Chap002.ppt buy n buy law makers our two

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1. Chapter 02
International Financial
Markets: Structure and
Innovation
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

2. Learning ObjectivesLearning Objectives
A.A.Describe FX markets, structure and Describe FX markets, structure and
participants.participants.
B.B.Use FX direct and indirect quotes, Use FX direct and indirect quotes,
compute transaction costs and calculate compute transaction costs and calculate
cross rates.cross rates.
C.C.Classify international banking Classify international banking
transactions.transactions.
D.D.Describe Euro-markets (short- and long-Describe Euro-markets (short- and long-
term) and global equity markets.term) and global equity markets.
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3. A1. Foreign Exchange (FX): A1. Foreign Exchange (FX):
OverviewOverview
Focus on spot market (current exchange of Focus on spot market (current exchange of
one currency for another) in this chapterone currency for another) in this chapter
Large market with daily volume greater Large market with daily volume greater
than that of any other financial marketthan that of any other financial market
3 reasons for transactions:3 reasons for transactions:
MNCs and other entities have business related MNCs and other entities have business related
needs to convert currencyneeds to convert currency
Banks and other intermediaries ‘service’ others Banks and other intermediaries ‘service’ others
by converting currenciesby converting currencies
Investment funds have portfolio related needs Investment funds have portfolio related needs
to convert currenciesto convert currencies
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4. A2. FX Markets: MNC A2. FX Markets: MNC
ParticipationParticipation
MNCs convert currencies to facilitate MNCs convert currencies to facilitate
transactions with subsidiaries, affiliates, transactions with subsidiaries, affiliates,
suppliers and customerssuppliers and customers
3 specific ways of participation:3 specific ways of participation:
MNCs purchase inputs/components from MNCs purchase inputs/components from
foreign suppliersforeign suppliers
MNCs sell goods and services in foreign MNCs sell goods and services in foreign
marketsmarkets
MNCs make cross-border investments in real MNCs make cross-border investments in real
assetsassets
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5. A3. FX: Banks & Other A3. FX: Banks & Other
ParticipantsParticipants
Banks: most important players, make up Banks: most important players, make up
the Interbank marketthe Interbank market
Other financial institutions: mutual funds, Other financial institutions: mutual funds,
hedge fundshedge funds
Governments: not the largest player, but Governments: not the largest player, but
very influentialvery influential
Individuals: tourism and investment needs Individuals: tourism and investment needs
met through currency transactionsmet through currency transactions
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6. A4. FX Markets: Size & A4. FX Markets: Size &
StructureStructure
Overall size is USD 3 trillion a day of which Overall size is USD 3 trillion a day of which
USD 1 trillion is spot (rest ‘future’ contracts)USD 1 trillion is spot (rest ‘future’ contracts)
Average transaction size is USD 4 millionAverage transaction size is USD 4 million
Major currencies are USD, EUR, JPY and Major currencies are USD, EUR, JPY and
GBPGBP
USD in 86% of all transactionsUSD in 86% of all transactions
Large banks serve as market-makersLarge banks serve as market-makers
Markets are over-the-counter (OTC) Markets are over-the-counter (OTC)
electronic marketselectronic markets
Settlement is electronically conducted. US Settlement is electronically conducted. US
systems include Fedwire and CHIPSsystems include Fedwire and CHIPS
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7. B1. FX: Direct vs. Indirect QuoteB1. FX: Direct vs. Indirect Quote
Direct Quote
‘USD 1.25 per
EUR’
Or
‘EURUSD=1.25’
Indirect Quote
‘EUR 0.80 per
USD’
Or
‘USDEUR=0.80’
EUR 1
USD 1.25
USD 1
EUR 0.80
EQUALS
EQUALS
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8. B2. FX: Bid and AskB2. FX: Bid and Ask
EURUSD is quoted at 1.5511-1.5514EURUSD is quoted at 1.5511-1.5514
The bank is willing to purchase EUR by paying The bank is willing to purchase EUR by paying
USD 1.5511USD 1.5511
The bank is willing to sell EUR by receiving USD The bank is willing to sell EUR by receiving USD
1.55141.5514
%.01934.0
5514.1
5511.15514.1
EURUSDfor ask -bidPercent 


