Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter 4: The FX market

One’s own currency has been used to buy foreign exchange, and in doing so the buyer has converted its purchasing power into the purchasing power of the seller’s country. The market for foreign exchange is the largest financial market in the world by virtually any standard. The foreign exchange (FX) market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, trading in foreign currency options, and futures contracts, and currency swaps.

The structure of the FX market is an outgrowth of one of the primary functions of a commercial banker: to assist clients in the conduct of international commerce. The spot and forward FX markets are over-the-counter (OTC) markets; that is, trading does not take place in a central marketplace where buyers and sellers congregate. Rather, the FX market is a worldwide linkage of bank currency traders, nonbank dealers, and FX brokers, who assist in trades, connected to one another via a network of telephones, computer terminals, and automated dealing systems.

The market for foreign exchange can be viewed as a two-tier market:

• One tier is the wholesale or interbank market;

• One tier is the retail or client market.

The FX market participants can be categorized in 5 groups:

1. International banks. These provide the core of the FX market;

2. Bank customers. These are served by the international banks;

3. Nonbank dealers. These are large nonbank financial institutions such as investment banks, mutual funds, pension funds, and hedge funds, whose size and frequency of trades make it cost-effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs;

4. FX brokers. These march dealer orders to buy and sell currencies for a fee, but do not take a position themselves;

5. Central banks. This is the national money authority of a particular country that can intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it ‘fixes’ or ‘pegs’ its currency against. Intervention is the process of using foreign currency in order to increase its supply and lower its price.

The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another, called correspondent banking accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market. The Society for Worldwide Interbank Financial Telecommunication (SWIFT) allows international commercial banks to communicate instructions. It is a nonprofit message transfer system with headquarters in Brussels, with intercontinental switching centers in the Netherlands and Virginia.

The spot market involves almost the immediate purchase or sale of foreign exchange. The spot rate currency quotations can be stated in direct or indirect terms. E.g. Direct quotations can be done from the US perspective – that is, the price of one unit of the foreign currency in US dollars. E.g. indirect quotations can also be done from the US perspective – that is, the price of one unit of US dollars expressed in foreign currency. Most currencies in the interbank market are quoted in European terms – that is, the US dollar is priced in terms of the foreign currency (indirect quotation). Some currencies are quoted in American terms. S(j/k) refers to the price of one unit of currency k in terms of currency j. A cross-exchange rate is an exchange rate between a currency pair where neither currency is the US dollar.

In FX transaction there is generally a bid-ask spread. The Interbank FX traders buy currency for inventory at the bid price and sell from inventory at the higher offer or ask price. The retail bid-ask spread is wider than the interbank spread – that is, lower bid and higher ask prices apply to the smaller sums traded at the retail level. This is necessary to cover the fixed costs of a transaction that exists regardless of which tier the trade is made in.

In dealer jargon, a non-dollar trade such as a trade of British pounds for Swiss francs is referred to as a currency against currency trade. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. However, if their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible – an arbitrage is a zero-risk, zero-investment strategy from which a profit is guaranteed. Triangular arbitrage is the process of trading out of the US dollar into a secondary currency, then trading it for a third currency, which is in turn traded for US dollars. The purpose is to earn arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate.

The forward market involves contracting today for the future purchase or sale of foreign exchange. The forward price may be the same as the spot price, but usually it is higher (at a premium) or lower (at a discount) than the spot price. Forward rate: F_N(j/k) refers to the price of one unit of currency k in terms of currency j for delivery in N months. According to the forward rate, when a foreign currency is trading at a premium to the dollar in American terms, we can say that the market expects the dollar to depreciate, or become less valuable relative to the foreign currency. Consequently, it costs more dollars to buy one unit of the foreign currency forward. The situation the other way around is called appreciate. One can buy (take a long position) or sell (take a short position) foreign exchange forward. It is common to express the premium or discount of a forward rate as an annualized percentage deviation from the spot rate. The forward premium (discount) is useful for comparing against the interest rate differential between two countries. The forward premium (discount) van be calculated using American or European terms quotations.

