case
of other Euro currencies, the concerned countries maintain such record of transactions.
The controls and regulations which had been in existence in U.S.A. were directly
responsible for the evolution and growth of the Euro Dollar markets. It was precisely to
overcome such difficulties arising out of the monetary regulations which did not become
applicable on such markets outside the geographical territory of U.S.A. that these markets
have come into existence and are making tremendous growth.
As an important instrument of the overall policy of U.S.A. there have been restrictions
imposed by the U.S. Federal Reserve Board on the U.S. Commercial banks an payment of
interest rates, on deposits received from individuals.
The financial instructions operative in the global currency markets are.
1. The U.S. Banks (2) The consortia Movement and
3. The European Banking Response.
SUMMARY
The global currency Market have emerged only after II world war. The financial
environment has been under going tremendous changes during the past 3 decades. The
transactions from the fixed exchange rate system to the flexible exchange rate system has not
been without its own share of difficulties. However the wide spread feeling that market force
have to be rekoned with for financial well ? being of the economy, has made its adoption
even in developing and transitional economies much easier.).
Further the need for greater cooperation among nations in financial matter has forced
the growth of global institutions such as the I.M.F. W.B etc.,
These institutions are fostering the growth and development of rich and poor nations
alike. It is possible that with the development of money, capital, and force markets
worldwide, the economic gap between nations would cease to exist in the years to come.
KEY WORDS
Balance of Payment
The measure of difference between the net inflow and the met outflow of domestic
financial liabilities.
Bond
A long term debt instrument
Currency Risk
Risk due to changes in exchange value of a currency that affects the returns an loans
and investments denominated in foreign currency.
Euro ? Dollar
A U.S. Dollar denominated deposit made out side the U.S.
Financial Sector.
The segment of economy comprising of financial intuitions and market instruments.
LIBOR
London Inter bank Offer rates. The prime rate at which international lending is
made. It represent the cheapest rate at which funds flow between international banks.
Supply side Economics.
The view that Govt. policy should ensure on increase in private incentives to supply
additional goods and services.
LESSON ? 4
The Size and structure of European Markets
The European Market has 2 broad divisions in their size and structure. Here the term
size refers to the various institutions dealing with the European currency. The term
structure refers to the various countries of Europe with which the entire currency market
revolves.
The 2 broad divisions of this European Markets are:-
1.
International Money markets and
2.
International capital markets.
Introduction
The term European markets is used generally in a broad sense which includes both the
money market and the Capital Market. If the financial transactions (lending and borrowing)
takes place between 2 or more countries, we tend to call that there exists European Market
among the participating countries (All the 12 leading countries of Europe). These are the
specific set of countries ? in the narrow sense of course, there are no restrictions among these
countries, unless otherwise Specified.
There are chances for this European markets to develop at any part of the world
subject to legal regulations. Allowing such to organize and continue and also there is enough
attraction from the potential users of the European markets services.
As on date, however there are only 3 most important international market centres in
the world ? London, Luxemberg, Paris, and Belgium. Most of the advanced countries in
Europe have a well ? developed domestic markets but are reputed internationally. Contrary
to this, there are also some countries whose domestic markets are not so efficient and
advanced but buy acquired a lot of international reputation, such as Luxemburg, Switzerland
etc., due to their favourable conditions.
Political stability, very less interference through controls and regulations by local
governments monetary authorities, efficiency and expenses of the agents dealing with such
market transactions, determine the basis for the development of any country as an
international financial centre. In countries where the lenders and borrowers and the
syndicates find it favourable, automatically is receives enough international alteration.
The term European market represent to such markets which primarily deal in short
term claims, with a maturity period of not exceeding 1 year. The term Maturity period
should not be confused with the term original maturity period of a financial instrument.
Suppose that an instrument having an original maturity of say 10 years, but at a particular
date, it has its remaining period of say, 3 months (i.e., it has been issued 9 years and 9 months
ago originally), it must be considered as on that reference date, as a many market claim and it
should not be treated as that of a capital market.
Functions of European money market.
Money markets in any European nation are expected to serve 2 important purposes.
Firstly, they provide the means through which the central bank can influence its monetary
policy, for example, if the central Bank, through its open market operations involving in the
purchases and / or rules of government securities, it affects commercial Bankers reserves and
their credit ? creating capacities and money supply. Secondly, to the direct resources from the
sectors with surplus funds to the deficit ? sectors. For example, generally the surplus ? sector
consists of individuals, while the deficiat ? sectors consist of companies and governments.
Characteristics of the European currency instruments.
The is a lot of variation in the currency instruments dealt with in the money markets (both
domestic and international) due to the type of the issuer (i.e., Institutions, Government or
Companies etc.,) the term of maturity (30 days, 3 months, and 6 months and 364 days ? size ?
(Small, medium and large) and such other factors, there exists some commonalities which
may be called as their Characteristics. They are:-
1.
They can be bought and sold immediately.
2.
There is usually a very active secondary market for these instruments.
3.
The costs of transacting in these assets is usually lower and also relatively lower
than their domestic counterparts (in case of international instruments).
4.
They possess highest liquidity with them which is next only to the actual
currencies. and
5.
A corollary which follows (from points 3 above is) that they are rightly given the
name as Near Money.
Nature of European Money Markets
Any typical money market is highly competitive. There is almost a perfect knowledge
available with the rates published on a daily basis news papers, also available on
telephone. In addition, the participants vary and they have a wide range of securities
which they can choose from within their own money markets of a foreign nation.
INTERNATIONALISATION OF CURRENCIES
It is interesting to know as to how the financing got internationalized (more specifically
within Europe). Borrowers, basic in recent years, 3 main sources of raising funds, namely
(1)Cash, generated internally (in case of firms, private finances, borrowing from the
general pubic, commercial bank, Term ? deposits from the public etc ) (2) External Short
? term funds and (3) external long ? term funds. As regards external financing in
concerned it could be either from lenders or investors. The investors buy the securities
issued by the borrowers in the financial markets which are generally tradable or
negotiable.
The pattern of financing companies, by the nations financial markets, in U.K. they
obtain 60 to 70 per cent, while in Germany it is between 40 to 50 per cent while the
companies, till 1975 got as high as 70 per cent from outside sources, it reserved
dramatically within a decade. By 1985 almost the same 70% of funds for Japanese
companies have been supplied by the internal sources.
There has been a financial de regulation which stared in the U.S. in 1981 and in Japan
in 1980. Following this, banks have been forced to commit funds with various institutions
at the existing markets rates. Due to the consequent changes, the cost of obtaining bank
loans by the firms have risen such that they realised that they can get financed cheaper by
issuing Commercial paper by their bankers. Hence, the share of Banks has been n the
decline in the short ? term credit markets.
With sophistication in Technology, communication and the removed of the controls in
foreign markets. Firms, and other borrowers have started comparing the domestic and
foreign markets and thus becoming irresponsive to changes in them. Also the gap
between these 2 markets has slowly disappeared. Thus, there has been a globalization of
Financial markets since early 1980s. This is responsible for on un preecedented amount
of compotation between the major financial centres and institutions. Thereby, hence has
been a considerable reduction in the costs associated with the issuance of new securities.
Money Market Instruments in the New York Market.
A Review of U.S. Money Market
To start with, the U.S. money market is a wholesale market for money instruments which
are of high quality and, of course, having short maturity periods. Though the Federal
Reserve system of U.S. classifies money market instruments to be having original
maturity of lower than one year, the bulk of the trading in U.S. takes place in very short ?
term maturities. There is also a very active secondary market for such instruments.
Though the New York market happens to be a large one, there is nothing like a central
exchange for such instruments. The work of total market transaction each day is of the
order of a few hundreds of Billions of dollars.
The Federal Reserve system came into force in 1914 and since then the Federal
Reserve Bank (Commercial banks) by asking them to buy and sell the Federal Funds.
Money Market Instruments
The Major instruments constituting the U.S. Money market are Federal Funds, Treasury
Bills and government Agency Paper, Euro ? Dollars, certificates of Deposits (C.D.S.) and
re ? purchase agreement.
Regarding the marketing of the above instruments, there is no secondary market in
case of the Federal Funds, though it exists in principle for the Bank accounts its is
confined to a limited extent. There is an the other hand, a very active secondary market in
a the Treasury Bills and the Federal Governments Agency Papers / notes
The Money Market instruments are many
1. Federal Funds.
These federal fund are used by commercial Banks in meeting the reserve requirements
norm efficiently. From time to time the Federal Reserve Bank (U.S. Central Bank)
changes the minimum reserve to be held by the commercial Banks, as a part of its
monetary policy These Fed Funds are the most liquid assets which bear some interest.
There is very little credit risk and the borrowers and lenders are known to each other. The
interest risk on these Fed funds are the mot liquid assets which bear some interest. There
is very little credit risk and the borrowers and lenders are known to each other. The
interest ? rate serves as the base ? rates for the entire money market.
2. Treasury Bills
These bills are popularly known as T bills, They consist of a set of securities issued
by the Treasury an behalf of the government to meet the latter`s spending obligations. There
are 3 categories of securities under the T ? Bills short, medium and long ? term maturities
These are called as Bills (if original maturity is less than 1 year) Notes (if it is between 1-
10 years) and Bonds (if it is more than 10 years).
As regards the composition of investors for T bills is concerned, the pension Funds,
Companies and banks, the central banks of non U.S. Nations, sometimes, the foreign
institutional investors, individuals do buy them, if there is an attractive interest rate. These T
? Bills are totally free from default risk, and have active secondary markets.
3. Euro ? Dollars.
Due to certain regulations in the U.S. Money market, the Euro ? Dollar market came
into existence. The Euro Dollars are the U.S. Dollar traded outside the territory of U.S.A. In
the post ? war period, the strained selections between the format soviet Union and the U.S.A.
has, to a large extent, changed the nature of the Euro Dollar market. The balances held by the
entire eastern block of countries were transferred from banks of New York to namely
London, following apprehension of attachment by the U.S. government.
Presently the Euro ? Dollar market is seen as an extension of the domestic U.S.
money market. Due to a lot of demand for such assets, there has been a tremendous growth of
the market outside U.S. with about 70% of the wider Euro ? currency market consisting
exclusively of U.S. Dollars.
4. Certificates of Deposits (C.Ds)
The commercial banks have started using these certificates from late 1960s mainly to
counter the corporate treasures from the large scale use of commercial papers and T.Bills to
fund the private firms. A CD is an unsecured liability (of Banks) having the denominations
of $1,00,000 and more. Their original maturities of 2 week to 5 years or more suggest that
they are short to medium term instruments. The rate of interest on the C.Ds is paid on the
basis of the face ? values. Normally, institutions and companies are major investors who
prefer liquid low ? risk investments.
At times, the Banks also issue long ? term CDs. There is a 2 way procedures for
payment of interest rates. If the terms of CD is 18 months or less a variable interest is paid
with a revision in interest rate once in 3 months, at the discretion of the Banks issuing them,
If the term exceeds 18months there will be a fixed rate of interest promised at the time of
issuing them.
5. Banker`s Acceptance
A Banker`s Acceptance (BA) is an unconditional order in writing to pay a specified
sum to the bearer or any other designated party by him at a particular time is future (i.e., not
instantly). If it is accepted by a Bank, it impiles that the Bank has guaranteed payment and it
becomes a negotiable instrument.
6. Commercial Paper
A commercial Paper (CP) is an unsecured promissory note issued by very large
private companies and financial companies having a short and original maturities. Majority
of the CPs have 30 days or less of original maturity, while most of the CPs have 270 days of
original maturity. The Securities and Exchange commission (SEC) may rarely permit some
companies to issue CPS of more than 270days.
International money market is technically the Euro - Currency market. The prefix
Euro is used for historical reasons because of the U.S.dollars, very largely deposited
outside U.S.A in Europe, particularly in London. The Euro ? currency market is operated by
foreign banks called Euro ? Banks and U.S. Banks foreign brokers, operating in other
countries. The Euro ? currency markets enable the investors to hold short ? term claims on
commercial banks. Then loans are advanced on a floating rate basis calculated as a fixed
percentage over the London Inter bank offer Rate (LIBOR).
International Bank Market
Under the Structure of European markets the developmental activity undertaken by
almost all countries after the Second world war. (both the war ? affected and the Third world
countries) necessitated the world economics to come closer and act as a united world
economy. In the pre ? 1944 period, there had not been much scope for international banking
activity excepting providing foreign exchange and facilitating foreign trade ? New activities,
financial techniques etc have been incorporated since them.
From 1973 Oil Crisis there we a need for the Petro Dollars re ? cycling. Here the
International banks played a very crucial, role in re cycling funds from the oil exporting
countries (OPEC ? Organisation of petroleum Exporting countries) to the oil importing
countries. By 1979, nearly 1/3 of the total lending was to the least Developed countries
(LDCS), and communist countries but together. Another note ? worthy point is that during
the same year (1979) over 80% of the total outstanding loans were only denominated in U.S.
Dollars.
The European banks have very sound capital in Euro ? currency and a fast growing
market. However. They are very week in a competitive world. While the Japanese banks
have powerful corporate customers, larger asset base and one of the strongest economies of
the world. However they are unable to consolidate their position due to lack of dynamism
and innovativeness and other domestic problems. Majority of the American banks have
relatively weak capital base, much of their loans advanced to the LDCs (High risk loans) but
with enough experience they have gained both within the nation as well as outside their
performance has been quite impressive Banks like Citi Corp., J.P.Morgan have been
investing in areas like information systems, computers etc and are highly innovative.
International European capital Market
The structure and size of the European Market includes international capital markets,
International investor, the Bond issue Drill and the instruments in New York and Tokyo
markets.
The importance of capital markets for the efficient transfer of funds between the
borrowers and lenders cannot be overstaed. Individual who have insufficient wealth to take
advantage of all their investment opportunities that yield rates of returns, higher than the
market rate are able to borrow funds and invest more than they would without capital
markets.
We know that countries need to borrow externally in the European market due to:
a. The gap between the current external receipts and payments.
b. The gap between domestic savings and investments.
c. These external funds come in the form of grants loans and equity investments.
International Capital markets
The role played by the commercial banks as a source of external finance for
developing countries has comedown since the 1980s and this could be attributed to: -
a. The losses sustained by the international banks on third world debt in 1980s.
b. The imposition of capital adequacy norms which have made it difficult and costly, for the
Banks to take on additional assets.
The international capital markets have grown in size and structure at a very rapid
pace. The multilateral agencies such as the world Bank also raise bulk of their resources in
the world capital markets and this in a way, has added to the growing importance of the
international capital markets.
The principal instruments dealt with in the international capital markets are (as in the
domestic market) (1) The Bond and equity issues (2) Euro Bonds (3) Foreign Bonds (4) Euro
conversable Bonds, Floating rate notes (5) The global depositings receipts (6) American
depository receipts, Asian Dragon Bonds etc are the various instruments dealt with in the
international capital markets.
The major centres which deal in these instruments are the New york stock exchange,
The Tokyo stock exchange, the capital market of London, Luxemburg etc.,
The International Investor in European Market
There are 2 categories among the International investors (1) The Institutional Investor
and. (2). The individual Investor.
The first category includes big mutual funds and personal funds. They are keen to
diversify investments all over the world and willing to invest a part, albeit small of their
portfolios, in third world companies and stock markets.
From the pure financial point of view, investors ought to consider the possibility of
expending their investments beyond the geographical limit of their own countries, if only
because of the diversity of investment ? possibilities that are available. If the investment is
larger than the assets in one country as large as the U.S.A, the investors may be able to
reduce the risk of their investment portfolio by diversifying across countries.
With a growing awareness of the benefits of diversification, the funds in industrial
countries are increasingly looking at the emerging markets for investments in equities. For
instance, in 1992 alone, U.S. outflows into bonds and equities exceeded U.S. $ 50 Billions
when we take of Equity Investment, accompanied by technology and management from the
foreign investors and is the largest element of Equally Funds for most of the countries.
Foreign Direct Investments totaled U.S.$226 Billions in 1990. The total net source flows
from OECD countries to developing countries in the form of FDI has steadily gone up from
about $11.3 Billions in 1985 to around $ 29 Billion in 1992. The higher returns on
investments in poor countries in estimated to increase the FDI flow from $40 Billion a year in
1992 to around $80 Billion a year by the end of the country.
Portfolio investments, on the other hand are aimed at capital appreciation and the
portfolio investors also do not bring in any technology. Portfolio investments are of 4 types.
1. Close ? ended country funds floated abroad.
They operate in the same way as domestic mutual funds.
2. Open ended country funds.
These are also mutual funds but with no specific maturity date.
3. Foreign Institutional Investors (FIIs)
They invest directly in stock markets.
4. Equity (or conversable bond) issues in foreign markets.
Portfolio investments to developing countries have more than doubled between 1989
and 1991 from $3.4 Billions to $7.3 Billions, accordingly to the world Bank Research
Observer (January 1993)
BOND MARKET
Bond is a promise, under seal, to pay money. This term is generally used to designate
the promise made by a corporation, either public or private, to pay money to the bearer. The
public issue of bonds can be divided between those issued by Governments or their agencies
and those issued by private institutes.
In every country, bond issues represent 75% or more of the total issues of securities.
Equity shares account for the remaining 25% The issue of international bonds to finance
cross border capital flows has a history of more than 150 years. As early as 19th century, the
foreign issuers of bonds, mainly governments and Railway companies used the London
market to raise funds.
EURO BONDS
When the Bonds are sold principally in countries other than the country of the
currency in which the issue is denominated, it is called as Euro Bond issue for example, a
Dollar Bond issued in Europe is a Euro (Dollar) Bond in the Euro ? Bond market, The rates
of one ? currency bond are directly related to the long ? term rate in the home country of the
currency, the Euro ? rate for short maturities of that currency, the rates in other currencies,
and currency regulations and restrictions. For example, the Euro ? Dollar bond rare depends
all the U.S. long ? term rates, the Euro ? Dollar rates (and therefore an U.S. Short ? term
rates) and the long ? term rates in other countries.
FOREIGN BONDS
A foreign bond is an international bond sold by a foreign borrower, but denominated
in the currency of the country in which it is placed. It is under written and sold by a national
underwriting syndicate in the lending country. For example, an Indian company might float a
Bond Issue in the U.S. Capital market, where it will be quoted and traded. Many foreign
bonds were issued in the domestic markets of U.S. U.K., Germany, Japan, Netherlands,
Switzerland etc., The foreign bonds are referred to as Yankee Bonds (these issued in
domestic markets of U.S). Bull dog Bonds (in U.K.), Samurai bonds (in Japan) etc.,
The interest rate on foreign bonds are directly co ? related with the rates prevailing in
the given country adjusted by whatever regulation that affects the foreign bonds. In recent
times, the foreign governments have come to be the major borrowers in the foreign bond
market.
Lesson ? 5
Regulatory Systems of Foreign Exchange
The well ? established Regulatory System of foreign exchange is
spread over in all the activities of the foreign exchange market. Some
of them are explained here?under.
1. Foreign Exchange Derivations:
A derivative is a financial contract whose value depends on the values of
one or more underlying assets, or indices of the asset values. The underlying assets could be
(1)
Equities
(2)
Currencies
(3)
Commodities
(4) Interest Rates and (5) Price Index.
The derivations account for approximately 80% of the financial market activity in the
developed world ? North America, Europe, and East Asia. Derivatives are almost like
insurance. The difference is that the insurance protects against the firm ? specific risks
whereas the derivatives take care of the market risks. It is widely used as an instrument of
risk management. Investors are increasingly making use of derivatives to hedge against the
risk of losses and enhance the value of their risks.
According to Mr.J.P. Morgan, the derivatives do not make risks disappear but they
make it possible to exchange a risk, you would rather not take for one, you are more willing
to accept. Derivatives are dynamic. The risk profile of derivatives transaction changes
constantly as markets and prices move up or down.
In to-day`s contest of open economics with floating exchange rates being the order of
the day, the world is a riskier place now than what it was 20 years ago. All business firms
face an ever ? growing exposure to risk from all sides ? volatility beyond a certain degree can
put a firm out of business, in spite of it being efficient otherwise.
Taxonomically, derivatives can be classified as options, futures, swaps and of course,
the forward exchange contracts. There are hybrids like swaptions, option and futures etc., But
we confine ourselves to the recent but emerging as the dominant instruments or products to
manage risk in the arena of international finance, namely (a) currency options (b) currency
futures and (c) currency swaps.
2. Currency Options:
A currency option is an arrangement between an option holder and an option writer.
The option holder is the buyer and the option writer is the seller of an option. A currency
option gives the buyer the right, but not the obligation to either buy or sell a specified
quantity of one currency in exchange for another, at a pre-determined exchange rate, which is
known as the Strike Price. However, the option to buy or sell must be exercised on or
before a specified expiry date.
Though, a holder has no obligation to exercise an option, the writer of the option must
comply with its terms and should be prepared to buy or sell the under lying currency when a
holder decides to exercise an option.
Features of Currency Options:
Currency options are of 2 types, namely (1) over ? the ? counter (OTC) options and
(2) Exchange ? Traded options.
The OTC options can be arranged individually with a bank whereas the exchange -
traded options can be purchased only through a broker on an options exchange such as
Phildelphia stock Exchange (PHLX), Chicago Mercantile Exchange (CME) etc.,
Call options Vs put options:
A call options gives its holder the right but not the obligation, to buy the specified
amount or quantity of a currency usually against the U.S. $ at the strike price. On the other
hand, a put option gives its holders the right to U.S. $.
Quantity of Currency:
The option agreement specifics the quantity of currency, an option buyer can purchase
or sell, In the case of Exchange - traded options, the quantity is a standard amount. For
example, on PHLX, the currency options traded are currently restricted to the following
currencies against the U.S. Dollar.
OPTION
QUANTITY
Pound Sterling
? 31,250
Australian Dollar
A$ 50,000
Canadian Dollar
C$ 50,000
Japanese Yen
? 6,250,000
ECUS
cus 62,500
Deutsche Mark
DM 62,500
Swiss France
SFR62,500
French France
FFr 250,00
Strike Price:
The exchange rate at which the holder has the right, but not the obligation, to exchange the
currencies when an option is written, the strike price might be higher, lower or exactly the
same as the current spot rate. Thus a strike price could be (1) at ? the - money (2) in ? the ?
money and (3) out ? of - the ? money
At ? the ? money ? option:
An option whose strike price is the same as the current market price exchange rate.
Normally, an at -the ? money option would be used by a customer who wants to guarantee
today`s rate while allowing himself some profit potential if the exchange rate were to be more
in his favour.
In ? the ? money option:
An option whose strike rate is more favourable than the current spot rate. This would
attract a lower premium, but offers less protection to the holder.
3. Premium:
The cost of the option paid up ? front by the purchaser to the writer of an option. It is
normally paid in 2 working days after deal date and represents to maximum amount that can
be lost by the holder. The writer charges the premium since he is willing to absorb the
currency risk. The risk is that the option ? holder will exercise the option and the write of the
option will make and the difference between the strike rate and market rate of exchange on
the expiry date.
Expiry Date:
The date on which the right to exercise the option ends.
American and European option:
An American option can be exercised on or before its expiry date, for example: a 3
months American option purchased on January 1st can be exercised on any day on or before
the expiry date i.e. on 1st April, European option, on the other hand, can be exercised only an
the expiry date. For instance, in the above example, if it were to be a European option, it can
be exercised only on the expiry date i.e. 1st of April.
American options are preferred when the holder is uncertain about the exact date of an
underlying transaction for which the option is being used as a hedge, for example, if a U.K.
company expects to receive $ 1 Million between the end of March and at the end of April,
which it will then, sell for sterling, if it could arrange an American OTC put option with a
Bank to sell $ at any time upto 30th April, so that the option can be exercised as soon the $ are
received. Whereas with a European option the company would have to wait until 30th April,
regardless of when the $ are received, if it wished to exercise the option.
If the currency options are bought to hedge an exposure in a particular currency, the
buyer must feel at the risk of reduction justifies the premium to be paid, an option is
preferred to the other alternatives of hedging such as futures, forward exchange Control act.
In general, the option route is a desirable method of hedging a currency exposure for a
buyer, who can lock ? in a worst possible exchange rate to avoid the risk of an adverse rate
movement and at the same time benefit from any favourable movement in the rate by
choosing to allow the option to lapse and buy or sell in the spot market.
4. Currency option versus forward contracts:
Forward exchange contracts, are widely used for hedging a currency exposure as they
enable a company to lock ? in a rate which is acceptable to the company for a future currency
transaction. Currency options could also be used for the same purpose. It would be possible
to buy a currency option with a strike price equal to the currently available rate for a forward
contract, so that the option holder would secure an exchange rate that is at worst, the same as
the forward rate. However, the advantage of a currency option have a forward exchange
contract lies in the fact that the option holder has the choice not to exercise the option and
instead transact at the spot rate, if the rate movement is in his favour.
Limitation of option:
(1)
Regular use of option involves high premium costs. The buyer of an option must
be satisfied that these costs justify the risk that is being hedged.
(2)
Only a limited number of currencies are available in traded options. The trading
centres are also limited in number.
Currency Futures
A currency future is a contract for the purchase or sale of a standard quantity of one
currency in exchange for another currency at a specified exchange rate, to be delivered at a
specified future time. Normally the maturity dates of currency futures are 10th March, 10th
June, 10th September and 10th December. These are bought and sold on a future exchange at
the stock exchange.
Trading in currency futures began on 16th May 1972 at the International Monetary
Market (IMM) which is a division of Chicago Mercantile Exchange (CCME). Most of the
currency futures are for a major currency against the U.S. $. The currency futures contracts
that are traded on the CME are in sterling (?), Deustch Marks (DM) Japanese Yen (?) swiss
Francs (sFr) French Francs (FFr) Canadian Dollars (C$) and EcUs.
The exchange provides 3 essential elements.
1.
An efficient central market which brings together differing view points of future
values.
2.
An open market available to all participants including inter-bank foreign exchange
dealers and
3.
A market that eliminates certain credit risks. The clearing house acts as the seller
to every buyer and as a buyer to every seller in each futures transaction.
5. SWAPS:
A swap is an arrangement between 2 parties for the exchange of a stream of cash ?
flows over a specified term. The Currency swaps involve the exchange of a stream of cash ?
flow in one currency for a stream of cash ? flows in another currency.
The swap market can be said to date from 1981, the year in which IBM and world
Bank effected a swap transaction. There are many types of swaps such as Currency swaps,
Interest Rate Swaps etc. All these swaps work on the principle that different institutions
have different comparative advantages, and that as a result, there can be gains from any 2
institutions trading with each other, Now, we will discuss in detail about the currency swaps
and interest rate swaps.
Currency swaps
These are the agreements to exchange payments in one currency for these in another.
The structure of a currency swap in similar to a forward contract or futures contract in foreign
exchange, most of these swaps involve the U.S. $ on one side of the transaction, However,
direct currency combination like the D.M. & Y are also gaining importance. A currency swap
normally consists of the following 3 elements.
1.
There is an exchange of principal at the beginning of the swap. One party
exchanges one currency for another currency at an agreed rate of exchange.
2.
At regular intervals, normally 6 monthly or annually, there is an exchange of
payments. It is convenient to think of these as interest payments on the swapped
amount of principal. But it must be remembered that swaps are not loans. The
amount to be exchanged by each party is calculated as a Swap Rate on the
amount of principal exchanged. This might be fixed rate or floating rate.
3.
At the end of the term of the swap, there is a re-exchange of the principal amounts
with each party repaying the currency that was received at the start of the swap
period. The rate of exchange is therefore exactly the same as for the initial
exchange of principal.
Interest Rate Swaps
An interest rate swap is an agreement between 2 parties to exchange fixed interest rate
payments for floating interest rate payment or vice versa in the same currency, calculated
with reference to an agreed national amount of principal.
The principal amount which is equivalent to the value of the underlying assets or
liabilities that are swapped is never physically exchanged but is used merely to calculate
interest payments. The purpose of the swap is to transform a fixed rate liability into a floating
rate liability and vice versa. The floating rate that is used in most swaps is calculated with
reference to London Inter Bank Offer Rate (LIBOR). Interest rate swaps have a similar
structure to interest rate futures in the sense that the terms of the future obligations under the
swap are determined today. The motive underlying an interest swap is to exploit a
comparative advantage and to make a gain from the swap.
LESSON 6
The major instruments constituting the U.S. Money market are the following.
1.
Federal Funds
2.
Treasury Bills
3.
Euro ? Dollars
4.
Certificates of deposits
5.
Bankers Acceptance and
6.
Commercial paper
Let us briefly discuss about these instruments
1. Federal Funds:
These are popularly called as Fed Funds. These funds are used by the commercial
Banks in meeting the reserve requirement norms efficiently. From time to time the Federal
Reserve Bank (U.S. Central Bank) changes the minimum reserve to be held by the
commercial banks as a part of its monetary policy. These Fed Funds are the most liquid assets
which bear some interest. There is very little credit risk and the borrowers and lenders are
known to each other. The interest risk on these Fed Funds serves as the base rates of the
entire money market.
In the pre-1979 era, these have been used as a service primarily to implement the
monetary policy. In the early 1980s it has been used as an instrument to control money
supply shifting away the emphasis from controlling interest rate, following volatile interest
rates in money market by rate 1980s, again the fed funds are used to manage the interest rate
in money market. The rate of interest on the fed funds is the single most important one in the
entire U.S. money market.
2. Treasury Bills
These treasury bills (otherwise called as T. Bills) consist of a set of securities issued,
by the treasury, on behalf of the government to meet the latter`s spending obligations. There
are 3 categories of securities under the T. Bills ? short ? medium and long term maturities.
These are called as Bills (if the original maturity is less than 1 year) Notes (if it is
between 1 ? 10 years) and Bonds (if it is more than 10 years).
As regards the composition of investors for T. Bills, pension funds companies and
Banks of non-U.S. nations, sometimes, foreign institutional investors, institutional do buy
them if there is an attractive interest ? rate. These T. Bills are totally free form default risk
and have active secondary market.
3. Euro ? Dollars:
Due to certain regulations in the U.S. money market, the Euro ? Dollar market came
into existence. Euro ? Dollars are traded outside the territory of U.S.A. In the post ? war
period, the strained relations between the former soviet Union and U.S. has, to large extent,
changed the nature of the Euro ? Dollar market. The balances held by the entire Eastern block
of countries were transferred from banks of New York to mainly London following
apprehensions of attachment by U.S. Government.
Presently, the Euro-Dollar market is seen, simply as an extension of the domestic U.S.
money market. Due to a lot of demand for such assets, there has been a tremendous growth of
the market outside U.S. with about 70% of the wider Euro ? Currency market consisting
exclusively U.S. Dollars.
4. Certificates of Deposits (CDs):
The commercial Banks have started using these certificates of deposit (CDs) from late
1960s mainly to counter the corporate treasures from the large scale use of commercial
papers and denominations of $1,00,000 and more. The original maturities of 2 weeks to 5
years or more, suggest that they are short to medium term instruments. The rate of interest on
the CDs is paid on the basis of the face values. Normally institutions and companies are the
major investors who prefer liquid low ? risk investments.
At times, banks also issue long ? term CDs. Here, there is a 2 way procedure with
respect to payment of interest rates. If the terms of CD is 18 months or less, a variable interest
is paid with a revision in interest rate once in 3 months or 6 months, at the discretion of the
Banks issuing them.
5. Banker`s Acceptances (B.A.)
A Banker`s acceptance is an unconditional order in writing to pay a specified sum to
the bearer or any other designated party, by him at a particular time in future (i.e. not
instantly) if it is accepted by a bank, it implies that the bank has guaranteed payment and it
becomes a negotiable (tradable) instrument.
In most of the countries, the BAs are used to finance international trade. In some
cases, as in U.S.A. a part of the international trade is also financed using the BAs. The
mechanism involved is simple. The exporter issues a time draft, specifying the name of the
bearer and time at which the payment may be made. Once the goods have been physically
possessed by the importer, the importer accepts the draft and returns to the exporter.
The exporter has 2 options, namely, he may either discount the draft with a Bank ( i.e.
offering at a lesser value than its face value because of obtaining liquid cash) or he may keep
it with him till to maturity date (normally a maximum of original maturity of 6 months).
There is little default risk in the use of the B.A.s and they have got popularized as a low ?
cost source to finance foreign trade, because of very nominal discount rate.
6. Commercial Paper:
A commercial paper (CP) is an unsecured promissory note issued by very large
private companies and financial companies having a short and fixed maturities. Majority of
CPs have 30 days or less of original maturity; while most of the CPs have 270 days of the
original maturity. The securities and exchange commission (SEC) may rarely permit some
companies to issue CPs of more than 270 days.
If companies are very popular, they will issue CPs directly without the involvement of
Banks. The financial companies generally issue CPs directly to the investor while others
make use of investment dealers. The discount rate (at which it is soled) depends on factors
like reputation of issuer, maturity (remaining) and the sum. Due to higher default risk and
lesser liquidity, they fix higher rates of discount.
The preceding section we have seen some important money market instruments (of
U.S.A.) and their basic features. Let us now turn to the instruments dealt in the international
market.
International money market is technically the Euro ? Currency market. The prefix
Euro is used for historical reason because of the U.S. Dollar were largely deposited outside
U.S.A. in Europe particularly in London, Again the currency which is forming the larger
share in the Euro ? Currency markets happens to be the U.S. Dollar. Although in the recent
past, other (non ? dollar) currencies have started becoming significant (for example).
Deutsete mark and swiss francs), still the dollar continues to be the single most important
currency.
The Euro-currency market is operated by foreign banks called Euro Banks and U.S.
Bank`s foreign branches (operating in other countries). Generally, there is some amount of
ambiguity between the 2 markets namely, the Euro ? currency and Euro ? Bank markets. The
Euro ? currency markets enable the investors to hold short ? term claims are commercial
banks. Normally, loans are advanced on floating rate basis, calculated as a fixed percentage
over the London Inter Bank Offer Rate (LIBOR).
Most of the loans are of 6 months duration. Shorter periods are also possible. These
commercial Banks, in turn, function as intermediaries between investors and final borrowers.
Banks transform the short-term claims into long ? term claims on the final borrowers. While
in Euro ? Bond market, banks play a significant role, Basically Euro Bonds are directly
issued by the financial borrowers. These Euro ? Bonds are traded outside the country in
whose currency, the bond is denominated (i.e. Euro ? Dollar Bonds, for example, will be sold
outside U.S.A. since such bonds are denominated in U.S.s currency)
* * * * * * * * *
Unit III
INTERNATIONAL FINANCIAL MARKETS
NATURE AND FUNCTIONS
International financial markets undertake intermediation by transferring purchasing
power from lenders and investors to parties who desire to acquire assets that they expect top
yield future benefits. International financial transactions involve exchange of assets between
residents of different financial centres across national boundaries. International financial
centres are reservoirs of savings and transfer them to their most efficient use irrespective of
where the savings are generated.
There are three important functions of financial markets. First, the interactions of
buyers and sellers in the markets determine the prices of the assets traded which is called the
price discovery process. Secondly, the financial markets ensure liquidity by providing a
mechanism for an investor to sell a financial asset. Finally, the financial markets reduce the
cost of transactions and information.
Money and Capital Market
Like their domestic counterpart, international financial markets may be divided into
money and capital markets. Money markets deal with assets created or traded with relatively
short maturity, say less than a year. Capital markets deal with instruments whose maturity
exceeds one year or which lack definite maturity. Again on lines similar to domestic markets
in the international financial markets also we have primary and secondary markets dealing
with issue of new instruments and trading in existing instruments and trading in existing
instruments and negotiable debt instruments, respectively. In international financial markets
as in the domestic markets there is a symbiotic relationship between primary and secondary
markets.
CATEGORIES OF MARKETS
According to Garbbe, international financial markets consist of international markets
for foreign exchange, Euro currencies and Euro bonds. In view of the development and rapid
growth of swaps and globalization of equity markets, international financial markets have
been categorized into five markets here: foreign exchange market: lending by financial
institutions; issue and trading of negotiable instruments of debt; issue and trading of equity
securities; and lastly internationally arranged swaps. The rates of foreign exchange as well as
interest rates fluctuate and to hedge against the risk of loss arising out of changes in them
derivative instruments are traded in the organized exchages as well as in over the counter
markets. Most of the derivatives except the interest rate swaps are short term in nature.
Derivatives involve creation of assets that are based on other financial assets.
International Money Market
A money market is a market for instruments and a means of lending (or investing) and
borrowing funds for relatively short periods, typically regards as from one day to one year.
Such means and instruments include short term bank loans. Treasury bills, bank certificates
of deposit, commercial paper, banker`s acceptances and repurchase agreements and other
short term asset backed claims.
As a key elements of the financial system of a country, the money market plays a
crucial economic role that if reconciling the cash needs of so called deficit units (such as
farmers needing to borrow in anticipation of their later harvest revenues), with the investment
needs of surplus units (such as insurance companies wanting to invest cash productively prior
to making long term investment choices). Holding or borrowing liquid claims is more
productive than holding cash balances. A smoothly functioning money market can perform
these functions very efficiently if borrowing lending spreads (or bid offers spreads for traded
instruments) are small (operational efficiency), and if funds are lent to those who can make
the most productive use of them (allocation efficiency). Both borrowers and lenders prefer to
meet their short term needs without bearing the liquidity risk or interest rate risk that
characterizes longer term instruments, and money market instruments allow this. In addition
money market investors tend not to want to spend much time analyzing credit risk, so money
market instruments are generally characterized by a high degree of safety of principal. Thus
the money market sets a market interest rate that balances cash management needs, and sets
different rates for different uses that balance their risks and potential for productive use.
Unlike stock or futures markets, the money markets of the major industrial countries have no
central location; they operate as a telephone market that is accessible from all parts of the
world.
The international money market can be regarded as the market for short term
financing and investment instruments that are issued or traded internationally. The core of
this market is the Eurocurrency market, where bank deposits are issued and traded outside of
the country that issued the currency. Other instruments to be discussed in this chapter such as
Euro commercial paper and floating rate notes, serve some what different purposes and
attract a different investment clientele. However, each is to a degree a substitute for each of
the other instruments, and the yield and price of each are sensitive to many of the same
influences, se we may feel justified in lumping them together in something called a market.
The fact that many of the other instruments of the international money market are priced off
LIBOR, the interest rate of Eurodollar deposits, suggest that market participants themselves
regard the different instruments as having a common frame of reference.
Today many domestic cash and derivative instruments, such as US. Treasury bills and
Eurocurrency futures contracts are traded globally and so are effectively parts of the
international money market. Euromarkets instruments simply represent part of a spectrum of
financial claims available in the money market of a particular currency, claims that are
distinguished by risk, cost and liquidity just like domestic money market instrument.
However domestic money markets are called upon to play public as well as private roles. The
latter include the following three functions.
The money market, along with the bond market, is used to finance the government
deficit.
The transmission of monetary policy (including exchange rate policy) is typically
done through the money market, either through banks or through freely traded money
market instruments.
The government uses the institutions of the money market to influence credit
allocation toward favored uses in the economy.
Returns on Money Market Instruments
The manager of cash will wish to consider the alternative money market instruments she
has at her disposal by comparing their returns, risks and other characteristics. In principle, the
rage includes all the instruments in two dozen or so domestic money markets open to
international investors. Realistically, through one would normally limit one`s attention to a
few major currencies and to the more liquid instruments.
For some the starting point would be US Treasury bills and some will be constrained to
that class of risk. Most international investors will look for a better return than can be had in
government Treasury bills, however, so their staring point would be short term Euro deposits.
To compare instruments one should be able to express their returns on a comparable
basis. Doing so is complicated by the different maturities and payment characteristics of even
the limited range of investments considered here, and by the different delivery and accrued
interest calculations adopted by participants in different markets.
The basis idea of a retunes is that you invest a sum of money today and you get some
more back at a later date. The increase, expressed as an annualized percentage of the original
investment, is typically how we measure return. Thus if you invest Y100 today and you
receive Y107 in one year the return is 7 percent. In practice this idea takes three different
forms.
1. The bank discount rate
2. The add on yield
3. The yield to maturity, known in the Euromarkets as the bond equivalent yield.
1. The bank discount rate method is a formula devised to make calculations easy to do by
hand but its use persists in these days of financial calculations and computers for money
market instruments such as Treasury bills, banker`s acceptances and commercial paper.
These carry no coupon but are sold on a discount basis from a face principal value of 100.
Discount 360
Bank discount rate =
-
100
Days
Where Discount is the dollar amount of discount from the fact value of $100 and Days is the
actual number of days to maturity.
2. The add on yield is used in Eurodollar ? and Euro currency deposit calculations because
these are typically issued at a price of 100 and the coupon added on at the end.
The formula change to
Interest Payment 360
Add-on yield
=
-
100
Days
Where
Interest payment is the dollar amount of payment made at maturity on an
investment of $100.
Days is the number of days to maturity,
for example, if the interest payment on a 90 day Eurodollar deposit is $ 2.5, then the
add on yield is 10 percent
The trouble with the add on yield is that it ignores compounding, which car be important
because a one year Euro deposit that pays interest semiannually is more desirable than one
that pays annually. To take compounding into amount we need the yield to maturity or the
bond equivalent yield.
1. The bond equivalent yield or yield to maturity is the rate that equates the present value of
all future interest and principal payments with the market price of the instrument. If as in the
Eurobond market, interest is paid annually, we can solve the following equation for r, the
yield to maturity:
C C
C FV
P =
------ + -------- + .. ---------- + ----------
1 + r (1 + r)2 (1 + r)n (1 + r)n
Where
P is the present market price of the instrument
C is the annual coupon payment
N is the number if years to maturity
FV is the face value of the instrument (usually 100)
For portion of a year we use the 30/160 conversion, which assumes that each month has 30
days ad each year 360 days.
Eurocurrency Time Deposits and Certificates of Deposit
The overwhelming majority of bank deposits in the Eurocurrency market take the
forms of non negotiable time deposits. An investor puts her money in credit suiss, London
branch, today: she get is back, plus interest in three months time. Canceling a time deposit is
awkward and expensive, so the investor sacrifices liquidity. Those who want greater liquidity
invest in shorter maturities. A very high proportion of Eurodollar time deposits, especially in
the interbank market, mature in one week or less.