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9. B3. FX: Transaction CostsB3. FX: Transaction Costs
EXAMPLE: A Brazilian firm wishes to EXAMPLE: A Brazilian firm wishes to
purchase USD 400,000. It approaches purchase USD 400,000. It approaches
Unibanco for a quote. Unibanco quotes Unibanco for a quote. Unibanco quotes
USDBRL at 1.4015 – 1.4037. Also USDBRL at 1.4015 – 1.4037. Also
Unibanco imposes a commission of BRL Unibanco imposes a commission of BRL
200 on each transaction. 200 on each transaction.
Firm Pays =Firm Pays =
680,5612004037.1000,400 BRL
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10. B3. FX: Transaction Costs (cont.)B3. FX: Transaction Costs (cont.)
If there are no transaction costs, firm would If there are no transaction costs, firm would
pay =pay =
Transaction Costs = Transaction Costs =
Transaction Costs % = Transaction Costs % =
640040,561680,561 
040,561
2
4037.14015.1
000,400 BRL


%114.0
040,561
640

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11. B4. FX: Cross RatesB4. FX: Cross Rates
EXAMPLE: The EUR is quoted directly and EXAMPLE: The EUR is quoted directly and
indirectly relative to USD at 1.5514 and 0.64458 indirectly relative to USD at 1.5514 and 0.64458
respectively. The JPY is quoted directly and respectively. The JPY is quoted directly and
indirectly relative to the USD at 0.0100 and indirectly relative to the USD at 0.0100 and
100.00 respectively. Calculate the cross rate 100.00 respectively. Calculate the cross rate
between EUR and JPY using one of the between EUR and JPY using one of the
following two approaches.following two approaches.
SolutionSolution::
Value of EUR expressed in JPY = EURJPYValue of EUR expressed in JPY = EURJPY
= Direct quote of EUR / Direct quote of = Direct quote of EUR / Direct quote of
JPYJPY
= 1.5514 / 0.0100 = 1.5514 / 0.0100
= 155.14= 155.14
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12. C1. International BankingC1. International Banking

Classification of Banking Positions
Residents Non-Residents
Domestic Currency A B
Foreign Currency D C
B+C = external or cross-border positions
C+D = foreign currency positions (also known as Eurocurrency)
B+C+D = international positions
A+B+C+D = global positions
Source: BIS, Guide to the International Banking Statistics, 2003

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13. C2. Classifying deposits, C2. Classifying deposits,
ExampleExample
EXAMPLE: Consider the following transactions of a EXAMPLE: Consider the following transactions of a
French bank. It accepts two deposits from a French French bank. It accepts two deposits from a French
citizen: EUR 5,000 and USD 10,000. It also citizen: EUR 5,000 and USD 10,000. It also
accepts two deposits from a Japanese citizen: JPY accepts two deposits from a Japanese citizen: JPY
2,500,000 and EUR 8,000. Classify these deposits.2,500,000 and EUR 8,000. Classify these deposits.
SolutionSolution::
External positions = JPY 2,500,000 + EUR 8,000External positions = JPY 2,500,000 + EUR 8,000
Foreign currency positions = USD 10,000 + JPY Foreign currency positions = USD 10,000 + JPY
2,500,0002,500,000
International positions = USD 10,000 + JPY International positions = USD 10,000 + JPY
2,500,000 + EUR 8,0002,500,000 + EUR 8,000
Global positions = USD 10,000 + JPY 2,500,000 + Global positions = USD 10,000 + JPY 2,500,000 +
EUR 13,000EUR 13,000
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14. D1. Eurodollars & LIBORD1. Eurodollars & LIBOR
Eurocurrency or foreign currency transactions Eurocurrency or foreign currency transactions
in the USD are called in the USD are called EurodollarEurodollar
transactionstransactions
The key indicator for this market is the The key indicator for this market is the
London Inter Bank Offer RateLondon Inter Bank Offer Rate (LIBOR) (LIBOR), the , the
rate offered by Eurobanks for loans to other rate offered by Eurobanks for loans to other
institutionsinstitutions
LIBOR rates are compiled by the British LIBOR rates are compiled by the British
Banker’s Association, and disseminated at 11 Banker’s Association, and disseminated at 11
AM Greenwich Mean Time, reflect rates at AM Greenwich Mean Time, reflect rates at
which banks are willing to lend to each otherwhich banks are willing to lend to each other
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15. D2. LIBOR ConventionD2. LIBOR Convention
MNC deposits $3 million for 60 days at a MNC deposits $3 million for 60 days at a
LIBOR rate of 5%. LIBOR uses simple LIBOR rate of 5%. LIBOR uses simple
interest ‘actual/360’ basisinterest ‘actual/360’ basis
.000,025,3
360
60
%51000,000,3 FV 