Forward swap trades can be classified as outright or swap transactions. From the bank’s standpoint, an outright forward transaction is an uncovered speculative position in a currency, even though it might be part of a currency hedge to the bank customer on the other side of the transaction. Swap transactions provide mean for the bank to mitigate the currency exposure in a forward trade. A forward swap transaction is the simultaneous sale (purchase) of spot foreign exchange against a forward purchase (sale) of approximately an equal amount of the foreign currency. Quoting forward rates in terms of forwards point is convenient for 2 reasons:

1. Forward points may remain constant for long periods of time, even if the spot rates fluctuate frequently

2. In swap transactions where the trade is attempting to minimize currency exposure, the actual spot and outright forward rates are often of no consequence.

An exchange-traded fund (ETF) is a portfolio of financial assets in which shares representing fractional ownership of the fund trade on an organized exchange. Like mutual funds, ETFs allow small investors the opportunity to invest in portfolios of financial assets that they would find difficult to construct individually.

Chapter 5: Exchange rate determination and international parity conditions

Interest rate parity (IRP) is an arbitrage condition that must hold when international financial markets are in equilibrium. You can invest your funds in two alternative ways: you could choose to invest domestically at the US interest rate or you could invest in a foreign country at the foreign interest rate and hedge exchange risk by selling the maturity value of the foreign investment forward. The law of one price (LOP) applies to the international money market instruments. It is the requirement that similar commodities or securities should be trading at the same or similar prices. The IRP can be derived by constructing an arbitrage portfolio, which involves no net investment, as well as no risk, and then requiring that such a portfolio should not generate any net cash flow in equilibrium. Market equilibrium requires that the net cash flow on the maturity date be zero:

(1 + i_£)F – (1 + i_$)S = 0

The IRP relationship is sometimes approximated as follows:

(i_$ - i_£) = [(F – S)/S] * (1 + i_£) ≈ (F-S)/S

When the IRP holds, you will be indifferent between investing yout money in the US and in the UK (or other foreign country) with forward hedging. However, when IRP is violated, you prefer one to another. You will be better of by investing in the US (UK; foreign country) if (1 + i_$) is greater (less) than (F/S) (1 + i_£). When you need to borrow, on the other hand, you will choose to borrow where the dollar interest is lower. When IRP does not hold, the situation also gives rise to covered interest arbitrage opportunities. Assume that every trader will borrow in the US as much as possible, lend in the UK, buy the pound spot, and, at the same time, sell the pound forward. Then, the following adjustments will occur to the initial market condition:

• The interest rate will rise in the US;

• The interest rate will fall in the UK;

• The pound will appreciate in the spot market;

• The pound will depreciate in the forward market.

Covered interest arbitrage (CIA) activities will increase the interest rate differential (horizontal arrow in exhibit 5.3), and, at the same time, lower the forward premium/discount (vertical arrow in exhibit 5.3). since the foreign exchange and money markets share the burden of adjustments, the actual path of adjustments to IRP can be depicted by the dotted arrow in exhibit 5.3.

Being an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has an immediate implication for exchange rate determination.

Appendix 1

Under certain conditions the forward exchange rate can be viewed as the expected future sport exchange rate conditional on all relevant information being available now, that is:

F = E(S_t+1 | I_t)

Where S_t+1 is the future spot rate when the forward contract matures, and I_t denotes the set of information currently available.

Appendix 2

The expected future exchange rate is a major determinant of the current exchange rate; when people expect the exchange rate to go up in the future, it goes up. Exchange rate behavior is also driven by news events. People form their expectation based on the set of information (I_t) they posses. As a result, the exchange rate will tend to exhibit a dynamic and volatile short-term behavior, responding to various news events. When the forward exchange rate F is replaced by the expected future spot exchange rate E(S_t+1), we obtain:

(i_$ - i_£) ≈ E(e)

This equation states hat the interest rate differential between a pair of countries is (approximately) equal to the expected rate of change in the exchange rate. This relationship is known as the uncovered interest rate parity. This parity often does not hold, giving rise to uncovered interest arbitrage opportunities. A popular example of such trade is provided by currency carry trade which involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging.