Alternatively, the invest can buy a negotiable Euro certificate of deposit (Euro CD),
which is simply a time deposit that is transferable and thus has the elements of a security.
Some banks are a little reluctant to issue CDs, because they would prefer not to have their
paper traded in a secondary market, especially at times when the bank might be seeking
additional short term funding. The secondary paper might compete with the primary paper
being offered. Other will issue CDs readily if investors prefer them, perhaps paying ?
percent or ore below their equivalent time deposit rate to reflect the additional liquidity and
the somewhat greater documentary inconvenience of CDs.
Other banks (particularly if they wish to have their names better known in the market)
might deliberately undertake a funding program using Euro CDs. In this circumstance, the
CDs are to be distributed like securities, so as to increase awareness of the issuers name and
raise a larger volume of funds for longer maturities than might be possible in the
conventional eurodeposit market.
Bankers Acceptances and Letters of Credit
Banker`s acceptances are money market instruments arising, typically, from international
trade transactions that are financed by banks. The banker`s acceptance (BA) itself represents
an obligation be a specific bank to pay a certain amount on a certain date in the future. To
simplify a bit, it is a claim ob the bank that differs little from other short term claims such as
CDs. Indeed Bas, when they are traded in a secondary market, trade at a return that seldom
deviates much from comparable CDs issued by the same bank.
Letters of credit (L/C) are documents issued by banks in which the bank promises to pay a
certain amount on a certain date, if and only if documents are presented to the bank as
specified in the terms of the credit. A letter of credit is generally regarded as a very strong
legal commitment on the part of a bank to pay if the conditions of trade documents are
fulfilled.
In a typical export transaction, the exporter will want to be paid once the goods arrive
(and are what they are supposed to be) in the foreign port. So the exporter asks for acceptance
is the importers bank of a time draft (essentially an invoice that requests payment on a future
date). Upon acceptance by the importers bank, the innocuous little time draft becomes a
valuable document, a banker acceptance. Acceptance means that the bank obliges itself to
pay the face amount upon the due date.
The means by which an exporter gets paid is be selling this BA to its own bank, which
can hold it as an investment or sell it in the secondary market, when it becomes \a money
market instrument. Bankers acceptances are sold at a discount from face value, like Treasury
bills and commercial paper, and yields are quoted as discount yields. Why should the bank
pay the exporter? The reason is that it has promised the exporter hat it will do so upon
presentation of documents conveying title to the goods. That promise is what we gave
described as the letter of credit.
Stand by letters of credit are related instruments entailing a commitment to pay on the part
of a bank, but they normally do not involve the direct purchase of merchandise or the
presentation of title documents.
Euronotes and Eurocommercial Paper
These instruments are short term unsecured promissory notes issued by corporations
and banks. Euronotes, the more general term, encompasses note issuance facilities, those that
are underwritten, as well as those that are not underwritten. The term Eurocommercial paper
is generally taken to mean notes that are issued without being backed by an underwriting
facilities that is, without out the support of a medium term commitment by a group of banks
to provide funds in the event that the borrower is unable to roll over its Euronotes on
acceptable terms. The Euronotes market takes the form of non underwritten Eurocommercial
paper (ECP), so the actual paper that an investor will find available for investment is likely to
be ECP.
Like US commercial paper, Euronotes and ECP are traded by conversion on a
discount basis, and interest is calculated as actual/360, meaning that the price is set as 100
minus the discount interest rate multiplied by the actual number of days to maturity, over
360.
International Financial Market Instruments
Funds are raised from the international financial market also through the sale of
securities, such as international equities or Euro equities, Euro bonds, medium term and short
term Euro notes and Euro commercial papers.
International Equities
International equities or the Euro equities do not represent debt, nor do they represent
foreign direct investment. They are comparatively a new instrument representing foreign
portfolio equity investment. In this case, the investor gets the divided n and not the interest as
in case of debt instruments. On the other hand, it does not have the same pattern of voting
right that it does have in the case of foreign direct investment. In fact, international equities
are a compromise between the debt and the foreign direct investment. They are the
instruments that are presently on the preference list of the investors as well as the issuers.
This has enabled Euro equity issues to surge to US $ 7.3 billion during 1990 and to US $ 44
billion in 1995 (BIS, 1997) from a mere US $ 2.7 billion during 1985.
Benefit to Issuer/ Investor
The issuers issue international equities under certain conditions and with certain
objectives. First, when the domestic capital market is already flooded with its shares, the
issuing company does not like toad further stress to the domestic stock of shares since such
additions will cause a fall in the share prices. In order to maintain the share prices, the
company issues international equities. Secondly, the presence of restriction on the issue of
shares in the domestic market facilitates the issue of Euro equities. Thirdly the co company
issues international equities also for the sake of gaining international recognition among the
public. Fourthly, international equities bring in foreign exchange which is vital for a firm in a
developing country. Fifthly, international capital is available at lower cost though the Euro
equities. Sixthly, funds raised through such an instrument do not add to the foreign exchange
exposure.
From the viewpoint of the investors, international equities bring in diversification
benefits and raise return with a given risk or lower the risk with a given return. If investment
is made in international equalities along with international bonds, diversification benefits are
still greater.
Procedure of Issue
When a company plans to issue international equity, it decides about the size of the
issue, the market where the equities are to be issued, the price of the issue, and about many
other formalities. It approaches the lead manager normally an investment bank ? which has a
better knowledge of the international financial market. The lead manager examines the risk
factors of the issue as well as its prospect. It suggest about the details of the issue as also
whether the shares are to be routed through the American depository or through the global
depository. When the lead manager gives a green signal, the issuing company prepares the
prospectus, etc. and takes permission from the regulatory authorities. After getting approval
from the regulatory authorities, it deposits the shares to be issued with the custodian bank
located in the domestic country. The custodian bank is appointed by the depository in
consultation with the share issuing company.
When the shares are deposited with the custodian bank, the latter asks the depository
located in a foreign country to issue depository receipts in lieu of the shares held. The ratio
between the number of shares and the number of depository receipt is decided well before the
actual issue, In fact, the fixing up of the issue price or the ratio between the depository
receipts and the shares depends upon a host of economic variables. Generally the issues are
priced at discount insofar as the earning per share drops in proportion to the increase in
capital. The market price of depository receipt in international market is largely dependent
upon earnings potential, industry fundamental, and macro economic fundamentals.
The depository, which is a bank or financial institution situated in a international
financial centre, functions as a link between the issuing company and the investor. O getting
information from the issuing company about the launch, the depository issues the depository
receipts. The American depository issues American depository receipts (ADRs), while the
depository in the international financial market outside the USA issues global depository
receipts (GDRs).
When GDRs are purchased by the investors, the proceeds flow from the depository to
the custodian bank and from the custodian bank to the issuing company. The company enters
the name of the investor in the register of the shareholders. The investor has the right to
surrender GDRs and to take back the investment. For the surrender, the investor deposits the
GDRs with the depository who in turn informs the custodian who will issue the share
certificates in exchange for the GDRs. The proceeds from the sale of shares are converted
into foreign investors. It may be noted here that once the GDR is surrendered in exchange for
the shares, such shares cannot be converted back into GDRs.
Again the investors can sell the GDR back in the issuing company`s domestic capital
market. In order to discourage this practice, the issuer introduced a clause, known as lock in
period, during which this practice is prohibited.
In the process of the issue, the role of underwriting and listing is very important. The
lead manager functions normally as an underwriter and charges underwriting fee, the listing
agent, who is normally the lead manager, makes an application to the stock exchange for
listing. The agent guides the issuing company and helps it file the required documents with
the stock exchange. After the formalities are complete, GDRs are traded on the stock
exchange. There are also international clearing houses, such as Euro ? clear and CEDEL that
facilitate the settlement of transactions.
The question of voting rights is also important. Since GDR investors keep changing
from time to time, they do not seem very much interested in the voting rights even though
these cannot be denies to them. There are different procedures followed in this respect. One is
that the issuing company and the overseas depository enter into an agreement which enables a
depository to vote either with the majority voters or according to the wishes of the
management. In the other procedure, it is understood that the depository votes in the same
proportion as the rest of the shareholders do. Again, there is one more alternative where the
depository votes in accordance with the instructions of a nominee of the management.
The cost of international equity is normally not large, although commission,
management fee, etc, are paid to the lead manager according to the different functions
performed by it. The depository incurs some expenses. Theses approximate to 3 ? 4 per cent
of the issue amount.
Documentation
There are many documents used in the process of the issue of international equity.
These are:
1. The prospectus containing detailed information about the issue and the issuer.
2. The depository agreement the agreement between the issuing company and the
depository ? that contains, among other things, the rules followed for converting the
shares into GDRs and back.
3. The underwriting agreement concluded between the issuing company and the
underwriter, normally the lead manager, accompanies the issue.
4. A copy of the agreement concluded between the custodian and the depository is also
enclosed.
5. A copy of the trust deed is enclosed which provides for the duties and responsibilities of
the trustee regarding servicing of the issue.
6. A copy of the agreement with the listing stock exchange is annexed so that the investors
are well aware of the secondary market for the issue.
Besides a subscription agreement is also enclosed the means of which the lead manager
and the syndicate members agree to subscribe to the issue.
INTERNATIONAL BONDS
International bonds are a debt instrument. They are issued by international agencies,
governments and companies for borrowing foreign currency for a specified period of time.
The issuer pays interest to the creditor and makes repayment of capital. There are different
types of such bonds. The procedure of issue is very specific. All these need some explanation
here.
Types of International Bonds
Foreign bonds and Euro bonds
International bonds are classified as foreign bonds and Euro bonds. There is a
difference between the two, primarily on four counts. First, in the case of foreign bond, the
issuer selects a foreign financial market where the bonds are issued in the currency of that
very country. If an Indian company issues bond in New York and the bond is denominated in
a currency other than the currency of the country where the bonds are issued. If the Indian
company`s bond is denominated in US dollar, the bonds will be used in any country other
than the USA. Then only it will be called Euro bond.
Secondly, foreign bonds are underwritten normally by the underwriters of the country
where they are issued. But the Euro bonds are underwritten by the underwriters of multi
nationality.
Thirdly, the maturity of a foreign bond is determined keeping in mind the investors of
a particular country where it is issued. On the other hand, the Euro bonds are tailored to the
needs of the multinational investors. In the beginning, the Euro bond market was dominated
by individuals who had generally a choice for shorter maturity, but now the institutional
investors dominate the scenes who do not seek Euro bond maturity necessarily to march their
liabilities. The result is that the maturity of Eurobonds is diverse. In England, Euro bonds
with maturity between 8 and 12 years are known as intermediate Euro bonds.
Fourthly, foreign bonds are normally subjected to governmental regulations in the
country where they are issued. For example in the case of Yankee bonds (the bonds issued in
the USA), the regulatory thrust lies on disclosures. In some of the European countries, the
thrust lies on the resource allocation and on monetary control. Samurai bonds (bonds issued
in Japan) involved minimum credit rating requirements prior to 1996. But the Euro bonds are
free from the rules and regulations of the country where they are issued. The reason is that the
currency of denomination is not the currency of that country and so it does not have a direct
impact on the balance of payments.
Global bonds
It is the World Bank which issued the global bonds for the first time in 1989 ands
11990. Since 1992, such bonds are being issued also be companies. Presently, there are seven
currencies in which such bonds are denominated namely, the Australian dollar, Canadian
dollar, Japanese yen, DM, Finnish markka, Swedish krona and Euro. The special features of
the global bonds are:
They carry high ratings
They are normally large in size
They are offered for simultaneous placement in different countries
They are traded on home market basis in different regions.
Straight bonds
The straight bonds are the traditional type of bonds. In this case, interest rate is fixed.
The interest rate is known as coupon rate. It is fixed with reference to rates on treasury bonds
for comparable maturity. The credit standing of the borrower is also taken into consideration
for fixing the coupon rate.
Straight bonds are of many varieties. First, there is bullet redemption bond where the
repayment of principal is made at the end of the maturity and not in installments every year.
Second, there is rising coupon bond where coupon rate rises over time. The benefit is that the
borrower has to pa small amount of interest payment during early years of debt. Third, there
are zero coupon bonds. It carries no interest payment. But since there is no interest payment,
it is issued at discount. It is the discount that compensates for the loss of interest faced by the
creditors. Such bond was issued for the first time in 1981. Fourth in case of bond with
currency options, the investor has the right to receive payments in a currency other than the
currency of the issue. Fifth, bull and bear bonds are indexed to some specific benchmark and
are issued in two trenches. The bull bonds are those where the amount of redemption rises
with a rise in the indeed. The bear bonds are those where the amount of redemption falls with
a fall in the index. Finally, debt warrant bonds have a call warrant attached with them.
(Warrants are zero coupon bonds.) The creditors have the right to purchase another bond at a
given price.
Floating rate notes
Bonds, which do not carry fixed rate of interest, are known as floating rate notes
(FRNs). Such bonds were issued for the first time in Italy during 1970 and they have become
common in recent times. The interest rate is quoted as a premium or discount to a reference
rate which is invariably LIBOR. The interest rate is revised periodically, say, at every three
month or every six month period, depending upon the period to which the interest rate is
referenced to. For example, if the interest rate is referenced to one month LIBOR, it would be
revised every month.
FRNs are available in different forms. In the case of perpetual FRNs, the principal
amount is never repaid. This means they are like equity shares. They were popular during
mid 1980s, but when the investors began to ask for higher rate of interest, many issuers could
not afford paying higher rates of interest. Such bonds lost their popularity.
Secondly, there are minimax FRNs where minimum and maximum rates
are mentioned. The minimum rate is beneficial for the investors, while the
maximum rate is beneficial for the issuer. If LIBOR rises beyond the maximum
rate, it is only the maximum rate that is payable. Similarly, the minimum rate is
payable even if LIBOR falls below the minimum.
The third form is the drop lock FRN where the investor has the right to convert the
FRN into a straight bond. Sometimes the conversion is automatic if the reference rate drops
below a mentioned floor rate.
Fourthly, there is flop flop FRN. It was first issued b the World Bank. In this case, the
investor has the option of converting FRN into a three month note with a flat three month
yield. Again the note cab is converted into a perpetual note after the completion of the thee
month period.
Fifthly, there are mismatch FRNs. In this case, the interest rate is fixed monthly, but
interest is paid six monthly. In such a situation, the investor may go for arbitrage on account
of difference in interest rates. Such FRNs are also known as rolling rate FRNs.
Sixthly, one of the recent innovations has come in form of hybrid fixed rate reverse
floating rate notes. They were used in Deutsch mark segment of the market in 1990. These
instruments paid a high fixed interest rate for a couple of years. The investors received the
difference between LIBOR and even a higher fixed interest rate. They reaped profits with the
lowering of LIBOR.
Convertible bonds
International bonds are also convertible bonds meaning that these variant are
convertible into equity shares. Some of the convertible bonds have detachable warrants
involving acquisition rights. In other cases, there is automatic convertibility into a specified
number of shares.
Convertible bonds command a comparatively high market value because of the
convertibility privilege. The value is the sum of the naked value existing in the absence of
conversion and the conversion value. The conversion price per share is computed by dividing
the bonds face value by the conversion factor, where the conversion factor represents the
number of shares into which each bond could be exchanged. Suppose, a bond having a face
value of $ 1000 can be exchanged for 15 shares the conversion price will be equal to;
1000/15 = $ 66.66
Thus, if the market price of share is less than $ 60, bondholders will not be interested in
converting the bond into equity share. This is so because for a bond of $ 1000, a creditor will
get 15 shares or $ 900 only. But if the market price of share is $80, the investors will convert
the bond into equity shares and sell the equity shares in the market. This way each bond for $
1000 will fetch $ 1200. In other words, the price of convertible bonds depends upon the price
of the equity shares.
In the case of bonds with detachable warrants, the warrant can be detached from the
bond and cab be traded independently. The issuer has a double source of financing. The
bonds remain outstanding even if the warrants are exercised.
From the viewpoint of the borrowers, convertible bonds cost less because they have
lower coupon. They also help decrease the debt equity after conversion. From the investor`s
point of view, convertible bonds represent a better option as the investors get a fixed income
in the form of interest prior to conversion. After conversion, they become the owner of the
company.
Cocktail bonds
Bonds are often denominated in a mixture of currency. Such bonds are known as
cocktail bonds. There are two forms of cocktail bonds ? one is denominated in SDRs
represent a weighted average of five currencies, while the Euro represents a basket of 11
currencies. The investors purchasing the cocktail bonds get automatically the currency
diversification benefits. The foreign exchange risk on account of depreciation of any one
currency is offset be appreciation of another currency.
Procedure of Issue
There are different stages involved in the issue of international bonds. Since the issuer
? normally a government or a company ? does not have a detailed idea about the international
financial market, nor it is easy for the issuer to perform several formalities, it approaches a
lead manager who advises the issuer on different aspects of the issue. Normally, the lead
manager is a commercial bank or an investment bank. The issuer selects a particular lead
manager on the reports published by different agencies about the performance of the
investment banks I the area of lead managing. The lead manager advises the issuer regarding
the main features of the issue, the timing, price, maturity and the size of the issue and bout
the buyer`s potential. The lead manager takes help from the co-manager, although the bulk of
the work is done by itself.
After getting advice from the lead manager, the issuer prepares the prospectus and
other legal documents. In this process, the issuers own accountant, auditors, legal counsel are
very important for designing the issue in accordance with the financial need of the company
as well as with regulatory provisions existing in the country. Sometimes the advice of the
lead manager is also sought in order to make the issue suitable for indicators prevailing in the
international financial market. The lead manager charges fee for the advice. The fee is known
as management fee. When all this is over, the issuer takes approval from the regulatory
authorities. After the approval, it launches the issue.
The second stage begins when the issue is launched. Investors look at the credit rating
of the issuer as well as who is underwriting the issue. This is why the lead manager along
with co managers helps in the credit rating of the issuer by a well recognized credit rating
institution. At the same time, it functions as an underwriter and charges underwriting fee.
The third stage begins after the underwriting process is complete. This stage includes
the process of selling the bonds. More often, the lead manager functions as a selling group
and for that it charges commission at varying rates.
The investors, on the other end, are individuals. They are institutions, such as
investment trust, banks and companies. They often purchase the bond through their buying
agents. There are also trustees who are usually a bank appointed by the issuer. Their duty is
to protect the interest of the investors, especially in vase of default by the borrower.
Sometimes the lead manager acts as a trustee. Finally, there are listing institutions. They
enlist the bonds for secondary marketing. The secondary market for international bonds is
mainly an over the counter market, although the bonds are listed with the stock exchages.
It may be noted that the entire procedure of the international bond issue is complete
within a specified time span. After the press release of the prospectus, it takes 27 days. The
first 12 days are spent on sales campaign which is known as the offering period. On the 12th
day, underwriting agreement is signed, which is known as the pricing day. During the
following 15 days, bonds are sold and delivered and the necessary payments made.
Documentation
Documentation requirements for a bonds issue are complex. There are seven
documents that are required. The first is the prospectus. It informs about the issuer, its
management and about it`s past, present and future operation. It also covers the political and
economic make up of the country. The second is the subscription agreement. It comprises
denomination, coupon rate, issue price and maturity of the bond, underwriting commitments,
details of selling arrangements, closing date and the terms of payment, names of the paying
agents and trustees, details of lilting conditions under which agreement cab be terminated, the
legal jurisdiction and rules regarding compensation in case of misrepresentations or breach of
warranties. The third important document is the trust deed which is an agreement between the
issuer and the trustee for an orderly servicing of the bond. The fourth document is the listing
agreement that shows listing centers. The fifth document is the paying agency agreement
executed between the issuer and the bank that pays the agent for servicing of the bond. The
sixth document is the underwriting agreement that brings in confidence among the investors.
The last document is a copy of the selling group agreement that tells about the agencies
involved in the sale of the bond. All these documents accompany the bond certificate.
Secondary Market Operation
Facilitates do exist for secondary market operation for foreign bonds and Euro bonds.
In the case of the former, listing is done on a particular stock exchange in a particular
country. But for Euro bonds, many financial centers are involved. This is why transaction
takes place in over the counter market. However listing with international stock exchange
helps Euro bonds in determination their price, depending upon the performance of the issuer
and the demand for the issue. When the price is determined and the issue is ready for sale, the
stock exchange helps the deal. Normally, there is spread of one half of one per cent between
bid and offer prices. Settlement instructions are routed through the clearing house located in
Brussels and Luxembourg, and delivery of bonds is made against payment. Clearing may also
take place through book entries.
Sometimes, before the secondary market starts functioning, the particular Euro bond
is in great demand. Such trading is known as grey trading, although such cases are rare.
For smooth operation of the clearing houses and operation of the secondary market,
there is an Association of International Bond Dealers, which was set up under Swiss law as
far back as in 1969. It frames rules for smooth operation.
Development of International Bond Market
Foreign bonds emerged on a substantial scale as early as in 1950s. The US dollar was
then the strongest currency. In order to obtain US dollar, issuers from different countries
issued bonds in the US financial market. These Yankee bonds were very popular. However,
with weakening balance of payments, the US Government imposed restrictions on the issue
of Yankee bonds in 1960s. The restrictions provided impetus for the emergence of Euro
bonds. The first Euro bond was issued b an Italian borrower, Autos trade in 1963. Many other
Euro bonds were issued subsequently. But since bank lending dominated the financial scene
till early 1980s, sizeable growth in Euro bond market took place only thereafter. The total
bond volume increased from US $ 38 billion in 1980 to US $169 billion in 1985 and to US $
230 billion in 1990 (BIS, 1992).
During 1990s, owing to greater liberalization in the international financial market,
which was more apparent in Germany, France and Japan, the size of the bond market grew at
a faster rate. By March 1995, the amount involved was over US $ 2210 billion. In 1995, the
straight bonds dominated the scene as they accounted for over three fourths of the issue.
FRNs accounted for around one ? seventh. The rest was accounted for by convertible bonds.
Again, it was found that Japanese yen denominated bonds were mainly fixed rate bonds,
while floating rate bonds were denominated mainly in A British pound. The Swiss franc
denominated bonds were normally the convertible bonds (BIS 1997). Yet again, around two
fifths of the total issues in 1995 were denominated in US dollar, a little less than one fifth in
Japanese yen, about one seventh in DM, and the rest of the bonds were denominated in other
currencies. In the case of bonds issued by the firms and governments of developing countries,
57 per cent of the issue was represented by US dollar and over one- quarter was denominated
in Japanese yen. The share of DM was hardly one- tenth. The value of yen bonds increased
during 12990s because may Latin American Brady bonds came to be denominated in yen in
view of greater attraction for them among Japanese investors (BIS 1997).
In 1995 the average size of maturity of international bonds was 4.3 years, but
subsequently, it rose due to longer term bonds issued by many corporations. Again, after the
Mexican crisis of 1994, some of the Latin American governments tried to re establish
benchmarks in international financial market and issued international bonds. This resulted in
the growth of sovereign bonds during these years.
SHORT ? TERM AND MEDIUM ? TERM INSTRMENTS
Euro Notes
Euro Notes are like promissory notes issued by companies for obtaining short term
funds. They emerged in early 1980s with growing securitization in the international financial
market. They are denominated in any currency other than the currency of the country where
they are issued. They represent low cost funding route. Documentation facilities are the
minimum. They can be easily tailored to suit the requirements of different kinds of
borrowers. Investors too prefer them in view of short maturity.
When the issuer plans to issue Euro notes, it hires the services of facility agents or the
lead arranger. On the advice of the lead arranger, it issues the notes, gets them underwritten
and sells them through the placement agents. After the selling period is over the underwriter
buys the unsold issues.
When the issuer plans to issue Euro notes, it hires the services of facility agents or the
lead arranger. On the advice of the lead arranger, it issues the notes, gets them underwritten
and sells them through the placement agents. After the selling period is over, the underwriter
buys the unsold issues.
The Euro notes carry three main cost components: 1, underwriting fee; 2, one time
management fee for structuring, pricing and documentation; and 3, margin on the notes
themselves. The margin is either in the form of spread above/below LIBOR or built into the
note price itself.
The documentation is standardized. The documents accompanying notes are usually
underwriting agreement, paying agency agreement, and information memorandum showing,
among other things, the financial position of the issuer. The notes are settled either through
physical delivery or through clearing.
In course of time, a few variants of Euro notes issue system have evolved. The first is
the revolving underwriting facility in which there is a sole placement agent who allocates the
notes among investors at a uniform pre set yield. The second is the tender panel system in
which the placement agent forms a panel of banks for placing Euro notes on behalf of the
issuer. The tender panel members submit tenders to the placement agent indicating the
amount and price of notes they would like to acquire. In this case, price is set by open
competition and so it goes in favour of the issuer. But the placement agent may not have the
same level of commitment as it is found in the case of the sole placement agent. The third
variant is continuous tender panel in which the underwriters constitute a tender panel for each
draw down of notes. They buy them, if left unsold, during the offer period. This system
brings in competition among the underwriters.
Euro Commercial papers
Another attractive form of short term debt instrument that emerged during mid ?
1980s came to be known as Euro commercial paper (ECP). It is a promissory note like the
short term Euro notes although it is different from Euro notes in some ways. It is not
underwritten, while the Euro notes are underwritten. The reason is that ECP is issued only by
those companies that possess a high degree of rating. Again, the ECP route for raising funds
is
normally
investor
driven,
while
the
Euro notes is said to be borrower driven.
ECP came up on the pattern of domestic market commercial papers that had a
beginning in the USA and then in Canada as back as in 1950s. The prefix Euro means that
the ECP is issued outside the country in the currency in which it is denominated. Most of the
ECPs are denominated in US dollars, but they are different from the US commercial papers
on the sense that the ECPs have longer maturity going up to one year. Moreover, ECPs are
structured on the basis of all in costs, whereas in US commercial papers, various charges,
such as front end fee and commission are collected separately.
The detailed features of ECPs vary from one country to another. They involve market
based interest rate, LIBOR. The issue is normally arranged through placement agents as in
the case of Euro notes. The amount varies from US $ 10 million to US $ 1 billion or above.
The ECPs are issued either in interest bearing form or in a discounted form with interest built
in the issue price itself. On completion of the maturity, they are settled generally at the
clearing houses, such as Cedel (Luxembourg) Euro clear (Brussels), First Chicago (London)
or Chases Manhattan (London) so that the physical delivery is avoided. The settlement is
complete normally within two days.
ECPs face minimal documentation. Over and above, they are not underwritten. This is
why their use has been large since their very inception. The outstanding amount of
transaction through ECPs rose from US $ 13.9 billion in 1986 to US $ 79.6 billion in 1991.
By March 1995, the amount was US $ 81.3 billion, over three fourths of which were
denominated in the US dollar (BIS, 1997).
Medium- term Euro Notes
Medium term Euro notes are just an extension of short term Euro notes as they fill the
gap existing in the maturity structure of international financial market instruments. They are a
compromise between short term Euro notes and long term Euro bonds as their maturity
ranges between one year and five to seven years.
The short term Euro notes are allowed to roll over repeatedly over five to seven years.
Every three or six months, the short term Euro notes are redeemed and a fresh issue is made.
Alternatively, a medium term Euro note is issued to get medium term Euro note is issued to
get medium term funds in foreign currency without any need for redemption and fresh issue.
Medium term Euro notes are not underwritten, yet there is provision for underwriting.
This is for ensuring the borrowers that they get the funds even if they lack sufficient
creditworthiness. They are issued broadly on the pattern of US medium term notes that are
found there since early 1970s. Medium term Euro notes carry fixed rate of interest, although
floating rates are also there. In recent years, multicurrency structure has come up. The issuers
are mainly banks, sovereigns and international agencies.
The medium term Euro notes been popular. The outstanding amount, which was just
US $ 0.4 billion at the end of 1986, grew to US $ 9.6 billion by 1990 and to US $ 347.1
billion by March 1995 (BIS, 1997). The galloping growth in such issues shows the
tremendous popularity of this instrument.
Of late, the Euro market has come up with global medium term note issues. Under
this programme, issues of different credit ratings are able to raise funds through accessing
retail as well as institutional investors. This is a comparatively new programme.
Overview of the Financial International Financial Market
When a multinational enterprise finalizes its foreign investment project, it needs to
select a p-particular source, or a mix of sources of funds to finance the investment project.
Here it may be noted that a ,multinational enterprise position itself on a better footing than a
domestic firm as far as the procurement of funds is concerned. A domestic firm gets funds
normally from domestic sources. It does get funds from the international financial market too
but it is not as easy as in case of a multinationals enterprise. The latter can use the parent
companies funds for its foreign investment project. It can also get funds from the host country
financial market, but more importantly, it tries to get funds from the international financial
market. It selects a particular source or a mix of sources or a particular type or types of funds
that suits its corporate objectives.
CHANNERLS FOR INTERNATIONAL FLOW OF FUNDS
The international financial market can be compartmentalized into two segments. One
is the international money market which is represented by the flow of short term funds.
International banks or the short term securities come under this segment. On the other hand,
the international capital market forms the other segment where medium and long term funds
flow.
Irrespective of such a distinction between the two segments, there are a number of
agencies and instruments through which funds move to the be official or non official. Among
the official agencies, are the multilateral institutions, such as international development banks
and regional development banks, and the bilateral agencies, such as the different
governmental agencies. Multilateral or bilateral funds can be Concessional or
nonconcessional. The highly concessional funds or funds having a large grant element are
known as official development assistance.
INTERNATIONAL FINANCIAL MARKET
Offical sources
- Multilateral agencies
International development banks, such as the world Bank, IFC, etc
Regional development banks, such as Asian Development Bank, etc
- Bilateral agencies or the different governmental agencies
Non governmental agencies
- Borrowing and lending market involving international banks
- Securities market
Debt securities
Equities
The non official channel comprises the borrowing and the lending streams such as the
international banks on the one hand, and on the other, the securities market in which the Euro
equities and the debt instruments, such as international bonds, medium term Euro notes, short
term Euro notes and Euro commercial papers are sold and purchased. It may be noted that the
operation of the international financial market spreads beyond the lending and borrowing of
funds or the sale and purchase of securities. Swap is also very common and it forms and
integral part of international financial market. If a borrower needs fixed rate funds but has
access to the floating rate loan market, he can go in for an interest rate swap in order to
exchange the floating rate loan for the fixed rate loan. Similarly, it a borrower does not get
loan in a particular currency, the loan can be swapped for obtaining the desired currency.
CHANING STRUCTURE OF THE INTERNATIONAL FINANCIAL MARKET
Multilateral Agencies
When one studies the development of the international financial market over the past
half century, many structural changes are manifest over the years. This has been in fact the
result of the changing supply position of and demand position for international funds
consequence upon the large scale adoption of economic development programmes, growth of
international trade, and the fast growing activities of the multinational corporations. On
scrutinizing the official channels, it is found that up to the mid 1940s, there was no
multinational agency to provide funds and only in 1945 was the international Bank for
Reconstruction and Development (IBRD) established that provided in the beginning loans for
reconstruction of the war ravaged economies of Western Europe and then from 1948 began
providing development loans. The IBRD function was limited to lending and so the provision
of equity finance lay beyond its scope. Moreover it lent only after the guarantee by the
borrowing government. To overcome these problems, the International Finance Corporation
(IFC) was established in 1956 which provided loans even without government guarantee and
provided equity finance as well. However one unsolved problem remained. It was that the
poorer countries of the developing world were not in a position to utilize the costly resources
of the IBRD because those funds carried the market rate of interest (Sharan, 1991). For their
benefit, another sister institution was created in 1960 named as International Development
Association (IDA). The two institutions IBRD and IDA together came to be known as the
World Bank.
When IBRD was established, its main objective was not to mmake direct laos but to
encourage privatre investment. It began lending on a large scale only whe the desired amount
of private investment failed to come up. Lending then became its major function but the issue
of encouragement to international investment remained. And to this end, the Multilateral
Investment Guarantee Agency (MIGA) was established in 1988 to cover the non commercial
risks of the foreign investors. All these four institutions ? IBRD, IDA, IFC and MIGA ?
together are now known as the World Bank Group.
When the World Bank Group emerged as a major funding agency, it was felt that its
lending norms did not equally suit different member countries because the economic and
political conditions as well as the requirements of the different regions of the globe were
different. Thus, for tuning of the funding in line with varying requirements of the different
regions, it was decided to set yup regional development banks open the pattern of the
international development banks. The decade of the 1960s marked the establishment of
regional development banks in Latin America, Africa and Asia. The Asian Development
Bank began operation from December 1966.
Bilateral Agencies
The history of bilateral lending is not older than that of multilateral lending. During
the first half of the twentieth century, funds flowed from the empire to its colonies for
meeting a part of the budgetary deficit of the colonial government but it was not ma normal
practice, nor was it ever considered as the external assistance thaw we mean in the present
day context. Bilateral economic assistance was for the first time announced by the US
president Truman in January 1951. In fact the motivation behind the announcement was
primarily political and economic. The cold was between the USA and the then USSR was at
units peak those days and the US government tried to befriend the developing countries to
bring them into its own camp in order to make itself politically more powerful. It would US
economy to come close to the developing economies and also to get the desired raw material
and foodstuffs therefore. The economic assistance could help build the infrastructural
facilities in the developing countries that could in turn help increase the US private
investment in those countries.
In the second half of the 1950s, the USSR bloc too announced its external assistance
programme in order to counter the US move. By the later 1950s, many other governments of
the organization of Economic Cooperation and Development (OECD) announced external
assistance programmes and bilateral lending came into full bloom from the 1960s. In some
cases, government joined hands with private agencies and the export credit came to form a
sizeable part of the bilateral assistance programme.
FACTORS BEHIND EMERGENCE OF EURO BANKS
It may be mentioned that after Stalins death, the then USSR moved away from the
closed economic policy and its trade with the West and the South began to expand since the
later 1950s or the early 1960s. Those days the US dollar was the most desired currency in
international transactions, so the USSR earned US dollars through trade and tried to earn
more of this currency in view of its great strength in international transaction. Since the cold
was between the two super powers was then at its peak, it preferred to keep its earned dollars
in a bank outside the USA. London and a few other European financial centres were the best
choice as they possessed the requisite infrastructure and a stable political climate. Those
dollar deposits in London and other European country based banks came to be known as Euro
dollars and the banks accepting such deposits came to be known as Euro banks.
In the wake of the foreign exchange crisis of 1955 ? 57, the British government
placed restrictions on the use of pound sterling for external transactions and the dollar was in
great demand in the UK for external transactions, in view of the readily available supply of
dollars. Moreover, the emerging convertibility of some European currencies by late 1950s led
to the emergence of an active foreign exchange market in Europe linking the US dollar with
those European currencies. These links enhanced in turn, the use of the US dollar by the
banks located in Europe.
The emergence of Euro banking got support from some capital control measures by
the US government in the wake of the balance of payments crisis in the 1960s. In early 1965,
the introduction of voluntary foreign directly to the non residents, whereas this provision did
not apply to foreign branches of the US banks. As a result, the foreign operation of the US
banks shifted from those located in the USA to those located in other countries, mainly ion
Europe. Statistics show that the number of US banks having foreign branches rose from 11 in
1964 to 125 in 1973, the number of foreign branches of those banks moved up from 181 to
699 during this period and the assets of those branches whet up from US $ 7.0 billion to US $
118 billion during the same period (Johnston, 1982).
Some of the European governments imposed restrictions on holding of deposits by
non residents in domestic currency and on paying of interest on non resident deposits. This
encouraged the non residents to hold deposits in Euro banks that were not subject top such
regulations. The US Government too imposed an interest rate ceiling when credit was tight
and the market interest rate had risen. The US banks could not raise the interest rate. On the
contrary, the Euro banks that were not under the purview of such ceilings, raised interest rate
on deposits and attracted depositors away from the US based banks.
Again, when domestic credit was restricted, companies borrowed from Euro banks
normally at lower rates of interest, and the increased lending and deposits contributed to the
growth of the Euro banks. It was not only that the US banks came to be based in Europe; the
European banks too spread their branches overseas perhaps as a defensive measure. Statistics
reveal that the number of overseas branches increased from 1860 in 1961 to 3764 in 1973.
The number of foreign branches of UK based banks alone rose from 1105 to 1973 during the
same period (Bhatt, 1991).
Off ? shore Banking Centre`s
In the 1970s, a new type of international banks emerged that were different from the
traditional banks or from the Euro banks and that came to be known as off ? shore banking
centres (OBCs). The distinctive feature of the OBCs was that they dealt with non residents
only; although like the Euro banks, they did not deal in the currency o9f the host country. In
fact, they channeled funds from one country to another without influencing the domestic
financial market.
OBC a proliferated in those places and in those countries where: the governmental
control and regulations were the least interfering, tax rates were very low, necessary
infrastructure for their smooth operation, such as good systems of communication, a
supportive climate and an experienced financial community, etc. existed, and which were
politically and economically stable.
Looking at the specific cases, one finds that it was the non-flexibility of governmental
restrictions that discouraged the growth of OBCs in Germany, France and Japan. On the other
hand, it was this flexibility that helped London, Luxembourg, Singapore, Hong Kong and
many others to attract OBCs. OBCs grew in the Bahamas, Luxembourg, Cayman Islands and
in Panama in view of low rates of taxes. Better communication facilities and availability of
experienced personnel were the additional factors for London based OBCs. Presence of
exchange control measure came in way of the growth of OBCs in the Latin American
countries. On the contrary, Kuwait and Bahrain attracted OBCs on account of least
governmental interference. Whatever might the reasons for their growth have been, the OBCs
attracted a large number of borrowers and lenders. The foreign currency liabilities of OBCs
in European reporting countries rose from US $ 79.3 billion in 1970 to US $ 801 billion in
1979 and the total liabilities of US banks branches in the Bahamas and Cayman Islands alone
grew fro m US $ 4.8 billion to US $ 121.8 billion during the same period (Johnson, 1982).
Syndication of Lending
Another structural change that took place during the 1970s was evident in the form of
syndicated lending. In the wake if the international oil price rise, a number of oil ? importing
countries experienced huge deficit on their current account. Consequently, they had to resort
to bigger loans that were normally not within the capacity of a single bank to provide. The
banks joined hands for providing these large loans. They did it so also re reduce the
individual risk of lending. Besides, from the borrower`s point of view, the cost of the
syndicated loans was smaller than the sum of the cost of individual loans borrowed from
many banks. Whatever the reasons for the coming together of the banks, such lending came
to be known as syndicated lending. Such loans served the interest of both lenders and
borrowers and so they took a great leap forward. Taking birth in early 1970s, they crossed US
$ 88 billion mark by 1980 and reached US $ 320 billion by 1995 (IMF, 1997).
Syndicated loans are different from general loans in that one of the lending banks is
the lead manager who originates the transaction, structures it, selects the lending members,
supervises the documentation, and in many cases, services the loan after agreement is
complete. It serves as a link between the borrower and the other banks of the syndicate. It
collects interest and principal from the borrower and disburses the collected amount among
the co-leaders. For its functions, the lead bank charges and additional fee.
Move towards Securitisation
There was a big leap in bank lending during the 1960s and more particularly during
the 1970s after the international banks had acquired the surplus of oil exporting countries.
During the 1980s, however, a number of factors emerged on the international economy scene,
which led to a shift from bank lending to growing Securitisation in the international financial
market. With the stagnant oil prices, the international banks could not sustain any sizeable
increase in loans, and external indebtedness in some of the borrowing countries turned
unmanageable. The borrowers found themselves unable to repay loans. M?xico`s refusal to
repay loans added fuel to the firs. The risk of repayment got so considerable that the banks
hesitated in lending. A drop in long term interest rates during the 1980s, with the
reappearance of positive real interest rates, and more importantly, a rising trend in the yield
from the long term bonds, investors preferred to invest in international bonds. The rising
intermediation cost associated with bank lending also pushed the borrowers away from bank
borrowing to borrowing through the use of securities (Honeygold, 1989). Moreover, the
securities proved highly liquid as the investors could sell them in the secondary market which
had also developed along with the growth in Securitisation.
The more commonly used securities were international bonds for long term funds,
medium term Euro notes that were meant for medium term funds, and Euro bonds had taken
birth in the earlier decade, but the other instruments emerged in the 1980s. The Euro equities
were also issued through the global depository. Known as portfolio equity investment they
became an important vehicle for transfer of resources in the international financial market
during the later 1980s and 1990s.
Banks` Off ? Balance Sheet Activities
The slump in the banks lending activities during the 1980s resulted not only in greater
use of international securities but also in a shift in favour of the off balance sheet activities of
the international banks. It was because the banks had to maintain their earnings and the
capital adequacy norms in the wake of the eroded lending business. These activities were
nothing but the participation of the banks in the foreign exchange market. The banks involved
themselves greatly in the swap deals, in the forward currency market, and in the market for
currency options. The revolution in the telecommunication system and the greater use of
computers eased their job considerably.
Apart from the fallen lending business, the other factor responsible for the growing
off balance sheet activities was the fierce competition with the non banking financial
companies. The banks were compelled to adopt additional functions in order to prove their
superiority over the non banking companies.
Impact of structural change
Whatever the reasons for the structural change, there has definitely been product
innovation and improvement in financial technology in the international financial market that
has helped the borrowers as well as the lenders and investors. All this has led to a
considerable cut in transaction cost and to greater efficiency in the allocation n of capital that
might have a positive bearing on the world output. This is not all; with international
diversification of the investment portfolio, the risk of investment has been reduced. The
financial market now has greater liquidity as a result of which the volume of credit has
increased. However, it cannot be denied that this has had an adverse effect on the traditional
activities of the international banks. Since different segments of the international financial
market are closely interwoven as a result of improvement in communication facilities, the
shock in one part of the market is transmitted easily to other markets. Again, sometimes, the
international financial market experiences an excess iof liquidity which is not a healthy sign
but the benefits from the structural change seem to outweigh the costs.
SELECTION OF SOURCES AND FORMS OF FUNDS
When a firm selects a particular source or form of funds, it does so in order to suit its
corporate objectives. Some of the major objectives are the minimization of the effective cost
of funds, matching the raised funds with target debt- equity, and the target current-liability-
long-term-liability ratio, and avoidance of lengthy legal and procedural formalities.