%.178.51
000,000,3
000,025,3
return annual Effective
60/365







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16. D3. Eurocurrency MarketsD3. Eurocurrency Markets
Eurodollar, Euroyen, Europound and other Eurodollar, Euroyen, Europound and other
instruments make up the Eurocurrency instruments make up the Eurocurrency
markets (move toward renaming to foreign markets (move toward renaming to foreign
currency markets, because of confusion with currency markets, because of confusion with
EUR)EUR)
Eurdollar origins:Eurdollar origins:
Regulation Q (investors searched abroad for Regulation Q (investors searched abroad for
better interestbetter interest
External holdings of USD (current account External holdings of USD (current account
deficits)deficits)
Innovation by Midland Bank in 1955, thwarting Innovation by Midland Bank in 1955, thwarting
regulation and creating this marketregulation and creating this market
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17. D4. EurocreditsD4. Eurocredits
Medium-term marketsMedium-term markets
Main instrument is Floating Rate Note (FRN)Main instrument is Floating Rate Note (FRN)
Coupon specified as ‘LIBOR + X’Coupon specified as ‘LIBOR + X’
At any point in time, only the next coupon is At any point in time, only the next coupon is
known, others depend on future values of known, others depend on future values of
LIBORLIBOR
Term Structure models or prices from futures Term Structure models or prices from futures
markets may be used to infer future values of markets may be used to infer future values of
LIBORLIBOR
Fixed rate instruments known as EuronotesFixed rate instruments known as Euronotes
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18. D5. EurobondsD5. Eurobonds
Mismatch between country of issue and Mismatch between country of issue and
currency denomination (e.g., USD bonds currency denomination (e.g., USD bonds
issued outside of US)issued outside of US)
First Eurobond issued in 1963 by AutostradeFirst Eurobond issued in 1963 by Autostrade
Traditionally, Eurobonds were bearer bondsTraditionally, Eurobonds were bearer bonds
Main currencies: USD, EUR, JPYMain currencies: USD, EUR, JPY
Median issue: USD 100 millionMedian issue: USD 100 million
Most are fixed rate instrumentsMost are fixed rate instruments
Development: Global bonds, issued Development: Global bonds, issued
simultaneously around the world, often USD 1 simultaneously around the world, often USD 1
billion or greaterbillion or greater
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19. D6. Global EquityD6. Global Equity
US equity markets are important part of US equity markets are important part of
global equity markets (1/3 of value global equity markets (1/3 of value
approximately)approximately)
NYSE and NASDAQ continue to innovate NYSE and NASDAQ continue to innovate
and lead trading practicesand lead trading practices
Emerging markets are becoming more Emerging markets are becoming more
importantimportant
Electronic trading is becoming more Electronic trading is becoming more
importantimportant
Cross-border listing is increasingCross-border listing is increasing
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