Although IRP tends to hold quite well, it may not hold precisely, all the time for at least two reasons:

• Transaction costs

• Capital controls

Because of bid-ask spreads, arbitrage profit from each dollar borrowed may become nonpositive:

(F^a/S^a)(1+ i_£^b) – (1 – i_$^a) ≤ 0

This is so because:

(F^a/S^a) < (F/S)

(1+ i_£^b) < (1+ i_£)

(1+ i_£^a) > (1+ i_$)

In case the arbitrage profit turns negative because of transaction costs, the current deviation from IRP does not represent a profitable arbitrage opportunity. IRP deviations within the band (exhibit 5.5) do not represent profitable arbitrage opportunities. Also, for various macroeconomic reasons, governments sometimes restrict capital flows, inbound and/or outbound. These control measures imposed by governments can effectively impair the arbitrage process, and, as a result, deviations from IRP may persist.

When the LOP is applied internationally to a standard commodity basket, we obtain the theory of purchasing power parity (PPP). It states that the exchange rate between currencies of the two countries should be equal to the ratio of the countries’ price level. Formally PPP, states that the exchange rate between the dollar and the pound should be:

S = P_$/P_£

where S is the dollar price of one pound. This relationship is called the absolute version of PPP. The relative version is:

Appendix 3

where e is the rate of change in the exchange rate. It is noted that even if absolute PPP does not hold, relative PPP may hold.

Whether PPP holds or not has important implications for international trade. If it hlds and thus the differential inflation rates between countries are exactly offset by exchange rates, countries’ competitive positions in world export markets will not be systematically affected by exchange rate changes. However, if there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates, affecting the international competitive positions of countries. This, in turn, would affect countries’ trade balances. The real exchange rate, q, which measures deviations from PPP, can be defined as follows:

Appendix 4

If PPP holds, the real exchange rate will be unity, q = 1. When PPP is violated, the real exchange rate will deviate from unity.

• q = 1: competitiveness of the domestic country unaltered;

• q < 1: competitiveness of the domestic country improves;

• q > 1: competitiveness of the domestic country deteriorates.

The real effective exchange rate is a weighted average of bilateral real exchange rates, with the weight for each foreign currency determined by the country’s share in the domestic country’s international trade. The real effective exchange rate rises if domestic inflation exceeds inflation abroad and the nominal exchange rate fails to depreciate to compensate for the higher domestic inflation rate. Therefore, if the real effective exchange rate falls (rises), the domestic country’s competitiveness improves (declines).

The Fisher effect holds that an increase (decrease) in the expected inflation rate in a country will cause a proportionate increase (decrease) in the interest rate in the country. For the US the effect can be written as:

i_$ = ρ_$ + E(π_$)+ ρ_$E(π_$) ≈ ρ_$ + E(π_$)

where ρ_$ denotes the equilibrium expected ‘real’ interest rate in the US. The fisher effect should hold in each country as long as the bond market is efficient. The effect implies that the expected inflation rate is the difference between the nominal and real interest rates in each country, that is:

E(π_$) = (i_$ - ρ_$)/(1+ ρ_$) ≈ i_$ − ρ_$

E(π_£) = (i_£ - ρ_£)/(1+ ρ_£) ≈ i_£ − ρ_£

E(e) = (i_$ − i_£)/ (1 + i_£) ≈ i_$ − i_£

This last equation is known as the international Fisher effect (IFE). It suggests that the nominal interest rate differential reflects the expected change in exchange rate. When the international Fisher effect is combined with IRP, we obtain:

(F – S)/S = E(e)

Which is referred to as forward expectations parity (FEP). Forward parity states that any forward premium/discount is equal to the expected change in the exchange rate. When investors are risk-neutral, forward parity will hold as long as the foreign exchange market is informationally efficient. Otherwise, it need not hold even if the market is efficient.