Minimisation of Cost of Funds
Minimisation of the cost of capital is the very motive behind selection of the sources
of funds. The effective cost of the funds depends inter alia on the rate of interest and the
changes in the exchange rate or in the value of the borrowed currency. The effective cost of
borrowing in a foreign market is obtained as
Kbf = (1 + rf) (1 + Ef) ? 1
Where rf is the rate of interest in the foreign market and Ef is the change in the exchange rate.
For example, if interest rate in the London money market is 12 per cent compared to
14 per cent in New York, and the pound sterling is expected to appreciate by 4 per cent, the
effective cost of borrowing in pounds would be
(1.12 x 1.04) ? 1 = 16.48%
In this case, the multinational enterprise will borrow from the New York money
market despite the fact that the rate of interest is lower in the London money market because
the effective cost of borrowing in pounds at 12% interest rate is
(0.6) x
In case where the firm borrows from more than one financial market, the weighted
average of effective cost of borrowing in different currencies is computed. Suppose the firm
borrows not only in pounds but also in Japanese yen. Because there is 60.0 probabilities for
3.0 depreciation and effective cost of the yen with 13.0% interest rate is
(0.6) x
= 0.10514 = 10.51%
If the firm borrows in the two currencies in equal proportion, the weighted average of
effective cost of the total borrowing is
(15.58% + 10.51%)/2 = 13.05%
In this case, the firm would like to borrow from the Japanese financial market in
greater proportion so that the effective cost of total borrowing becomes lower.
Again the effective cost of total borrowing will be lower if there is negative
correlation in the movement of the value of different currencies. The cost may move up if the
correlation coefficient is positive. So the firm takes into account not only the expected change
in the value of the currencies but also the correlat5ion coefficient of the expected change in
the value of different currencies so as to lower the effective cost of total borrowing.
In this case, the firm would like to borrow from the Japanese financial market in
greater proportion so that the effective cost of total borrowing becomes lower.
Again the effective cost of total borrowing will be lower if there is negative
correlation in the movement of the value of different currencies. The cost may move up if the
correlation coefficient is positive. So the firm takes into account not only the expected change
in the value of the currencies but also the correlation coefficient of the expected change in the
value of different currencies so as to lower the effective cost of total borrowing.
Borrowing to conform to Capital Structure Norms
The other question concerning sourcing of funds is related essentially to minimizing
the cost of capital, but not through selection of currency of borrowing but by adhering to the
capital structure norms. The net income approach suggests that with rise in debt equity ratio
in the capital structure, the weighted average cost of capital slips downwards. It is because
cost of debt is tax deductible and so it is lower than the cost of equity. The more the share of
the cheaper form of capital in the capital structure, the lower is the overall cost of capital. On
the other hand, Miller and Modigliani feel that with the increase in debt ratio, the risk borne
by the equity holders increases and as a result, the weighted average cost of capital remains
the same despite any change in the debt equity ratio. The wide disparity between these two
approaches has led to a middle approach, according to which, up to a certain level of debt
equity ratio, the weighted average cist of capital goes on declining, but beyond that point, it
tends to increase (sharan, 1991).
Whenever a multinational enterprise raises funds, it does it through mixing debt
capital with equity in a way that minimizes the cost of capital. However, the multinational
firm is in a better position than a domestic firm as far as supporting a higher debt ratio is
concerned because its cash flow is greatly diversified over different countries. The study of
sekely and Collins (1988) examines the capital structure norms among 677 firms in 9
industries in 23 countries and finds that the debt ratio may be large or small depending upon
economic, social, cultural and political factors. Since these factors vary among countries, the
capital structure norms too vary widely among them. On the whole, debt ratio is found to be
large in Scandinavian, Mediterranean and some of the Asian Countries. It is low in case of
some of the South Asian, Latin American and Anglo American countries.
An important question that arises is whether the affiliates of the multinational
corporations should follow the host country norms or be guided by their parent company
norms. If the norms in the home country and the host country are similar, there is no problem,
but if they are different, it becomes an important decision. If the capital structure norms
conform to the local norms in the host country, they are well in line with the monetary and
financial policy of the host government. They help evaluate return on equity investment
relative to local competitors in a particular industry. On the other hand, when the norms
conform to the parent company global target debt ratio, they are more suited to maximizing
the global profit. They may have a comparative advantage over the local firms in the host
country. Moreover, a high debt ratio in one country may offset the low debt ratio in another
country; and on the whole, it is best suited for the firm as a whole.
Selection of an optimal Maturity
While raising funds from the international financial market, a multinational firm likes
to maintain a proper balance between the short term liabilities and the long term liabilities.
There is no confusion about financing of fixed assets because they are financed with long
term capital bet as far as financing of current assets is concerned, determining the best ratio
between the long term capital and the short term capital is an important issue. The normal
view is that the permanent current assets should be financed with long term capital and the
fluctuating part of the current assets should be financed with short term capital. This is but a
trade off between liquidity and profitability. Long term capital is more liquid but lowers
profitability. Short term capital, on the other hand, does not pushdown profitability so much
but is less liquid. However, if the finance manager is conservative, he uses more of long term
capital. If he is aggressive Short term capital is greatly used. Thus whenever a multinational
enterprise raises funds, it has in mind a perfect trade off between short term capital and long
term capital.
Avoidance of Legal and Procedural Formalities
Any firm raising funds does not like to undergo too many procedural formalities.
From this viewpoint, the issue of international bonds is too complex, much more complex
than the Euro notes. Again the borrowing programme can be designed only in the framework
of local laws. If the government prohibits the issue of a particular instrument, the borrower
cannot issue it despite its cost efficiency. For example, prior to 1992, the Indian Government
had not allowed the Indian companies to issue Euro equities or Euro Convertible bonds.
Sometimes these considerations become really significant.
1 International Financial Markets and Instruments
The gap between savings and investment is widening gradually in the developing
countries. The growing demand for capital inflows in the developing countries forced them
to depend on external sources for debt or equity capital.
The need for external borrowings in a country's economy can be gauged from the national
income and balance of payment position. From the macro economic theories, the current
account surplus or deficit in BOP of a country is nothing but the difference between the
domestic savings and domestic investments. If the domestic savings exceed domestic
investment a surplus in current account would result increasing the reserves of the country. A
deficit in current account would emerge if the domestic savings is less than domestic
investment.
To recall from the chapter on BOP, national income can be defined in the following formats.
Y
=
C + I + G + (X ? M)
Y
=
C + S + T
Where,
Y
=
National Income
X : Exports
C
=
Consumption
M : Imports
I
=
Investment
S : Private savings
G
=
Government
T : Tax
By equating (i) and (ii) we get
C + I + G + ( X ? M)
=
C + S + T
i.e. I + G + (X ? M)
=
S + T
ie. S + (T ? G)
=
I + ( X ? M)
Since (T ? G) gives the public savings, we can write the above relationship as Private savings
+ Public savings = I + (X ? M)
.....(iii)
If (X ? M) gives the net of foreign exchange inflows/outflows of the current account in BOP
statement we can conclude in a broader perspective, that the gross domestic savings are equal
to the sum of gross domestic capital formation and foreign investment.
Basing on BOP position of a country, the sources of external funds can be broadly classified
into the following categories :
i.
External assistance in the form of aid.
ii.
Commercial borrowings.
iii.
Short-term credit.
iv.
Foreign direct investment.
The flow of external funds into a country depends on various factors like the policy
guidelines of the country on commercial borrowings by individual entities, the exchange
control regulations of the country, the interest rate ceilings in the financial sector and the
structure of taxation. The integration of financial markets across countries has opened up the
international markets and large varieties of financial instruments have merged to suit the
changing needs of the international investor. In this chapter, we briefly discuss various
instruments that are available in international financial markets.
The financial markets across countries facilitate the financial intermediation /
disintermediation and transfer of surplus funds from the savers to the deficit units. The
gradual liberalization of the financial sector in the developing countries initiated in early '70s
started providing multiple instruments to the savers and the issuers converging the needs of
suppliers of the resources with that of the users of the resources.
ORIGIN OF INTERNATIONAL FINANACIAL MARKETS
The genesis of the present international markets can be traced back to 1960s, when
there was a real demand for high quality dollar-denominated bonds from wealthy Europeans
(and others) who wished to hold their assets outside their home countries or in currencies
other than their own. these investors were driven by the twin concerns of avoiding taxes in
their home country and protecting themselves against the falling value of domestic
currencies. The bonds which were then available for investment were subjected to
withholding tax. Further, it was also necessary to register the ownership of the bonds.
Dollar denominated Euro-bonds were designed to address these concerns. These were issued
in bearer forms and so, there was no record of ownership and no tax was withheld.
Also, until 1970, the International Capital Market focused on debt financing and the
equity finances were raised by the corporate entities primarily in the domestic markets. This
was due to the restrictions on cross-border equity investments prevailing until then in many
countries. Investors too preferred to invest in domestic equity issues due to perceived risks
implied in foreign equity issues either related to foreign currency exposure or related to
apprehensions of restrictions on such investments by the regulators.
Major changes have occurred since the '70s which have witnessed expanding and
fluctuating trade volumes and patterns with various blocks experiencing extremes in fortunes
in their exports/imports. This was the period which saw the removal of exchange controls by
countries like the UK, France and Japan which gave a further boost to financial market
operations. In addition to this, the application of new technology to financial services, the
institutionalization of savings and the deregulation of markets have played an important role
in channelizing the funds from surplus units to deficit units across the globe. The
international capital markets also became a major source of external finance for national with
low internal savings. The markets were classified into Euro Market, American Market and
Other Foreign Markets.
The following figure shows the various sources of external finance and various
channels for accessing external funds.
Figure 1
IMF
IFC
ADB
Country Funds
Global Mutual Funds
Pensio Funds
Commercial Banks etc.
Surplus
Deficit
Units
Units
International Financial
Markets
Money
Capital
Markets
Markets
India's presence in International Markets
India has made its presence felt in the international financial markets though to a very
small extent. There has been a total turnaround in the market sentiment for Indian paper
since 1991-1992 ? albeit with a difference.
So far the traditional avenues for raising capital abroad have been through bank
borrowings, syndicated loans, lines of credit, bonds and floating rate notes. Access to the
international capital markets was only through debt instruments and was mostly limited to
financial institutions and public sector units, although there were a few cases of private
companies also. With the downward revision of India's credit rating to the non-investment
grade, borrowing in the international capital markets dried up with most of the Lenders being
off limits (crossing the exposure limit) on India. The picture has since changed. There were
a variety of reasons for the international markets to view India differently reforms.
Improved perception of India's economic reforms
Improved export performance
Modest to healthy economic indicators
Inflation contained to single digit
Improved Forex reserves position
Improve performance of Indian companies
Improved confidence of the FIIs in the economy
Lack of investment opportunities worldwide and
Decline in rate of return on investments in developed markets.
It was in March 1992, that the government first permitted a few Indian companies to tap the
international equity market and till date a number of Indian companies have successfully
taken the equity / equity-related route.
INSTRUMENTS AVAILABLE IN THE INTERNATIONAL FINANCIAL MARKETS
As in any domestic capital structuring we can segregate international financing into two
broad categories. These are :
i.
Equity financing and
ii.
Debt financing.
The various instruments used to raise funds abroad include; Equity, straight debt
or hybrid instruments. The following figure shows the classification of international
capital markets based on instruments used and market(s) accessed.
Figure 2
International Capital Markets
International Bond market
International Equity Market
Foreign bonds
Euro Bond
Foreign Equity
Euro Equity
- Yankee Bonds
- Euro/Dollar
- ADR
- GDR
- Samurai Bonds
- Euro / Yen
- IDR/EDR
- Buildog Bonds
- Euro /Pounds
Debt Instruments
The issue of bonds to finance cross-border capital flows has a history of more than 150 years.
In the 19th century, foreign issuers of bonds, mainly governments and railway companies,
used the London market to raise funds.
International bonds are classified broadly under two categories:
Foreign Bonds : These are the bonds floated in the domestic market denominated in
domestic currency by non-resident entities. Dollar denominated bonds issued in the US
domestic markets by non-US companies are known as Yankee Bonds, Yen denominated
bonds issued in Japanese domestic market by non-Japanese companies are known as Samurai
Bonds and Pound denominated bonds issued in the UK by non-UK companies are known as
Bulldog Bonds. Similarly, currency sectors of other foreign bond markets have special
names like Rambrand Dutch Guilder, and Matador Spanish Peseta etc.
Eurobonds: The term 'Euro' originated in the fifties when the USA under the Marshall Plan
was assisting the European nations in the rebuilding process a after the devastation caused by
the Second World War. The dollars that were in use outside the US came to be called as
"Eurodollars". In This context the term Euro` signifies a currency outside its home country.
The term 'Eurobonds' thus refer to bonds issued and sold outside the home country of the
currency. For example, a dollar denominated bond issued in the UK is a Euro (dollar) bond,
similarly, a Yen denominated bond issued in the US is a Euro (Yen) bond.
The companies wishing to come out with shorter maturities have an option to issue
Euronotes in the European Markets. The important ones being Commercial Paper (CP), Note
Issuance Facilities (NIF) and Medium-Term Notes (MTNs).
Euro-Commercial Paper issued with maturity of up to one year, are not underwritten
and are unsecured .Note Issuance Facilities (NIFs) are underwritten and have a maturity of up
to one year. Standby NIFs are those formally designated instruments which back
Commercial Paper to raise short-term finances. A variation of NIF is the Multiple
Component Facility (MCF), where a borrower is enabled to draw funds in a number of ways,
as a part of overall NIF program. These options are referred to as short-term advances and
banker's acceptances, and afford opportunities for choosing the maturity, currency and
interest rate basis.
Medium-Term Notes, on the other hand, are non-underwritten and are issued for
maturities of more than one year with several trances depending upon the preferred
maturities. It is to be noted that in similar circumstances, a typical CP program allows for a
series of note issues having regard to the maturity of the overall program.
The borrowings in the international capital markets are in the form of Euro Loans
which are basically loans from the bank to the companies which need long-term and medium-
term funds. Broadly, two distinct practices of arranging syndicated credits have emerged in
Euromarkets, club loans and syndicated loans. The Club Loan is a private arrangement
between lending banks and a borrower. When the loan amounts are small and the parties are
familiar with each other; lending banks form a club and advance a loan hence the name of
club loan. Syndicated Euro credit, however, has a full-fledged public arrangement for
organizing a loan transaction. It is treated as an integral part of the financial market
mechanism with a wide network of banks participating in the transaction over the globe.
Typically, a syndicated loan is available for a maturity of seven years with shorter period
transactions having a maturity of 3 to 5 years.
Equity Instruments
Until the end of 1970s, International Capital Markets focused on debt financing and
the equity finances were raised by the corporate entities primarily in the domestic markets.
This was due to restrictions on cross-border equity investments prevailing until then in many
countries. Inventors too preferred to invest in domestic equity issues due to perceived risks
implied in foreign equity issue either related to foreign currency exposure or related to
apprehensions of restrictions on such investments by the national authorities.
Early '80s witnessed liberalization of many domestic economies and globalization of
the same. Issuers from developing countries, where issue of dollar/foreign currency
denominated equity shares are not permitted, are now able to access international equity
markets through the issue of an intermediate instrument called 'Depository Receipt'.
A Depository Receipt (DR) is a negotiable certificate issued by a depository bank
which represents the beneficial interest in shares issued by a company. These shares are
deposited with a local 'custodian' appointed by the depository, which issues receipts against
the deposit of shares.
According to the placements planned, DRs are referred to as (i) Global Depository Receipts
(GDRs) (ii) American Depository Receipts (ADRs) and (iii) International Depository
Receipts (IDRs). Each of the Depository Receipt represents a specified number of shares in
the domestic markets. Usually, in countries with capital account convertibility, the GDRs
and domestic shares are convertible (may be redeemed) mutually. This implies that, an
equity shareholder may deposit the specified number of shares and obtain the GDR and vice
versa. The holder of GDR is entitled to a dividend on the value of the underlying shares of
the GDR (issued normally in the currency of the investor country). As far as Indian
companies are concerned, the dividends are announced as a percentage of the value of GR
sans premium in rupee terms converted at the prevailing exchange rate.
However, until the global Depository Receipts (GDRs)/American Depository
Receipts (ADRs/International Depository Receipts (IDRs) are converted, the holder cannot
claim any voting right and also, there is no foreign exchange risk for the company. These
types of instruments are ideal for companies which prefer a large shareholder base and
international presence. The company will be listed at the prescribed stock exchange
providing liquidity for the instrument.
Quasi-instruments
These instruments are considered as debt instruments for a time-frame and are
converted into equity at the option of the investor (or at company's option) after the expiry of
that particular time-frame. The examples of these are Warrants, Foreign Currency
Convertible Bonds (FCCBs), etc. Warrants are normally issued along with other debt
instruments so as to act as a 'sweetener'.
FCCBs have a fixed coupon rate with a legal payment obligation. It has greater
flexibility with the conversion option - at the choice of the investor ? to equity. The price of
the conversion of FCCB closely resembles the trading price of the shares at the stock
exchange. Also, the company may incorporate a 'call option' at the choice of the issuer to
obtain FCCBs before maturity. This may be due to the adverse market conditions, changes in
the shareholding pattern, changes of tax laws etc.
A Euro Convertible Bond is issued for investment in Europe. It is a quasi-equity issue
made outside the domestic market and provides the holder with an option to convert the
instrument from debt to equity. An added feature now-a-days is to allow conversion of Euro
Convertible Bond into GDR. Till conversion, interest is paid in US dollars and bond
redemption is also done in US dollars, thus while the investor would prefer the convertible
bond as an investment instrument, the issuing company tends to prefer a GDR. An investor
can exercise the conversion option at any time or at specified points during the convertible
life. The investor exchanges the convertible bond for a specified number of shares.
PLAYERS IN THE INTERNATIONAL FINANCIAL MARKETS
Borrowers/Issuers, Lenders/Investors and Intermediaries are the major players of the
international markets. The role of these players is discussed below.
Borrowers/Issuers
These primarily are corporates, banks, financial institutions, government and quasi-
government bodies and supranational organizations, which need Forex funds for various
reasons. The important reasons for corporate borrowings are, need for foreign currencies for
operation in markets abroad, dull/saturated domestic market and expansion of operations into
other countries.
Governments borrow in the global financial market for adjusting the balance of payments
mismatches, to gain net capital investments abroad and to keep a sufficient inventory of
foreign currency reserves for contingencies like supporting the domestic currency against
speculative pressures.
Further, the supranational organizations like the International Monetary Fund (IMF),
World Bank, International Finance Corporation, Asian Development Bank, etc., borrower
usually, long-term funds to finance diversified financing, sometimes linked to swaps for
hedging current/interest rate exposures. These supranational are also typical examples of
large entities appearing in the global markets as both issuers and borers.
Lenders / Investors
In case of Euro-loans, the enders are mainly banks who possess inherent confidence
on the credibility of the borrowing corporate or any other entity mentioned above. In case of
a GDR, it is the institutional investors and high net worth individuals (referred as Belgian
Dentists) who subscribe to the equity of the corporate. For an ADR, it is the institutional
investor or the individual investor through the Qualified Institutional Buyer who puts in the
money in the instrument depending on the statutory status attributed to the ADR as per the
statutory requirements of the land.
Investors in the global markets come in a large range who invest to suit their own
requirements, investment objectives, risk taking abilities and liabilities. The investor range
includes private individuals investing through Swiss banks, the IMF and the World Bank.
The other major investors are insurance companies, professional pension fund managers and
investment trusts. In the United Kingdom, with London still a major force in the
international finance market, it is the pension fund and insurance companies which are the
major investors in the equity markets and bond markets. In the USA and Japan, the private
player has an important role in the equity markets. In Germany, on the other hand,
commercial banks play a dominant role as investors.
Institutional investors can also be classified as :
Market Specific Investors: Specialize in specific instruments like equity, convertibles, fixed
interest bonds, floating rate bonds, etc.
Time Specific Investors: Specialize in specific maturity instruments like long-term,
medium-term, short-term etc.
Industry Specific Investors: Specialize in specific industries like chemical, pharmaceutical,
steel, automobiles etc.
Intermediaries
The intermediaries involved in International Capital Markets include Lead
managers/Co-lead Managers, Underwriters, Agents and Trustees, lawyers and Auditors,
Listing Agents and Stock Exchanges, Depository Banks and Custodians.
An overview of the functions performed by each of them is given below:
i)
Lead and Co-managers: The responsibilities of a Lead Manager include
undertaking due diligence and preparing the offer circular, marketing the issues
including arranging the road shows. Lead manger, sometimes in consultation with
the issuer, can choose to invite a syndicate of investment banks to buy some of the
Bonds/DRs and help sell the remainder to other investors. 'Co-managers' are thus
invited to join the deal, each of whom agrees to take a substantial portion of the
issue to sell to their investor clients. Quite often there will be more than one lead
manager as mandates are sometimes jointly won, or the investment bank which
actually won the mandate from the issuer may decide that it needs another
institution to ensure a successful launch.
Two or more managers may also reflect the fact that a geographical spread of
placing power is required or deemed appropriate.
One of the lead manager will 'run the books' for the issue. This essentially
involves arranging the whole issue, sending out invitation telexes, allotting
Bonds/DRs etc.
ii)
Underwriters : The lead manager(s) and co-managers act as underwriters for the
issue, taking on the risk of interest rate / markets moving against them before they
have placed Bonds/DRs. Lead manager(s) may also invite additional investment
banks to act as sub-underwriters, thus forming a larger underwriting group. a
third group of investment banks may also be invited to join the issue as members
of selling group, but these institutions only receive a commission in respect of any
Bonds /DRs sold and do not act as underwriters. The co-managers and the
underwriters are also members of the selling group.
Figure 3
The Selling Group
Lead
Co-Manager
Underwriting
Selling Group
Manager
Group
iii)
Agents and Trustees: These intermediaries are involved in the issue of
bonds/convertibles. The issuer of bonds/convertibles, in association with the lead
manager, must appoint 'paying agents' in different financial centers, who will
arrange for the payment of interest and principal due to investors under the terms
of the issue. These paying agents will be banks.
iv)
Lawyers and auditors: The lead manager will appoint a prominent firm of
solicitors to draw up documentation evidencing Bond/DRs issue. The various
draft documents will be scrutinized by lawyers acting for the issuer and in due
course by the co-managers and any other party signing a document related to the
issue. Many of these documents are prepared in standard forms, but each needs to
be reviewed carefully to ensure that all parties to the transactions are fully
satisfied with the wording. The issuer will also appoint legal advisors to seek
advice on matters pertaining to Indian/English/American law and to comment on
necessary legal documentation. Auditors or reporting accountants will become
involved as well, supplying financial information summaries and an audit report
which will be incorporated into the 'offering circular'. The auditors provide
comfort letters to the lead manager on the financial health of the issuer. Further,
they also provide a statement of difference between the UK and the Indian GAAP
in case of GDR issue.
v)
Listing Agents and Stock Exchanges : The listing agent facilitates the
documentation and listing process for listing on stock exchange and keeps on file
information regarding the issuer such as Annual Reports, Articles of Association,
the Depository Agreement, etc.
The Stock Exchange (Luxembourg/London/AMEX/NYSE as the case may be)
reviews the issuers application for listing of the bonds/DRS and provides
comments on offering circular prior to accepting the securities for listing.
vi)
Depository Bank: Depository Bank is involved only in the issue of DRs. It is
responsible for issuing the actual DRs. disseminating information from the issuer
to the DR holders, paying any dividends or other distributions and facilitating the
exchange of DRs into underlying shares when presented for redemption.
vi)
Custodian : The custodian holds the shares underlying DRs on behalf of the
Depository and is responsible for collecting rupee dividends on the underlying
shares and repatriation of the same to the Depository in US dollars/foreign
currency.
vii)
Printers : The printers are responsible for printing and delivery of the
preliminary and final offering circulars as well as the DRs/Bond certificates.
see Appendix-IV for information about various intermediaries involved in
international issues of SCICI Ltd. (Convertible Issue) and EID Parry Ltd. (GDR
issue).
RESOURCE MOBILIZATION - THE DECISION CRITERIA
Resource mobilization at competitive cost is a critical issue which confronts every
management. In the past, Indian companies could access only the domestic capital market.
Liberalization process has opened new avenues for Indian companies in terms of markets and
instruments.
i.
Currency Requirements: A decision has to be taken about the currency needs of
the company, keeping in view the future expansion plans, capital imports, export
earnings/potential export earnings. A conscious view on the exchange rate also
needs to the taken.
ii.
Pricing: Pricing of an international issue would be a factor of interest rates and
the value of the underlying stock in the domestic market. Based on these factors,
the issue price conversion (for convertible) premium would be decided. Given the
arbitrage available between interest rates in rupees and say, US dollars, and given
the strength of the rupee, as well as the resilience a company can have in its
operations against exchange fluctuation risk, due to export earnings, it is possible
to take advantage of the low interest rates that are prevailing in the international
markets. The above is possible without dilution of the value of the underlying
stock. This is so, because, in the case of international issues, open pricing/book
building is possible, which has the advantage of allowing the company to
maximize the proceeds, enabling the foreign investors to set the premium ensuring
transparency and creating price tension.
iii.
Investment: AT present greater flexibility is available in structuring an
international issue in terms of pure equity offering, a debt instrument or a hybrid
instrument like Foreign Currency Convertible Bond (FCCB). Each company can
take a view on instrument depending upon the financials of the company and its
future plans.
iv.
Depth of the Market: Relatively larger issues can be floated, marketed and
absorbed in international markets more easily than in the domestic markets.
v.
International Positioning: Planning for an international offering has to be a part
of the long-term perspective of a company. An international issue positions the
issuing company, for a much higher visibility and an international exposure.
Besides, it opens up new avenues for further fund-raising activities.
vi.
Regulatory Aspects: For an international issue, approvals are required from the
government of India and the Reserve Bank of India, whereas for a domestic issue
the requirements to be satisfied are those of the SEBI and the stock exchanges.
vii.
Disclosure Requirements: The disclosure requirements for an international issue
are more stringent as compared with a domestic issue. The requirements would,
however, differ depending upon the market addressed and the place where listing
is sought.
viii.
Investment Climate: The international offering would be affected by factors like
the international liquidity and the country risk, which will not have an effect in a
domestic issue. With the current country rating, companies have to depend on the
strength of their balance sheets to raise funds at competitive rates the international
markets.
EQUITY INSTRUMENTS
Global Depository Receipts
The advent of GDRs in India has been mainly due to the balance of payments crisis in the
early '90s. At this time India did not have enough foreign exchange balance even to meet the
requirements of a fortnight's imports. International institutions were not willing to lend
because of non-investment credit rating of India. Out of compulsions, rather than by choice,
the government (accepting the World Bank suggestions on tiding over the financial
predicament) gave the permission to allow fundamentally strong private corporate to raise
funds in international capital markets through equity or equity-related instruments. The
Foreign Exchange Regulation ct (FERA) was modified to facilitate investment by foreign
investors up to 51% of the equity-capital of the companies. Investment even beyond this
limit is also being permitted by the Government.
Prior to this, the companies in need of the foreign exchange component or resources for their
projects had to rely on the government of India or otherwise rely partly on the government
and partly on the financial institutions. These foreign currency loans utilized by the
companies (whether through the financial institutions or through the government agency)
were paid from the government allocation from the IMF, World Bank or other Government
credits. This, in turn created liability for the remittance of interest and principal, in foreign
currencies which was to be met by way of earnings through exports and other grants received
by the government. However, with a rapid deterioration in the foreign exchange reserves
consequent to Gulf War and its subsequent oil crisis, the companies were asked to get their
own foreign currencies which led to the advent of the GDRs.
THE INSTRUMENT
As mentioned earlier, GDRs are essentially those instruments which possess a certain number
of underlying shares in the custodial domestic bank of the company. That is, a GDR is a
negotiable instrument which represents publicly traded local-currency-equity share. By law,
a GDR is any instrument in the form of a depository receipt or certificate created by the
Overseas Depository Bank outside India and issued to non-resident investors against the issue
of ordinary shares or foreign currency convertible bonds of the issuing company. Usually, a
typical GDR is denominated in US dollars whereas the underlying shares would be
denominated in the local currency of the Issuer. GDRs may be ? at the request of the investor
? converted into equity shares by cancellation of GDRs through the intermediation of the
depository and the sale of underlying shares in the domestic market through the local
custodian.
GDRs, per se, are considered as common equity of the issuing company and are entitled to
dividends and voting rights since the date of its issuance. The company effectively transacts
with only one entity ? the Overseas Depository ? for all the transactions. The voting rights of
the shares are exercise d by the Depository as per the understanding between the issuing
company and the GDR holders.
ISSUANCE OF GDR
The following are the sequence of activities that take place during the issuance of GDRs :
a.
Shareholder Approval Needed : The issuance of an equity instrument like the GDR
needs the mandate of the shareholders of the company issuing it. The terms of the
issue will have to be decided before such a mandate is sought from the shareholders.
There should be an authorization from the Board of Directors for floating a Euro-issue
and for calling a general meeting for the purpose. A committee of directors is
generally constituted and conferred with necessary powers for the approval of (i) the
offering memorandum; (ii) Fixation of issue price (iii) opening of bank account
outside India and operation of the said account and (iv) for notifying the stock
exchange about the date of the board meeting when the proposal will be considered
and also inform it about the decisions taken.
After all this, the shareholders should approve the issue by a special resolution passed
at a general meeting as per Section 81 of the Companies Act, 1956. It stipulates that,
if a company proposes any issue of capital after two years from the formation of the
company or at any time after one year from the allotment of shares that the company
has made for the first time after its formation ? whichever is earlier ? the company has
to offer such issues first to the shareholders of the company.
b.
Appointment of Lead Manager: Lead Manager is an important cog in the wheel of
the Euro-issue and is the vital link between the government and investors with the
issuers. Practically, it is the lead manager who is responsible for the eventual success
or failure of a Euro-issue when all the other factors are same. Hence, the choice of a
suitable lead manager is as significant as any other issue activity. An ideal lead
manager is selected after preliminary meetings with merchant bankers. The merchant
bankers are evaluated on various parameters such as (i) Marketing ability (ii)
Marketing research capability (iii) Market making capability (iv) Track record (v)
Competitive fee structure and (vi) Placement skills. A beauty parade, which is
basically the presentations made by the various merchant bankers, is held by the
company to help it decide on the final choice of the lead manager after they are
filtered by the above parameters. The final appointment of lead manager is done after
the approval by the government.
The lead manager advises the company in the following areas after taking into
consideration the needs of the company, the industry in which the company is
engaged, the international
monetary and securities markets, the general economic conditions and the terms of
the issue viz., quantum of issue, type of security needed to be issued (GDR in this
case), stages of conversion, price of equity, shares on conversion, rate of interest,
redemption date etc.
c. Finalization of Issue Structure : On completion of the formalities of issue structure
in consultation with the lead manager, the company should obtain the final approval
from the government. For this purpose, the company should furnish the information
about the entities involved in the GDR issue and the following parameters to the
government.
i.
Lead Manager
xii.
Indian Custodian
ii.
Co-Lead Manager
xiii.
Isue structure and denomination of
underlying shares represented by
the GDRs
iii.
Currency
xiv.
Issue amount
iv.
Issue Price (approximate range in xv.
Green Shoe option
case of GDR)
v.
Form and Denomination
xvi.
Warrants attached, if any
vi.
Negative Pledge provisions
xvii.
Listing modalities
vii.
Taxation
xviii.
Selling commission
viii.
Commissions
xix.
Underwriting commission
ix.
Reimbursable expenses
xx.
Legal expenses, printing expenses,
depository fees, and other out-of-
pocket expenses
x.
Governing Laws
xxi.
Taxation procedure
xi.
Overseas Depository Institution
The government, after considering all the above information will give a final approval for the
issue ? if satisfied.
Table ? I
Bookrunners of International Bonds
Amt US$
Pos
Manager or Group
Iss.
% Share
(bn)
1
Salomon Smith Barney International
172.75
490
10.27
2
Deusche Bank
144.05
576
8.56
3
Morgan Stanley Dean Witter
137.83
593
8.19
4
JP Morgan
131.76
427
7.83
5
Merrill Lynch & Co
126.97
431
7.55
6
Credit Suisse First Boston
119.92
512
7.13
7
Lehman Brothers
104.05
413
6.19
8
Goldman Sachs & Co
89.39
299
5.31
9
UBS Warburg
81.39
333
4.84
10 Barclays Capital
69.73
311
4.09
11 ABN AMRO
61.57
314
3.66
12 BNP Paribas
51.67
289
3.07
13 HSBC
44.55
471
2.65
14 Bresdner Kleinwort Wasserstein
44.04
261
2.62
15 Bank of America
21.78
58
1.29
16 Societe Generale
19.54
89
1.16
17 Bear Stens & Co
18.37
53
1.09
18 Hypovereinsbank ? Bayerische Hypo-
16.98
122
1.01
und Vereinsbank
19 Credit Agricole Indosuez
16.93
103
1.01
20 Commerzbank Securities
16.93
141
1.01
Total
1,682.26
6542
100.00
THE DOCUMENTATION
Documentation for Euro equities is a complex and elaborate process in the procedure
of GDR launch. A typical Euro-issue consists of the following main documents :
a.
Prospectus
b.
Depository agreement
c.
Custodian agreement
d.
Subscription agreement
e.
Paying and conversion agency agreement
f.
Trust deed
g.
Underwriting agreement and
h.
Listing agreement.
A brief discussion on the contents and the relevance of each of these documents is
given below:
a.
Prospectus : As in domestic equity market, the prospectus is a major document
containing all the relevant information concerning the issues ? like the investment
considerations, terms and conditions, use of proceeds, capitalization details, share
information, industry review and overall description of the issuing company. As a
marketing strategy, companies generally issue a preliminary prospectus which is
referred to as pathfinder which will judge the potential demand for the equity that is
being launched in the markets.
The aspects that need to be covered in the main prospectus may be grouped as
follows
i.
Financial Matters : Apart from the financials of the company, the prospectus
should include a statement setting out important accounting policies of the
company and a summary of significant differences between Indian GAAP and
the UK GAAP and the US GAAP (in case of an ADR).
ii.
Non- financial Matters : This may cover all aspects of management with the
information relating to their background, names of nominee directors along
with the names of the financial institutions which they represent and the names
of senior management team. All other non-financial aspects that influence the
working of the company need to be mentioned in the prospectus.
iii.
Issue Particulars : The issue size, the ruling domestic price, the number of
underlying shares for each GDR and other information relevant for the issue as
such, may be mentioned here.
iv.
Other Information : Statement regarding application to a foreign stock
exchange for listing the securities and issuing of global certificates to a
specified nominee as operator of the Euro-Clear (international clearing house
in Euro-securities) system like Cedel (one of the major clearing houses in
Eurobond market clearing, handling and storing the securities).
Option provided to the lead manager to cover over-allotments, exercisable on
or before the business day prior to the closing date of subscribe for additional
securities in the aggregate up to a specified limit.
b.
Depository Agreement : This is the agreement between the issuing company and the
overseas depository providing a set of rules for withdrawal of deposits and for their
conversion into shares. Voting rights of a depository are also define. Usually, GDRs
or Euro convertible bonds are admitted to the clearing system, and settlements are
made only by book entries. The agreement lays down the procedure for the
information transmission to be passed onto the GDR holders.
c.
Underwriting Agreement: As in domestic equity market, underwriters play the role of
'assurers' for picking the GDRs at a predetermined price depending on the market
response. The agreement is for this purpose, between the company (guided by its lead
manager) and the underwriter.
d.
Subscription Agreement: The lead manager and the syndicated members form a part
of the investors who subscribe to GDRs or Euro convertible bonds as per this
agreement. There is no binding, however, on the secondary market transaction on
these entities i.e. market making facility.
e.
Custodian Agreement: It is an agreement between the depository and the custodian.
In this agreement the depository and the custodian determine the process of
conversion of underlying shares into depository receipts and vice versa. For the
process of conversion of the GDRs into shares, (popularly termed as RE-
materialization) shares have to be released by the Custodian.
f.
Trust Deed and Paying and Conversion Agreement: While the trust deed is a standard
document which provides for duties and responsibilities of trustees, the paying and
conversion agreement enables the paying and conversion agency which performs a
typical banking function by undertaking to service the bonds until the conversion, and
arranging for conversion of bonds into GDRs or shares, as necessary.
g.
Listing Agreement : As far as the listing is concerned, most of the companies which
issue a GDR prefer Luxembourg Stock Exchange as the listing requirements in this
exchange are by far, the most simplest. The New York Stock Exchange (NYSE) and
the Tokyo Stock Exchange (TSE) have the most stringent listing requirements.
London Stock Exchange and the Singapore Stock Exchange fit in the middle with
relatively less listing requirements than the NYSE and TSE.
The listing agents have the onus of fulfilling listing requirements of a chosen stock
exchange. The requirements of London Stock Exchange are provided in the 48-hour
documents. The 48-hour documents are the final documents that have to be lodged at
the exchange not later than mid-day, at least two business days prior to the
consideration of the application for admission to listing. These documents, among
other things should include the following :
An application for admission to listing.
Declaration of compliance in the appropriate form issued by the exchange.
Three copies of the listing particulars / equivalent offering document relating to the
issue. The contents of these documents should meet the relevant requirements.
A copy of any shareholders' resolution that is relevant to the issue of such securities.
A copy of the board resolution authorizing the issue, the application for listing and the
publication of the relevant documents.
In case of a new company, a copy of the incorporation certificate, memorandum of
certificate and articles of association.
THE LAUNCH
Two of the major approaches for launching of a Euro-Issue are Euro-Equity Syndication and
Segmented Syndication. Euro-Equity syndication attempts to group together the placement
strengths of the intermediaries, without any formal regional allocations. Segmented
syndication, on the other hand, seeks to form a geographically targeted syndicated structure,
so as to achieve broader distribution of paper by approaching both institutional and retail
investors. As compared to Euro syndication, segmented syndication can be expected to
achieve orderly and coordinated placement by restricting the choice of syndicate members
with definite strengths in specific markets.
MARKETING
It is not only the Indian issues which thrive on suave marketing, but also the GDR and
other International bond offerings. A judicious mix of financials and marketing would help
in raising the investors interest in the issue. Most of the marketing activities are handled by
the lead manager in consonance with the advertising agencies. A back-up material consisting
of preliminary offering circular, recent annual report, interim financial statements, copies of
newspaper articles about the business of the company and a review of the structure and
performance of the Indian stock market, among other things is prepared.
Road shows form a pre-dominant facet of the launch of any GDR. They are a series
of face-to-face presentations with fund managers and analysts and is a vital part of marketing
process. Road shows, which involve much more than must inform about the company are
getting increasing attention from the investors and the fund mangers. Road shows for Euro
equities acquire considerable greater degree of risk than under any other financial instrument.
Road Shows are backed by the information of the financials and operations and a view
regarding the future profitability and growth prospects. This gives an opportunity to the
investors (generally, fund managers) to interact with the senior management of the issuing
company and understand the activities of the issuer company which may eventually lead to
the investment in the company. These are normally conducted at the financial centers of the
globe like London, New York, Boston, Los Angeles, Paris, Edinburgh, Geneva, Hong Kong,
etc.
The back-up material prepared will support presentations made by the company`s
senior personnel inviting the fund managers to invest in the company. The price that is
preferred for a particular number of shares is noted by the boo-runner at each of such
presentations and the eventual price that is most likely to find favor with the fund manager is
finalized. This will go a long way in making the issue to be accepted.
PRICING AND CLOSING
This forms the most vital part of the whole process of a GDR issue. The pricing is
key to the overall performance of a GDR after the same has been listed. The price is
determined after the underwriters response has been considered and an inference of the
response may be drawn.
The final price is determined after the Book Runner closes the books after the
completion of the Road Shows. The book-runner keeps the books open for 1-2 weeks, for the
potential investors to start placing their orders/bids with details of price and quantity. After
analyzing all the bids at the end of book-building period, lead managers, in consultation with
the issuer, will fix a particular price for the issue which will be communicated back to the
bidders/investors and a fresh demand figure is arrived at. If there is excess demand, the
company can go in for green shoe option` where it can issue additional GDRs in excess of
target amount.
A tombstone advertisement will be issued in the financial press to publicize
syndicated loans and other funding deals. Following this, the GDRs will get listed in the
notified stock exchange signaling the consummation of the process of the issue of stock
exchange.
The time period that is generally needed for typical GDR issue is given in the
following table. The table is arranged sequentially so as to convey information on the step-
by-step process that is followed.
Table 2 : Indicative Time Table
Stage
Administrative
Time in
weeks
Initial Decision
i.
Meeting between issuer and lead
1 and 2
manager and planning of an issue
ii.
Issue structure finalized with due
regard to domestic regulatory
environment
iii.
Draft documentation
iv.
Due diligences process
v.
Board meeting proceeded by
shareholder`s approval
vi.
Fixing parties to issue (including
depository/custodian)
Approvals and
i. Official approvals ?steps initiated
3 and 4
drafts finalization ii. Comfort and consent letters finalized
with auditors
iii. Legal opinion formats drafted and
finalized
iv. Approvals obtained
Pre-launch
i.
Road show preparations and
7 and 8
formalities
presentations
ii.
Pathfinder prospectus finalized
iii.
Listing preparations in final
stages
Launch of issues
i.
Roadshows organized
ii.
Documentation circulated among
syndicate
iii.
Investors contacted
Pricing and
i.
Final terms fixed
Closing
ii.
Allocation of securities to
investors
iii.
Final prospectus to be kept
ready
iv.
Final listing documents lodged
with stock exchange
v.
Subscription agreement signed
vi.
Delivery of global certificate
vii.
Closing documents signed
viii.
Payment to the issuer
ix.
Tombstone advertisement
Source : Global Capital Markets : Shopping for finance; PR Joshi, Tata Mc-Graw,
1996 ed.
COSTS
The cost incurred by the company is proportional to the issue size. The lead manager,
justifiably, takes the lion`s share in the issue expenses of the GDR. With the increased
acceptance of marketing as a vital tool for the success of the issue, the cost that is incurred on
marketing is fast increasing. The following table gives an indication on the total expanses
incurred by a GDR issue.
Table 3 : GDR Issue : Fees and Expenses
Item
Pre cent of issue amount
Underwriting Fee
0.60 ? 1.00
Management Fee
0.60 ? 1.00
Selling Commission
1.80 ? 3.00
Total Fees
3.00 ? 5.00
Source : Global Capital Markets, P.R. Joshi.
Other expenses include lead manager`s expenses, printing costs, accounting fees,
listing fees, road show expenses, etc.
There has, however, been a considerable fall in the quality of the GDR issues made by
the Indian companies. The sole reason why some of the Indian companies came out with a
Euro-issue was their eagerness to flaunt the GDR issue as a symbol of being well known in
the international markets. Some of the companies coming out with GDRs could not explain
the core business they are in and also whether they have judiciously utilized the investment
made by the GDR holders.
Table ? 4
The Present Scenario
Indian GDR Issues as on 05.11.98
Issue
Issue
Share
GDR
Issue
size
Company Name
Month &
price
(Rs.
Per
(no.Mn)
Year
Mn)
GDR
Arvind Mills
Jan-94
9.78
125
1
12.78
Ashok Leyland
Mar-95
12.79
137.5
3
10.77
BSES
Mar-96
14.4
125
3
8.68
Bajaj Auto
Oct-94
25.3
110
1
4.43
Bombay Dyeing
Nov-93
9.2
50
1
5.43
CESC
Apr-94
10.67
125
1
11.72
Century Textiles
Sept-94
254
100
1
0.39
Core Healthcare
Jul-94
12.6
70
1
5.56
Crompton Greaves
Jul-96
7.86
50
1
6.61
D C C Ltd.
May-94
13.55
25
5
1.85
Dr. Reddy`s Lab
Jul-94
11.16
48
1
4.3
EI Hotels
Oct-94
9.3
40
1
4.3
E I D Parry India
Jul-94
8.39
40
1
4.77
Finolex
Jul-94
16.6
55
1
3.31
Flex Industries
Nov-95
8.05
30
2
3.73
Gujarat Ambuja
Dec-93
5.95
80
1
13.45
G E Shipping
Feb-94
15.94
100
5
6.27
Guj. Narmada Valley Fert.
Oct-94
12.75
62
5
4.86
Garden Silk Mills
Mar-94
26.28
50
5
1.9
Grasim
May-94
20.5
100
1
4.88
Himachal Futuristic Comm.
Aug-95
9.3
50
4
5.38
Hindustan Development Corp.
Sep-94
2.05
76
1
37.07
Hindalco
Jul-94
16
100
1
6.25
ICICI
Aug-96
11.5
230
5
20
Indian Aluminium Co.
Feb-94
6.76
60
1
8.88
India Cements
Oct-94
4.22
90
1
10.66
Indian Hotels
May-95
16.6
86.2
1
5.19
Indian Rayon
Feb-94
22.51
125
1
5.55
Indo Gulf Fertilisers & Chem.
Feb-94
4.51
100
1
22.17
Indo Rama Synthetics India
Mar-96
11.37
50
10
4.4
IPCL
Dc-94
13.87
85
3
6.13
I T C Ltd.
Oct-93
7.65
69
1
9.02
J.K. Corp.
Oct-94
8
55
1
6.88
Jain Irrigation Systems
Feb-94
11.12
30
1
2.7
J C T Ltd.
Aug-94
16.96
45
10
2.65
Kesoram Industries
Aug-96
1.6
30
1
18.75
L&T
Feb-96
15.35
150
2
9.77
Mahindra & Mahindra
Nov-93
4.48
75
1
16.73
NEPC-Micon
Nov-94
3.18
45
1
14.15
Oriental Hotels
Dec-94
12.75
30
1
2.35
Ranbaxy
Jul-94
19.37
100
1
5.16
Raymond
Nov-94
10.61
60
2
5.66
Reliance
Feb-94
24.1
300
2
12.45
SBI
Oct-96
14.15
369.98
2
26.15
S.I. Viscose
Aug-94
6.37
45
1
7.06
Shriram Industrial Enterp
Oct-94
14.64
40
3
2.73
SAIL
Mar-96
12.97
125
15
9.64
Sanghi Ployesters
Aug-94
9.56
50
5
5.23
SPIC
Sep-93
11.15
65
5
5.83
Sterlite Industries India
Dec-93
17.88
100
1
5.59
Tata Power Co.
Feb-94
710
65
10
0.09
Telco
Aug-96
14.25
200
1
14.04
Tube Investments Of India
May-94
6.57
45
1
6.83
United Phosphorus
Feb-94
20.5
55
1
5.36
Usha Beltron
Oct-94
10.7
35
1
3.27
VSNL
Mar-97
13.93
448
0.5
32.16
Videocon
Jan-94
8.1
90
1
11.11
Wockhardt Ltd.
Feb-94
14.35
75
1
5.23
MTNL
Dec-97
11.96
358.8
2
30
* ADR ? listed at Nasdaq.
American Depository Receipts
Until 1990, companies had to issue separate receipts in the US (ADRs) and in Europe
(IDRs) to access both the markets. The weakness was that there was no cross-border trading
possible as ADRs had to be traded, settled and cleared through the Depository Trust
Company (DTC) in the Us, while the IDRs could be Rule 144A and Regulations of the SEC
of the US allowed non-US companies to raise capital in the US market without having to
register the securities with the SEC or changing the financial statements to reflect the US
accounting principles. Rule 144A is designed to facilitate certain investment bodies called
Qualified Institutional Buyers (QIBs) to invest in overseas (non-US) companies without those
companies needing to go through the SEC registration process.
The Instrument
ADR is a dollar denominated negotiable certificate, it represents non-US company`s
publicly traded equity. It was devised in the late 1920s, to help Americans invest in overseas
securities and to assist non-US companies wishing to have their stock traded in the American
Markets. ADRs are divided into 3 levels based on the regulation and privilege of each
company`s issue.
i.
ADR Level-I : It is often the first step for an issuer into the US public equity
market. Issuer can enlarge the market for existing shares and thus diversify the
investor base. In this instrument only minimum disclosure is required to the SEC
and the issuer need not comply with the US GAAP (Generally, Accepted
Accounting Principles) This type of instrument is traded in the US OTC market.
The issuer is not allowed to raise fresh capital or list on any one of the national
stock exchanges.
ii.
ADR Level-II : Through this level of ADR the company can enlarge the investor
base for existing shares to a greater extent. However, significant disclosures have
to be made to the SEC. The company is allowed to list in the American Stock
Exchange (AMEX) or New York Stock Exchange (BYSE) which implies that the
company must meet the listing requirements of the particular exchange.
iii.
ADR Level-III : This level of ADR is used for raising fresh capital through public
offering in the US Capital Markets. The company has to be registered with the
SEC and comply with the listing requirements of AMEX/NYSE while following
the US-GAAP.
The reason for this may be attributed to the stiff disclosure requirements and accounting
standards as per he US GAAP. The following table gives an indication on the difference
between the US and Indian GAAP.
Table 5
Summary of Significant differences between the Indian Accounting Standards and the
US GAAP
India
USA
Financial Statements
No Specific format is
necessary as long as they comply with
Prepared in accordance
the disclosure requirements of the US
with the requirements of Schedule VI
Accounting Standards.
of the Companies Act, 1956
Consolidation
Consolidation of group
Not required
company accounts is mandatory.
Earnings Per Share Data
Disclosure is mandatory.
No
disclosure
This includes the EPS calculated using
requirements except those under
the
weighted
average
shares
Schedule VI, Part IV to the Companies
outstanding (simple and complex
Act, 1956
capital structures) method and fully
diluted EPS (considering the effect of
warrants or options outstanding).
Taxation
Deferred tax assets or
Normally provided for,
liabilities should be booked using the
based on the taxes payable method.
asset-liability approach.
Revaluation of assets not
Fixed Assets and Depreciation
permitted. Depreciation is over the
Revaluation of assets
useful economic lines of assets.
permitted. Depreciation in based
Depreciation and profit/loss on sale is
(usually) on rats set out in Schedule
based on historic cost.
XIV to the Companies Act, 1956.
Permitted and is shown
Investment in Own Shares
as reduction from shareholders equity
Expressly prohibited
Costs are expenses as
R&D
incurred.
Costs can be capitalized
subject to the conditions of AS-8,
R&D, issued by the ICAI.
India
USA
Related Party Transactions
Disclosures are stringent
No specific disclosures
and require descriptions of nature of
required. Auditors have a duty to
relationships and control, transactions,
report certain transactions entered into
amounts involved and amounts due.
by related parties as defined under the
Companies Act, 1956.
Goodwill
Treated as any other
No standard except for
intangible asset and is capitalized and
brief references in AS-10, fixed assets
amortized. The maximum carry
and
AS-14,
Accounting
for
forward period is 40 years.
amalgamations. Goodwill arising from
amalgamations can be written-off over
5 years.
Concept does not exist.
Pre-operative Expenses
Allowed to be deferred
and written-off over a period of 3-5
years or 10 years.
Mandatory
disclosures
about
current
and
long-term
Assets and Liabilities
components separately. Current
No mandatory disclosure
component normally refers to one year
of current and long-term components.
of the period of the operating cycle.
Exchange gain/loss is
taken to the income statement. The
Foreign Currency Transactions
concept of capitalization of exchange
Exchange fluctuations on
fluctuations arising from foreign
liabilities incurred for fixed assets can
currency
liabilities
incurred
for
be capitalized.
acquiring fixed assets does not exist.
Mandatory
for
SEC-
registered
companies
to
report
Segmental Reporting
revenues
and
net
income
by
Requirements exist for
geographic
regions
and
disclosure of quantitative particulars
products/business lines; report sales to
only as prescribed in Schedule VI to the
outstanding
receivables
from
Companies Act, 1956.
unaffiliated
customers;,
report
identifiable assets by geographical
regions and products/business lines.
Mandatory for all assets.
Impairment Evaluation
Future undiscounted cash flows from
No Standards.
use and disposal of the assets are first
compared to its carrying value to
determine the impairment situation.
Impairment loss is then recognized on
the basis of the fair value of the asset.
Disclosure
of
the
facts
and
circumstances that led to impairment is
mandatory.
Mandatory fair values are
Fair Value Disclosures
ascertained based on certain specific
Schedule VI (Directors to
principles for items, such as loans,
state expressly if, in their opinion, the
current assets, current liabilities etc.
current assets are not expected to
realized their cost if they are
sold)Requirements exist for disclosure
of quantitative particulars only as
prescribed in Schedule VI
Source : KPMG Peat Marwick.
Intermediaries that are involved in an ADR issue perform the same work as in the case of a
GDR issue. Additionally, the intermediaries involved will liaison with the QIBs for investing
in ADRs. Some of the well known intermediaries for ADRs/GDRs are, Merrill Lynch
International Ltd., Goldmann Sachs & Co. James Capel & Co., Lehman International, Robert
Fleing Inc, Jardine Fleming, CS First Boston, JP Morgan, Etc.
Regulatory Framework
At the outset, it should be clear that the regulatory framework for the ADRs is
provided by Securities and Exchange Commission which operates through two main statutes,
the Securities Act of 1933, and the Securities Exchange Act of 1934. The Securities
Exchange Act provides for the disclosure and its periodic updating. As far as Indian
regulatory procedures are concerned, the Ministry of Finance is yet to come out with
comprehensive set of guidelines.
Rule 415 of the Securities Exchange Act of 1934, refers to Shelf Registration and
applies to the issue of ADRs. Under this rule, select foreign companies are offered the
facility to register the necessary documents before the actual issuance of securities. For this,
issuers are required to prepare the prospectus in two parts: Basic and supplementary. While
the basic prospectus has to be filed at the time of shelf registration, the supplementary
prospectus has to be filed at the time of the actual issuance of the securities. Wrapping
around the basic prospectus, the supplementary prospectus records the recent developments
in addition to filing a detailed financial condition statement. Underwriting arrangements, the
certifications of auditors and legal counsel have to be procured for the actual issue of
securities. New shelf filings, are required if the issuer seeks to raise larger amounts than
originally '1ndicated. Also, the issuer has the option to go in for de novo registration.
Shelf registration has been found to be useful to issuers as it reduces the incidence of
fees considerably. More importantly, shelf registration affords the issuers opportunities for
quickly accessing the markets as "the offering process is substantially simplified.
POTENTIAL
Though there has been an increase in the limit of FII investment in an Indian
company to 10% with the increase in the overall investment limit to 30%, FIls eager to invest
in certain blue chip companies are finding the GDRJADR route as convenient to invest in
such companies. The first company to have received the approval to issue ADR is BPL
Cellular Holdings. The approval is given on caseto-case basis by the Ministry of Finance.
DEBT
INSTRUME
NTS
E
ur
o
b
o
n
ds
The process of lending money by investing in bonds originated during the 19th
century when the merchant bankers began their operations in the international
markets~ Issuance of Eurobonds became easier with no exchange controls and no
government restrictions on the transfer of funds in international markets. Slowly, the
US dollar came to be accepted as an international currency and New York joined the
family of money centers of the world. The first Eurobond was made for US$ 15
million only for the Italian motorway company - Autostrada, and the total Eurobond
volume in the year of 1963 was US$ 150 million. World Bank entered international
markets in a big way to raise finance by issuing bonds.
THE INSTRUMENTS
All Eurobonds, through their features can appeal to any class of issuer or investor.
The characteristics which make them unique and flexible are,
a.No withholding of taxes of any kind on interests
payments.
b. A fundamental requirement is that the bonds are in
bearer form with interest coupon attached,
c. The bonds are listed on one or more stock exchanges but
issues are generally traded in the over-the-counter
market.
Typically, a Eurobond is issued outside the country of the currency in which it IS
denominated. It is like any other Euro instrument and through intemationa: syndication and
underwriting, the paper is sold without any limit of geographical boundaries. Eurobonds, are
generally listed on world's stock exchanges, usually on the Luxembourg Stock Exchange.
There were various innovations in the structuring of bond issues during the eighties.
These structures used swap technique to switch from one currency to another, or to
acquire multi-currency positions. Another variation was in the form of equity-related
bonds as convertibles or bonds with equity warrants. Zero-coupon bonds were issued
capitalizing on the tax treatment.
Bond issue structures can be classified into two broad categories: Fixed rate bonds
(also referred as straights) and
Floating-Rate Notes (FRNs).
Table 6: Top 20 Bookrunners Jan. 1 to Dec. 31 2001
Pos. Bank Name
Amt US$ (m) No.
% Share
1. Barclays
46,079.20
227
8.94
2. Citigroup Inc
38,404.22
184
7.45
3. Deutsche Bank AG .
31,660.44
156
6.14
4. JP Morgan
28,078.71
119
5.44
5. Royal Bank of Scotland
27,929.72
192
5.42
6. HSBC
22,644.77
130
4.39
7. BNP Paribas
22.275.19
140
4.32
Dresdner Kleinwort
8.
19,345.40
110
3.75
Wasserstein
9. ABN-AMRO Bank NV
15,854.36
98
3.07
West LB
15,105.90
109
2.93
10.
Total
515,694.38
1,116
100.00
Source: Dealogic Loanware.
a.
Fixed Rate Bonds / Straight Debt Bonds : Straight Debt Bonds are fixed interest
bearing securities which are redeemable at face value. These unsecured bonds which
are floated in domestic markets or international markets, are denominated in the
respective currency with interest rates fixed on the basis of a certain formula
applicable in a given market. The bonds issued in the Euro-market referred to as
Euro-bonds, have interest rates fixed with reference to the creditworthiness of the
issuer. The yields on these instruments depend on short-term interest rates. LIB OR is
the most commonly used benchmark for measuring the yields on these bonds. The
interest rate on dollar denominated bonds are set at a margin over the US treasury
yields. The redemption of straights is done by bullet payment, where the repayment
of debt will be in one lump sum at the end of the maturity period, and annual
servicing. Further, there is no tax deduction at source on the income of these bonds.
These bonds are listed either on London, Luxembourg or Singapore stock exchanges.
In addition to the fixed rate bonds, there are the zero coupon bonds which do not pay
the investors any interest and therefore, are not taxable on a year-to-year basis.
Instead, the differential between maturity value and the issue price could be treated as
capital gains and taxed at a lower rate accordingly. The first zero-coupon bond was
floated in Euromarkets in 1981 for Pepsico which was made at a price of 67.5% for a
maturity of three years, with repayment at 100% on the maturity date. This has
provided a yield of 14.14% to the investors.
b. Floating Rate Notes (FRNs): FRNs can be described as a bond issue with a maturity
period varying from 5-7 years having varying coupon rates - either pegged to another
security or re-fixed at periodic intervals. Conventionally, the paper is referred to as notes
and not as bonds. The spreads or margin on these notes will be above 6 months LIB OR
for Eurodollar deposits.
The bulk of the issues in the seventies were denominated in US dollars. Later, the concept
was applied to other currencies, like Pound Sterling, Deutsche Mark, European currency units
and others. Extensive usage of these FRNs is done by both American and Non-American
Banks who would borrow to obtain dollar without exhausting credit lines with other banks.
Thus, FRNs represent an additional way to raise capital for them. To cater to the varying
shifts in the investor preferences and borrowers' financial requirements, variations have been
introduced in the basic FRN concept. FRNs have thus been restructured into the following
types:
Flip-Flop FRNs: The investors have the option to convert the paper into flat interest
paying instrument at the end of a particular period. The investor could change his
mind and convert the note into perpetual note once again at maturity. World Bank had
come out with a FRNs issue with perpetual life and having a spread of 50 basis points
over the US treasury rate. Every 6 months the investors had the option of converting
the FRN into 3-month note with a flat 3-month yield. The investor could also revert
his decision and change it to a perpetual note.
Mismatch FRNs: These notes have semi-annual interest payments though the actual
rate is fixed monthly. This enables investors to benefit from arbitrage arising on
account of differentials in interest rates for different maturities. They are also known
as rolling rate FRNs.
Mini-Max FRNs: These notes include both minimum and maximum coupons. The
investors will earn a minimum rate as well as a maximum rate on these notes.
Depending on the differential between these rates the spreads are earned on these
notes. These notes are also known as collared FRNs.
Capped FRNs: An interest rate cap is given over which the borrower is not required to
service the notes, even if Libor goes above that level. Typically, the investors have
margins higher than that is normally applicable.
VRN-Stl1lctured FRNs: These represent long-dated paper with variable interest
spreads, with margins over Libor. The margins rise for longer maturities.
Perpetual FRNs: These notes which are irredeemable are also known as perpetual
floaters or undated issues
PR
O
CE
DU
RE
Coming out with a bond issue is the most complex and elaborate of the
procedures of all the funding programs. Bonds need to be carefully designed and
executed, especially as these are placed with international clientele.
The success of the bond issue depends not so much on costs as on the position
and capabilities of the bidders for launching the issue. The cheapest bid therefore,
may not be the best bid because the track record and current market standing of the
bidders would have to be carefully weighed while choosing the lead manager.
Therefore, the mandate of the bond issue has to be awarded after proper deliberation
on the modalities involved. The bids should include all necessary information relating
to the placement strategy, market support operations, listing details, paying agency
arrangements, delivery and handling of notes and trustee arrangements.
After the receipt of a mandate, the mandated bank (referred to as lead manager
or arrangers) has to initiate steps for the formation of a syndicate group to complete
bond issue formalities. Since, it is the key member of the syndicate group, it is
responsible for a series of tasks starting with the launching of the issue till its
closure.
a.
Syndication: In particular, the Arranger's (lead managers) duties commence with a
credit appraisal of the issuer on the basis of a financial and operational data. The lead
manager has to
organize detailed negotiations with the issuer for the purposes of
settling various terms and conditions. A time table too has to be drawn for going' through
various stages of bond issue floatation.
It is also the lead managers' responsibility for drafting documents with the help of legal
counsels.
Bond issue documentation comprises, besides prospectus, subscription
agreement, underwriting
agreement, selling agency agreement, paying agency agreement,
listing agreement and the trust
deed. These agreements have the same kind of properties
as in the case of a GDR issue mentioned
earlier in the chapter.
Traditionally, international markets have been following open priced syndication
procedures. Under this, the lead manager keeps pricing open until the subscription
agreement is actually signed. The lead manager assesses not only the market mood but the
precise level at which an issue would be supported and subscriptions can be procured in
adequate measure.
International markets have also come up with an innovative method of syndication
referred to as bought-outdeal process. Under this system, pre priced issue (pre-printed by the
lead manager and
co-management group) are presented to the market and the issuer knows
the exact issue 'price and
coupon rate before the former is launched in the market.
b.
Launching, Offering and Closing: Placement of new bond issues in markets follows a
standard route. On receipt of various approvals and authorizations by the issuer, news
concerning bond issue floatation is carried through the appropriate media. With the
announcement of a bond issue launch, invitation telexes are sent to underwriters and to
selling group members inviting their support. The main function' of underwriting is to
take up the issue on execution of the underwriting agreement. It is CUSIO~, ;0:them to
sell the issue subsequently. underwriting is done b:. wee groups the managers, major
underwriting and minor underwriting. While the me commitments on the first two
categories of underwriting will be an average of 1 percent of the issue, the last category
of underwriting will have a commitment of 0.5 percent of the issue.
Compared to underwriting, selling is organized in a different manner. While
underwriters take title to the issue so underwritten, selling group members do not take
title as they undertake to sell the issue if support is obtained. The selling group,
therefore, do not carry any risk - in a technical sense compared to the underwriting
group.
The next stage in bond issue floatation is the offering. During this phase, terms
consisting of coupon rate and issue price are finalized. Pricing is determined 011 the
basis of the underwriters' response, and is undertaken one day before the offering. The
lead managers, jointly with co-managers, have to assess the mood and response of the
market and weigh the response of the underwriters accordingly. The two-day period
prior to the offer is, therefore, very crucial and hectic discussions and negotiations are
undertaken in order to arrive at a correct bond issue pricing.
During the offering period, the issuer and the lead manager organize a sales
campaign. Various markets are tapped by means of road shows. These are in fact
investor meetings where the offering of a bond is formally presented to investors.
Road shows are organized at various centers and are important from the point of view
of placing the issue. The offering phase is concluded with the actual sale of bonds,
signing of necessary agreements and publicity regarding the. transaction coming to an
end.
Given below is the time schedule for the various activities in a Eurodollar bond issue.
For frequent issuers of bonds, the time schedule is shorter as the familiarity of the
parties with the process ensures expeditious completion of various stages.
Table 7: Time Schedule for a Traditional Eurodollar Bond Issue
Week of X - 14
Initial organizational meeting with the company to discuss:
a.
Basic terms and conditions
b.
Time schedule and allocation of responsibilities
c.
Marketing and syndication strategy (possible syndicate
tour)
d.
General form and content of offering circular, subscription
and fiscal agency/trust deed and pa) in agency agreements
e.
Selection of trustee or fiscal agent and paying agents Work
begins on:
Work Begins on :
Offering circular (due diligence investigation)
b.
Agreement
among
managers,
subscription
agreement and underwriting agreement
c.
Syndicate telexes and press release
d.
List of syndicate members
e.
Listing application
f.
Sales material (optional)
Week of X -7
Final authorizations and board approvals obtained
b. Working party meetings as necessary to prepare
documents
c. Drafts of documents sent to. printers
d. Borrower and lead manager discuss pre-
announcement terms
and commission ideas
e.
Preparation of statistical comparison and other sales
materials (optional)
X-DAy
Announcement of issue released to press and stock exchanges
(Announcement day)
Lead manager sends:
a. Invitation telex to co-managers and underwriters
b. Invitation telex to selling group members
c. Sales telex to foreign branch offices (optional)
Listing application made
.
Documents and letters sent to the printer for final printing Co-
managers and underwriters required to telex or cable acceptance
of
underwriting
commitment
to
lead
manager'
Underwriters/Selling Group Members are mailed: .
a. Preliminary offering circular
b. Execution copies of underwriting/selling group agreement
Syndicate tour organized and carried out (optional)
Indications of syndicate and investor interest are recorded in the
X+ 1
book
Pre-allotments are made in the amount of not less than 50% of
underwriting commitment
. Documents sent to listing agent
Progress of note printer is monitored
Advertising agency contacted for preparation of tombstone
advertisement and list of likely newspapers and magazines
Preparation of fmal press release
Preparation of pricing information and other arrangements for
pricing day and signing ceremony
X+3
Allotments determined internally by lead manager and telexed to
syndicate
X + 1 through X + 3 Deadline for receipt by co-managers the draft agreements requiring
(Offering period)
signature
Deadline for receipt by co-managers the draft of prospectus (or in
exceptional circumstances, prospectus to be made available for
viewing at the office of the lead manager)
Final pricing meeting with borrowers (if an open-priced issue) All
syndicate agreements to be signed
Signatures on the subscription agreement
Release of final press announcement
Final terms released to listing agent, document and bond printers
and advertising agency for tombstone
Printing of final prospectus (next day mailing)
New issue supported by a syndicate bid until distribution judged
complete. Syndicate notified when trading restrictions are lifted
Printing of dimities bonds
Preparation of final copy of tombstone advertisement
Trust deed or fiscal agency agreement signed
Listing application checked to assure listing on or before closing
Closing memorandum reviewed setting out arrangements for
closing Delivery and payment instruction forms` received from
underwriters and selling group members
Co-managers, underwriters and selling group members make
payment for securities acquired through accounts with Euro clear or
Cedel
Pre-closing meeting held to determine receipt of all necessary
authorizations, legal opinions and cold comfort letter
Packaging and delivery arrangements for bonds are checked
Closing documents delivered
Payment for the delivery of securities
Signature of paying agency agreement
Publication of tombstone advertisement
Preparation of bible containing offering documents and closing
papers
Syndicate stabilization can also continue up to 30 days after closing
Source: Global Capital Markets. P R Joshi.
LISTING
Bond issue are listed at one or more stock exchanges depending upon the type of bond issue,
the currency of
denomination and the desire of the issuer to seek a quotation at various centers. Generally the
Eurobonds
denominated in dollars are listed at London/Luxembourg Stock Exchanges, the bonds
denominated ill
French Franc at Luxembourg Stock Exchange and those bonds denominated in DM at
German Stock
Exchanges. Bonds issued in domestic markets like Japan, Switzerland or Germany have to
be
listed as per the requirements. Bond issue procedures are finally concluded with the
tombstone
advertisement and bible compilation.
CLEARING ARRANGEMENTS
With a view to facilitating both new issue and secondary market
operations, clearing house arrangements have been made and systems laid
down for handling transactions. Eurobonds are usually handed over to
either the Euro clear system (Brussels) or Cedel (Luxembourg). The two
systems have been linked by what is known as an electric bridge.
Euroclear and Cedel follow two distinct practices, fungible and
non-fungible accounts, for concluding transactions between parties. While
the fungible accounts system is most popular in Euromarkets, the non-
fungible system is useful for control purposes. In a fungible account
system, details regarding the identity of the owners and location of
individual securities are not .provided. Euroclear system handles trades on
fungible basis, whereas Cedel permits both procedures.
The two clearing systems have been providing various other
facilities, apart from settlement of secondary market trading transactions.
For instance, finance is provided by them for facilitating market-making
operations.
THE PRESENT SCENARIO
India relied heavily on Eurocredits during the early eighties.
During the mid eighties India entered Japanese markets with
floatation's of privately placed Shibosai issues. This was
followed by public bond issues in German and Swiss markets
during the later half of the eighties. Towards the end of the
decade, a couple of public sector institutions floated
Eurodollar issues for the first time. However, either because
of selective approvals by the government or sensitivities of
the markets concerned, only four organizations had entered
the external bond markets before the forex crisis of 1991
closed market doors to India. The ensuring three-year period
(1991-93) saw the sensitive external bond market lose
confidence in India. However, the scene has improved and
some of the big Indian corporate houses have been tapping
the international bond markets.
Foreign Bonds
a. Yankee Bonds: These are US dollar denominated issues by foreign
borrowers (usually foreign governments or entities,
supranationals and highly rated corporate borrowers) in
the US bond markets~ Yankee bond has certain peculiar
features associated with the US domestic market. SEC
regulates the international bond issues and requires
complete disclosure documents in detail than the
prospectus used in Eurobond issues, foreign borrower
Will have to adopt the US accounting practices and the
US credit rating agencies will have to provide rating for
these bonds. These bonds are sponsored by a US
domestic underwriting syndicate and require Securities
and Exchange Board registration prior to selling them in
the domestic US market. Reliance Industries Ltd. has
been the most successful corporate to tap this instrument
with a 50-year, $50 million Yankee Bond issue.
b. Samurai Bonds: These are bonds issued by non-Japanese
borrowers in the domestic Japanese markets. Borrowers
are supranationals and have at least a minimum
investment grade rating (A rated). The maturities range
between 3-20 years. The priority for allowing issuance of
Samurai bonds is given to the sovereigns after the
supranationals and their entities and to high quality
private corporations specifically if there are Japanese
trade links. This is also a registered bond and the
settlement and administrative procedures make it
relatively costly. Among the Yen financing instruments,
this instrument is the most expensive in terms of issuing
costs. As this instrument is issued for the public, the
arrangements for underwriting and selling have to be
made which involves large documentation.
There are two major parties to a Samurai bond issue, the
securities house, which acts as lead arranger, and the
bank, acting as a chief commissioned company. The
process followed is generally the same as is followed
elsewhere for the Eurobonds. However, it is to be noted
that the documentation and formalities are friendly and
hospitable.
c. Bulldog Bonds: These are sterling denominated foreign
bonds which are raised in the UK domestic securities
market. The maturity of these bonds will
be either for very short periods (5 years) or for very long
maturities (25 years and above). Bonds with intermediate
maturity periods are rare. These bulldog bonds are
generally subscribed by long-term institutional investors
like pension funds and life insurance companies. These
bonds are generally redeemed on bullet basis (one time
lump sum payment on maturity), however, due to the
long maturities, early amortizations, say 5 equal annual
installments prior to the maturity date, may also be
allowed. A margin on the UK government bond will be
the yield earned on this paper. These bonds which are
offered either by placing or offer for sale process, will
have to be listed on the London Stock Exchange.
d. Shibosai Bonds: These are the privately placed bonds issued in the
Japanese markets. The qualifying criteria is less stringent as compared
to Samurai or Euro Y en bonds. Shibosai bonds are offered to a
different market segment that consists of institutional investors,
including banks. The eligibility criteria, amount, maturity and
redemption as well as coupon rate and issue price are all governed by
Japan's Ministry of Finance (MoF) guidelines. In terms of eligibility,
MoF has classified various borrowers (sovereign and corporate) into
different groups. The rated borrowers are divided into three groups in
accordance with the rating, while non-rated borrowers are segmented
on the basis of country rating or previous bond issue floatation
experience. The pricing formula is elaborate and starts with the
computation of base rate, spreads being added according to the credit
rating of the borrowers. The procedures for completing bond issue
formalities are elaborate and take about forty-five days after the
mandate is awarded.
Eu
ro
Not
es
In the early '80s, the international capital markets wert;
faced with problems of country defaults, uncertain supply of
OPEC deposits, which were the main source of deposits in
the '70s, and the macroeconomic imbalances which were
resulting in rising inflation and volatility in exchange and
interest rates. All these factors enhanced the risks in the
international financial sphere.
The search in mid-eighties for a paper that goes beyond the
interbank market for arranging funds and which has wider
support for resource raising through primary investors in
various markets has contributed to the birth of Euronotes. A
Series of developments during the eighties, triggered by the
bank credit crisis provided impetus to the process of origin
of these notes
THE INSTRUMENTS
Euronotes as a concept is different from syndicated bank
credit and IS different from Eurobonds in terms of its
structure and maturity period. Euronotes command the price
of a short-term instrument usually a few basis points over
LIBOR and in
many instances at sub-LIB OR levels. The documentation
formalities are minimal (unlike in the case of syndicated
credits or bond issues) and cost savings can be achieved on
that score too. The funding instrument in the form of
Euronotes possess flexibility and can be tailored to suit the
specific requirements of different types of borrowers. There
are numerous applications of basic concepts of Euronotes.
These may be categorized under the following heads:
a. Commercial Paper: These are short-term unsecured
promissory notes which repay a fixed amount on a certain
future date. Euronotes, underlying CP, are unsecured and
stand on the general creditworthiness of the issuers.
Referred as Euro Commercial Paper, these papers are not
underwritten and have maturities up to one year, mostly by
way of three-month or six-month paper. Even though
maturities are short, the overall funding program could be
for medium-to long-term. Usually, the borrowers plan a
series of tranches to match their funding needs throughout
the life of the program once they are established.
It takes about four to five weeks after the initial decision is
taken by the concerned parties. Issuer of CP initiates
proceedings by selecting a dealer and an issuing and paying
agent. While it is not mandatory to have ratings, issuers
often seek ratings for a successful launching of CP
programs.
The documentation is simple and comprises an
information memorandum, dealer agreement, issuing and
paying agency agreement and the actual notes. The information
memorandum is a fairly standard and routine document and
carries basic information concerning the issuer. The relevant
operational information and financials are summarized in an
information memorandum for CP, which has to be updated
periodically. In terms of disclosure requirements, the
information memorandum is expected to help investors
independently judge the creditworthiness of the CP issuer.
A significant variation of commercial paper is the asset-backed
CP which is backed by financial assets such as mortgages or
credit card receivables.
Note Issuance Facilities (NIFs): The currency involved is
mostly US dollars. A NIF is a medium-term legally binding
commitment under which a borrower can issue short-telm
paper, of up to one year.. The underlying currency is mostly US
dollar. Underwriting banks are committed either to purchase
any notes which the borrower is unable to sell, or to provide
standing credit. These can be re-issued periodically.
In a typical NIF program, the issuer instructs the lead manager
to issue Euro notes at desired intervals. Maximum and
minimum amounts of each issue are also specified. The lead
manager sells the notes as per the placement agreement of the
sole placing agent, multiple agents or a tender panel that
bids competitively for the paper. In cases where .there is sole
placing agency arrangement, the structure is called a Revolving
Underwriting Facility (RUF). The notes are offered for sale
during a specified selling perio?
usually ranging between three to ten
business days.
NIFs primarily appeal to professional investors. These include
commercial banks, and non-bank financial institutions such as
insurance companies and provident funds. The underwriting
support is provided by commercial banks. Savings bank,
investment companies and insurance companies also play a
small role.
NIFs carry three major cost components, underwriting fees
(payable on the full amount of underwriting), a one-time
management fee (for structuring, pricing, syndication and
documentation) and margin on the notes themselves. The
margin on Euronotes is expressed either in the form of spreads
over LIB OR or built into the NIF pricing itself.
c.
Medium-Term Notes (MTNs): MTNs are defined as
sequentially issued fixed interest securities which have a
maturity of over one year. A typical MTN program enables an
issuer to issue Euronotes for different maturities, from over
one year up to the desired level of maturity. These are
essentially fixed rate funding arrangements as the price of each
preferred maturity is determined and fixed up front at the time
of launching. These are conceived as non-underwritten
facilities, even though international markets have sta!1ed
offering underwriting support in specific instances.
A Global MTN (G-MTN) is issued worldwide by tapping Euro
as well as the US markets under the same program. In view of
placement of certain proportion of notes in the US markets,
issuers are required to seek shelf registration from SEC.
Under G-MTN programs, issuers of different credit ratings are
able to raise finance by accessing retail as well as institutional
investors. In view of flexible access, speed and efficiency, and
enhanced investor base G-MlN programs afford numerous
benefits to the issuers.
Spreads paid on MTNs depend on credit ratings,
tteasury yield curve and the familiarity of the issuers
among investors. Investors include Private Banks,
Pension Funds, Mutual Funds and Insurance
Companies.
T
H
E
I
N
D
I
A
N
S
C
E
N
E
Until 1994, there were only a few banks
and financial institutions that have come
out with a CP and RUF-type program.
With the opening of the international
markets in 1994, serious attempts must
be made by the Indian borrowers to
explore this route as a drive towards
resource diversification. In the overal1
context, there is certainly considerable
scope for prime Indian corporates to
access the Euronote market.
EURO
CREDIT
SYNDIC
ATION
T
h
e
G
e
n
e
s
i
s
Syndicated Euro-credits are in existence
since the late 1960s. The first syndicate was
organized by Bankers' Trust in an effort to
arrange a large credit for Austria. During
the early seventies, Euromarkets saw the
demand for Euro credits increasing from
non-traditional and hitherto untested
borrowers. The period after first oil crisis
was marked by a boom phase. To cope with
the increasing demand for funds, lenders
expanded
their
business
without
undertaking due credit appraisal of their
clients or the countries thus financed.
Further, the European banks had short-term
deposits while bulk of borrowers required
long-term deposits. These landings were at
fixed rates thus exposing these banks to
interest rate risks. The banks evolved the
concept of lending funds for medium long-
term i.e. 7-15 years on a variable interest
rate basis Linked to the Interbank Rate
(LIBOR). Revision of rates would take
place every 3-6 months. These loans are
218
extended in currencies denominated by
US$, Yen, DM, Swiss Franc and European
Currency Unit (ECU). Amortization of the
loan would be by way of half-yearly
installments 'on completion of 2-3 years of
grace period. At present, this instrument on
a variable interest rate basis has emerged as
one of the most notable .and popular
financing instruments in the international
financial markets. Syndicated Credit
reIDalnS as :he simplest way for different
types of borrowers to raise forex finance
Syndicates are classified into two types -
club k'ans and syndicated loans.
The club loan is a private arrangement
between lending ban1r.5 and a borrower.
Conventionally, the entry into Euromarkets
for a funding deal IS wel1-publicized.
When the loan amounts are smal1 and
parties familiar with each other, lending
banks form a club and advance a loan.
Therefore, in view of this private
arrangement, an information memorandum
is not complied and neither is the deal
publicized in the financial press.
Syndicate credits are created when lenders
and borrowers come together and execute
an agreement, defing terms and conditions,
under which a loan can be advanced. These
procedures and practices have, over the
years, been developed and perfected so that
a standard package has evolved now.
219
Documentation formalities
Along with. the syndication process, the
lead manager/lead bank also initiates
action of drafting the loan documentation,
comprising an information memorandum
and loan agreement. The information
memorandum describes the borrowing
entity, its formation, ownership and
management. A somewhat detailed
account of operations, past and present,
and the cash flow position (along with a
summary of the financials) fund an
important place in it. It must be noted that
the information memorandum does not
have the same status and recognition as a
prospectus; neither does the lead manager
take any responsibility for its accuracy.
The information memorandum also contains a
detailed description of the guarantor, in case
loans carry a state guarantee. Many developing
country transactions carry the guarantee .of
their respective governments and conventions
have evolved for describing the guarantor.
Since the information memorandum is
registered with any stock exchange, it does not
carry the weightage of a bond issue prospectus.
However, it is an important document from the
commercial point of view. Prospective lenders
rely upon the statements it carries and hence
due diligence must be observed.
220
The principal loan document is the loan
agreement and it is the responsibility of the lead
manager to draft and conclude it satisfactorily.
The agreement is signed by all participating
banks and the borrower. It describes the basic
transaction, drawdown arrangements, interest
rate and its determination, commitment fees,
warranties
and
undertakings,
default
circumstances, financial covenants (if any),
'agent bank' and the participating banks. The
loan is underwritten by a
management group assembled by the lead bank.
Sometimes the lead bank itself underwrites
more than half of the loan amount.
Pricing
Method
ology
The loan, will be charged at an interest rate
that is linked to the LIB OR. The rate will be
LIBOR plus the spread the bank would like to
maintain. This spread which may be any where
from 0.125 percent to 1.5 percent, may remain
constant over the life of the loan or may be
changed after a certain fixed number of years.
In addition, the lead manager's fee, which will
be 0.125 percent of the loan, the commitment
fee of 0.5 percent on the un drawn loan amount
and agent's fee will be the total annual charges.
Front-end charges include participation fee for
the banks taking part in the loan and the
management fees for the underwriting banks
221
and lead banks. These loans will require a bank
guarantee and the bank should confirm to the
capital adequacy norms. However, there are no
other collaterals attached.
Indian Scenario
While the early '80s saw the Indian PSUs, banks, and Fls raise
funds by way of syndicated loans, subsequent rating position of
India, did not seem to be congenial for the same. Future
borrowings with this method of loan syndication will also depend
to a large extent on this sovereign rating.
Offshore
Ban
kin
g
Offshore banking has been described aptly by Giddy as "financial
intermediation performed primarily for borrowers and depositors
who are not residents of the country where the bank is located. Its
principal attraction is its freedom from expensive and intrusive
official regulation". In simple words, offshore banking involves a
bank offering its services of accepting deposits from, and
extending credit to foreign residents, in any currency. These
activities are free from capital controls, taxes and reserve
requirements.
222
UNIT-IV
INTERNATIONAL MONEY MARKET INSTRUMENTS
AND INSTITUTIONS; GDRS, ADRS, IDRS, EURO BONDS, EURO
LOANS, REPOS, CPS, DERVIATIVES, FLOATING RATE
INSTRUMENTS, LOAN SYNDICATION AND EURO DEPOSIT,
IMF; IBRD, DEVELOPMENT BANKS.
Objectives
Having gone through this unit, one may be able to understand.
The concept and mechanism of GDR.
The significance of ADRs.
The nature of global debt market and various global debt
instruments
The special features of euro market instruments
The function of international financial institutions Viz., IMF,
IBRD, Development banks.
There are different types of equity investment instruments in
international market. International equity offering generally takes any
one of the two forms , viz , i) dual syndicate equity offering , where the
equity offering is split into overseas and domestic trenches and each is
handled by separate lead manager and ii) euro equity offering where one
trenched is placed overseas and managed by one lead manager GDRs,
ADR AND IDRS (Global , American and internationals depository
Receipts) are the prime modes of Euro-equity offerings.
Global Depository Receipt (GDR)
A Global Depository Receipt (GDR) is a dollar denominated
instrument traded on a stock exchange in Europe or the US or both. It
represents a certain number of underlying equity shares.
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The shares are issued by the company to an intermediary called
depository in whose name the shares are registered. It is the depository
which subsequently issues the GDRs. The physical possession of the
equity shares is with another intermediary called the custodian who is an
agent of the depository. Thus while a GDR represents the issuing
company`s shares, it has a distinct identity and in fact does not figure in
the books of issuer.