Some corporations generate their own forecasts about how the foreign exchange markets will develop, while others subscribe to outside services for a fee. Three distinct approaches are most used as a forecasting technique:

• Efficient market approach. The efficient market hypothesis (EMH) has strong implications for forecasting. When markets are efficient the exchange rate follows a random walk, and the future exchange rate is expected to be the same as the current exchange rate, that is S_t = E(S_t+1). The random walk hypothesis suggests that today’s exchange rate is the best predictor of tomorrow's exchange rate. However, there is no theoretical reason why exchange rates should follow a pure random walk. F_t = E(S_t+1 | I_t). this approach has two advantages. First, since the approach is based on market-determined prices, it is costless to generate forecasts. Both the current spot and forward rates are public information. second, given the efficiency of foreign exchange markets, it is difficult to outperform the market-based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate.

• Fundamental approach. An example of the fundamental approach is the monetary approach that is determined by three independent variables: relative money supplies; relative velocity of monies; and relative national outputs.

  _{Appendix 5}

  Where s is the natural logarithm of the spot exchange rate; m – m* is the natural logarithm of domestic/foreign money supply; v – v* is the natural logarithm of the domestic/foreign velocity of money; y – y* is the natural logarithm of foreign/domestic output; u is the random error term, with mean equal to zero; and α and β are model parameters. This approach has three main difficulties. First, one has to forecast a set of independent variables to forecast the exchange rates. The forecasting will be subject to errors. Second, the parameters values may change over time because of changes in government policies and/or the underlying structure of the economy. Third, the model itself can be wrong.

• Technical approach. This approach analyzes the past behavior of exchange rates for the purpose of identifying patterns and then projects them into the future to generate forecasts. It based on the premise that history repeats itself. Academic studies tend to discredit the validity of technical analysis. Many traders depend on this type of analyses for their trading strategies.

Chapter 6: foreign currency options and futures

Forward and future contracts are both classified as derivative or contingent claim securities because their values are derived from or contingent upon the value of the underlying securities. But while a futures contract is similar to a forward contract, there are many distinctions between the two. A forward contract is tailor-made for a client by his international bank, whereas a futures contract has standardized features and its exchange-traded – traded on organized exchanges rather than over the counter. The main standardized features are the contract size specifying the amount of the underlying foreign currency for future purchase or sale and the maturity date of the contract. A position in multiple contracts may be necessary to establish a sizable hedge or speculative position. Futures contracts have specified delivery months during the year in which contracts mature on a specified day of the month. An initial performance bond (formerly called margin) must be deposited into a collateral account to establish futures position. The major difference between a forward contract and a futures contract is the way the underlying asset is priced for future purchase or sale. A forward contract states a price for the future transaction. A futures contract is settled-up/market-to-market, daily at the settlement price – a price representative of futures transaction prices at the close of daily trading on the exchange. A buyer of a futures contract (holding a long position) in which the settlement price is higher (lower) than the previous day’s settlement price has a positive (negative) settlement for the day. The seller of the futures contract (short position) will have his performance bond account increased (decreased) by the amount the long’s performance bond account is decreased (increased). Therefore, futures trading between the long and the short is a zero-sum game – the sum of the long and short’s daily settlement is zero. If the investor’s performance bond account falls below a maintenance performance bond level (roughly equal to 75% of the initial performance bond), additional funds must be deposited into the account to bring it back to the initial performance bond level in order to keep the position open. The market-to-market feature of futures markets means that market participants realize their profits or suffer their losses on a day-to-day basis rather than all at once at maturity as with a forward contract.