The concept of GDRs has been in use since 1927 in Western capital
markets. Originally they were designed as an instrument to enable US
investors to trade in securities that were not listed in US exchanged in the
form of American depository receipts (ADRs). Issue traded outside the
US were called International Depository Recipt (IDR) issues.
Until 1983, the market for depository receipts was largely investor
driven and depository banks often issued them without the consent of the
company concerned. In 1983, the securities and exchanged commission
(SEC) of the US made it mandatory for certain amount of information to
be provide by the companies.
Till 1990, the companies had to issue separate receipts in the
United states (ADRs) and in Europe (IDRs). Its inherent weakness was
that there was no cross border trading possible as ADRs had to be traded,
settled and charged through DTC (an international settlement systems in
the US) while the IDRs could only be traded and settled via Euro clear in
Europe.
In 1990, changes in Rule 144A and regulation 5 of the SEC
allowed companies to raise capital without having to register the securities
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within the SEC or changing financial statements to reflects US accounting
principles. The GDR evolved out of these changes.
Under Rule 144A, the purchaser may offer and resell those
securities to any Qualified Institutional Buyer (QIB) If:
1) The securities are not same class as securities of the issuer quoted
in NASDAQ or listed on a US stock Exchange.
2) The buyer is advised that the seller is relying on Rule 144A; and
3) unless the issuer is a reporting company or is exempt from
exchange Act registration under Rule 12g 3-2(b), the buyer, upon
request, has the right to receive at or prior to the time of sale,
specific financial statements of the issuer and information as to its
business.
In view of the foregoing, it is permissible for a foreign private
issues to sell its shares through an underwriter into the US provided the
shares are eligible for Rule 144A treatment and US market is limited to
QIBs. To accompliosh this, the underwriter would purchase the securities
from the issues in a transaction exempt from the registration requirements
of the securities Act and relying upon Rule 144A, resell those securities to
QIBs in the US.
A leading south Korean trading company, Samsung co. Ltd. Which
floted a truly global instrument in December 1990, tradable both in
Europe and in the US, set the trend for GDR issues. The GDR issue
allowed the company to raise capital both in US and Europe
simultaneously through one security.
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Depository Receipts (DRs) are offered for subscription as under:
a) Unsponsored : Issued by one or more depositores in response to
market demand.
Today this is obsolete.
b) Sponsored : This is prominent today thanks to flexibility to list on
a national exchange in the US and the ability to raise capital.
1) Private Placement (!$$A) DRs: A company can access the US
and other markets through a private placement of sponsored DRs.
In this a company can raise3 capital by pacing DRs with large
institutional investors and avoid registering with the SEC. The
National Association Of Securities Deal (NASD) of the US has
established an Electronic Trading System similar to NASDAQ,
called PORTAL within which Rule 144A eligible securities
approved by NASD for deposit may traded by QIBs.
2) Sponsored Level DRs: This is the simplest method for companies
to access the US and non-US capital markets. Level-I DRs trade
on the OTC market and as a result the company does not have to
compy with US generally accepted accounting principles (US
GAAP) or full securities and exchange commission (SEC)
disclosures. Under this, companies enjoy the benefits of a publicly
traded security without changing the current reporting process.
3) Sponsored Level II and III DRs: Companies that wish to either
list their securities on an exchange in the US or raise capital, use
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sponsored level II and III DRs respectively. Each level requires
different SEC registration and reporting plus adherence to US
GAAP. The companies must also meet the listing requirements of
the National Exchange or NASDAQ whichever it chooses.
Need for GDR issues by Indian Companies
The specific needs of Indian companies to issue GDRs are as
follows.
i)To raise valuable foreign exchange, ii) to meet the expansion
and diversification needs of these companies, iii) to globalize
the demand for the scrips of these companies, iv) to leverage the
corporate names of these companies in the global capital market,
v) to mitigate the rising cost of domestic capital due to stringent
monetary conditions at home and vi) to broad-base share
holdings in these companies are the specific needs that were
sought to be fulfilled by these GDR companies.
Requirements for Issuing GDRs
In a directive issued on November 12, 1993, the
Government of India laid down certain provision governing issues of
GDRs and foreign currency bonds. The key provisions are as follows:
Prior permission from the deportment of Economic Affairs,
ministry of Finance is mandatory.
Company seeking such approval must have a consists track
record of good performance.
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The custodian shall be a Domestic Custodian Bank.
The aggregate of the foreign investment in the company,
direct or indirect, shall not exceed 51% of the issued and
subscribed capital of the issuing company ( This is exclusive
of general permission of offshore funds or
FIIs to invest upto 24% or 30% as the case may be.
In addition the notification contains details of taxation
are men tioned in the text. Dividends are subject to a 10%
withholding tax and capital gains (if the underlying shares
are sold in India or to an India resident) at maximum
marginal rate if short term (holding period less than 12
months) and 10% if long term are provided for.
Subsequently, in may 1994, the Government of India
issued further guidelines intended to further regulate the
access and the use of funds. The May 1994 guideliens
specify inter alia:
1) A company can make a GDR issue only once in a period
of 12 months. A group of companies can make no more
than two issues.
2) The funds mobilized must be used within a year of the
issue date for one or more of the following purposes:
a. Import of capital equipment.
b. Purchase of domestic plant, equipment and buildings.
c. Prepayment or scheduled repayment of an existing
foreign currency liability.
d. Funds a joint venture or a project abroad provided the
same has been approved by the Government.
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e. Up to 15% of the issue proceeds can be utilized for
general corporate restructuring purposes.
3) On a case-by-case the Government may approve
retention of the proceeds abroad to be used as
prescribed. Otherwise the funds must be repatriated to
India within two weeks of the issue.
4) In certain cases, GDR investment will be treated on par
with foreign direct investment and hence will require
prior clearance by the Foreign Investment Promotion
Board (FIPB).
The guidelines are subject to review and
revision every three months. GDR can be offered to US investors only if
very stringent requirements of registration with the SEC are complied
with. However, under an exemption granted by Rule 144A of the
securities Act, securities can be offered to Qualified Institutional Buyers
(QIBs) without going through the registration process.
Parties to GDRs
The key involved in a GDR issue apart from the issuing company
are:
i) The lead manager (s0 : An investment bank which has the primary
responsibility for assessing the market and successfully marketing the
issue. It helps the company at all stages from preparing the
documentation, making investor presentation, selection of other manager
(subscribers) and post-issue support. It also owes a responsibility to
investors or presenting an accurate picture of the company`s present status
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and future prospects, to the best of its knowledge. This means that it must
exercise due diligence in collecting and evaluating all possible
information which may have a bearing on the issue.
ii) Others managers or managers or subscribers to the issue agree to take
and market parts of the issue as negotiated with the lead manager.
iii) Depository: A bank or financial institution, appointed by the issuing
company which has certain duties and functions to be discharged vis-?-vis
the GDR holders and the company. For this it receives compensation both
from the company as well as the GDR holders.
iv) Custodian: A bank appointed by the depository, generally in
consultation with the issuing company which keeps custody of all
deposited property such as share certificates, dividends, right and bonus
shares etc. It receives its fees from the depository.
v) Clearing systems : EUROCLEAR (Brussels), CEDEL (London) are the
registrars in Europe and Depository Trust company (DTC) is the registrar
in USA who keep records of all particulars of GDRs and GDR holders.
Steps in issue of GDRs
The steps involved in the GDR mechanism can be summarized as
follows:
i) The amount of issue is finalized in US dollars. The company considers
factors such as gearing, dilution effect on future earnings per share etc.
The lead manager assesses the market conditions.
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ii) The lead manager and other managers agree to subscribe to the issue at
a price to be determined on the issue date. These agreements are
embodies in a subscription agreement signed oon the issue date.
iii) Usually, the lead manager has an option to subscribe to specified
additional quantity of GDRs. This option called green shoe has to be
exercised within a certain number of days.
iv) Simultaneously, the Depository and the Custodian are appointed and
the issuer is ready to launch the issue.
v) The company issues a share certificate equal to the number of GDRs to
be sold. This certificate is in the name of the Depository, kept in custody
of the custodian. Before receipts of the proceeds of the issue, the
certificate is kept in escrow.
vi) Investors pay money to the subscribers.
vii) The subscribers (i.e. the lead managers and other managers to the
issue) deposit the funds with the Depository after deducting their
commissions and expenses.
Viii) The company registers the depository or its nominee as holder of
shares in its register of shareholders.
ix) The Depository delivers the European Master GDR to a common
depository for CEDEL and EUROCLER and holds an American Master
GDR registered in the name of DTC or its nominee.
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x) CEDEL, EUROVLRAR and DTC allot GDRs to each ultimate
investors based on the data provided by the managers through the
depository.
xi) The GDR holders pick up their GDR certificates. Anytime after a
specified cooling off period after close of the issue they can convert
their GDRs into the underlying shares by surrendering the GDR to the
depository. The Custodian will issue the share certificates in exchange for
the GDR.
xii) Once surrendered in exchange for shares, such shares can not be
reconverted into GDRs. That is there is no fungiability.
xiii) The GDRs are listed on stock exchanges in Europe such as
Luxembourg and London.
Xiv) Dividends paid will be collected by the custodian converted into
local currency and distributed to GDR holders.
The costs of the issue consist of various fees, commission and
expenses paid to the lead manager and other managers, fees and expenses
paid to the depository, preparation of documents, legal fees, expenses
involved in investor presentation (road shows etc.) listing fees for the
stock exchanges, stamp duties etc. Fees and commissions paid to
managers vary but are generally in the neighborhood of 3-4% of the issue
amount. This is for less than issue costs in India which rage between 8%
to 15% of the issue size.
GDR holders have the right to dividends, the right to subscribe to
new shares and the rights to bonus shares. All these rights are exercised
through the depository. The depository convert the dividends from rupees
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to foreign currency. GDR holders have no voting rights. The depository
may vote if necessary as per the Depository Agreement.
American Depositary Receipt (ADR)
ADRs are financial assets that are issued by U.S.
banks and represent indirect ownership of a certain number of shares of a
specific foreign firm that are held on deposit in a bank in the firm`s home
country. The advantage of ADRs over direct ownership is that the
investor need not worry about the delivery of the stock certificates is that
the investor need not worry about the delivery of the stock certificates or
converting divided payments from a foreign currency into U.S. dollors.
The depository bank automatically does the converting for the investor
and also forwards all financial reports from the firm. The investor pays
the bank a relatively small fee for these services. Typically non-Canadian
firms utilize ADRs. For example, Mexican firms are traded in this
manner in the United States ? at yearend 1993, all 13 Mexican firms with
their stock listed on the NYSE utilised ADRs. In March 1999, the first
even ADR issue by an Indian firm took off. The Information Technology
Ltd., floated ADRs which were received very well.
One study that examined the diversification
implications of investing in ADRs found that such securities were of
notable benefit to U.S. investers. Specifically, a sample of 45 ADRs was
examined and compared with a sample of 45 U.S. securities over the
period from 1973 to 1983. Using an index based on all NYSE ? listed
stocks, the betas of the ADRs had an average value of .26, which was
much lower than the average beta of 1.01 for thye U.S. securities.
Furthermore, the correlation of the ADRs returns with those of the NYSE
market portfolio averaged 0.33, whereas U.S. securities had a notably
higher average correlation of .53.
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Given these two observations, it is not surprising
that portfolios formed from U>S> securities and ADRs had much lower
standard deviations than portfolios consisting of just U.S securities. For
example, portfolios consisting of 10 U.S. securities had an average
monthly standard deviation of 5.50%, whereas a 10-security portfolio split
evenly between U.S. securities and ADRs had an average monthly
standard deviation of 4.41%. Thus in contrast to investing in
multinationals, it seems that investing in ADRs brings significant benefits
in terms of risk reduction.
The SEC currently requires that foreign firms prepare
their financial statements using U.S. generally accounting principles
(GAAP) if they want their shares or ADRs to be listed on a U.S. exchange
or an NASDAQ. There are two consequences of this requirement. First,
many foreign firms have their shares and ADRs traded in the part of the
over-the-counter market that does not involve NASDAQ> Second, many
large and actively traded foreign firms have decided against listing their
shares in the United States. This has caused U.S. exchanges to fear that
certain foreign exchangers which do not have such reporting requirements
(particularly London) will reign as the financial centers of the world in the
future. In response to the complaints of the exchanges, the SEC argues
that this requirement is necessary to protect U.S. investors and that it
would be patently unfair to U.S. firms if they had to meet such
requirements but their foreign competitors did not have to do so.
DEBT INSTRUMENTS
Debt instruments ADR . global debt market is much older than
global equity market . earlier the multipapted and bilater . debt
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instruments in full form. Debt instruments took several forms viz. straight
bonds. Syndicated loans. Floatiog rate bonds. Converfible bonds etc.
VARIETIES OF GLOBAL MARKET DEBT INSTRUMENTS
Debt investment guarantees periodic current return and priority
repayment of capital over equity investment i9n the event of winding up.
Of course, debt investments are redeemable after a fixed time period,
usually 7 years or so. Secuity is there. Risk averse investors go for this
investment. A brief description of debt instruments available in the Euro-
market.
Bonds: For starters, there is a veritable plethora of securities, such as
Euro-bonds, Yankee bonds, Samurai bonds, and Dragon bonds which tap
the European, US, Japanese, and Asia-Pacific markets, respectively.
More specifically, Eurobonds are unsecured debt securities maturing at
least a year after the launch. Usually fixed-rate instruments, with bullet
repayments-one-shot redemption-these bonds are listed on stock
exchanges abroad. And borrowers access global investors with deep
pockets: individuals with high net worth as well as institutions.
The volume of Eurobonds issues from the world`s emerging markets
hovered around the $29-billion mark, with the average size of an issue
being $127 million some five years ago. The most popular instrument
among emerging market borrowers: a Eurobond with a 144-A trance.
That is, a public offering in the Euro-market and a private offering in the
US.
Foreign Commercial Paper: Commercial papers are continuously
offered unsecured debt by the borrower. Most FCPs mature in 30, 60, or
90 days and are sold at a discount to their face value. That reflects the
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interest on the instrument as well as the overall yield to the investor. It`s
extremely flexible, since commercial papers can be structured according
to different maturities, amounts and rates according to the issuer`s needs
for funds.
Fixed/Floating Rate Notes: This debt instrument matures in 90 days`
time but it can be extended at the issuer`s option for an additional period
at each maturity date; simultaneously, the interest rate also increases.
Several variations are possible; extendable bonds and stepped-up coupon
put table bonds. As the term suggests, hold on to the bonds for some
more time usually at a higher coupon rate.
As for stepped-up coupon put table bonds, they are a hybrid
between debt with warrants and extendable bonds or notes. After a
specified period of time, investors can either put the bonds back up t the
issuer or hold on to the bonds for a stated period at a higher-stepped-up-
coupon rate.
Flip-Flop Notes: A bond with reverse flexibility, a flip-flop note offers
investors the option to convert to another debt instrument. And in some
cases, investors can even go back to the original bond at a later date. The
option changes the maturity of the issue and the interest rate profile. It
gives issuers the opportunity to persuade investors to accept lower interest
rates, thus reducing their costs. Conversely, investors have options which
come in handy when interest rates fluctuate sharply.
Dutch Auction Notes: Here, investors bid for seven-year notes on which
the coupon rate is re priced every 35 days. As a result, the notes are sold at
the lowest yield possible. Bids are conducted through a real auction by
dealers in the US markets. The main advantage is that these notes provide
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money for longer periods than commercial paper, since they are re priced
only once every 35 days and, unlike commercial paper, are not redeemed
and resold.
Bunny Bonds: These bonds permit investors to deploy their interest
income from a host bond into more bonds with the same terms and
conditions. Since the option to reinvest interest at the original yield is
attractive to long-term investors, like the pension fun ds, companies find it
a cheap source of finance.
Euro-rupee Bonds: It doesn`t exist yet, but several foreign institutions
are toying with the idea of gobbling together such a tool for wary
companies. Denominated in rupees, Euro-rupee bonds can be listed in,
say, Luxembourg. Interest will be paid out in rupees, and investors play
the risks of currency fluctuations.
Euro-convertible Bonds: It`s the most exciting
Euro-option available. Equity-linked debt instruments, which can be
converted into GDRs. ECBs represent the best of both worlds. And they
may soon overtake GDRs in terms of their popularity in this country.
Traditionally, investors have the option to convert any such bonds
into equity according to a pre-determined formula-and, appropriately,
even at a pre-determined exchange rate. Such bonds allow investors the
flexibility to remain with the debt instrument if the share price refuses to
rise. These bonds have also spawned subtle variations like those with call
and put options, which allow the issuer to insist on conversion beyond
certain limits or permit investors to sell the bonds back to the issuer.
What`s more significant are the structural variations that the Euro-market
is becoming famous for.
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Deep Discount Convertibles:
Such a bond is usually at a price which is 70 to 80 per cent of its
face value. And the initial conversion prices and the coupon rate levels,
are lower than that of a conventional Eurobond.
ECBs with Warrants:
Strictly speaking, these financial instruments are nothing but
derivatives of Euro-bonds. They are combination of debt, with the
investor getting an option on the issuer`s equity. The equity, or warrant, is
detachable from the host bond and it can be cased after specific points of
time. However, the bonds, which have a debt life of seven to 10 year,
remain ourstanding until they mature. There can be expectations of the
issuer and the lender. For instance, they could be zero coupon which
carry a conversion option as a predetermined price, which are called liquid
yield option notes.
Bell Spread Warrants
These warrants offer an investor exposure to the underlying share
between a lower level, L , and an upper level, U,. The lower level is ser
to provide a return to investor above and divided yield on the share. After
maturity- usually three years ? if the share is below the level L, then the
investor receives the difference from the company.
Compenasating for the downside protection, the issuer can cap the
up-side potential on the share. When it matures, if the issuer`s share price
is above the level U, the issuer has to pay out only the amount U. If the
stock is between L and U on maturity, the issuer has a choice of either
paying the investor cash or delivering shares. As the minimum return is
set above the divided yield on shares, the structure works best for
companies with a low divided yield.
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Money-back Warrants(MBWs): MBWs entitle an investor to receive a
certain predetermined sum from the issuer provided the investor holds the
warrant until it natures, and does not convert it into shares. To the
investor, the cost of doing so is not only the cash he loses, but also the
interest foregone on the sum of the money. This means that companies
must offer a higher premium than they normally do.
Syndicated Loan:
The earlier to be evolved and, for a time, the most dominate from a
cross border lending was the syndicated bank loan. Thought the late
seventies and early eighties most of the developing country borrowers
relied on this source since their credit rating and reputation were not good
enough for them to avail of other avenues such as bond issues. A large
bank loan could be arranged in a reasonably short time and with few
formalities. This was also a period during which banks found themselves
being flooded with inflows of short term funds and a relatively repressed
demand for loans from their traditional developed country borrowers.
EURO MARKET INSTRUMENTS.
To day instruments market is integrated and globalized one. the
euro market speaks of the integrated nature of the global investement
market. It is mainly interbank market dealing is euro currency deposit and
euro currency loans. Some of the instruments dealt in the market are; euro
bonds. Commercial pages, certificate of deposits. Floating rate notes etc. a
brief description of these instruments are given here.
Eurocurrency deposits
Eurocurrency deposit refers to the deposit if a currency with the
banks outside the country where the currency is legal tender. Hence
Eurocurrency deposit consists of all deposits of currencies placed with
banks outside their home currency. Deposits are placed at call or for fixed
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periods as time deposits. Call deposits may be made for overnight, two
days or seven days notices. Time deposits are accepted in the periods of
1,3,6, and 12 months. In general the deposits are accepted in the
Eurocurrency market for a minimum of U. S. dollar 50,000/- or its
equivalent in other currencies.
Certificate of deposit
Certificate of deposit is a certificate issued by a bank evidencing
receipt of money and carries the bank`s guarantee for the repayment of
principal and interest.
Certificate of deposits are negotiable instruments and are issued
payable to bearer and are trended in the secondary market. The certificate
of deposits are issued for a minimum denomination of U.S dollar 50,000/-
and for a maximum period, generally, of 1 year.
Certificates of deposits provided an excellent avenue to the
investors in Eurocurrency market who would like to park their surplus in
the high interest instrument eith liquidity. For example if an investor say
bank has surplus fun which it would like to invest for a period of say 3
months it can buy a C.D. for 3 months. IF need be, the bank can sell the
C.D. in the secondary market and liquidate it.
Types of Certificates of deposits
1. Straight or Top CDs: These are certificates of deposits with a fixed
rate of interest and a fixed data of maturity (Generally 1-12
months) . The interest is fixed in term of LIBOR and interest rate
depends on the issuing bank and liquidity position in the market.
2. Floating Rate CDs: These are certificates of deposits which are
issued with the interest rate linked to the LIBOR rate and are
normally issued for a period of maximum of 3 years. Interest rate
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is reviewed at predetermined periodicity say every six months and
adjusted in line with the base rate LIBOR rate.
3. Discount CDs: These are issues at a discount and are paid at
maturity for the face value, the difference between the issues price
and face value representation the interest.
4. Trenches CDs: A Tranche CD is a share in a programme of CD
issues by a bank upto predetermined level. Each Tranche CD
carries the same rate of interest and matures on the same date.
They are normally placed directly with the investors and they
represent short term bonds. These CDs are issued with maturities
upto 5 years.
EUROCREDITS
In THE Eurocurrency market, most of the lending takes places in
the form of Eurocredit. Eurocredit are medium and long term loans given
by the banks in curricies which need not necessarily be those of the
lenders or borrowers.
Security aspects of Eurocredit
Eurocredfits are provided mostly without any collateral security but
the emphasis is on the credit rating of the borrower. In view of the
diffifulties experienced in enforcing securities the lending is made on
strength of the standing of the borrower in the market.
Nature of Facility
Eurocredit are extended either as revolving credits or as ten credits.
Under revolving dredit, a limit is fixed for a borrower and he can draw
wnenever ha needs and interest willl be levied only on the amount drawn.
On the unutilized portion of the sanctioned limit, a commitment fee may
be charged. Under the term credit credit facilities, the credit is extended
for a specified term like say 3 year, the amountis disbursed as per the term
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of the contract. The repayment takes place over a period of time as per
the agreed schedule.
Eurocredits are extended generally for a period of 5 to 8 years. In
some cases it may go upto 15 years.
Interest
A special feature of Eurocredit is the method of fixing the interest
rate. Interest rate are tied to bench mark of references rate. The bench
mark is the London interbank Offered Rate. For dollar credits LIBOR is
used as benchmark while LUXIBOR (LUXEMboung Interbank Offered
Rate) is used as benchmark rate for credits extended in Deutschemark and
for credits in Pound Sterling Paris Interbank offered rate(PIBOR) is taken
as the base rate. The interest is quoted as so many basic points above the
reference rate like 100 basic points above LIBOR above LUXIBOR etc,
This is known as margin and the margin depends on the credit rating of
the borrowing, and his bargaining power. The interest is reviewed every
six months and changed in tune with the reference rate.
Currency
The credits are generally extended in U.S. dollar but other
currencies are also used for lending. IN some cases, the credit agreement
provides for currency option. Under the arrangement the loan is originally
given is one currency with the option to the borrower to roll the loan is a
different currency if need be. This helps the borrower to protect against
exchange risk.
EURO LOAN SYNDICATION
Euro Loan syndication was one of the earlier forms of lending
evolved and remains to be one of the dominat form of crossborder
lending. When the size od the lending is huge running into a few hundred
million or billions, a few banks join together and provide the loan. This is
loan syndication is simple term. It owes its evolution to U.S. Laws which
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fixed certain limits on lending exposure of a single bank on a single
borrower.
A syndicated credit is the agreement between two or more lending
institutions to provide a borrower a credit facility utilizing common loan
documentation.
An appropriate definition will be.
International syndicated credits are managed and underwritten by
one or more financial institution normally from a location other than
domicile of the borrower to include lender from differing banking
geographic which provides the borrower access to more than its own
currency of domicile.
In arranging a syndicated loan the following player take a major
role.
1. Managing Bank: Managing bank is appointed by the borrower to
arrange the credit. The managing bank helps the borrower to draw
up the loan application, it negotiates the term and conditions with
other banks and arranges the syndicate. The managing bank`s role
comes to en end with the signing of loan aggrement by the
borrower and the participating banks
2. Lead Bank: Lead Bank is the bank which provides the major chunk
of the loan.
3. Agent Bank: Agent Bank is the bank appointed by the lenders to
look after their interest one the loan agreement is signed. They
take over from the managing bank.
4. Participating Bank: The participates in a syndicated loan fall into
the following segments.
1.1. The wholesale large commercial banks who arrange the credits,
take lion`s shares.
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1.2. The retail sector small banks take whatever share is given to
them and take a participation in the loan syndication.
Loan syndication is the most popular method of raising shot term
and medium term loans. Most of the developing country borrowers
rely on this sources oc credits since their ratings and market
standing are not good enough to avail of other avenues like bond
issues etc, A large bank loan could be arranged in a reasonably
short time and with few formalities. Minimum amount of
syndicated loan raised is normally 50 million US dollar and the
maximum amount is normally 5 billion US dollar and are given for
a period ranging from 365 days to 20 years.
Apart from interest the following fees are payable in a
syndicated loan:
1. Management Fee is the fees payable to managing bank
which arranges the credit. It is payable upfront and is fixed
as a percentage of the loan arranged
2. Participation Fee is the fee payable to the participants in
the syndicate. A part of the management fee is passed on to
the participant banks in proportion to their share as
participation fee.
3. Commitment fee is the charge paid on undrawn balances of
the credit. This is also known as facility fee and is levied to
compensate the banks for keeping funds ready.
4. Agency Fee is the fee payable to the agent bank which takes
care of disbursement of the credit after sanction, recovery of
loan instalments ans distribution of principal plus interest to
the participants and this is an annual fee.
Unique features of syndicated loans:
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1. Access to Euro-currency markets
a) Free from Regulatory Control
b) Offshore banking- global converge
c) Flexibility to suit the borrower`s and lender`s changing
needs.
2. Recycling of Eurodeposits from surplus to deficit areas.
3. Transform short term enrodeposits to medium/long term
euro credits.
Concepts of Loan Syndication
1. Agreement between two or more lenders
2. Common borrower.
3. Common documentation.
4. Different from unsyndicated or independent borrowings
from multiple banks.
Advantages to Lenders
1. Spreading of risk.
2. Access to big borrowers.
3. Access to credit judgments/ marketing skills of
sophisticated banks.
4. Sources of fees i.e non interest income.
5. Advertisement.
Advantages to the Borrower
1. Ability to raise Jumbo loans in one stroke.
2. Single tap funding.
3. One set documentation. Hence less hassle.
4. Flexibility in the borrowing and speed which ensures timely
delivery of credit.
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Protection to the Lenders
To protect their interest the lending bank lays down certain
financial covenants which are included in the agreement. The covenants
are financial values or rations to be maintained by the borrower and the
following are the few.
a) Debt-equity ratio
b) Dividend payout ration
c) Debt service coverage ration
Normally the lending banks analysis before sanction the credit
standing of the borrower, his country`s credit standing, and his country`s
economic and political situation. Even though all members of a syndicate
sign a common loan agreement each lending bank is responsible for its
own decision.
Any misrepresentation of fact by the borrower or failure to perform
the covenants is defaults by the borrower. Default with any single lending
bank will be construed as default with all banks. Since the credits fall
outside the jurisdiction of any court the legel recourse is difficult and
hence settlement through political negotiation is normally resorted to in
care of defaults.
EUROBONDS
Eurobonds constitute a major source of borrowing in the
Eurocurrency market. A bond is a debt security issued by the borrower
which is purchased by the investor and it involves I the process some
intermediaries like underwriters, merchant bankers etc. Eurobonds are
bonds of international borrower`s sole in different markets simultaneously
by a group of international banks. The bonds are issued on behalf of
governments, big multinational corporations, etc.
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Euro bonds are unsecured securities and hence normally issued by
Governments, Governmental Corporations, local bodies which are
generally guaranteed by the Governments of the countries concerned and
big multinational borrowers of good credit rating. The bonds are sold by a
group of international banks which form a syndicate. The lead bank in the
syndicate, advises the issuer of the bond on the size of the issue, terms and
conditions, timing of the issue etc., and take up the responsibility of
coordinating the issue. Lead managers take the assistance of co-managing
banks. Each issue is underwritten by a group of underwriters and then are
sold.
Feature of Eurobonds
Eurobonds are mostly bearer bonds and are generally denominated
in U.S. dollar, issued in the denominations of U.S. dollar 10,000/- The
bonds are issued for a period of about 5 to 7 years though in some cases
they are issued for a longer duration.
Types of bonds
The following are the types of bonds:
1.
Straight or fixed rate bonds
2.
Convertible bonds
3.
Currency option bonds
4.
Planning rate bonds/Notes
5.
Zero coupon bonds
(I) Straight or fixed rate bonds: These are the traditional bonds
which are debt instruments carrying a fixed interest with a fixed maturity
period with interest payable at a fixed predetermined interval, say 6
months or 1 year. The period of such bonds vary from 5 to 25 years but
commonly bonds are issued by a period of 15 years.
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These are issued for a face value with a certain percentage of
interest payable at a certain periodicity and are redeemable after the
expiry of the period specified.
These bonds are traded in the secondary markets which provide
liquidity to the bonds.
Though the bonds are issued for a fixed maturity, some bonds are
issued with a clause that the bonds are redeemable by the issuer, at
issuer`s choice, prior to its maturity at a price which is above the face
value (call price). There are known as callable bonds and are a simple
variant of straight bond. This feature of the bond allows the issuers to
restructure their liability and provides flexibility.
A puttable bond is another variant of straight bonds and is opposite
to callable bond. It allows the investor to surrender the bonds to the issuer
of the bond prior to maturity of the bonds, at the discretion of the investor,
after a certain period after issue. This provides liquidity to the investor
and may have to pay for this privilege in the form of lower interest.
Though the interest is fixed on the bonds, the yield varies with the
purchase price of the bonds. The market price at which the bond is bought
by the investor either in the primary market (new issue market) or in the
secondary market (an existing issue made sometime in the past) is its
purchase price which may be same as the face value of the bond or may
be lower or higher than the face value depending upon whether the bond
was purchased at a discount or at a premium. The yield varies with the
purchase price of the bond.
(ii) Euro Convertible Bonds: These are similar to fixed or
straight bonds with an option to convert them at the discretion of the
investor into the equity shares of the issuing company. The conversion
will be done at a price (which determines the number of shares for which
the bond will be exchanged) after expiry of a certain period of time. These
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convertible bonds are similar in nature to the convertible debentures in our
country.
Conversion of the bond into equity shares is done at the discretion
of the bond holder and he can opt for it if the market prices of the shares
are higher than the conversion price.
Convertible bonds are attractive from investment perspective
because it gives the investor an opportunity to participate in the
company`s growth. Additionally, the bonds are normally issued in a
currency other than the currency in which the shares are denominated and
hence conversion into shares in a different currency provides the investor
much needed currency diversification in investments.
This instrument is preferred by those who find the domestic (their
country) debt market to be restrictive for short maturities, high rates of
interest and various covenants of commercial loans in foreign currency
unacceptable. This also favoured by those who wish to prevent immediate
dilution of equity and possible loss of control over management.
Hence Euro convertible bonds are equity linked debt security
instruments that can be converted into shares.
Warrants: This is a variant of the convertible bonds. The bond is
issued with warrants which are detachable. The warrant gives the holder
the right to purchase a financial asset say shares at a stated price. The
warrants are tradable. The investor can keep the bond and trade the
warrant for the shares.
(iii) Currency option bonds: These bonds are similar in nature to
the straight bonds with a difference that it is issued in one currency with
an option to take interest and principal in another currency. The rate at
which the conversion takes place from one currency into another depends
upon the terms of the issue. The rate may be fixed at the time of issue of
bonds or at floating rates. Due to fluctuations observed in foreign
exchange market the later option of floating rates are more popular and
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under this the rate of conversion is the spot rate quoted in the market three
business days before the due date of payment of principal and interest.
(iv) Floating rate bonds/Notes: These are similar to the straight
or fixed rate bonds as far as maturity and denomination are concerned but
the difference is that unlike the fixed rate bond where the interest rate is
fixed, in this the interest rate is varying in nature.
The interest rate is linked to a base rate like LIBOR and the interest
payable on the bond for the next six months or one year is set with
reference to the base rate. The rate of interest is adjusted every six
months or one year depending on the terms for the issue.
In some cases, a ceiling is put on the interest rate on the bond and
in some cases a floor rate is fixed.
The floating rate bonds offer flexibility to the investors who can
block their funds for a long term with benefits of the short term interest
movements, i.e. if an investor invests for a period of say 10 years and if
the money market shows gradual increase in the interest rates his funds do
not get blocked at lower rates but interest keep changing with the changes
in the interest rates in the market FRNs are normally issued by bankers.
(v) Zero Coupan Bonds: These bonds are purchased at a
substantial discount from the face value of the bond and are redeemed at
face value on maturity. There are no interim interest payments. The
difference between the purchase price and face value is the return on the
investment.
These bonds are similar to cumulative deposits or cash certificates
of banks in our country.
Distinction between Eurobonds, domestic bonds and foreign bonds
Domestic bonds are bonds issued by a resident issuer in the
country of its residence, denominated in the currency of the country.
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Example: State Bank of India bonds sold in India to Indian
residents denominated in Indian rupees is domestic bond.
Foreign bonds are bonds issued by a non resident entity
denominated in the currency of the country where the bond is issued.
Example: India Development Bonds issued by State Bank of India
in U.S.A. denominated in U.S. dollars are foreign bonds.
Eurobonds are bonds denominated in a currency other than the
currency of the country in which they are issued.
Example: A German multinational issuing bonds in London
denominated in U.S. dollar qualifies for a Eurobond.
The foreign bonds and domestic bonds are subject to regulations by
regulatory authorities and disclosure norms while Eurobonds are not
governed by any such regulation or disclosure norms.
Many Eurobonds are listed on stock exchanges in Europe and this
require filing of certain financial reports by the issuers to the exchange on
a regular basis.
OTHER EURO-INSTRUMENTS
Note Issuance Facility and Euro Commercial Paper are dealt her.
Note Issuance Facility
This is an innovation of early 80`s. It combines the features of
syndicated banks loans and floating rate notes issued to the investors. This
instrument satisfies the investors` need for short term investment and
borrowers` need for medium term funding.
In this instrument the issuer obtains medium term funding by
issuing short term notes to the investor directly and keep them rolling over
repeatedly. Thus every six months or one year, the previous issue would
be redeemed and a fresh issue will be made. In order to ensure that the
issuer gets the fund whether or not the notes are taken up by the market, a
group of underwriters (syndicate of banks) underwrite the issues and
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thereby undertake an obligation to take up the part of issue which is not
subscribed to by the market. The issuer of the bond pays a fee for this
underwriting facility.
Note issuance facility represents a combination that best suits all
parties. Parties with good rating can raise funds at a rate lower than the
rate at which banks lend. Investors who generally prefer short term
investments find this attractive as they are redeemed in a short time by the
issuer and reissued. Underwriting facility ensures smooth flow of funds to
the borrower. This ensures income to the banks by way of underwriting
fees.
Commercial Papers
Commercial Paper (CP) is a short term unsecured promissory note
that is generally sold by large corporations on discount basis to
institutional investors and other corporates for maturities ranging from 7
to 365 days. Commercial paper is cheap and flexible source of fund for
highly rated borrowers as it works out cheaper than bank loans. For an
investor it is an attractive short term investment which offers higher
interest than bank accounts.
In U.S.A. the commercial paper is in existence for more than 100
years and accounts more than 400 billion US dollars. U.S.A. is the largest
commercial paper market. It is used extensively by U.S. and non U.S.
corporations. Any issuer who wants to launch a C.P. in U.S.A. has to get it
rated by Moody`s or by Standard and Poor`s Corporation, the credit rating
agencies. The commercial papers then can be placed either directly or
through C.P. dealers. The major investors are Corporates, Trusts,
Insurance Companies, Pension Funds and other funds, banks etc.
Commercial papers can be issued either directly in their own name
or with third party support in the form of standby letters. Most C.P.
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programs have a back-up credit line of a commercial bank covering at
least 50% of the issue.
In Europe, commercial paper evolved out of Euronotes like Note
issuance facility, which are under-written facilities. As the underwriting
facility is expensive, in 1984, Saint Gobbain, an issuer and Banque Indo-
Suez dealer issued Euronotes without underwriting facility and thus
became the first Euro-CP issuer. The commercial paper issues in the
Euromarkets developed rapidly in an environment of securitisation and
disintermediation of traditional banking.
Euro CPs are not rated by rating agencies as the Euro investors are
not keen about the ratings of issuers.
Advantages of Euro CP`s to borrowers
1.
Cheaper source of funds.
2.
Simplicity in documentation, low cost of arrangement, absence of
rating requirements.
3.
Flexible maturity.
4.
Diversification of short term funding through market that is found
attractive by wide variety of investors.
5.
Flexibility in limits determined by the issuer`s cash flow
requirements at any point of time.
6.
A successful Euro CP programme will enhance the reputation of
the issuer worldwide among the investing community.
Different between Euro & U.S. CP Programmes
Euro CP Programme
U.S. CP Programme
1. Do not distinguish the issuer`s U.S. investors expect higher
nationalities
returns from foreign issuers of
comparable rating with U.S.
issuers
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2. Low rated CPs are issued by U.S. Better rated CPs are issued by
issuers
issuers
3. Central Banks, Corporate funds are Money market funds are the
the investors
investors
4. Euro CP is traded in secondary Held by the investor until
market
maturity
5. Very competitive
Less competitive
6. No credit rating required
Credit rating required
7. Priced in relation to Bank rate
Priced in relation to treasury
bill, Bank CD rates
8. Time consuming process
Simple process
In recent years, the growth in the number of new issues and volume
has slowed down in Euro commercial paper markets. As a result of some
defaults, investors` concern about credit worthiness has increased
dramatically.
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A brief description about global financial institutions and
Development banks are given below
INTERNATIONAL BANK FOR RECONSTRUCTION AND
DEVELOPMENT (IBRD OR THE WORLD BANK)
The International Bank for Reconstruction and Development (the
IBRD or the World Bank) came to be established by the international
Economic Conference at Bretton Woods in July 1944. The World Bank
started functioning from June 1946.
Objectives of the World Bank
The objectives of the World Bank set forth in the Bretton Woods
Agreement are as follows:
To render assistance in the reconstruction and development of
member countries by facilitating investment of capital for
productive purposes and help restoration of economies from
enormous destruction brought about by the World War 11(1939-45)
(Reconstruction), and also to provide encouragement to the
development of productive resources of less developed countries
(hence the word 'Development' in the full title of the World Bank)
To promote private foreign investment by means such as
participation in loans or guarantee for loans made by private
investors, as also to supplement private investment by its own
(World Bank's) loans or finances.
255
To promote long-term balanced growth of international trade and
help achieve equilibrium in balance of payments position of
member countries by encouraging international investments for the
development of productive resources and thereby rendering
assistance in raising productivity, and standard of living of people
in the member-countries.
To make arrangements for loans or guarantees in respect of
international loans so that large and small useful projects are
rendered assistance.
Membership and Organisation of the World Bank
The World Bank (as also the International Monetary Fund - IMF)
had 149 members in April 1986.
All powers of the World Bank are vested in and exercised by the
Board of Governors. Each member-country sends its one Governor for a
period of 5 years. There is also an Alternate Governor. These Governors
meet once annually. For the purpose of carrying out day-to-day functions
of the World Bank, the Governors have delegated their powers to a Board
of Executive Directors who meet once every month. At present there are
22 Executive Directors-six are appointed by five member-countries
contributing the largest shares of the World Bank's capital, and 16
Executive Directors are elected by the Governors of the remaining
member-countries. These Executive Directors are elected for a period of 2
years. The President of the World Bank is also the Chairman of the Board
of Executive Directors. The voting powers of the Executive Directors are
in proportion to the capital subscribed by member- countries. The
Executive Directors are responsible for matters of policy and their
approval is necessary for all the loans by the World Bank. The day-to-day
administration of the World Bank (including making recommendations
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regarding granting of loans and recommendations regarding questions of
policy to the Executive Directors) is the responsibility of the President of
the World Bank.
The President of the World Bank is assisted by a number of Vice-
Presidents and Directors of various Departments for different regions. The
President of the World Bank carries on his duties with the assistance of
about 6,000 staff members who carry on the day-to-day routine working
of the World Bank.
Capital Structure of the World Bank
The World Bank commenced with an authorised capital of US
dollars 10 billion, divided into 1,00,000 shares of US dollars 100,000
each. Of this authorised capital, US dollars, 9,400 million were actually
subscribed.
As in June 1985, the authorised capital stock of the World Bank
comprises of 7,16,500 authorised shares of the par value of SDRl ,00,000
each. Of those 58,154 had been subscribed. Thus, the subscribed capital of
the World Bank is SDR 51,315 each. Ten percent of the subscribed capital
has been called and paid by member- countries. The remaining 90 per cent
of the authorised capital is subject to call when the World Bank requires it
to meet demand for loans or for guaranteeing loans to member-countries.
The World Bank's funding strategy or strategy for raising financial
resources follow the four basic objectives: (1) To ensure availability of
funds to the World Bank (by maintaing unutilised access of funds in
markets in which the World Bank borrows); (2) To minimise the effective
cost of loans to borrowers (through currency mix of the Bank's
borrowings); (3) To have control over volatility in net income and overall
loan charges (for which the Bank started in 1982 variable lending rates
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system that uniformly adjusts interest charges applicable to all outstanding
balance on all loans); (4) To provide appropriate degree of maturity
transformation between Bank's borrowing and lending.
Borrowing and Lending Activities of the World Bank
The World Bank gives loans primarily from its own medium and
long-term borrowings in the international capital markets and Currency
Swap Agreements (CSA). Under the CSA, proceeds of a borrowing
country are converted into a different currency and at the same time a
forward exchange agreement is executed providing for a schedule of
future exchanges of the two currencies in order to recover the currency
converted.
The World Bank can also borrow under the Discount-Note
Programme, by placing bonds and notes directly with governments of
member-countries, with government agencies and their central banks.
Also, the World Bank offers issues to investors and in public markets
through investing banking firms, commercial banks and investment banks.
The total borrowing of the World Bank under its various schemes
in the fiscal year 1984 amounted to US dollars 9.8 billion. Also, a
substantial amount of the World Bank's resources accrue from the Bank's
retained earnings and repayment of loans borrowed earlier from the World
Bank.
Lending Operations of the World Bank
Following are the ways in which the World Bank gives loans to its
member-countries :-
(i) By granting loans out of its own funds; (ii) By participating in
loans out of funds raised in the market of a member-country or otherwise
borrowed by the World Bank; and (iii) By providing guarantee in part or
258
in full for loans made by private investors through the usual investment
channels.
It is stipulated that the total amount of outstanding loans or
guarantees provided by the World Bank should not exceed 100 per cent of
the Bank's unimpaired subscribed capital, reserves and surplus.
The World Bank gives loans or its guarantees on the following
conditions:
(i) The World Bank is satisfied that in the prevailing market
conditions, the borrower is unable to obtain loans under conditions which
the Bank considers reasonable; (ii) The loans are for reconstruction or
development (except in special cirsumstances); (iii) If the central bank of
the member- country gives full guarantee for repayment of the principal,
interest on loan and Other related charges; (iv) The project for which the
loan from the World Bank is being sought is recommended by a
competent committee after a careful study in its written report; and (v)
The bonrower is in a position to meet the Bank's obligations.
The World Bank gives medium-term loans and long-term loans
usually running up to the completion of the project for which the Bank has
given the loan. Long-term loans are repayable over a period of 20 years or
less, with a grace period of 5 years. It is observed that interest rate charged
by the World Bank is calculated in accordance with guidelines related to
its (i.e. Bank's) cost of borrowing. And, therefore, the World Bank loans
carry different rates of interest. There is in addition an annual commitment
charge of 0.75 per cent per year on the outstanding balances.
The total World Bank lending during the fiscal year 1985
amounted to US dollars 11.4 billion.
259
The World Bank's Other Activities
The World Bank's other activities include items such as training,
technical assistance, inter-organisational cooperation, economic research
and studies, evaluation operations and settlement of investment disputes
among member-countries of the World Bank and the IMF.
The World Bank set up Staff College in 1958. It is known as the
Economic Development Institute (EDI). The EDI is meant for training
senior officials of developing countries. The training is in macro-
economic planning, pricing and development policies, management of
agricultural research, training in rural health care, industrial policy,
railway management and so on.
The World Bank renders technical assistance which is an integral
part of the World Bank's programme of activities. This technical
assistance is concerned with feasibility studies, engineering designs,
construction supervision, management training, and diagnostic and
institutional studies.
The World Bank also serves as executing agency in the case of
projects financed by the United Nations Development Programme
(UNDP). An important function of the World Bank concerns inter-
organisational cooperation based on formal agreements such as
cooperative programmes between the FAO, the UNESCO, the WHO, the
UNCTAD, the GATT, the United Nations Environmental Programme, the
ILO, the Asian Development Bank (the ADB), etc.
The World Bank sets aside roughly 3 per cent of its administrative
budget for economic and social research. These research programmes
started in 1971. About 165 research programmes have already been
260
completed and about 180 were in progress in 1985. The World Bank also
renders assistance to research programmes in developing member-
countries.
The World Bank helps borrowers of the Bank in post-evaluation of
the Bank-assisted projects through its Operation Evaluation Department.
The World Bank has also set up 'International Centre of Settlement
of Investment Disputes' between member-countries. For example, the
World Bank successfully solved the problem of river water dispute
between India and Pakistan and the Suez Canal dispute between Egypt
and the United Kingdom.
The World Bank and India
India is one of the founder-members of the World Bank. In that
capacity, India held a permanent seat on its Board of Executive Directors
for a number of years. That position was threatened when China applied
for membership of the World Bank.
The World Bank has been rendering substantial assistance to India
in her efforts at planned economic development. This the World Bank
does by granting loans, rendering expert advice in various spheres, and
training Indian personnel at the Economic Development Institute (which
was established to train senior officials of member-developing countries).
The World Bank has a Chief Mission at New Delhi and it conducts
on behalf of the World Bank monitoring and consultation in respect of
Bank-aided projects in India.
It needs to be emphasised that since its establishment, India
happens to be the largest recipient of the World Bank financial assistance.
The Bank since 1949 was committed to 84 loans to India totalling US
dollars.7274.7 million till June 1984. In 1984 India borrowed 1.7 billion
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US dollars from the World Bank, and 670 million US dollars from the
IDA and about 2 billion US dollars from commercial sources.
The World Bank has been rendering assistance to India in respect
of projects such as developmentof ports, oil exploration including
Bombay High, gas-power projects, coal, iron, aluminium, railway
modernisation, fertiliser plants, technical assistance and industrial
development finance.
It was at the instance of the World Bank that the Aid India
Consortium of 12 developed countries was established and it has been
helping India substantially by granting loans and other assistance. The
World Bank helped India to solve the almost intractable problem of the
Indus Water dispute with Pakistan.
Thus, India has received substantial Financial and non-financial
assistance from the World .Bank for the development of industries,
energy, transport, agriculture, etc.
262
INTERNATIONAL MONETARY FUND (IMF)
The Articles of Agreement of the IMF were formulated at Bretton
Woods in the United States in July 1944. The IMF came into existence in
December 1945 and it commenced its operations in March 1947.
The Objectives of the IMF
The following objectives of the IMF have been set forth in the
Articles of Agreement:
To promote international monetary cooperation through a
permanent institution providing the machinery for consultation and
collaboration on international monetary matters
To help bring about expansion and balanced growth of international
trade and thereby contribute to the maintenance of high levels of
employment and real income among member-countries;
To promote exchange rate stability and thus help avoid competitive
exchange rate depreciation;
To provide facilities for multilateral conversions of national
currencies and help removal of exchange controls and exchange
restrictions; and
To render help to member-countries to correct maladjustment in
their balance of payments.
The IMF aims at promoting international monetary cooperation
facilitating expansion and balanced growth of international trade thereby
helping member-countries to utilise more efficiently their productive
resources and help them to raise real income of the people in the member-
263
countries, to promote exchange rate stability and avoid competitive
exchange rate depreciation, to facilitate multilateral exchange rate system,
to help shorten duration of disequilibrium in balance of payments of
member-countries, and to create confidence among member-countries by
providing it resources for correcting maladjustment in balance of
payments thus ensuring national prosperity.
Organisation of the IMF
The organisation of the IMF is comprised of Board of Governors,
Executive Board, Managing Director, Council and staff. Its headquarter is
in Washington in the United States. In addition, there are standing and ad
hoc committees appointed by the Board of Governors and the Executive
Board. In the case of the IMF, the Board of Governors and the Executive
Board are decision-making organs. Their decisions are binding on the
member-countries of the IMF.
The Board of Governors is the Apex Body of the IMF. It is
composed of one Governor and one Alternate Governor appointed by each
member- country. The normal practice is that a member-country appoints
its finance minister or governor of its central bank as the Governor on the
Board of Governors of the IMF. The Alternate Governor appointed by a
member-country can participate in the meetings of the Board of
Governors; but he has power to vote, only if the Governor is absent from
the meeting.
The Board of Governors of the IMF meets once a year. Detailed
account of the activities of the IMF of the previous year is provided before
the meeting. Special meeting of the Board of Governors can be called by
any of the five member-countries having 25 per cent or more of the total
voting rights.
264
The Board of Governors has delegated to the Executive Board, as a
matter of practice, its major decision-making power such as making
available the imp's resources to member-countries which have made
applications for funds, review of charges and remuneration and review of
consultation between the IMF and its member-countries.
The Executive Board of the IMF has 21 members at present. Of
these five are appointed by the five member-countries having largest
quotas of subscriptions to the IMF. The rest of the members of the
Executive Board are elected for a period of 2 years by the remaining
member-countries roughly on geographical basis.
The Managing Director of the IMF is elected by the Board of
Executive Directors. He is an important international official. As
chairman of the executive Board, the Managing Director has no voting
power at the meeting of the Executive Board.
The Executive Board is the most powerful body of the IMF and
exercises vast powers conferred by the Articles of Agreement and
delegated to it by the Board of Governors. It exercises powers that relate
to financial activities as also it exercises regulatory and supervisory
powers. The Executive Board meets several times a week and may be said
to be in continuous session.
The Managing Director, in addition to acting as the Chairman of
the Executive Board of the IMF, is also responsible for the organisation
and administration of the personnel of the IMF.
Functions Performed by the IMF
It is the duty of the IMF to see that a member-country observes the
provisions of the Bretton Woods Articles of Agreement; the IMF is a sort
of guardian of 'good conduct' of member-countries in respect of their
265
balance of payments. The IMF aims at reducing trade barriers like tariff
and other international trade restrictions such as exchange controls. The
IMF sees that no member-country will without the prior permission of the
IMF impose restrictions on making payments or engage in discriminating
arrangements or practise the system of multiple exchange rate. The IMF
keeps watch on exchange rate policies adopted and followed by the
member-countries.
The IMF also gives technical advice to its member-countries on
monetary and fiscal policies and problems. It conducts research studies
and provides technical experts to member-countries facing balance of
payments problems. It also conducts short-term courses on monetary,
fiscal and balance of payments for personnel from member-countries.
Lending Operations of the IMF
The IMF is an important international institution. The financial
resources at its disposal come from quota subscriptions of the member-
countries. Also, the IMF can increase its financial resources by selling
gold to its member-countries or by borrowing from governments or
central banks of member-countries or from the Bank of International
Settlements or if need be from the OPEC.
According to the provisions of the IMF, a member-country can
borrow from the Fund by purchasing the needed foreign currencies in
exchange of its own currency up to 125 per cent of its quota. However,
during any one year, a country can borrow (i.e. purchase) foreign
currencies only up to 25 percent of its quota limit The member-country
borrowing foreign exchange from the Fund pays for it in terms of its own
currency. But the borrowing country is expected to pay back the loan in
foreign currency in which the country has borrowed (which means the
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country should buy back its currency in return of the foreign currency
which it had borrowed before).
The IMF will grant loans to member-countries to correct
disequilibrium in their balance of payments position; but such
disequilibrium must be of a temporary type (as for example, due to crop
failure on account of drought necessitating foodgrain imports of
substantial quantities).
But if disequilibrium in the balance of payments position of a
member-country is due to certain fundamental causes such as over-
valuation of its currency, under such circumstances, the IMF will not be in
a position to help the member-country by lending its financial resources,
but will advise the government of the country to bring the value of its
currency in line with value of other currencies.
Thus, the IMF gives short-term loans to member-countries to
correct temporary disequilibrium (i.e. temporary deficits) in balance of
payments position of member-countries.
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INTERNATIONAL DEVELOPMENT ASSOCIATION (IDA)
It was suggested in 1958 that a new international institution to be
known as International Development Association (IDA) be established
and administered by the World Bank.
The IDA started functioning from 8th November 1960.
Aims and Objectives of the IDA
The main objective of the IDA has been to provide financial
assistance to less developed countries (LDCs) on soft loan basis, which
means on terms imposing a lower servicing charge on loans than on
conventional loans by the World Bank to its member-countries.
In this connection, the Articles of Agreement concerning the IDA
states: ".........to promote economic development, increase productivity
and thus raise standard of living in the less developed areas of the world
included within the Association's membership, in particular by providing
finance to meet their important development requirements on terms which
are more flexible and bear less heavily on the balance of payments than
those of conventional loans, thereby furthering the development
objectives of International Bank for Reconstruction and Development and
supplementing its activities.
Thus, the IDA grants development loans on concessional and
flexible terms than World Bank loans of conventional type. These loans
from the IDA are for a period of 5 to 15 years or even more. The IDA
provides a certain percentage of the cost of a project that is meant not only
for meeting foreign exchange part of the project but also part of the cost of
the project in local currency. Many countries which are unable to borrow
from the World Bank (because their projects are not regarded as credit-
worthy by the World Bank) are financed by the IDA. For example, such
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loans of IDA are for the purpose of water supply, construction of
hospitals, housing and sanitary arrangements- objectives or projects for
which World Bank loan facilities are not available.
The IDA loans bear a much lower rate of interest than those of the
World Bank. In some cases, if warranted, IDA loans bear no interest at all
but only administrative charge levied by the IDA. In a number of cases in
recent years IDA has given loans to LDCs at ? percent rate of interest.
Another important aspect of IDA loans is that the loans can be
repaid in local currencies of borrowing countries. This ensures that the
IDA loans do not have adverse effect on balance of payments of the
LDCs.
Membership and Organisation of the IDA
It is provided that any member-country of the World Bank can
become a member of the IDA, provided that a country is ready to
subscribe to the IDA at the rate of 5 percent of its existing World Bank
share capital subscription quota. As on 30th June 1975, of the 125
member-countries of the World Bank, 114 countries were admitted as
members of IDA. Of them 10 are developed countries and 94 developing
countries.
The organisation of the IDA is similar to that of the World Bank.
Thus, IDA has its Board of Governors, Executive Directors and a
President, all of whom are holders of these positions in the World Bank.
They serve as ex-officio members in the IDA.
The initial subscription of member-countries to IDA amounted to
1,000 million US dollars. For the purpose of subscription and voting
power, member-countries of IDA are divided into two parts. Part I
consists of member-countries which are relatively more developed and
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which have paid their entire subscription quota in gold or freely
convertible currencies which IDA can use for granting loans to LDCs.
Part II consists of member-countries which are less developed; they are
required to pay only 10 per cent of their subscription quota in gold or
freely convertible currencies and the remaining 90 per cent in their own
national currencies which cannot be used by IDA for granting loans
without the previous consent of the member-country whose currency is
going to be lent. It was also conceived that the IDA would be receiving
additional financial resources from countries mentioned in Part I (i. e.
developed countries) from time to time to augment IDA's financial
resources and enable it to carry on its lending operations on a larger scale.
During 1972-74, the Part I members of the IDA provided 2,410 million
US dollars as supplementary resources. Since the establishment of the
IDA, Part I countries have provided supplementary financial resources
three times.
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ASIAN DEVELOPMENT BANK (ADB)
The World Bank had been trying to set up regional development
banks and some regional banks have been established for developing
countries in Latin America, Africa and Asia.
The Economic Commission for Asia and Far Fast (ECAFE) had
made in 1963 a suggestion for a regional development bank for Asian
countries. Representatives of the major Asian countries met at Manila in
December 1965 to finalise the proposal and the Asian Development Bank
came to be formally established in December 1966.
Objective and Functions of the ADB
The basic objective behind the establishment of the ADB is "to
promote economic development of and mutual cooperation among the
countries of Asia". The ADB's objective is 10 help accelerate the process
of economic development of developing countries in the Asian region.
To realise the objective the ADB performs the following functions :
To promote investment of public and private capital for
economic development of Asian countries;
To channelise investible funds of the ADB for the
implementation of those projects which are important for the
development of major sectors of the country's economies;
To render assistance to member-countries in coordinating
their programmes and policies of economic development and
at the same time to promote inter-regional trade and
cooperation among countries of the Asian region;
To promote technical assistance for the execution of projects;
and
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To mobilise funds for economic development of member-
countries by extending cooperation to the world Bank,
ECAFE and other United Nations bodies and public as also
private institutions located among member-countries.
Membership, Capital Resources and Organisation
The membership of the ADB is open to all countries in Asia, but
for procuring additional and substantial financial and other resources,
many developed countries of other regions are also admitted as members
of the ADB.
By the end of June 1975 , the ADB had 27 Asian members and 14
non-regional members, thus making a total of 41 members.
The authorised capital (in terms of US dollars ) of the ADB was
3366 millions US dollars as on 31 December 1974. The subscribed capital
on that date was 2770 million US dollars.
Besides subscribed capital, the ADB has also raised additional
financial resources through borrowings. By December 1973 the total
amount of outstanding borrowings by the ADB was 293 million US
dollars, about 30% of this being borrowings from Japan in yens.
At the time of the establishment of the ADB, member-countries
were asked to deposit only 50% of its subscribed capital in their national
currencies.
The Board of Governors is free to call the remainder of the
member-country's subscribed capital, whenever the ADB needs additional
funds for carrying on its lending activities.
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Some of the important non-regional members of the ADB are:
United States, the United Kingdom, West Germany, and Canada. Japan is
the principal subscriber to the ADB, apart from contributing substantial
share capital of the ADB.
Out of the total voting power, 20% has been allocated among
member-countries equally, whereas the remaining 80% has been allocated
on the basis of subscribed share capital by each member of ADB.
The management of the ADB is entrusted to the Board of
Governors constituted by representatives of the member-countries of the
ADB. The Board of Governors meets once a year, whereas for routine
decision-making and carrying on the ADB's lending and other operations,
a ten-member Board of Directors has been constituted.
In April 1974 there came to be established a fund known as the
Asian Development Fund. It is a multi-purpose fund, the proceeds of
which are to be utilised for providing concessional loans to the relatively
poorer member-countries of the ADB. Ten member-countries had
subscribed 245.4 million US dollars to the Asian Development Fund by
December 1974.
Lending Operations of the ADB
The ADB provides loans to its member-countries keeping in view
the following considerations:
(1) Larger portions of ADB loans should be given to relatively poorer
among developing countries in Asia;
(2) The government of the borrowing country has approved the loan
by ADB being given to the private or public sector enterprise;
(3) The Chairman of ADB has received a detailed report of the
project for which the ADB is to provide loan;
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(4) The ADB while giving loan also takes into consideration
prospects of loans which the applicant may receive from other
than ADB source.
(5) Generally the ADB loans are to be used within the markets of
member-countries for purchase of essential goods, etc; but the
Board of Directors with a two-third majority can allow the ADB
loan to be used in markets of non-member countries; and
(6) The ADB will function strictly keeping in view the sound
principles of banking.
During 1968-73 the ADB approved loans totalling (in terms of US
dollars) 1376 million US dollars to 21 countries for 189 projects. Of these,
industrial development projects were given a quarter of the total loans;
24% of loans were given for development of transport and communication
projects; 26.5 % for electrical power projects; 12.5% for agricultural
development projects; 11.2% for water supply projects and 1 % for
educational projects.
During 1974 the ADB sanctioned loans worth (in terms of US
dollars) 547.7 million of which 186.9 million were for industrial
development projects; 134 million for agricultural development projects;
76.55 million for power projects; and 81.5 million for transport and
communication projects. There appeared an evident shift in the sectoral
allocation of ADB's lending policy in 1974.
If the period of 1968-74 is considered, of the total loans approved,
17.5 % were given to South Korea; 12.5 % to the Phillipines; 10.63 % to
Malaysia; 9.4% to the Republic of China; and 8.5 % to Singapore. This
means that more than 50 % of the total loans sanctioned were given
during this period to East Asian countries-India did not ask for any loan
during this period; but Bangladesh received 9.5 % of the total loans during
274
this period. The ADB charges 8 ? % interest on its loans, though at the
time of its establishment the rate of interest charged was 6.78% which was
raised to 7?% in May 1970 and to 8 ? % in September 1974.
Self assessment questions
1. What is GDR? Explain the steps in isruing GDRs.
2. Explain the need for iming GDRs.
3. Explain different form forgein equity investement.
4. Explain the features of ADR.
5. Explain the feature of bond market?
6. Briefly describe the variation of global market debt
instrument.
7. What is commercial paper? What are its advantages?
8. Distinguish between euro & us cp programmes .
9. Explain the features of different types of euro bonds
10. Describe the mechanism of euro loan syndication .
11. Define cerficate of deposit . explain its types.
12. Discuss the role of world bank .
13. Explain the objectives, structure and functioning 0f
IMF.
14. What is ADB? How it renders developmental
assistance?
Suggested readings
1. International financial management ? PGApte
2. Modern investment- Russell J.Fuller and Jame L.Farnel Jr.
3. International economics, Franics Cherunilan .
4. Foreign Exchange: Practice, Concepts, & Control, C.Jeevanandam
275
UNIT ? V
LESSON - 1
COMPARISION OF DOMESTIC, FOREIGN AND EURO
MARKETS
Objective: In this lesson, we will introduce you the meaning and comparison of
domestic, foreign and euro markets. This lesson is concept based. After you
workout this lesson, you should be able to:
Know the meaning and comparison of domestic, foreign and euro
markets.
Understand the different market structures for global exposure.
FOREIGN EXCHANGE MARKET
The foreign exchange market is the market in which currencies are bought and
sold against each other. It is the largest market in the world. The most recent
Bank of International Settlement survey stated that over USD$ 900 billion were
traded worldwide each day. During peak volume periods, this figure can reach
up wards of USD$1.8 trillion per day.` This corresponds to 160(!) times the
daily volume of the NYSE. Bulk of this is accounted for by a small number of
currencies--the US dollar, Euro, Yen, Pound Sterling, Swiss franc, Canadian
dollar, and Australian dollar. Prior to the introduction of Euro in 1999,
Deutschemark held an important position.
For the month of April 2004, the survey of foreign exchange market activity
carried out by the Bank for International Settlements (BIS) reported the
following currency pair wise breakup of all foreign exchange transactions
around the world excluding inter-dealer trades:
USD/EURO: 31.82% USD/YEN: 18.81% USD/POUND: 15.56%
USD/SWISS FRANC: 4.97% USD/CANADIAN DOLLAR: 4.52%
USD/AUSTRALIAN DOLLAR: 5.7 1% USD/All Others: 18.61%
The same survey reported the following breakup for rupee-foreign currency
transactions in the Indian market:
Rs/USD: 96.23% Rs/EURO: 0.86% Rs/YEN: 2.08%
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Rs/POUND: 0.68% Rs/All Others: 0.15%
The foreign exchange market is an over-the-counter market. This means that
there is no single physical or electronic market place or an organized exchange
(like a stock exchange) with a central trade clearing mechanism where traders
meet and exchange currencies. The market itself is actually a worldwide
network of inter-bank traders, consisting primarily of banks, connected by
telephone lines and computers. While a large part of interbank trading takes
place with electronic trading systems such as Reuters Dealing 2000 and
Electronic Broking Systems, banks and large commercial i.e. corporate
customers still use the telephone to negotiate prices and consummate the deal.
After the transaction, the resulting market bid/ask price is then fed into computer
terminals provided by official market reporting service companies (net- works
such as Reuters?, Bridge Information Systems?, Telerate?). The prices
displayed on official quote screens reflect one of maybe dozens of simultaneous
dea1s` that took place at any given moment. New technologies such as the
Interpreter 6000 Voice Recognition System--VRS--which allows forex traders
to enter orders using spoken commands, are presently being tested and may be
widely adopted by the inter-bank community in the years to come. Online
trading systems have also been devised and may become the norm in the near
future. However, for corporate customers of banks, dealing on the telephone will
continue to be an important channel. Geographically, the markets span all the
time zones from New Zealand to the West Coast of the United States. When it is
3.00 p.m. in Tokyo it is 2.00 p.m. in Hong Kong. When it is 3.00 p.m. in Hong
Kong it is 1.00 p.m. in Singapore. At 3.00 p.m. in Singapore it is 12.00 noon in
Bahrain. When it is 3.00 p.m. in Bahrain it is noon in Frankfurt and Zurich and
11.00 am. in London. 3.00 p.m. in London is 10.00 am, in New York. By the
time New York is starting to wind down at 3.00 p.m. it is noon in Los Angeles.
By the time it is 3.00 p.m. in Los Angeles it is 9.00 am of the next day in
Sydney. The gap between New York closing and Tokyo opening is about 21/2
hours. Thus the market functions virtually 24 hours enabling a trader to offset a
position created in one market using another market. The five major centers of
interbank currency trading, which handle more than two thirds of all forex
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transactions, are London, New York, Tokyo. Zurich, and Frankfurt.
Transactions in Hong Kong, Singapore, Paris and Sydney account for bulk of
the rest of the market.
STRUCTURE OF THE FOREIGN EXCHANGE MARKET
Some of us are familiar with the retail market in foreign exchange. This is the
market in which travelers and tourists exchange one currency for another in the
form of currency notes or travelers` cheques. The total turnover and average
transaction size are very small. The spread between buying and selling prices is
large.
The market referred to in Section I of this chapter is the wholesale market, often
called the interbank market. The major categories of participants in this market
are commercial banks, investment institutions, non-financial corporations and
central banks. The average transaction size is very large. For example, the
average transaction in the US market was reported to be 4 million dollars with
many transactions being of much larger size.
Among the participants in this market, primary price makers or professional
dealers make a two-way market to each other and to their clients i.e. on request
they will quote a two-way price--a price to buy currency X against Y and a
price to sell X against Y, and be prepared to take either the buy or the sell side.
This group includes mainly commercial banks but some large investment dealers
and a few large corporations have also assumed the role of primary dealers.
Primary price makers perform an important role in taking positions off the hands
of another dealer or corporate customer and then offsetting these by doing an
opposite deal with another entity which has a matching requirement. Thus a
primary dealer will sell US dollars against Rupees to one corporate customer,
carry the position for a while and offset it by buying US dollars against Rupees
from another customer or professional dealer. In the meanwhile if the price has
moved against the dealer he bears the loss. For instance, he might have agreed to
buy Rupees i.e. sell dollars at a rate Rs 43.85 per dollar: by the time he covers
his position, the market may have moved so that he must acquire the dollars i.e.
sell rupees at a price of Rs 44.05 per dollar. If the transaction is for 1 million, he
loses I, 50,000 rupees. The difference between the buying and selling prices--
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the so-called bid-offer spread--provides a cushion against such losses. During
times of high volatility the spread tends to widen.
In addition, of course the spread allows banks to recover the costs of the dealing
function and make a profit. In fact, for many banks forex dealing makes a
substantial contribution to their bottom lines.
Among the primary price makers there is a kind of layering or a pyramid. A few
giant multinational banks deal in a large number of currencies, in large amounts
and often deal directly with each other with out using brokers. Their transactions
can have significant influence on the market. In the second tier are large banks
which deal in a smaller number of currencies and use the services of brokers
more often. Lastly, there are small local institutions which make market in a
very small number of major currencies against their home currency. For instance
in Mumbai, State Bank of India may make a market in say half a dozen
currencies while most other banks will deal mostly only in US dollars and Euro.
Many of the latter may have almost 100% of their deals in US dollars versus
Rupee.
In the retail market there are entities that quote foreign exchange rates but do not
make a two way market. They are secondary price makers. Restaurants, hotels,
shops catering to tourists buy foreign currency in payment of bills: some entities
specialize in retail business for travelers and buy and sell foreign currencies and
travelers` cheques. Typically their bid-ask spreads are much wider than those of
primary price makers.
Foreign currency brokers act as middlemen between two market makers. Their
main function is to pro vide information to market making banks about prices at
which there are firm buyers and sellers in a pair of currencies. A bank indicates
its willingness to buy or sell a specific amount of currency X against currency Y
at a specific price or give a price limit. The broker transmits this information to a
group of his clients via dedicated phone lines and collects a commission on
consummation of the deal. Till a deal is struck, the identities of the various
parties transmitting their orders to the broker are not revealed. Banks may also
use brokers to acquire information about the general state of the market even
when they do not have a specific deal in mind. Primary price makers may use
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brokers to show their prices to the market anonymously. By specializing in
certain pairs of currencies and maintaining constant contact with market makers
brokers tend to possess much more information than the dealers themselves. The
important thing is brokers do not buy or sell on their own account.
Finally, there are price takers who take the prices quoted by primary price
makers and buy or sell currencies for their own purposes but do not make a
market themselves. Corporations use the foreign exchange market for a variety
of purposes related to their operations. Among these are payments for imports,
con version of export receipts, hedging of receivables and payables, payment of
interest on foreign currency loans, placement of surplus funds and so forth.
Many companies, as a matter of policy, restrict their participation in the market
to transactions arising out of their business of producing and selling goods and
services. They do not take active positions in the market to profit from exchange
rate fluctuations. Others, mainly giant multinationals, utilize their considerable
financial expertise to take positions purely with the intention of generating
financial profits from exchange rate movements.
Central banks intervene in the market from time to time to attempt to move
exchange rates in a particular direction or moderate excessive fluctuations in the
exchange rate. In the case of limited flexibility systems like the EMS which
existed before the EMU came into being, or a fixed exchange rate system, these
interventions are obligatory and, when intervention limits are reached,
potentially unlimited. In other cases, though there is no commitment to defend
any particular rate, a central bank may still intervene to influence market
sentiment.
Of the total volume of transactions, about two-thirds is accounted for by
interbank transactions and the rest by transactions between banks and their non-
bank customers. This is implicit in the total turnover figure mentioned above
which is nearly ten times the value of world trade in goods and services. Thus
foreign exchange flows arising out of cross border exchanges of goods and
services account for a very small pro portion of the turnover in the foreign
exchange market.
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There is no distinct class of speculators in the foreign exchange market. Price
making banks often carry uncovered positions to profit from exchange rate
movements; so do corporations who have extensive foreign currency dealings
arising out of their operations. Financial and non-financial corporations, hedge
fund managers and even governments through their central banks often seek to
derive gains out of ex change rate movements by investing in assets
denominated in currencies which they think are going to appreciate. It is very
difficult to demarcate speculation from prudent business decisions. A non-
financial corporation which does not hedge its foreign currency export
receivable or import payable is as much a speculator as a fund manager who
moves funds out of one currency into another to profit from appreciation of the
latter currency.
TYPES OF TRANSACTIONS AND SETTLEMENT DATES
Settlement of a transaction takes place by transfers of deposits between the two
parties. The day on which these transfers are affected is called the settlement
date or the value date. Obviously, to affect the transfers, banks in the countries
of the two currencies involved must be open for business. The relevant countries
are called settlement locations. The locations of the two banks involved in the
trade are dealing locations which need not be the same as settlement locations.
Thus a London bank can sell Swiss francs against US dollar to a Paris bank.
Settlement locations may be New York and Geneva, while dealing locations are
London and Paris. The transaction can be settled only on a day on which both
US and Swiss banks are open.
Depending upon the time elapsed between the transaction date and the
settlement date, foreign exchange transactions can be categorized into spot and
forward transactions. A third category called swaps is combination of a spot and
a forward transaction (or a forward-forward swap i.e. a combination of two
forward transactions).
In a spot transaction the settlement or value date is usually two business days
ahead for European currencies and Asian currencies traded against the dollar.
Thus if a London bank sells yen against dollar to a Paris bank on Monday, the
London bank will turn over a yen deposit to the Paris bank on Wednesday and
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the Paris bank will transfer a dollar deposit to the London bank on the same day.
If State Bank of India sells dollars against Rupees to HDFC bank on a Tuesday,
on the following Thursday SBI will turn over a dollar deposit to HDFC and
HDFC will turn over a rupee deposit to SBI. The time gap is necessary for
confirming and clearing the deal through the communication network such as
SWIFT. (Note that by the two business days ahead rule, deals done on a
Thursday will be cleared the following Monday, while deals done on Friday will
have Tuesday of the following week as the value date if, Saturday and Sunday
arc bank holidays as they are in most financial centers). To reduce credit risk
(i.e. one of the parties failing to deliver on its side of the trade), both transfers
should take place on the same day. In the Dollar--Yen trade between the
London and Paris banks done on Monday, if the following Wednesday happens
to be a bank holiday in either Japan or US, the value date is shifted to the next
available business day, in this case Thursday. What about holidays in the dealing
locations? If Wednesday is a holiday in either UK or France, settlement is again
postponed to Thursday. What if Tuesday is a holiday in UK but not in France?
Then two business days would mean Wednesday for the Paris bank but
Thursday for the London bank. In such cases the normal practice is, if the Paris
bank made the market i.e. the London bank called for a quote, the value date
would be Wednesday while if London made the market it would be Thursday.
The settlement time is reduced to one business day for trades between currency
pairs such as the US dollar and Canadian dollar and US dollar and Mexican
peso.
Having understood value dates for spot transactions, let us look at value dates
for forward transactions. In a I-month (or 30 day) forward purchase of say
pounds against rupees, the rate of exchange is fixed on the transaction date; the
value date is arrived at as follows: first find the value date for a spot transaction
between the same currencies done on the same day and then add one calendar
month to arrive at the value date. Thus for a one month forward transaction
entered into on say June 20, the corresponding spot value date is June 22 and
one month forward value date is July 22, two months forward would be August
22 and so on. Standard forward contract maturities are 1 week, 2 weeks, 1, 2, 3,
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6, 9, and 12 months. The value dates are obtained by adding the relevant number
of calendar months to the appropriate spot value date. If the value date arrived at
in such a manner is ineligible because of bank holidays, then like in a spot deal,
it is shifted forward to the next eligible business day. However, there is one
important difference viz, rolling forward must not take you into the next
calendar month, in which case you must shift backward. Thus suppose a 3-
month forward deal is done on November 26. The spot date is November 28.
Adding three calendar months takes you to February 28. If February 28 is
ineligible, you cannot shift forward be cause that goes into March (assuming it is
not a leap year). It must be rolled back to February 27.
Though standard forward maturities are in whole number of months, banks
routinely offer forward con tracts for maturities which are not whole months.
Thus a corporation can enter into a forward contract for delivery say 73 days
from the date of transaction. Such contracts are called broken date or odd
date contracts. For some currency pairs, long dated forward contracts with
maturities extending out to five years are available.
A swap transaction in the foreign exchange market is a combination of a spot
and a forward in the opposite direction. Thus, a bank will buy Euros spot against
US dollar and simultaneously enter into a for ward transaction with the same
counterparty to sell Euros against US dollar. A spot 60-day Dollar--Euro swap
will consist of a spot purchase (sale) of dollars against the euro coupled with a
60day forward sale (purchase) of dollar against euro. When both the transactions
are forward transactions, we have a forward- forward swap. Thus a 1--3 month
dollar--sterling swap will consist of purchase (sale) of sterling versus dollars
one month forward coupled with a sale (purchase) of sterling versus dollars
three months forward. The uses of spot-forward and forward-forward swaps are
discussed in the next chapter. As the term swap implies, it is a temporary
exchange of one currency for another with an obligation to reverse it at a
specific future date. Forward contracts without an accompanying spot deal are
known as outright forward con tracts to distinguish them from swaps.
It has been estimated that about 40% of the turnover in the market is in the spot
segment, 50% in swaps and the rest in outright forward contracts. Outright
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forwards are most often used by corporations to cover their transactions
exposures.
Short date transactions are transactions which call for settlement before the spot
date. Cash transactions are for settlement same day while some deals will
involve settlements tomorrow i.e. one business day ahead when a spot deal
would be settled two business days later.
EXCHANGE RATE QUOTATIONS AND ARBITRAGE
An exchange rate between currencies A and B is simply the price of one in
terms of the other. It can be stated either as units of B per unit of A or units of A
per unit of B. In stating prices of goods and services in terms of money, the most
natural format is to state them as units of money per unit of the good--rupees
per litre (or per gallon or whatever) of milk--rather than as units of a good per
unit of money. When it is two monies, either way would be equally natural. The
choice of a unit is also a matter of convenience. (Price of rice is given in
rupees per kilogram in the retail market and rupees per quintal in wholesale
markets).
Before proceeding let us clarify the way we will designate the various currencies
in this book. The International Standards Organization has developed three letter
codes for all the currencies which abbreviate the name of the country as well as
the currency. These codes are used by the SWIFT network which affects inter-
bank funds transfers. Depending upon the context we will either use the full
name of a currency such as US dollar, Swiss franc, Pound sterling, etc. or the
ISO code. A complete list of ISO codes is given at the end of this book. Given
below are the codes for selected currencies which will be frequently used in the
various examples.
USD: US Dollar
EUR: Euro
GBP: British Pound
IEP: Irish Pound (Punt)
JPY: Japanese Yen
CHF: Swiss Franc
CAD: Canadian Dollar
AUD: Australian Dollar
SEK: Swedish Kroner
MEP: Mexican Peso
DKK: Danish Kroner NZD: New Zealand Dollar
INR: Indian Rupee SAR: Saudi Riyal
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Further, unless otherwise stated, Dollar will always mean the US dollar;
pound or sterling will always denote the British pound sterling and rupee
will invariably mean the Indian rupee. We will frequently use just the symbols
$, i and v to designate the USD, the GBP and the JPY respectively.
Spot Rate Quotations
In foreign exchange literature one comes across a variety of terminology which
can occasionally lead to unnecessary confusion about simple matters. You will
hear about quotations in European Terms and quotations in American Terms.
The former are quotes given as number of units of a currency per US dollar.
Thus EUR 1.0275 per USD, CHF 1.4500 per USD, INR 46.75 per USD are
quotes in European terms. Quotes in American terms are given as number of US
dollars per unit of a currency. Thus USD 0.4575 per CHF, USD 1.3542 per GBP
are quotes in American terms. The prevalence of this terminology is due to the
common practice mentioned above of quoting all exchange rates against the
dollar.
You will occasionally come across terminology such as direct quotes and
indirect quotes. (The latter are also called reciprocal or inverse quotes). In any
country, direct quotes are those that give units of the currency of that country
per unit of a foreign currency. Thus INR 46.00 per USD is a direct quote in
India and USD 0.98 10 per EUR is a direct quote in the US. Indirect or
reciprocal quotes are stated as number of units of a foreign currency per unit of
the home currency. Thus USD 2.2560 per INR 100 is an indirect quote in India.
Notice here that the unit for rupees is 100s. Similarly, for currencies like
Japanese Yen, Indonesian Rupiah, quotations may be in terms of 100 yen or 100
Rupiah. (The reason is otherwise we will have to deal with very small numbers).
The notational confusion can get further compounded when we have to deal
with two-way, bid-ask quotes for each exchange rate.
The Mechanics of Inter-bank Trading
As discussed above the main actors in the forex markets are the primary market
makers who trade on their own account and make a two-way bid-offer market.
They deal actively and continuously with each other and with their clients,
central banks and sometimes with currency brokers. In the process of dealing,
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they shift around their quotes, actively take positions, offset positions taken
earlier or roll them forward. Their performance is evaluated on the basis of the
amount of profit their activities yield and whether they are operating within the
risk parameters established by the management. It is a high tension business
which requires an alert mind, quick reflexes and the ability to keep one`s cool
under pressure.
The purpose of this section is to briefly outline the mechanics of actual currency
trading as practiced by the primary market makers. We wish to give the reader a
flavour of the various dimensions involved in operating in this huge, fast
changing and often extremely volatile global market. For more details the reader
can consult specialist texts such as Bishop and Dixon (1992), Luca (1995), Roth
(1996) and Taylor (1997). Even then, keep in mind that the only way to learn all
the intricacies of forex dealing is to actually do it.
Inter-bank dealing. We have said that primary dealers quote two-way prices
and are willing to deal on either side i.e. buy or sell the base currency upto
conventional amounts at those prices. However, in inter-bank markets, this is a
matter of mutual accommodation. A dealer will be shown a two-way quote only
if he or she extends that privilege to fellow dealers when they call for a quote.
Communications between dealers tend to be very terse. A typical spot
transaction would be dealt as follows:
Monday, September 21 10.45 am
BANK A: Bank A calling. DLR--CHF 25 please.
BANK B: Forty--Forty-five
(Bank B is specifying a two-way price--the price at which it will buy a US
dollar against Swiss franc and the price at which it is willing to sell a US dollar.
Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only
the last two decimals of the full quotation. For instance the full quotation might
be 1.5540/1.5545. Bank B will pay CHF 1.5540, its bid rate, when it buys a
dollar and will want to be paid CHF 1.5545. Its ask rate when it sells a dollar.
The last two decimals amount to hundredths of a hundredth and are called
points or pips in the forex jargon. The difference between the selling and
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buying price 0.0005 or 5 pips is the bid-ask spread. If the caller had been a
corporate customer, the dealer would have given the full quote.)
BANK A: Mine
(Bank A dealer finds bank B`s price acceptable and wishes to buy USD 25
million. She conveys this by saying mine i.e. I buy the specified quantity at
your specified price. If she wished to sell, she might have said Yours.)
BANK B: OK. I sell you USD25 million against CHF at 1.5545 value 23
September. UBS Geneva for my CHF.
(Bank B confirms the quantity, price and settlement date, It also specifies where
it would like its CHF to be transferred.)
BANK A: CITIBANK NYK for my dollars. Thanks & Bye
Bank B has been hit on it`s ask side i.e. the caller, bank A wished to buy
dollars.
When a dealer A calls another dealer B and asks for a quote between a pair of
currencies, dealer B may or may not wish to take on the resulting position on his
own books. If he does, he will quote a price based on his information about the
current market and the anticipated trends and take the deal on his own books.
This is known as warehousing the deal. If he does not wish to warehouse the
deal, he will immediately call a dealer C, get his quote and show that quote to A.
If A does a deal, B will immediately offset it with C. This is known as back-to-
back dealing. Normally, back-to-back deals are done when the client asks for a
quote on a currency which the dealer does not actively trade.
These days in the inter-bank market deals are mostly done with computerized
dealing systems such as Reuters. Real time information on exchange rates is
provided by a number of information services including Reuters, Bridge, and
Bloornberg.
Since most of the trading takes place between market making banks, it is a zero-
sum game i.e. gains made by one trader are reflected in losses made by another.
However, when central banks intervene, it is possible for banks as a group to
gain or lose at the expense of the central bank.
For dealing with their corporate customers, banks have corporate dealers who
are the contact points for the bank`s corporate customers. A corporate treasurer
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who needs to buy or sell foreign currency or just get a feel for the market would
contact a corporate dealer probably on the phone and ask for a quotation. The
corporate dealer will in turn request the bank`s inter-bank dealer on the
appropriate desk to provide a rate quotation which will be transmitted back to
the corporate client. Corporate dealers are generally not allowed to carry
positions; they must pass the positions to the appropriate inter-bank desk.
Exhibit 1 shows a schematic picture of corporate transactions with the bank. For
trade related purchases and sales, or other inward or outward forex remittances
corporate clients would contact import/export desks or non-trade remittance
desks who in turn contact the corporate forex dealer as shown in Exhibit (i).
Exhibit (i)
Corporate client of
Corporate forex
Inter-bank desk of
Bank A
desk of Bank A
Bank A
The Inter-Bank
Market
Bulk of the trading in convertible currencies takes place against the US dollar.