Two types of market participants are necessary for a derivatives market to operate most efficiently: speculators and hedgers. A speculator attempts to profit from a change in the future price. The speculator will take a long or short position in a futures contract depending upon his expectations of future price movements. A hedger wants to avoid price variation by locking in a purchase price of the underlying asset through a long position in the futures contract or a sales price through a short position. The hedger passes off the risk of price variation to the speculator, who is more willing to bear this risk. A reversing trade can be made in either market that will close out, or neutralize, a position. While futures contracts are useful for speculation and hedging, their standardized delivery dates are unlikely to correspond to the actual future dates when foreign exchange transactions will transpire. Thus, they are generally closed out in a reversing trade. The commission that buyers and sellers pay to transact in the futures market is a single amount paid up in front that covers the round-trip transactions of initiating and closing out the position.

In futures markets, a clearinghouse serves as the third party to all transaction. That is, the buyer of a futures contract effectively buys from the clearinghouse and the seller sells to the clearinghouse. The clearinghouse is made up of clearing members. Individual brokers who are not clearing members must deal through a clearing member to clear a customer’s trade. The clearing member stands in for the defaulting party in the event of a default, and, then, it tries to seek restitution from that party. The clearinghouse’s liability is limited because a contract holder’s position is market-to-market daily. Frequently, a futures exchange may have a daily price limit on futures price – a limit as to how much the settlement price can increase of decrease from the previous day’s settlement price.

For each currency future contract, an open interest is represented and is equal to the total number of short or long contracts outstanding for a particular delivery month in the derivative markets. Note that the open interest is greatest for each currency in the nearby contract.

Futures are priced very similar to forward contracts, we can use:

Appendix 6

to define the futures price. This works well since the similarities between the forward and the futures markets allow arbitrage opportunities if the prices between the markets are not roughly in accord. Both the forward market and the futures market are useful for price discovery, or obtaining the market’s forecast of the spot exchange rate at different future dates.

An option is a contract giving the owner the right, but not the obligation, to buy, or sell a given quantity of an asset at a specified price at some time in the future. An option is a derivative, or contingent claim, security. Its value is derived from its definable relationship with the underlying asset. An option to buy the underlying asset is a call option, and to sell the underlying asset is a put option. Buying/selling the underlying asset via the option is known as exercising the option. The state price paid (received) is known as the exercise or striking price. The buyer of an option is frequently referred to as the long and the seller of an option is referred to as the writer of the option, or the short.

For currency futures options the underlying asset is a futures contract on the foreign currency instead of the physical currency. One futures the contract underlies one options contract. Options on currency futures behave very similarly to options on the physical currency since the futures prices converge to the spot price as the futures contract nears maturity. Exercise of a futures option results in a long futures position for the call buyer or the put writer and a short futures position for the put buyer or the call writer. If the futures position is not offset prior to the futures expiration date, receipt or delivery of the underlying currency will, respectively, result or be required.

Assume at expiration, a European and an American option, both with the same exercise price, will have the same terminal value. For call options the time T expiration value per unit of foreign currency can be stated as:

Appendix 7

Where C_aT denotes the value of the American call at expiration, C_eT is the value of the European call at expiration, E is the exercise price per unit of foreign currency, S_T is the expiration date spot price, and Max is an abbreviation for denoting the maximum of the arguments within the brackets.

• A call (option) option with S_T > E (E > S_T) expires in-the-money and it will be exercised.

• If S_T = E the option expires at-the-money.

• If S_T < E (E < S_T) the call (put) option expires out-of-the-money and will not be exercised.

Analogously, at expiration a European put and an American put will have the same value. Algebraically, the expiration value can be stated as:

Appendix 8

Where P denotes the value of the put at expiration.

An American call or put option can be exercised at any time prior to expiration. Consequently, in a rational marketplace, American options will satisfy the following basic pricing relationships at time t prior to expiration:

Appendix 9

These equations mean that the American call and put premium at time t will be at least as large as the immediate exercise value, or intrinsic value, of the call or put option. The longer-term American option will have a market price at least as large as the shorter-term option, since the owner of a long-maturity American option can exercise it on any date that he could exercise a shorter maturity option, or at some later date after the shorter maturity option expires. The difference between the option premium and the option’s intrinsic value is nonnegative and is sometimes referred to as the option’s time value.