Thus quotations for Euro, Swiss francs, Yen, Pound Sterling, etc. will be
commonly given against the US dollar. If a corporate customer wants to buy or
sell Yen against Swiss franc, a cross-rate will be worked out from the USD/CHF
and USD/JPY quotation as explained in a later section. One reason for using a
common currency (called the vehicle currency) for all quotations is to
economize on the number of quotations. If n currencies are being traded, having
a quote for each pair will require n(n-1)/2 exchange rates.
Exhibit (ii)
Corporate desk
of Bank A
Corporate
Export/Import
Client
desks
Outward/Inward
288
remittances
(non-trade desk
With 10 currencies, 45 two-way quotes will be needed. By using a common
currency to quote against, the number is reduced to 9 or, in general. (n -1).
Also, by this means the possibility of triangular arbitrage (see below) is
minimized. However, some banks specialize in giving these so-called cross
rates. As we will see below, they can operate with a smaller bid-ask spread
provided there is sufficient turnover of business in the currency pair concerned.
In an ordinary foreign exchange transaction, no fees are charged. The bid-ask
spread itself is the transaction cost. Also, unlike the money or capital markets,
where different rates of interest are charged to different borrowers depending on
their creditworthiness, in the wholesale foreign exchange market no such
distinction is made. Default risk--the possibility that the counter-party in a
transaction may not deliver on its side of the deal--is handled by prescribing
limits on the size of positions a trader can take with different corporate
customers. In some cases, a bank may decline to do a deal with a corporation (or
even other bank) if it cannot assess the latter`s credit risk.
Communications pertaining to international financial transactions are handled
mainly by a large network called Society for Worldwide Inter-bank Financial
Telecommunication (SWIFT). This is a non-profit Belgian cooperative with
main and regional centers around the world connected by data transmission
lines. Depending on the location, a bank can access a regional processor or a
main center which then transmits the bank`s instructions and any relevant
information to the appropriate location.
Banks sometimes employ services of a currency broker to execute a deal. The
main advantage of dealing through a broker is anonymity. A bank dealer can
show his or her prices to the market without revealing the identity of the bank.
A broker receives orders from many clients who specify the prices at which they
are willing to buy or sell a currency and the amounts. Normally these are limit
prices i.e. a bank will specify the highest price it is willing to pay to buy a
289
currency or the lowest price at which it is willing to sell a currency. From among
these, the broker will announce the highest buying price (highest bid) and lowest
selling price (lowest offer) to all his clients without revealing the identity of the
parties who are willing to deal at those prices. A client wanting to buy a
currency can accept the best offer price currently available. Join the queue at
the best bid price currently shown or improve upon the highest bid currently
shown. Thus suppose a broker has conveyed the best GBP/USD bid as 1.5665
and best offer as 1.5680. If a dealer wishes to buy GBP, he can
(a) Accept the offer price of 1.5680. This guarantees immediate
execution.
(b) Or he can join the bid at 1 .5665. His order will get priority after all
earlier bids at that price have been processed.
(c) Or he can improve the bid to 1.5670. This has better chance of
execution. In recent times electronic broking has been gradually
replacing the traditional voice brokerage services.
Arbitrage in Spot Markets
Arbitraging between banks: Though one often hears the term market rate, but
it is not true that all hanks will have identical quotations for a given pair of
currencies at a given point of time. The rates will be close to each other but it
may be possible for a corporate customer to save some money by shopping
around. Let us explore the possible relationships between quotes offered by
different banks.
1. Suppose banks A and B arc quoting:
A
B
GBP/USD: 1 .4550/1 .4560
1.4538/1.4548
We will represent this as:
.____________ . Bank A
bid
ask
.____________ . Bank B
bid
ask
Obviously such a situation gives rise to an arbitrage opportunity.` Pounds can be
bought from B at $1 .4548 and sold to A at $1 .4550 for a net profit of $00002
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per pound without any risk or commitment of capital. One of the basic tenets of
modern finance is that markets are efficient and such arbitrage opportunities will
be quickly spotted and exploited by alert traders. The result will be, bank B will
have to raise its ask rate and/or A will have to lower its bid rate. The arbitrage
opportunity will disappear very fast. In fact, in the presence of profit-hungry
arbitragers. such an opportunity will rarely emerge in the first place.
2. Now suppose the quotes are as follows:
A
B
GBP/USD: 1.4550/1.4560
1.4545/1.4555
These can be represented as:
.____________ . A
.____________ . B
Thus the two quotes must overlap to prevent arbitrage. However, now bank A
will find that it is being hit on its bid side much more often i.e. it will he faced
with many more sellers of pound sterling than buyers while B will find that it is
con fronted largely with buyers of pound sterling and few sellers.
From time to time, a bank may deliberately move its quote in a fashion designed
to discourage one type of deal and encourage the opposite deal. Thus bank A
may have built a large net short position in sterling and may now want to
encourage sellers of pound and discourage buyers. Bank B may be in a reverse
position; it wants to encourage buyers and discourage sellers of sterling. Thus
regular clients of bank A wanting to buy pounds can save some money by going
to B and vice versa.
In practice, most corporations will not shop around to make a gain of a few
points unless the amount involved is very large. Customers who flit from bank
to bank in search of tiny savings often find that when it comes to executing a
complex transaction, no bank is willing to give them the kind of service that it
would give to its more loyal` customers. Also, even in routine foreign exchange
transactions, regular customers get better rates. Nevertheless, it is a good idea to
do some comparison shopping from time to time to keep the bank on is toes.
Inverse quotes and two-point arbitrage Consider the spot quotation:
USD/CHF: 1.4955/1.4962
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Suppose this is a quote available from a bank in Zurich. At the same time, a
bank in New York is offering the following spot quote:
CHF/USD: 0.6695/0.6699
Is there an arbitrage opportunity? Suppose we buy one million Swiss francs
against dollars from the Zurich bank and sell them to the New York bank. The
Zurich Bank will give CHF 1.4955 for every dollar it buys. It will cost us
$(l,000,000/l .4955) i.e. $6,68,700 to acquire the Swiss francs. In New York, the
bank will give $06695 for every CHF it purchases. Thus CHF I million can be
sold to the New York bank for $(0.6695 x 1000000) i.e. $6,69,500. We can
make a risk less profit of $800 with a couple of phone calls! Obviously, the
CHF/USD rates implied by the Swiss bank`s USD/CHF quotes and the New
York bank`s CHF /USD quotes are out of line.
Recall that (CHF/USD)ask is the rate that applies when the bank sells Swiss
francs in exchange for dollars. But this is precisely the deal we did with the
Zurich bank and for each Swiss franc we bought we had to pay $(l/l.4955)
which is nothing but l/(USD/CHF)bid. In the same way, the (CHF/USD)bid
implied by the Swiss bank`s IJSD/CHF quotes is l/(USD/CHF)ask. Thus we have
Implied (CHF/USD)bid = l/(USD/CHF)ask
Implied (CHF/USD)ask = l/(USD/CHF)bid
To prevent arbitrage, the New York bank`s (CHF/USD) quotes must overlap the
(CHF/USD) quotes implied by the Swiss bank`s quotes. The latter work out to
0.6684/0.6687. A CHF/USD quote such as 0.6686/0.6690 will not lead to
arbitrage though it may lead to a one-way market for the banks. The rates
actually found in the markets will obey the above relations to a very close
approximation.
The arbitrage transaction described above viz, buying a currency in one market
and selling it at a higher price in another market is called Two-Point
Arbitrage. Foreign exchange markets very quickly eliminate two-point
arbitrage opportunities if and when they arise.
Cross-rates and three-point arbitrage A New York bank is currently offering
these spot quotes:
USD/JPY: 110.25/111.10
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USD/AUD: 1.6520/1.6530
At the same time, a bank in Sydney is quoting:
AUD/JPY: 68.30/69.00
Is there an arbitrage opportunity? Consider this sequence of transactions:
(1) Sell Yen, buy US dollars and then sell US dollars and buy Australian
dollars. Do both these transactions in New York and
(2) Sell the Australian dollars for Yen in Sydney. The calculations are:
(Subscripts N and S denote rates in New York and Sydney respectively)
1 Yen sold in New York gets US${l/(USD/JPY)ask(N)1 = US$(1/111.10)
US$ [1/(USD/JPY )ask(N)] sold against AUD gets AUD {[1/(USD/JPY)ask(N)] (
USD/AUDbid(N)) } = AUD (l/111.l0)(l.6520)
And finally the amount of Yen obtained by selling AUD in Sydney is
?{[1(USD/JPY)ask(N)] (USD/AUD)bid(N)(AUD/JPY bid(S) }
= ? (1/111.10)(1.6520)(68.30) = ?1.0156
A risk-less profit of ?0.0156 per Yen. On a 100 million Yen, that implies a
profit of 1.56 million Yen, and 100 million Yen is considerably less than the
average size of transactions in the inter-bank market in a trading center like New
York.
Once again, the reason is that the AUD/JPY cross-rate implied by the USD/JPY
and USD/AUD rates in New York is out of line with the direct AUD/JPY rate
quoted by the Sydney bank. No arbitrage condition requires:
1
X (USD/AUD)
(USD/JPY)
bid(N) X (AUD/JPY) bid(S) 1
(i)
ask(N)
(Here we have added the subscripts (N) and (S) to denote rates in New York and
Sydney respectively. The reason for this will become apparent shortly.)
In other words
(USD/JPY)
(AUD/JPY)
ask(N)
bid(S)
(ii)
(USD/JPY)bid(N)
But recall from our discussion of inverse rates that
[1/(USD/AUDbid(N)] = (AUD/USD)ask(N)
Hence inequality (ii) implies
(AUD/JPY)bid(S) (USD/JPY)ask(N) X (AUD/USD)ask(N)
(iii)
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Now consider arbitrage in the reverse direction. Take a USD, buy Yen in New
York, sell Yen for AUD in Sydney and sell AUD for USD in New York. No
arbitrage profit condition means that you should not end up with more than one
dollar. This implies
1
1
(USD/JPY)bid(N) X
X
1
(iv)
(AUD/JPY)
(USD/JPY)
ask(S)
ask(N)
Recall once again that
l/(USD/AUD )ask(N) = (AUD/USD)bid(N)
So that equation (iv) can be rewritten as
(AUD/JPY)ask(S) (USD/JPY)bid(N) x (AUD/USD)bid(N) (v)
Instead of New York and Sydney we could simply have imagined two banks
quoting Yen versus AUD, one giving rates directly while the other giving the
rates derived from the USD/JPY and USD/AUD rates. The no arbitrage
conditions (iii) and (v) simply give us upper and lower bounds on the direct rates
in terms of the synthetic rates. To understand this clearly let us see how a
synthetic pair of AUD/JPY quotes is derived.
The synthetic (AUD/JPY)bid refers to a transaction in which the bank ends up
with AUD and the customer with JPY. This can be viewed as the end result of
two transactions:
1. In step one, the customer sells AUD and buys USD.
2. In step two, the customer sells USD acquired in step one and gets JPY.
Starting with AUD 1, the customer will get USD [1/(UDS/AUD)ask] in step one;
in exchange for this, in step two, the customer will get:
? {[1/{USD/AUD}ask] X (USD/JPY)bid}
Thus
Synthetic (AUD/JPY)ask = (USD/JPY)ask x (AUD/USD)ask
(vi)
This work as if AUD/JPY = (USD/JPY) *(AUD/USD)
Synthetic (AUD/JPY)ask = (USD/JPY)ask x (AUD/USD)ask
(vii)
Now notice that the right hand side of (vi) is same as (v) and that of (vii) is
identical to that of (iii).
Thus the no-arbitrage conditions say that
Direct (AUD/JPY)bid Synthetic (AUD/JPY)ask
(viii)
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Direct (AUD/JPY)ask Synthetic (AUD/JPY)bid
(ix)
Diagrammatically, these inequalities mean that we cannot have either of the
following situations:
Synthetic
Synthetic
.____________ . .____________ .
bid
ask
bid
ask
.____________ .
.____________.
bid
ask
bid
ask
direct direct
This is a familiar condition. Whenever there are two sets of quotes for a pair of
currencies, to prevent arbitrage they must overlap.
The term three-point arbitrage refers to the kind of transactions we described
above. Start with currency A, sell it for B, sell B for C and finally sell C back for
A ending up with more A than you began with. Efficient foreign exchange
markets do not permit riskless arbitrage profits of this kind. This is an instance
of the well known maxim in economics viz, there is no such thing as a free
lunch.
Notice that the synthetic cross rates between any pair of currencies X and Y,
calculated from the rates of these two currencies against a third currency Z,
impose only lower and upper limits on the rates a bank which is directly making
a market between X and Y may quote. In other words, a situation like the
following is perfectly acceptable: Synthetic
.____________ .
.____________ .
Direct
In fact you must have realized that in computing the synthetic (GBP/CAD) rates,
the bid-ask spreads in the (USD/CAD) and (GBP/USD) quotes are being
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compounded. A bank which specializes in making a CAD-GBP market can give
direct quotes with narrower spread provided it has a sufficiently large volume of
business in the two currencies.
LESSON - 2
HEDGING & SPECULATION
Objective: In this lesson, we will introduce you the meaning of hedging and
speculation. This lesson is based on international market structure. After you
workout this lesson, you should be able to:
Know the meaning hedging and speculation.
Understand the application of hedging and speculation in the global
market.
USING THE FORWARD MARKETS FOR HEDGING TRANSACTIONS
EXPOSURE
In the normal course of business, a firm will have several contractual exposures
in various currencies maturing at various dates. The net exposure in a given
currency at a given date is simply the difference between the total inflows and
total outflows to be settled on that date. Thus suppose Fantasy Jewelry Co. has
the following items outstanding:
Item
Value
Days to maturity
I.
USD receivable
800,000
60
2.
EUR payable
2,000,000
90
3.
USD interest payable
100,000
180
4.
USD payable
200,000
60
5.
USD purchased forward
300,000
60
6.
USD loan instalment due
250,000
60
7.
EUR purchased forward
1,000,000
90
Its net exposure in USD at 60 days is
(800,000 + 300,000) -- (200,000 + 250,000) = + USD 650,000
Whereas, it has a net exposure in EUR of -1,000,000 at 90 days.
The use of forward contracts to hedge transactions exposure at a single date is
quite straightforward. A contractual net inflow of foreign currency is sold
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forward and a contractual net outflow is bought forward. This removes all
uncertainty regarding the domestic currency value of the receivable or payable.`
Thus in the above example, to hedge the 60-day USD exposure Fantasy Jewelry
Co. can sell forward USD 650,000 while for the EUR exposure it can buy EUR
1,000,000 90 days forward.
What about exposures at different dates? One obvious solution is to hedge each
exposure separately with a forward sale or purchase contract as the case may be.
Thus in the example, the firm can hedge the 60-day USD exposure with a
forward sale and the 180-day USD exposure with a forward purchase. Is it
possible to hedge multiple exposures in a given currency with a single forward
contract? In the appendix we show that this can be done provided either interest
rate for various maturities are known with certainty or contracts known as
Forward Rate Agreements are available which permit a firm to lock in
borrowing or lending rates for future periods.
The Cost of a Forward Hedge
An important and often misunderstood concept is that of cost of forward
hedging. It is a common fallacy to claim that the cost of forward hedging is the
forward discount or premium. (If the foreign currency is sold at a discount, the
discount is claimed to be the cost of the hedge; if it is bought at a premium,
the premium is regarded as the cost. On this view, premium gained on forward
sale or discount obtained on forward purchase is a negative cost or a gain).
The genesis of this fallacy is in the accounting procedure used to record
transactions denominated in foreign currency and for which a forward hedge is
used. Suppose an Indian firm buys equipment worth Euro 1,000,000 from a
German supplier on 90-day credit. The account payable is then valued at today`s
spot rate which is say Rs 52.50. The firm covers the payable with a 90-day
forward purchase of Euros at a premium of say Rs 0.20 i.e. the 90-day forward
offer rate is Rs 52.70 per Euro. The firm has to pay Rs 52,700,000 to settle the
payable valued at Rs 52,500,000. In recording this transaction, the following
entries are made:
A/C Payable
52,500,000
Forward Loss
200,000
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Bank Account
52,700,000
Thus the premium paid is recorded as the cost of forward cover. By the same
logic, if the Euro had been at a forward discount, cost of forward cover would
have been negative. However, this is a conceptually erroneous way of
interpreting cost of forward cover.
The point is, the forward hedge must be compared not with today`s spot rate but
the ex-ante value of the payable if the firm does not hedge. Since the latter is
unknown today, the relevant comparison is between the forward rate and the
expected spot rate on the day the transaction is to be settled. The expected cost
of forward hedge for the above Indian firm is given by
F?(EUR/INR)ask -- S (EUR/INR) sk
Where the notation S denotes the spot rate expected to rule 90-days from
today.
If speculators are risk neutral and there are no transaction costs, F t,T = Set,T
i.e., the forward rate at time t for transactions maturing at T equals the
expectation at time t, of the spot rate at time T. In this case, the expected
cost/gain from forward cover is zero.
What if the speculators in the foreign exchange market are not risk neutral? In
this case we have
F t,T > Set,T
F t,T < Set,T
i.e., the former when speculators are on balance forward sellers and the latter
when they are net forward buyers. The argument here is that speculators will
demand a risk premium for assuming the risk of an uncertain future spot rate.
Even in this case the expected cost of hedging is zero. This is because the
hedgers are passing on the risk to the speculators and the risk premium paid is
the price of risk avoidance. The forward rate is the market`s certainty equivalent
of the uncertain future spot rate. This can be understood as follows. Suppose the
current USD/INR spot rate is 45.00 and the three month forward is 45.75. If you
take an uncovered long position in the forward contract, you would gain--the
bank which sells you the forward contract would lose--if the spot three months
later turns out to be greater than 45.75 and you would lose--the bank would
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gain--if it turns out to be below 45.75. If the forward rate quoted by the bank is
inordinately high, say Rs 60, so that the probability of your gaining is very
small, you would demand an upfront payment for taking a long position;
similarly if it is ridiculously low, say Rs 20, the probability of the short side
gaining is very low and the bank would demand upfront compensation. The
actual forward rate is such that risk adjusted gains equal risk adjusted losses so
that the forward contract has zero value--neither the buyer nor the seller
demands any payment at the initiation of the contract.
Hence presence of risk premium does not invalidate the contention that the
expected cost of forward hedging is zero. Transaction costs are a different
matter. As we have seen, the bid-ask spreads are generally wider in the forward
segment than in the spot segment so that even if there is no risk premium
Ft,T (EUR/INR)ask > St,T (EUR/INR)ask
and
Ft,T (EUR/INR)bid > St,T (EUR/INR)bid
Thus the only cost of a forward hedge is the larger spread in the forward market
compared to the spot market. The extent of the difference depends on the
relative depth of the two markets. For transactions between the major
convertible currencies, the short-maturity forward markets are nearly as deep as
the spot markets and the difference in spreads tends to be quite small.
The accounting problem mentioned above arises because the invoice amount is
converted into domestic currency at today`s spot rate. The correct procedure is
to use the forward rate for this purpose.
It must be emphasized that forward hedging of contractual exposures does not
stabilize a firm`s cash flows. Suppose an Indian exporter who has continuing
exports to the USA invoices his exports in US dollars and maintains US dollar
prices so as to retain its competitive position in the US market. Each USD
receivable is sold forward. The firm`s rupee cash flows will then fluctuate as the
USD/INR forward rate fluctuates; if it does not hedge, the fluctuations in the
cash flow will be proportional to the changes in the spot rate. Empirically, the
volatility of the forward rate is not significantly less than the spot rate. It could
also remove its contractual exposure by invoicing each shipment in rupees on
some kind of a cost-plus basis. Now, the dollar prices will fluctuate and so will
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the firm`s export volume and market share. Thus hedging a contractual exposure
just removes the uncertainty regarding the home currency value of that
particular item; it cannot stabilize the firm`s cash flows or profits.
HEDGING WITH THE MONEY MARKET
There is a close connection between Euro deposit markets and forward ex
change premiums and discounts on account of covered interest arbitrage. Firms
which have access to inter national money markets for short-term borrowing as
well as investment, can use the money market for hedging transactions
exposure.
Suppose a US firm has a 90-day Euro receivable of EUR 10,000,000. It
has access to Eurodeposit markets in EUR as well as USD. To cover this
exposure it can execute the following sequence of transactions:
1.
Borrow EUR in the London money market for 90 days.
2.
Convert spot to USD
3.
Use the proceeds in its operations e.g. to pay-off a short-term
bank loan or finance inventory.
4.
When the receivable is settled, use it to pay-off the EUR loan.
Suppose the rates are as follows:
EUR/USD Spot: 1.1062/70 90-day forward: 1.0990/1.1045
1
1
EUR interest rates: 5 / 5
4
2
3
Euro$ interest rates: 4 / 5.00
4
You can check that these rates do not imply a covered interest arbitrage
opportunity. Let us compare forward cover against the money market
cover.
With forward cover, each EUR sold will give an inflow of USD 1.0990 days
later. The present value of this (at 4.75% p.a.) is
1.0990/ [l + (0.0475/4)] = USD 1.0861
To cover using the money market, for each EUR of receivable, borrow EUR
1/Fl + (0.055/4] = EUR 0.9864. Sell this spot to get USD(0.9864 x 1.1062) =
USD 1.0911.
Pay-off the EUR loan when the receivable matures.
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Thus with money market cover, there is a net gain of USD 0.0051
per EUR of receivable or USD 51000 for the 10 million Euro
receivable.
Sometimes the money market hedge may turn out to be the more economical
alternative because of some constraints imposed by governments. For instance,
domestic firms may not be allowed access to the Euromarket in their home
currency or non-residents may not be permitted access to domestic money
markets. This will lead to significant differentials between the Euromarket and
domestic money market interest rates for the same currency. Since forward
premia/discounts are related to Euromarket interest differentials between two
currencies, such an imperfection will present opportunities for cost saving.
HEDGING WITH CURRENCY OPTIONS
Currency options provide a more flexible means to cover transactions exposure.
A contracted foreign currency outflow can be hedged by purchasing a call
option (or selling a put option) on the currency while an inflow can be hedged
by buying a put option. (Or, writing a call option. This is a covered call
strategy).
Options are particularly useful for hedging uncertain cash flows i.e. cash flows
that are contingent on other events. Typical situations are:
1. International tenders: Foreign exchange inflows will materialise only if
the bid is successful. If execution of the contract also involves purchase
of materials, equipment, etc. from third countries, there are contingent
foreign currency outflows too.
2. Foreign currency receivables with substantial default risk or political
risk e.g., the host government of a foreign subsidiary might suddenly
impose restrictions on dividend repatriation.
3. Risky portfolio investment: A fund manager say in UK might hold a
portfolio of foreign stocks/bonds currently worth say CHF 50 million,
which he is planning to liquidate in six months time. If he sells CHF 50
million forward and the portfolio declines in value because of a falling
Swiss stock market and rising interest rates, he will find himself to be
over-insured and short in CHF.
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We will discuss a few more examples of the use of options. We will particularly
focus on the comparison of options with forward hedge both with reference to
an open position. We will also illustrate some tailor-made hedges with option
combinations and exotic options such as barrier options.
On June 1, a UK firm has a CHF 5,00,000 payable due on September 1.
The market rates are as follows:
GBP/CHF Spot: 2.8 175/85
90-day Swap points: 60/55
September calls with a strike of 2.82 (GBP/CHF) are available for a premium of
0.20p per CHF. We will evaluate the forward hedge versus purchase of call
options both with reference to an open position. The strike price is equivalent to
GBP 0.3546 per CHF.
1. Open Position
Suppose the firm decides to leave the payable unhedged. If at maturity the
CHF/GBP spot rate is ST, the sterling value of the payable is (S.OO. In Figure
13.1 this appears as a straight line through the origin.
2. Forward Hedge
If the firm buys CHF 5,00,000 forward at the offer rate of CHF 2.8 130 per GBP
or ?0.3557 per CHF, the value of the payable is ?(500,000 x 0.3557) =
?1,77,850.
3. A Call option
Instead the firm buys call options on CHF 500,000 for a total premium expense
of ?1,000. At maturity, its cash outflow will be
? [(500,000) ST + 1025] for ST 0.3546
and ? [(500,000)(0.3546) + 1025] = ?178,325 for ST 0.3546
We have assumed here that the premium expense is financed by a 90-day
borrowing at 10%.
Open position and forward hedge are equivalent if the maturity CHF/GBP spot
rate equals the forward rate at the beginning viz. 0.3557. If it is higher, the firm
is better off with a forward hedge than with an open position, if lower, open
position would have been better.
Call option and open position are equivalent when
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(500,000) ST = (0.3546)(500,000) + 1025
i.e. when ST = 0.3567. At higher values, call option is better. Call option and
forward are equivalent when
(500,000) ST 1025 = (0.3575)(500.000)
i.e. when ST = 0.3537. At lower values than this the option alternative is better
because of its one-way privilege - the firm can buy CHF in the spot market
letting the option lapse.
Gains and Losses form Alternative Hedging Strategies
The call option becomes attractive relative to an open position for values of ST
beyond 0.3567. Relative to the forward hedge, the call option is better if the
CHF depreciates below 0.3537. The maximum gain from the forward hedge,
relative to the call is
(500,000XO.3546) + 1025 -- (0.3557)(500,000) = ?475
Where as, if the CHF depreciates sharply, call option can result in substantial
savings. For in stance at ST = 0.3520, saving from the call over the forward is
?825.
Thus whether the firm should choose the call option strategy, the forward hedge
or leave the exposure unhedged depends upon the view it takes of future spot
rate. It might do a probabilistic mean-variance analysis to compare the forward
hedge with the call if it can assign subjective probabilities to future values of the
spot rate. Thus suppose its forecast of ST can be summarised as follows:
ST
Probability
0.3557
0.60
0.35 10
0.30
0.3590
0.10
The firm considers the most probable value of maturity spot to be equal to the
current forward rate. But it thinks that there is a 30% chance of a very sharp
depreciation of the CHF (possibly because it thinks that the Swiss central bank
is shortly going to cut interest rates to stimulate the economy) and a 10% chance
of a very sharp appreciation. The expected cost with a forward hedge, relative to
an open position is then higher by ?540 and its standard deviation is 1279.6. For
an option, the expected cost is lower by ?475 with a standard deviation of 602.5.
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Thus in the mean-variance framework, call option should be the preferred choice
because of its smaller expected cost and smaller variance. If however, the
probabilities are changed to 0.60, 0.20 and 0.20, the choice is not clear; the
forward hedge now has a smaller expected cost compared to the call option (--
140 and --255 respectively) but a much larger variance. The choice now
depends upon the firm`s risk-return preferences.
A US firm has bid for a contract to supply computers and related
equipment to a Swiss buyer. The contract is valued at CHF 5 million. The
outcome of the competitive tender bidding will be known one month from
now and the equipment is to be supplied over two months following the
award of contract with payment being made on completion of delivery.
The firm would like to cover the potential exposure. Also, the management has
decided that any cover obtained must be offset if the firm is not awarded the
contract.
The current market rates are:
USD/CHF spot: 1.50 90-day forward: 1.46
(We are ignoring two-sided quotes. It does not make any substantive difference)
A put option on CHF with a strike price of CHF 1.45 per USD and maturity of
90 days is avail able for a premium of 2.8 or $0.028 per CHF.
The firm wishes to evaluate the following two alternatives:
1. Sell CHF 5 million 90-day forward at CHF 1 .46 per USD. If at the end
of the month the bid is not successful, the contract will be offset by a 2-
month forward purchase at the then ruling rate.
2. Purchase a put option. If the contract is not awarded, close out by selling
put options. (Assume that the options are bought on an options
exchange).
The firm must pay an up-front premium of $140,000.
If the contract is awarded, the original hedge is carried to maturity. Under each
contingency viz. the firm gets the contract and does not get the contract we will
evaluate the two alternatives. In each case we will consider three exchange rate
scenarios.
1. The Bid is Unsuccessful.
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The firm unwinds the hedge by either purchasing DEM 5 million 60-days
forward if the initial choice was a forward contract or by selling put options. We
consider the gain/loss from each choice under the following three exchange rate
scenarios at the end of one month:
(A) CHF has depreciated
USD/CHF Spot: 1.60
60-day forward: 1.62
1.45, 2 month put 7
(B) Spot rate unchanged
USD/CHF Spot: 1.50
60-day forward: 1.48
1.45,2 month put 2.3
(C) CHF has appreciated
USD/CHF Spot: 1.37
60-day forward: 1.35
1.45, 2 month put 0.02
Scenario (A)
Forward hedge--Firm unwinds by purchasing forward at 1.62. Realises a gain
of $ two months hence.
Put options--Firm sells puts on CHF 5 million at $0.07 per CHF for a total
premium in come of $350,000 accruing right away.
Scenario (B)
Forward hedge--Unwound at 1.48. Gain of $46,279 two months hence.
Put options--Sell puts. Premium income $1 15,000 right away.
Scenario (C)
Forward hedge--Unwound at a loss of $279,046 two months hence.
Put options--Premium income of $1,000 right away.
We have assumed that the forward hedge is unwound by means of another
forward which matures at the same time as the original contract.
Thus in the event of the bid being unsuccessful, the firm risks a large loss if the
CHF sharply appreciates in the interim and it has covered the uncertain inflow
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with a forward contract. With an option, at worst, its maximum loss is limited to
the upfront premium.
2. The bid is Successful
If the bid is successful, the put option hedge offers an advantage if over the next
three months the CHF experiences a sharp appreciation. If the CHF remains
unchanged or depreciates, the forward contract is more advantageous since it is
costless to enter into.
The firm in tendering a bid will wish to know how to incorporate the element of
currency risk. It can attempt to estimate the future spot rate and quote a foreign
currency price based on this forecast; if it overestimates the weakness of DEM
(underestimates its strength) it runs the risk of submitting an uncompetitive bid.
In the reverse case, its profit margins will shrink. It can decide on a hedging
device such as a put option and load the expected cost of the hedge into its price.
The timing, amount and the exercise price of the put option should be chosen to
correspond to the forward contract which the firm might have bought had the
receivable not been uncertain. This may not always be possible with exchange
traded options. Cost of the put option can be reduced by buying an out-of-the-
money option with lower strike and hence lower premium. Correspondingly, the
level of protection against depreciation is reduced. Alternatively, the firm need
not hedge the entire amount; if it is a frequent bidder for certain types of
contracts, it will have built up some experience pertaining to the probability of
success at various bid levels. It can reduce the cost of hedge by buying a put to
cover only a fraction of the expected receivable reflecting the probability of
success.
One important point should be kept in mind. The success or failure of the bid is
dependent upon several factors including competition. The exchange rate may
not be a factor at all or at best may be one of the many considerations
influencing the customer`s decision. The risk involved in the option however
derives only from the behaviour of the exchange rate and its volatility. Thus in
using the option as a hedge, the firm is trying to offset the risk of a diverse set of
risk factors with an instrument the risk of which derives from a single source.
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The option hedge may be better than a forward contract but may not necessarily
be the best hedge.
Consider the case of a Singapore firm which has imported textile and leather
products from an Indian supplier. The invoice is for INR 25 crores due in 180
days.
HEDGING WITH CURRENCY FUTURES
Hedging contractual foreign currency flows with currency futures is in many
respects similar to hedging with forward contracts. A receivable is hedged by
selling futures while a payable is hedged by buying futures.
A futures hedge differs from a forward hedge because of the intrinsic features of
futures contracts. Since amounts and delivery dates for futures are standardised,
a perfect futures hedge is generally not possible. The advantage of futures over
forwards is firstly easier access and secondly greater liquidity. Banks will enter
into forward contracts only with corporations (and in rare cases individuals)
with the highest credit rating. Second, a futures hedge is much easier to unwind
since there is an organised exchange with a large turnover.
INTERNAL HEDGING STRATEGIES
In addition to the various market-based hedging devices discussed so far, a firm
may be able to reduce or eliminate currency exposure by means of internal
strategies or invoicing arrangements like risk sharing between the firm and its
foreign customers. We take a look at some of the commonly used or
recommended methods.
Invoicing
We have already discussed above the problem of currency of invoicing. A firm
may be able to shift the entire exchange risk to the other party by invoicing its
exports in its home currency and insisting that its imports too be invoiced in its
home currency. As we have seen above, in the presence of well-functioning
forward markets this will not yield any added benefit compared to a forward
hedge. At times, it may diminish the firm`s competitive advantage if it refuses to
invoice its cross-border sales in the buyer`s currency.
Empirically, in a study of the financial structure of foreign trade Grassman
(1973) discovered the following regularities:
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1. Trade between developed countries in manufactured products is generally
invoiced in the exporter`s currency.
2. Trade in primary products and capital assets is generally invoiced in a major
vehicle currency such as the US dollar.
3. Trade between a developed and a less developed country tends to be invoiced
in the developed country`s currency.
4. If a country has a higher and more volatile inflation rate than its trading
partners, there is a tendency not to use that country`s currency in trade
invoicing.
Another hedging tool in this context is the use of currency cocktails for
invoicing. Thus for instance, a British importer of chemicals from Switzerland
can negotiate with the supplier that the invoice be partly in CHF and partly in
GBP.
If the parties agree on a price of say CHF 1,000 per litre and the spot rate is CHF
2.25 per GBP. the price may be stated as
[{CHF 550 + ?200) per litre]. This way both parties share the exposure. Another
possibility is to use one of the standard currency baskets such as the SDR for
invoicing trade transactions.
Basket invoicing offers the advantage of diversification and can reduce the
variance of home currency value of the payable or receivable as long as there is
no perfect correlation between the constituent currencies. The risk is reduced but
not eliminated. These days, OTC options on baskets of currencies are readily
available so that the residual risk can be hedged.
SPECULATION IN FOREIGN EXCHANGE AND MONEY MARKETS
Speculation in contrast to hedging involves deliberately creating positions in
order to profit from exchange rate and/or interest rate movements. The
speculator believes that market`s forecasts as reflected in forward rates and the
term structure of interest rates are wrong. He hopes to profit by taking open
positions at these prices.
Consider outright speculation in foreign exchange markets. Suppose a speculator
believes that the EUR is going to appreciate against the dollar by 5% over the
next three months. Further he finds that he can borrow 3-month dollars at 10%
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and invest 3-month EUR at 8%. He can speculate by borrowing dollars,
converting spot to EUR and keeping EUR on deposit. If his forecast
materialises, he will net a 2% (annualised) profit on reconversion of EUR into
dollars. Alternatively, these rates imply a 2% (annualised) premium on EUR; the
speculator can take an open long position in forward EUR, and sell EUR three
months later in the spot market for a net annualised profit of 2%.
Not hedging a receivable or payable is thus equivalent to speculation. If a firm
has a payable in a foreign currency and is confident that the currency is going to
depreciate more than what is implied in the forward rate (or appreciate less) it
speculates by not covering the payable.
Obviously, outright speculation is a high-risk activity. The risk of an open
position depends upon the covariance of exchange rate with other assets in the
speculator`s portfolio. A speculator who is not risk neutral will demand a
premium for undertaking the risk. Thus he will take an open long (short)
forward position if he expects the currency to appreciate (depreciate) more than
what is implied in the forward rate. However, exchange rate risk is diversifiable
and hence unsystematic. As a result, the risk premium--the amount by which
the forward rate has to be below or above the speculator`s expected future spot
rate--is likely to be quite small. Empirical investigations indicate that it is also
varies with time.
Speculating with futures is quite similar to speculating with forwards. The main
differences are, first, with futures since there are intermediate cash flows, the
investor must speculate on interest rate movements too and second, since most
futures contracts are liquidated prior to maturity, the relevant comparison is not
between expected maturity spot rate and futures price.
LESSON - 3
LENDING AND INVESTMENT
Objective: In this lesson, we will introduce you the meaning of lending and
investment. This lesson is concept based. After you workout this lesson, you
should be able to:
Know the meaning of lending and investment.
Understand the difference between lending and investment.
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SHORT-TERM BORROWING AND INVESTMENT
International money markets particularly in well developed financial centers like
London, New York and Tokyo offer a variety of instruments to raise short-term
financing as well as place short-term funds. The principal dimensions of the
borrowing-investment decisions are the instrument, currency, location of the
financial center and any tax related issues. Between them they decide the cost of
or return on funds, extent of currency exposure, the ease with which funds can
be moved from one location and currency to another and thus the overall
efficiency of the cash management function. In this section we will focus on the
cost/return dimension. The other considerations--location, currency, etc.--will
be taken up later.
Apart from bank loans, the other major instruments for short-term funding are
commercial paper and, in the US domestic money market, bankers` acceptances.
Commercial paper as a funding device is accessible only to corporations with
high creditworthiness. For such entities, it is a cheaper form of funding than a
bank loan.
On a covered basis, yields are equal (apart from transactions cost) across
Eurocurrencies. Hence on a covered basis, the choice of currency of borrowing
does not matter. Only when the borrower firm holds views regarding currency
movements which are different from market expectations as embodied in the
forward rate, does the currency of borrowing become an important choice
variable.
The international Fisher open condition,
iA ? iB = Se (A/B)
where Se (A/B): Expected depreciation of currency A against currency B.
However, if speculators are risk averse, a risk premium must be incorporated in
the above relationship:
iA ? IB = Se (A/B) +RP
where RP denotes the risk premium.
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This coupled with the interest parity relation implies F(A/B) = Se(A/B) + RP,
where F(A/B) is the relevant forward rate and Se(A/B) is the expected future
spot rate.
Note that the risk premium can be negative or positive depending upon whether
speculators as a group are required to be net short or long in the forward market.
Thus the forward rate can on average equal the future spot rate even in the
presence of a constant risk premium. However, in a particular instance, a firm
may have reasons to believe that the forward rate is and underestimate or
overestimate of the future spot rate. In such cases, the firm should compare the
effective expected cost of borrowing across different currencies and choose the
least cost alternative. Note that this involves risk and any saving on borrowing
cost reflects compensation for the added risk.
Following the same reasoning, on a covered basis the firm should be indifferent
between various currencies when it comes to placing temporary excess funds
since the covered yields are identical. Considerations such as availability of
various investment vehicles--deposits, CDs, CP, treasury bills, etc--and their
liquidity may lead to one currency being favoured over another. A firm willing
to take on added risk can make uncovered investments hoping to profit from its
superior forecasting ability.
SURPLUS AND MULTINATIONAL CORPORATION
In a multinational corporation with production and selling subsidiaries spread
around the world, cash in flows and outflows occur in diverse currencies. Apart
from cost and return considerations, several other factors influence the choice of
currencies and locations for holding cash balances.
The bid-ask spreads in exchange rate quotations represent transaction costs of
converting currencies into one another. There may of course be other costs such
as telephone calls, telexes, other paperwork, etc. Minimising transaction costs
would require that funds be kept in the currency in which they are received if
there is possibility that they might he needed later in the same currency. A
related but distinct consideration is that of liquidity viz, funds should be held in
a currency in which they are most likely to be needed. This may not be the same
as the currency in which the cash comes in. Militating against these factors is the
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political risk dimension. The parent firm may want to hold all surplus cash in its
home currency to minimise the risk of its assets being frozen by a foreign
government. However, this consideration would influence the location of the
financial center where the funds are held rather than the currency and is likely to
be of some importance only in the case of politically highly unstable countries.
Availability of investment vehicles and their liquidity is another important
factor. Major money market centers such as London, New York, Zurich and so
forth offer a wide variety of highly liquid money market instruments so that the
firm does not need to hold practically any idle cash balances.
Finally, withholding taxes may influence the choice. If balances are held in
interest bearing assets in a country which has a withholding tax on non-resident
interest income, and the tax rate exceeds the parent`s home country tax rate, the
parent may not be able to get full credit for the foreign tax paid and such a
location may therefore become unattractive for holding funds.
Investing Surplus Funds
Once the treasurer has identified the cash flows and determined how much
surplus funds are available in which currencies and for what durations, he or she
must choose appropriate investment vehicles so as to maximise the interest
income while at the same time minimising currency and credit risks and
ensuring sufficient liquidity to meet any unforeseen cash requirements.
The major investment vehicles available for short-term placement of funds are
(1) short-term bank de posits (2) fixed term money market deposits such as CDs
and (3) financial and commercial paper. The main considerations in choosing an
investment vehicle can be summarised as follows:
Yield: Total return on the investment including interest income and any capital
gain or loss. Very often security and liquidity considerations may take
precedence over yield.
Marketability: Since liquidity is an important consideration, the ease with
which the investment can be unwound is important. Instruments like CDs have
well developed secondary markets while CPs and trade related paper have
limited liquidity.
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Exchange Rate Risk: If funds eventually required in currency A are invested in
currency B, there is exchange rate risk. If covered, then as we saw above, there
is no advantage to switching currencies.
Price Risk: If a fixed-term investment such as a CD or a T-bill has to be
liquidated before maturity, there is the risk of capital loss if interest rates have
moved up in the meanwhile.
Transactions Costs: Brokerage commissions and other transactions costs can
significantly lower the realised yield particularly on short-term investments.
Money market investments are often available in fixed minimum sizes and
maturities which may not match the size of the available surplus and the
duration for which it is available.
Financing Short-Term Deficits
Just as judicious management of short-term surplus funds can earn extra income
for the firm, careful handling of short-term deficits can lead to significant
savings. The treasurer`s objective in this regard should be to minimise the
overall borrowing requirement consistent with the firm`s liquidity needs and to
fund these at the minimum possible all-in cost.
One of the cheapest ways of covering short-term deficits is internal funds. In a
multinational firm with several subsidiaries, it often happens that while one
division has a short-term funds requirement, another has surplus funds. While
the former may have to take an expensive bank loan or overdraft facility the
latter may not have very attractive investment opportunities beyond bank
deposits. A centralised cash management system with cash pooling described
below can efficiently allocate internal surpluses so as to optimise interest
earnings net of interest costs for the corporation as a whole. However, cross-
border inter-company loans are a complex area. There are issues related to
differences in tax regimes, existence of double taxation treaties, differences in
accounting norms, and exchange risk. Specialist advice is usually necessary to
exploit these opportunities in an optimal fashion.
External sources of short-term funding consist of overdraft facilities, fixed term
bank loans and advances and instruments like commercial paper, trade and
bankers` acceptances. Apart from the all-in cost of funding, considerations such
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as collateral or security requirements, flexibility in terms of repayment schedule,
speed with which a new facility can be arranged, effect on firm`s credit rating
and so forth also play a role in evaluating the funding options. The size and
maturity mismatch problems arise here too. For instance, suppose a treasurer
determines that he has a requirement of USD 60,000 for 30 days. An over draft
facility would cost him 8% while a 30-day term loan is available at 5% but the
minimum amount is USD 100,000. Surplus funds can be kept in a deposit
earning 3%. The problem again is to determine the breakeven size of funding
requirement such that if the actual need is larger than this, it is preferable to go
in for the term loan rather than an overdraft facility. In another case, an amount
of USD 100,000 is needed for 18 days whereas a term loan is for a minimum of
30 days. Once again the reader can determine the breakeven gap above which it
is preferable to take the loan and place the funds in a deposit during the days
they are not needed.
LESSON - 4
FOREX RISK AND EURO CURRENCY MARKETS FOR
LENDING & INVESTMENT
Objectives: In this lesson, we will introduce you to the meaning and nature of
foreign exchange risk and euro currency markets for lending & investment. This
lesson is concept based. After you workout this lesson, you should be able to:
Know the meaning and nature of foreign exchange risk and euro
currency markets for lending & investment.
FOREX RISK
The Dealing Room is rightly identified as a profit centre for a bank. In these
days of reducing spread between the lending and borrowing rates, banks have to
look to other sources to improve their bottom lines. Foreign exchange is one
area where the potential is vast. The progressive liberalisation being introduced
in the Indian foreign exchange market has improved the scope for dealers to
show their skills and earn for their banks. But at the same time, it may not be
forgotten that any scope for profits is associated with the risks of losing. It is
more so in the case of foreign exchange dealing where the vagaries of the
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market can play havoc. Unbridled enthusiasm has to be monitored so that the
bank does not expose itself to unduly huge risks.
The following are the major risks in foreign exchange dealings:
(a) Open Position Risk,
(b) Cash Balance Risk,
(c) Maturity Mismatches Risk,
(d) Credit Risk,
(e) Country Risk,
(f) (t) Overtrading Risk,
(g) Fraud Risk, and
(h) Operational Risks
1. OPEN POSITION RISK
The open position risk or the position risk refers to the risk of change in
exchange rates affecting the overbought or oversold position in foreign currency
held by a bank. Hence this can also be called the rate risk. The risk can be
avoided by keeping the position in foreign exchange square. The open position
in a foreign currency becomes inevitable for the following reasons:
(a) The dealing room may not obtain reports of all purchases of foreign
currencies made by branches on the same day. Each bank has few dealing rooms
mainly in metropolitan centre. The dealings with the customers are executed by
the branches of the bank spread over the entire country. The branches are
required to inform to the dealing room concerned immediately over
telecommunication whenever a purchase or sale exceeding a limit, say
equivalent of USD 1,000 takes place. Deals for smaller values will be taken into
account by the dealing room when the reports are received through mail on a
later date. Under this system imbalance may arise because:
(i) Smaller purchases and sales and not taken into account;
(ii) When communication system fails, even larger deals may also not be re
ported immediately; and
(iii)There may be wrong reporting or failure to report by branches.
(b) The imbalance may be because the bank is not able to carry out the cover
operation in the interbank market. This may be due to fact that counter party for
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the tenor and volume as required by the bank may not be available. Moreover
operations in the interbank are done in round a sum, which necessarily leaves
odd amounts in the exchange position uncovered.
(c) Sometimes the imbalance is deliberate. The dealer may foresee that the
foreign currency concerned may strengthen. In that case he would try to keep an
overbought position; when the currency strengthens he can sell at a profitable
rate. Conversely, when the expectation is that the foreign currency will weaken,
he will acquire an oversold position; he can acquire the currency later at a
cheaper rate and thus make a profit.
There is, however, a limit up to which the bank can keep open` position. If the
bank keeps a large open position and its expectation about the movement of the
currency fails, the result would be disastrous.
Internal Control: The appreciation of the various risks involved in exchange
dealings has led to adoption of certain controls by the banks. Each bank fixes
day-light limit` or intro-day limit for each currency. This is the limit up to
which the dealer can deal himself without reference to higher authorities. For
instance, a bank may fix the daylight limit for US dollar as USD 5 million. That
means the dealer can purchase and sell dollars so long as the balance
outstanding at any time during the day is not exceeding USD 5 million. In
addition the bank also fixes an overnight limit`, i.e., the extent to which the
currency position can be kept open at the end of the day. Normally the overnight
limit would be much less than the daylight limit. While the daylight limit
ensures that the bank does not acquire very large position in the currency which
it may find it difficult to cover in the market, the overnight position puts a
ceiling on the exchange risk to the bank. Apart from the above limits on
individual currencies, the bank would also place a aggregate limit on the foreign
exchange position for all the currencies put together. This would be smaller than
the total of individual overnight limit for each currency.
Cut Loss Limit: This limit is fixed to restrict loss due to adverse movement in
the exchange rates. The cut loss limit for dollar may be fixed at 5 paise. Suppose
the dealer holds overbought position of USD I million at a cost of Rs. 35.86 per
dollar. If the market rate for dollar moves down to less than Rs. 35.81, he should
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immediately square his position so that the loss can be restricted to 5 paise per
dollar or Rs. 50,000. Otherwise the continuous decline in dollar rate would
result in larger losses. The limit may be fixed with reference to the absolute
amount of loss. In that ease, if the exposure is higher in value, the per dollar
difference may be reduced to see that the absolute loss is not exceeding, say, Rs.
50,000.
Exchange Control Regulation: The Exchange Control Manual stipulates that
the authorised dealers should fix open position limits in each currency in
accordance with the guidelines issued by Reserve Bank. Before laying down
such limits authorised dealers should get them approved by Reserve Bank. Net
overnight position in the rupee should not exceed the limit laid down by Reserve
Bank from time to time. According to the guidelines, the banks should maintain
on an on going basis Tier I capital (i.e., paid-up capital, statutory reserves and
other dis closed free reserves at 5% of the open position limit approved by
Reserve Bank. Further, in general, overall open position limit should have a
reasonable relation o the capital of the bank.
2. CASH BALANCE RISK
Cash balance refers to actual balances maintained in the nostro accounts at the
end of each day. Balances in nostro accounts do not earn interest; while any
overdraft involves payment of interest. The endeavour should therefore be to
keep the minimum required balance in the nostro accounts. 1-lowever,
perfection on this count is not possible. Depending upon the requirement for a
single currency more than one nostro account may be maintained. Each of these
accounts is operated by a large number of branches. Communication delays
from branches to the dealer or from the foreign bank to the dealer may result in
distortions. The banks endeavour to obtain the statement of accounts from
foreign banks on a daily basis through telecommunication and monitor closely
the balances in nostro accounts. Reconciliation of balances of nostro accounts
almost on a continuous basis also helps in this regard.
Exchange Control Regulation: The Exchange Control requires authorised
dealers to maintain with overseas branches and correspondents, balances in
foreign currencies at levels which are commensurate with their normal business
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needs having regard to the number of correspondents and branches in the
country concerned and the number of offices and branches of the authorised
dealer in India operating on the accounts. While transacting foreign exchange
business in inter- bank market in India or overseas exchange markets, authorised
dealers should ensure that the balances are not accumulated in their accounts
abroad which are in excess of immediate needs such as payments towards
imports or maturing deliveries under forward contracts.
3. MATURITY MISMATCHES RISK
This risk arises on account of the maturity period of purchase and sale con tracts
in a foreign currency not coinciding or matching. The cash flows from purchases
and sales mismatch thereby leaving a gap at the end of each period. There fore
this risk is also known as liquidity risk or gap risk.
Mismatches in position may arise out of the following reasons
(i) Under forward contracts, the customers may exercise their option on any
day during the month which may not match with the option under the
cover con tract with the market with maturity towards the month end.
(ii) Non-availability of matching forward cover in the market for the volume
and maturity desired.
(iii) Small value of merchant contracts may not aggregate to the round sums
for which cover contracts are available.
(iv) In the interbank contracts, the buyer bank may pick up the contract on
any day during the option period.
(v) Mismatch may deliberately create to minimise swap costs or to take ad
vantage of changes in interest differential or the large swings in the demand
for spot and near forward currencies.
The mismatch can be corrected by undertaking a suitable swap. The risk
involved is that the cost of swap may turn out to be higher than that provided
for.
Internal control: At monthly intervals the purchases and sales are aggregated
maturity wise and the net balance arrived at. The following gap limits are
prescribed limit.
(a) A monthly gap limit for each currency. This is called the individual gap
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(b) A cumulative gap limit for all maturities for each currency which would
be less than the total of monthly gap limits.
(c) Cumulative gap limit for all currencies put together which would be less
than the total of cumulative gap limit for all currencies.
Maturity limit: Apart from the above, the bank may also fix the maximum
period upto which forward cover can be offered to the customer. This depends
upon the maximum maturity for which cover will be available in the market.
Exchange control regulations: It is stipulated that the authorised dealers
should, as far as possible, avoid outright forward or swap transactions which
result in maturity mismatches which are in excess of their aggregate gap limit.
(Aggregate gap limit is defined as the sum total of the gaps in each currency
arrived at by adding gaps in each month ignoring the plus or minus sign. In other
words, it is the gross gap for all the months put together. In the cumulative gap
limit mentioned above, monthly gaps are added considering the plus and minus
signs. It is the net gap cumulatively for all months.)
4. CREDIT RISK
Credit risk is the risk of failure of the counterparty to the contract. Credit risk is
classified into (a) contract risk, and (b) clean risk.
Contract risk arises when the failure of the counterparty is known to the bank
before it executes its part of the contract. Here the bank also refrains from the
contract. The loss to the bank is the loss arising out of exchange rate difference
that may arise when the bank has to cover the gap arising from failure of the
contract.
Clean risk arises when the bank has executed the contract, but the counter- party
dos not. The loss to the bank in this case is not only the exchange difference, but
the entire amount already deployed. This arises, because, due to time zone
differences between different centres, one currency is paid before the other is
received.
Internal control: The risk is controlled by fixing counterparty limits, both for
banks and merchant customers. Limits are fixed on the aggregate outstanding
commitments and separately for the amount of funds to be settled on a single
day.
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5. COUNTRY RISK
Also known as sovereign risk` or transfer risk` country risk relates to the
ability and willingness of a country to service its external liabilities. It refers to
the possibility that the government as well other borrowers of a particular
country may be unable to fulfill their obligations under foreign exchange
transactions due to reasons which are beyond the usual credit risks. For example,
an importer might have paid for the import, but due to moratorium imposed by
the government, the amount may not be repatriated.
Internal control: The country risk analysis is made by taking into account the
socio-economic and political situation of the country and a limit for exposure for
that country is fixed.
6. OVERTRADING RISK
A bank runs the risk of overtrading if the volume of transactions indulged by it
is beyond its administrative and financial capacity. In the anxiety to earn large
profits, the dealer or the bank may take up large deals, which a normal prudent
bank would have avoided. The deals may take speculative tendencies leading to
huge losses. Viewed from another angle, other operators in the market would
find that the counterparty limit for the bank is exceeded and quote further
transactions at higher premiums. Expenses may increase at a faster rate than the
earnings. There is therefore a need to restrict the dealings to prudent limits.
Internal control: The tendency to overtrading is controlled by fixing the
following limits
(a) A limit on the total value of all outstanding forward contracts; and (b) A
limit on the daily transaction value for all currencies together (turnover limit).
7. FRAUD RISK
Frauds may be indulged in by the dealers or by other operational staff for
personal gains or to conceal a genuine mistake committed earlier. Frauds may
take the form of dealing for one`s own benefit without putting them through the
bank accounts, undertaking unnecessary deals to pass on brokerage for a kick
back, sharing benefits by quoting unduly better rates to some banks and
customers etc. The losses from such fraudulent deals can be substantial.
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Internal control.: It is imperative that dealers be well supervised, honest and
well trained. Proper selection and proper training therefore play an important
role. The following procedural measures are taken to avoid frauds:
(a) Separation of dealing from back-up and accounting functions.
(b) On-going auditing, monitoring of positions, etc., to ensure compliance
with procedures.
(c) Regular follow-up of deal slips and contract confirmations.
(d) Regular reconciliation of nostro balances and prompt follow-up of
unreconciled items.
(e) Scrutiny of branch reports and pipe-line transactions.
(f) Maintenance of up-to-date records of currency position, exchange
position and counterparty registers, etc.
8. OPERATIONAL RISKS
These risks include inadvertent mistakes in the rates, amounts and counterparties
of deals, misdirection of funds, etc. The reasons may be human errors or
administrative inadequacies. The deals are done over telecommunication and
mistakes may be found only when the written confirm are received later. But
reversing such mistakes may involve exchange rate and interest losses for the
hank. If nostro reconciliation is not proper, the mistakes may remain undetected
for long periods. By the time they are found out, the relevant records may not be
available any more.
Internal Control: The internal control measures are same as that for preventing
frauds.
EURO CURRENCY MARKETS FOR LENDING AND INVESTMENT
Euro-currency market, also known as Euro-dollar market, is an international
capital market which specializes in borrowing and lending of currencies outside
the country of issue. Thus, deposits in dollars with a bank in London are Euro
dollars. Similarly, French francs held by banks in London are Euro-francs;
pound-sterling held by banks in Germany are Euro-sterling, and so on. They are
all Euro-currencies. Predominantly, the dealings in the market are in dollars and
hence the name Euro-dollar market is still in vogue.
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The main centres of Euro-currency are London and a few other places in
Europe. The growth of the market has extended beyond these limits and now it
includes a few centres of Asia too, such as Singapore. The centres in Asia are
known as Asian-dollar n the terms Euro-dollars and Euro-currency are used
universally to denote all such markets, including the Asian dollar market.
SPECIAL FEATURES OF THE MARKET
The following are the special features of the Euro-currency market:
1. Transactions in each currency take place outside the country of its issue. For
example, dollars earned by a Japanese firm from exports may be deposited with
a bank in London. The London bank is free to use the funds for lending to any
other bank. The bank may use it for lending to French Bank. Thus the utility of
the currency is entirely outside the control of the central bank of the country
issuing the currency. For this reason, Euro-currencies are also referred to as
offshore Currencies
2. Even though the currency is utilised outside the country of its origin, it has to
be held only in the country of its issue. To continue our example, the Japanese
firm deposits its dollar earnings with a bank in London. The London Bank will
keep the funds in a New York Bank in its own name. When the London Bank
lends the amount to the French Bank, it will give suitable instructions to the
New York Bank. On receipt of the instructions, the New York Batik will debit
the account of the London Bank and credit it to the account of the French Bank.
Thus ultimately the settlement of all dollar transactions takes place in New
York. Similarly, settlement of all Euro-sterling transactions is made in London,
all Euro-French franc transactions in Paris and so on.
3. Though Euro-currencies are outside the direct control of the monetary
authorities of their respective countries of issue, they are subject to some form of
indirect control. This is because the settlement of all transactions has to take
place only in the country of issue. If the country of issue imposes any
restrictions, the conversion of balances in the currency held outside the country
into another currency would also be affected. As already stated conversion into
another currency would involve clearing in the country of issue at some point of
the transaction. This automatically subjects them to the restriction.
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4. Euro-currency market is not a foreign exchange market. It is a market for
deposits with and between banks (inter-bank deposits) and for loans by banks to
the non-bank public. It is a market in which foreign currencies are lent and
borrowed as distinct from the foreign exchange market, where they are bought
and sold. It consists of a pool of predominantly short-term deposits which
provide the big single source of funds that commercial banks transform into
medium and occasionally long-term international loans or Euro-credits.
5. The transactions in the market involve huge amounts running into millions of
dollars. The large-scale financing has led to the development of syndications of
loans, where a large number of banks participate in the lending operations.
6. Euro currency is a market is a highly competitive market with free access for
new institutions in the market. Consequently, the margin between the interest
rates on deposits and adv has narrowed down considerably.
7. A special feature is the concept of floating rates of interest`. The rate of
interest is linked to a base rate, usually the London Inter-Bank Offered Rate
(LIBOR). The interest on the deposit or the advance would be reviewed
periodically and changed in accordance with change, if any, in LIBOR.
8. US dollar remains the leading currency traded in the Euro-currency market,
even though its share is declining. Other currencies traded in the market on large
scale are Deutsche mark, Japanese Yen, Pound Sterling and Swiss Franc.
9. The Euro-currency market can broadly be divided into four segments:
(i) Euro-credit markets, where international group of banks engage in lending
for medium and long term;
(ii) Euro-bond market, where banks raise funds on behalf of international
borrowers by issuing bonds; and
(iii) Euro-currency (deposits) market, where banks accept deposits, mostly for
short term.
(iv) Euro-notes market, where corporate raise funds.
The division is not watertight and the different segments overlap each other.
INTEREST RATE IN EURO-CURRENCY MARKETS
The interest rates in Euro-currency markets are determined by a multitude of
factors which affect the demand and supply conditions of the currency
concerned. Some of the factors are: (1) volume of world trade transacted in the
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currency, ii) domestic interest rates, (iii) domestic monetary policy and reserve
requirements. (iv) Domestic government regulation, and (v) relative strength of
the currency in the foreign exchange market. In practice, domestic interest rates
act as a floor to Eurocurrency rates because the funds flow into Eurocurrency
market seeking higher interest. Although the Eurocurrency market operates in a
number of centres around the world, interest rates for a particular currency are
consistent. Any temporary variations at different markets are quickly eliminated
by international arbitrage.
Interest in Eurocurrency market is generally a floating rate of interest.
Periodically, the interest rate will change with reference to a benchmark rate like
LIBOR. For instance, the interest on a Euro-bond for five years may be fixed at
ISO basis points over Libor. (One basis point is 1/100 of 1%). The Libor at the
time of issue plus 1.5% will be applicable for six months. At the end of this
period, Libor then prevailing will be reckoned and the interest for the next six
months will be based on the Libor then prevailing. This vi1l be repeated every
six months.
LIBOR is the London Inter-Bank Offered Rate` and represents the rate` which
banks in London will lend a currency to other banks for a specific maturity.
Since London is a major Eurocurrency market. Libor is used as the basis for
most Eurocurrency transactions) Libor varies for different maturities. Thus we
have 1 month Libor, 3 months Libor, 6 months Libor etc. Rates quoted by
different banks may vary slightly, the bigger banks offering lower rates. In
respect of a particular contract based on Libor, say a Eurobond issue, the rate is
fixed by nominating reference banks. The reference banks may be from among
those syndicating the issue. Or, to maintain neutrality, they may be banks
outside the syndicate. The rates quoted by these banks at a stipulated time, often
11 AM London time, two business days before start of the due date, is taken as
the basis. The average of such rates is rounded off to the nearest 1/8 per cent.
LIBID is the London Interbank Bid` rate. It is the rate at which banks accept
euro- deposits. Bid tates are lower than offered rates usually by 1/8 to 1/4
percent.
LIMEAN is the average of Libor and Libid.
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Prime Rate is the rate of interest charged by first class banks in USA on
advances to their first class borrowers. For example, it may relate to an advance
made to a multinational corporation with a very high credit rating. This rate is
usually a couple of percentage points higher than the discount and Federal funds
rate. While it follows the same trends, it is determined rate calculated from
money market rates, especially from the 90 days Certificate of Deposit rate.
Every bank in the USA announces independently its prime rate, but this tends to
influence the rate of other banks also. Similarly, the prime rate has influence
over the Eurodollar rate and is also influenced by it. A change in the prime rate
is followed by a change in the Eurocurrency rate and vice versa.
SIBOR represents the Singapore interbank Offered Rate Similar to Libor, it is
the rate at which principal banks in Singapore offer to lend Asian dollars and
other currencies to other banks. Sibor forms the basis for interest rate on Asian
dollar and syndicated loans.
EURO-CREDITS
Most of the lending in Euro-currency markets takes the form of Euro-credit.
Euro-credits are medium and long-term loans provided by international group of
banks in currencies which need not be those of the lenders or borrowers. Euro-
credit belongs to wholesale sector of the international capital market and
normally involves large amounts.
Security: Euro-credits are provided mostly without any collateral security from
the borrower. By experience banks in Euro-market have found that taking
security by way of, say mortgage, etc. on the assets of the borrower do not
provide any safeguard to the interests of the lender when the affairs of the
borrower really go bad. Therefore more emphasis is laid on the credit rating of
the borrower rather than on any tangible security. Providing Euro-credits as
unsecured facilities also renders the job easy by avoiding complicated
procedures to take charge of the security.
Type of facility: The conditions stipulated for drawing and repayment of the
facility depends upon the kind of credit provided. Euro-credits are normally pro
vided in either of the following two forms: (i) revolving credit and (ii) term
credit.
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Revolving credit is similar to a cash credit facility It is a standby facility to meet
temporary but recurring financial requirements of the borrower. Interest is
charged on the actual amount utilised; on the sanctioned but unutilized portion, a
commitment fee may be charged` Repayment is arranged by progressively
reducing the limit till the entire facility is thus reduced.
Term credit is similar to medium-term loans provided by banks. At the
beginning itself both the lenders and borrowers agree on the schedule of drawing
the facility. The facility is utilised in full for some time and then, in accordance
with the agreement already entered into, repayment begins. The repayment
schedule is fixed taking into account the expected revenue flow from the
investment.
The borrower is expected to give seven days notice when he wants to avail the
installment as per the schedule of drawings. Once he has given the notice to
avail of the drawing, he is irrevocably bound by it. Similarly, for forgoing the
drawing, seven days` notice is required to be given to the lenders. Many loan
agreements provide for pre-payment of the full amount without any penalty at
30 days or 60 days` notice. The provision helps the borrowing companies to
repay the loan and avail better conditions that may prevail in the market at a
later date.
Period: The period of euro-credits extends up to 15 years. But most of the
credits are for periods of 5 to 8 years. On an-average about 5% of the total
credits are for periods ranging from 1 to 5 years and about 10% from 10 to 15
years.
Interest: Interest is fixed at a certain percentage over a reference rate, generally
the interbank rate for Euro-currency deposits. For dollar loans the reference rate
is the LIBOR (London Inter-Bank Offered Rate) for Deutsche Mark it is
LUXIBOR (Luxemborg Interbank Offered Rate) which is the main centre for
interbank Euro-mark market. For similar reason, for 1oan in pound sterling the
Paris Interbank Offered Rate is taken as the basic rate.
Generally interest for dollar loans is fixed at a percentage over Libor say 1%
over Libor. The interest is revised every six months, considering the changes in
Libor. Thus, technically, the credit is rolled over` or renewed every SIX
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months. The difference between the interest charged on the loan and the Libor is
the lending margin, the lending margin is not fixed but depends upon the credit
rating of the borrower and his bargaining capacity.
Currency: Most of the loans raised are in dollars. Some loan agreements also
provide for currency option. That is, initially the loan is raised in dollars. The
borrower is given the option to roll over the loan in a different currency
according to his requirement. This again is possible provided the bank can
procure the required currency. The multi-currency option helps the borrower in
avoiding ex change risk and also does not involve the lending bank in any risk.
Syndication of Loans
Each euro-credit runs into a huge amount of a few hundred million dollars. It is
not safe or possible for a single bank to undertake the entire amount. Thus few
banks form a syndicate (similar to consortium lending in domestic banking) to
provide funds to the borrower. The practice is also partly due to the US laws
which provide limitations on loans of any single bank to any single borrower.
Bank syndicates are not permanent groupings. They are formed in each case by
banks willing to participate in the credit.
In arranging the credit the major role is played by (i) managing bank(s)
appointed by the borrower to arrange the credit; (ii) lead bank, providing most of
the money, and (iii) agent bank appointed by lenders to look after their interests
once the loan agreement is signed. All the functions may be rendered by a single
bank.
The managing bank(s) is/are appointed by the borrower to arrange the credit.
Earlier the management scene was dominated by British merchant banks and
other investment banks. They were ideally suited because of their international
connections with banks and borrowers. Commercial banks merely provided the
necessary funds. They did not take to management because they lacked
specialized person id or international connections to arrange credits themselves.
Then came consortium banks created by groups of large commercial banks to
undertake specialized international operations for all the shareholders. By 1970
management of most credit passed to world`s largest commercial banks. By this
time they had resources to meet increase in demand for credit and had acquired
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requisite technical expertise. They also felt the need to protect themselves
against exposure by taking active part in evaluation of borrowers, negotiation of
terms and supervision of loans. The attraction of management fee also added
strength to the decision.
As a result of the change in the scene the participants in the market fall into two
segments: (i) The wholesale large commercial banks who arrange credits, take
major share and are a force to reckon with; and (ii) retail sector small banks
taking what participation they can get.
The appointment of the managing bank is formalized with the award of man
date by the borrower. The managing bank helps the borrower in drawing up a
statement of the borrower`s financial condition and purpose of the credit and the
loan agreement. It negotiates terms with other banks and assembles the
syndicate. The manager`s function comes to an end with the signing of the loan
agreement by the borrower and the participating banks and the agent bank take
over from there.
But, in practice, the managing bank continues to keep in touch with the
borrowers to help protect the interests of the lending syndicate.
For the service rendered, the managing bank is entitled to the management fee at
a flat percentage of the loan. It is paid by the borrower at the time of signing of
the agreement.
The participants in the syndicate are entitled to participation fee. A part of the
management fee received by the managing bank is passed on to the participants
as the participation fee in proportion to the share of funds provided by each.
Participation fee is not payable if share of a bank is less than a prescribed
minimum.
A situation may arise where the borrower has to pay facility fee in addition to
the management fee. The facility fee is the commitment charge paid on un-
drawn portion of the credit to compensate the banks for keeping funds ready. It
is payable at an annual rate.
Protection to Lending Banks: One major step taken by lending banks to
protect their interests is to analyze the position of the borrower and his country`s
economic and political environment thoroughly before committing themselves
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on the loan. Even though all members of the syndicate sign a common loan
agreement, each lending bank is responsible for its o decision and surveillance
over the borrower. But the smaller banks may lack the desired infrastructure to
undertake a detailed country risk analysis. They, therefore, rely on the larger
banks.
Many covenants are included in the loan agreement safeguarding the interest of
the lending banks. Any misrepresentation by the borrower in the information
furnished to the syndicate or failure to perform the covenants will be considered
as default by the borrower. Default with any single lending bank will be
regarded as default with all banks. The covenants include negative lien
maintenance of ratios between assets and liabilities, limitation on dividends and
total debt service in relation to earnings etc. But recourse to legal protection is
rendered difficult be cause the credits fall outside the jurisdiction of any single
authority. Further complication is the legal status of governments and
international organizations as borrowers although many countries have passed
laws to waive sovereign immunity in commercial transactions. Therefore, in
case of default settlement by political negotiation rather than by litigations is the
order of the day.
The interests of the lending banks are protected better when there is co-financing
by official international organizations like IMF and World Bank In such cases
information about international financial flows and debtor countries becomes
easily available. In case of default IMF may propose conditions for management
of economies as a corrective measure. But co-financing by these institutions is
confined to a very few cases.
In case of weaker borrowers, the lending banks try to compensate the higher risk
which involved by prescribing higher lending margins. Higher margins may also
be a polite way of saying no to the proposal.
EURO-BONDS
A major source of borrowing at Euro-markets is though the issue of international
bonds known as Euro-bonds. Euro-bonds are those sold for international
borrowers in several markets simultaneously by international group of banks.
They are issued on behalf of multinational corporations, international agencies
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and governments. In the past borrowers were largely from industrialised
countries of late, developing countries have entered the market on a large scale.
Most of their borrowings had been balance of payments-oriented, either directly
or indirectly.
Euro-bond should be distinguished from foreign bonds. Foreign bond is issued
on behalf of a non-resident borrower as in the case of Euro-bond. But a foreign
bond is sold only in the domestic capital market of the Issuing country by a
group of banks in the market of issue. It is subject to regulations of the country
of issue. For example, a foreign bond may be issued on behalf of a Japanese
firm exclusively in West Germany. As against these restrictions a Euro-bond is
outside the regulations of a single country. The investors are spread world-wide.
Euro-bonds are unsecured securities. Therefore only borrowers of high financial
standing are able to issue such bonds. When they are issued by government
corporations and local bodies, they are guaranteed by the government of the
country concerned. Issues by subsidiaries normally carry guarantee of the parent
company.
Selling of euro-bonds is done through Syndicates. The Lead Managing Bank is
responsible for advising on the best size of the issue, terms and timing and for
coordinating the issue. Lead managers take the help of co-managing banks.
Entire issue is underwritten by the managers and a larger group of underwriting
banks. In addition there are still larger groups of selling banks.
The lead managing bank is entitled to the management fee, the underwriting
banks the underwriting allowance and selling banks to the selling concession.
All put together, the cost of issue may come to 2% to 2.5% of the value of the
issue. Initially the lead manager holds the entire commission allowance, etc. The
borrower gets the value of the issue less commission, etc., from the lead
manager. The lead manager allocates the bonds to all members of the selling
group at face value less their commission/allowance. Thereafter every member
is on its own. They can sell to investors at whatever prices they can obtain. Thus
no two investors in the Euro-bond market need pay the same price for newly
issued bonds.
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Features Most Euro-bonds are bearer securities Most of the bonds are de
nominated in US dollars, issued in denominations of USD 10,000. The average
maturity of Euro-bonds is about S to 6 years although it is normal to find issues
with maturity up to 15 years.
EURO-ISSUES
Access to Euro-equity market is made through the issue of:
(i) Foreign Currency Convertible Bonds; and
(ii) (ii) Depository Receipts.
Foreign currency convertible bond (FCCB) is a Euro-bond which can be
converted into shares at the option of the investor. This has also been explained
under Euro bonds`.
Depository Receipts, or the more popular among them, the Global Depository
Receipts are explained below.
Global Depository Receipt
A Global Depository Receipt is a negotiable instrument denominated in US
dollars that represents shares issued in a local currency. The shares of the issuing
company are issued in the name of an international bank, called the depository
who is located in a foreign country. The physical possessions of the shares
issued are with a custodian` in the issuing country. The shares are issued to the
depository in the local currency. Based on the shares held by it, the depository
issues the GDRs in US dollars. The dividend, after withholding tax etc., is paid
by the issuing company to the depositor in the local currency. The depository
converts the dividend received into US dollars at the ruling exchange rate and
distributes it among the GDR holders. GDRs are bearer instruments and traded
freely in international markets either through stock exchange mechanism or on
an Over The Counter` (OTC) basis. The settlements are done through
international clearing systems like Euroclear (Brussels) or CEDEL (London).
GDRs offer many advantages to the issuing company. The exchange risk is
borne by the investors as the payment towards dividend is made in the local
currency. There is no dispersal of voting rights as right to vote is vested only
with the depository and is regulated by an agreement between the company and
the depository. It enables the company to broaden the capital base by tapping
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large foreign equity markets. But the issue is subject to country risk analysis and
for companies from countries with poor credit rating, the issue may not be
successful or can succeed only at higher cost. The value of GDRs depends upon
the value of the shares of the company. The prospects of the company for future
issues may be affected by decline in share prices in the local market which may
be a market phenomenon unconnected with the performance of the company.
For the investors, it offers portfolio diversification in a freely traded instrument
in a convertible currency. The investors bear exchange risk as well as risk of
capital erosion.
GDRs have become very popular with Indian companies. About 58 companies
have tapped this source as against 10 companies which have raised
Euroconvertible bonds.
LESSON - 5
INTEREST RATE PARITY THEORY
Objectives: In this lesson, we will introduce you to the meaning and nature of
interest rate parity theory. This lesson is concept based. After you workout this
lesson, you should be able to:
Know the meaning and nature of interest rate parity theory.
INTEREST RATE PARITY THEORY
Spot and forward rates are closely linked to each other and to interest rates in
different currencies through the medium of arbitrage. Specifically, the
movement of funds between two currencies to take advantage of interest rate
differentials is a major determinant of the spread between forward and spot
rates. In fact, the forward discount or premium is closely related to the interest
differential between the two currencies.
According to interest rate parity (IRP) theory, the currency of the country with a
lower interest rate should be at a forward premium in terms of the currency of
the country with the higher rate. More specifically, in an efficient market with
no transaction costs, the interest differential should be (approximately) equal to
the forward differential. When this condition is met, the forward rate is said to
be at interest rate parity, and equilibrium prevails in the money markets.
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Interest parity ensures that the return on a hedged (or covered) foreign
investment will just equal the domestic interest rate on investments of identical
risk, thereby eliminating the possibility of having a money machine. When this
condition holds, the covered interest differential--the difference between ala
domestic interest rate and the hedged foreign rate -is zero. To illustrate this
condition, suppose an investor with $1,000,000 to invest for 90 days is trying to
decide between investing in U.S. dollars at 8% per annum (2% for 90 days) or in
euros at 6% per annum (1.5% for 90 days). The current spot rate is 1.13110/$,
and the 90-day forward rate is l.l2556/$. Exhibit 4.14 shows that regardless of
the investor`s currency choice, his hedged return will be identical. Specifically,
$1,000,000 invested in dollars for 90 days will yield $1,000,000X 1.02 =
$1,020,000. Alternatively, if the investor chooses to invest in euros on a hedged
basis, he will
1. Convert the $1,000,000 to euros at the spot rate of 11311019. This
yields 1,131,100 available for investment.
2. Invest the principal of 1,131,100 at 1.5% for 90 days. At the end of 90
days, the investor will have 1,148,066.50.
3. Simultaneously with the other transactions, sell the 1,148,066.50 in
principal plus interest forward at a rate of 1.12556/$ for delivery in 90
days. This transaction will yield 1,148,066.50/1.12556 $1,020,000 in 90
days.
If the covered interest differential between two money markets is nonzero, there
is an arbitrage incentive to move money from one market to the other. This
movement of money to take advantage of a covered interest differential is
known as covered interest arbitrage.
The transactions associated with covered interest arbitrage will affect prices ii
both the money and foreign exchange markets. In the previous example, pounds
are bought spot and sold forward, boosting the spot rate and lowering the
forward rate, the forward discount will tend to widen Simultaneously, as mono
flows from New York, interest rates there will tend to increase at the same limo
the inflow of funds to London will depress interest rates there. The process of
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covered interest arbitrage will continue until interest parity is achieved, unless
there government interference.
If this process is interfered with, covered interest differentials between nation al
money markets will not be arbitraged away. Interference often occurs because
many governments regulate and restrict flows of capital across their borders.
Moreover, just the risk of controls will be sufficient to yield prolonged
deviations from interest rate parity.
INTEREST RATE PARITY THEORY
In reality, the interest parity line is a band because transaction cogs, arising
from the spread on spot and forward contracts and brokerage fees on security
purchases and sales, cause effecthe yields to be lower than nominal yields. For
example, if transaction costs are 0.75%, a covered yield differential of only
0.5% will not be sufficient to induce a flow of funds. For interest arbitrage to
occur, the covered differential must exceed the transaction costs involved.
The covered interest arbitrage relationship can be stated formally. Let eo be the
current spot rate (dollar value of one unit of foreign currency) and f1 the end-of-
period forward rate. if rh, and rf are the prevailing interest rates in New York and,
say, London, respectively, then one dollar invested in New York will yield 1 + rh
at the end of the period; the same dollar invested in London will be worth (1 + rf
)f1/fe0 dollars at maturity This latter result can be seen as follows: One dollar
will convert into 1/4 pounds that, when invested at rf, will yield (1 + rf)/e0
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pounds at the end of the period. By selling the proceeds forward today, this
amount will be worth (1 + rf) f1/fe0 dollars when the investment matures.
Funds will flow from New York to London if and only if
1
( r ) f
1 + r
f
1
h <
e0
Conversely, funds will flow from London to New York if and only if
1
( r ) f
1 + r
f
1
h >
e0
Interest rate parity holds when there are no covered interest arbitrage
opportunities. On the basis of the previous discussion, this no-arbitrage
condition can be stated as follows:
1 r
f
h = 1
1 r
e
f
0
4.17
Using Interest Rate Parity to Calculate the $ / ? Forward Rate
The interest rate in the United States is 10%; in Japan, the comparable rate is
7%. The spot rate for the yen is $0.003800. If interest rate parity holds, hat is the
90-day forward rate?
Solution: According to IRP the 90-day forward rate on the Yen, f90 should be
$0.003828
1 ( 10
.
0
/ )
4
f90 = $0.003800 x
= $0.003828
1 ( 07
.
0
/ )
4
In other words, the 90-day forward Japanese yen should be selling at an
annualized premium of about 2.95% [4 X 0.003828 -- 0.003800)/0.0038].
Interest rate parity is often approximated by Equation 4.18.
f e
r
1
0
h ? rf =
e0
In effect, interest rate parity says that high inkiest rates on a currency are offset
by forward discounts and that low interest rates are offset by forward premiums.
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Transaction costs in the form of bid-ask spreads make the computations more
difficult, but the principle is the same: Compute the covered interest differential
to see whether there is an arbitrage opportunity.
Computing the Covered Interest Differential When Transaction Costs Exist
Suppose the annualized interest rate on 180-clay dollar deposits is 6 7/16--
5/16%, meaning that dollars can be borrowed at 6 7/16% (the ask rate) and lent
at 6 5/16% (the bid rate). At the same lime, the annualized interest rate on 180-
day Thai baht deposits is 9 3/8-1/8%. Spot and 180 day forward quotes on Thai
baht are B 31 .5107--46/$ and B 32.1027--87/$, respectively. Is there an
arbitrage opportunity? Compute the profit using B 10,000,000.
Solution. The only way to determine whether an arbitrage opportunit4 exists is
examine the two possibilities. Borrow dollars and lend Thai baht or borrow baht
and old dollars, both on a hedged basis. The key is to ensure that you are using
the correct bid ask interest and exchange rates. in this case, it turns out that there
is an arbitrage opportunity from borrowing Thai baht and lending dollars The
specific steps to implement this arbitrage are as follows:
1. Borrow B 10,000,000 at the ask rate of 9 3/8% for 180 days. This interest rate
translates into a 180 day rate of 0.09375/2 = 4.6875%, requiring repayment of B
10,468,750 in principal plus Interest at the end of 180 days.
2. Immediately convert the B 10,000,000 to dollars at the spot ask rate of B
31.51 46/$ (the baht cost of buying dollars spot). This yields $317,313.25
($10,000,000/31 .5146) available for investment.
3. Invest the principal of $317,31 3.25 at 0.063125/2 = 3.15625% for 180 days.
In one months, this investment will have grown to $327,328.44 ($317.313.25 X
1.0315625).
4. Simultaneously with the other transactions, sell the $327,328.44 in principal
plus interest forward at the bid rate of B 32.1027 (the rate at which dollars can
be converted into baht) for delivery in 180 days. This transaction will yield B
10,508,126.86 in 180 days.
5. At the end of six months, collect the $327,32844, deliver it to the bank
foreign exchange department in return for B 10,508.126.86, and use B
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10,468,750 of the proceeds to repay the loan. The gain on this net of transactions
is B 39,376.86.
UNCOVERED AND COVERED INTEREST RATE DIFFERENTIALS
(U.S. $ VERSUS OTHER CURRENCIES)
-- Uncovered interest rate differentials (three-month Eurodollar deposit
rates minus three-month Euro-deposit rates in named currency)
Covered interest rate differentials (uncovered differentials minus three-
month forward exchange rate premium)
PUT CALL OPTION INTEREST RATE PARITY
Interest rate parity relates the forward rate differential to the interest differential.
Another parity condition -- known as put-call option interest rate parity--
relates options prices to the Interest differential and, by extension, to the forward
differential. We are now going to derive the relation between put and call option
prices, the forward rate, and domestic and foreign interest rates. To do this, we
must first define the following parameters:
C = call option premium on a one period contract
P = put option premium on a one-period contract
X = exercise price on the put and call options (dollars per unit of foreign
currency)
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Other variables ? e0, e1 , f1 , rh and rf - are as defined earlier.
For illustrative purposes, Germany is taken to be the representative foreign
country in the following derivation. In order to price a call option on the euro
with a strike price of X in terms of a put option and forward contract, create the
following portfolio:
1. Lend 1/(1+ rf ) euros in Germany. This amount is the present value of 1 to
be received one period in the future. Hence, in one period, this investment will
be worth 1, which is equivalent to e1 dollars.
2. Buy a put option on I with an exercise price of X.
3. Borrow X/(1 + rh) dollars. This loan will cost X dollars to repay at the end of
the period given an interest rate of rh.
SELF?ASSESSMENT QUESTIONS (SAQs)
1. Suppose that the premium on March 20 on a June 20 yen put option is
0.0514 cents per yen it a strike price of $0.0077. The forward rate for
June 20 is ?1= $0.00787 and the quarterly U.S. interest rate is 2%. If
put-call parity holds, what is the current price of a June 20 PHLX yen
call option with an exercise price of $0.0077?
2. On June 25, the call premium on a December 25 PHLX contract is 6.65
cents per pound at a strike price of $1.81. The 180-day (annualized
interest rate is 7.5% in London and 4.75% in New York. If the current
spot rate is ?1=$1.8470 and put-call parity holds, what is the put
premium on a December 25 PHLX pound contract with an exercise price
of $1.81?
3. Write down the objectives of Hedging Policy.
4. How you evaluate the Interest Rate Options?
5. Compare the lending and investment policies in the global market.
6. What do you mean by cover deals?
7. Speculation is very complication in the global market`, explain it with
example.
8. Many finance managers view forward premia / discounts as a cost of
hedging. Explain why this is an incorrect view.
9. Explain the Bid Rate and Forward Rate.
10. Explain the Quotation.
REFERENCES:
Foreign Exchange Strategies: Spot, Forward and Options By Berg. M.
and G. Moore (1991).
International Financial Management By Mauric S, Dlevi.
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Foreign Exchange Handbook By H. P. Bhardwaj (1994).
International Financial Management By Apte P. G.
Foreign Exchange, International Finance and Risk Management By A.
V. Rajwade (2000).
International Financial Management By Henning, C. N., W. Piggot And
W. H. Scott.
Exchange Rate Arithmatic By C. Jeevanandham.
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This post was last modified on 14 March 2022