The pricing boundaries for European put and call premiums are more complex because they only can be exercised at expiration. Hence, there is a time value element to the boundary expressions. In the table presented above the costs and payoffs of two portfolios a US investor could make. Portfolio A involves purchasing a European call option and lending (investing) an amount equal to the present value of the exercise price, E, at the US interest rate, r_$, which we assume corresponds to the length of the investment period. By comparison, the US dollar investor could invest in portfolio B, which consists of lending the present value of one unit of foreign currency, i, at the foreign interest rate, r_i, which we assume to correspond to the length of the investment period. From this table, it is easily seen that if S_T > E, portfolios A and B pay off the same amount, equal to S_T. In case S_T ≤ E, portfolio A has a larger payoff than portfolio B. it follows that in a rational marketplace, portfolio A will be priced to sell for at least as much as portfolio B, that is:

Appendix 10

Ceteris paribus, when the call premium C_e (put premium P_e) will increase:

1. The larger (smaller) is S_t;

2. The smaller (larger) is E;

3. The smaller (larger) is r_i;

4. The larger (smaller) is r_$;

5. The larger (smaller) r_$ is relative to r_i.

Implicitly, both r_$ and r_i will be larger the longer the length of the option period. When they are not that much difference in size, a European FX call and put will increase in price when the option term-to-maturity increases. However, when r_$ is very much larger than r_i, a European FX call will increase in price, but the put premium will decrease when the option term-to-maturity increases. The opposite is true when r_i is very much larger than r_$.

European call and put prices on spot foreign exchange can be respectively states as:

Appendix 11

Chapter 7: The money market and international banking

International banks facilitate the imports and exports of their clients by arranging trade financing. They serve also their clients by arranging for foreign exchange necessary to conduct cross-border transactions and make foreign investments. Also, international banks have often facilities to trade foreign exchange products for their own account. The major features that distinguish international banks from domestic banks are the types of deposits they accept and the loans and investments they make. Not all, but many, international banks provide services and advice to their clients. Areas in which international banks typically have expertise are foreign exchange hedging strategies; interest rate and currency swap financing; and international cash management services. Banks that do provide a majority of these services are commonly known as universal banks or full service banks.

Rugman and Kamath (1987) provide a formal list of reasons why a bank may establish multinational operations:

• Low marginal costs – managerial and marketing knowledge developed at home can be used abroad with low marginal costs.

• Knowledge advantage – use of knowledge and personal contacts and credit investigations in foreign market.

• Home country information services – local firms may be able to obtain from a foreign subsidiary bank operating in their country more complete trade and financial market information about the subsidiary’s home country than they can obtain from their own domestic banks.

• Prestige – multinational banks have prestige, liquidity, and deposit safety that can be used to attract clients abroad.

• Regulation advantage – different regulations count for international banks. There may be reduced need to publish adequate financial information, lack of required deposit insurance and reserve requirements on foreign currency deposits, and the absence of territorial restrictions.

• Wholesale defensive strategy – banks follow their multinational customers abroad to prevent the erosion of their clientele to foreign banks seeking to service the multinational’s foreign subsidiaries.

• Retail defensive strategy – it helps prevent the erosion of the bank’s traveller’s check, tourist, and foreign business markets form foreign bank competition.

• Transaction costs – they may reduce their transaction costs and foreign exchange risk on currency conversion if government controls van be circumvented.

• Growth – growth prospects in the home nation may be limited.

• Risk reduction – international diversification may lead to greater stability of earnings. Offsetting business and monetary policy cycles across nations reduces the country-specific risk of any nation.

The major types of international banking offices are:

• Correspondent bank relationship – this relationship is established when two banks maintain a correspondent bank account with each other. This system enables a bank’s MNC client to conduct business worldwide through his local bank or its contacts. It is a beneficial relationship because a bank can service its MNC clients at a very low cost and without the need of having bank personnel physically located in many countries. On the contrary, its disadvantage is that the bank’s clients may not receive the level op service through the correspondent bank that they would if the bank had its own foreign facilities to service its clients.

• Representative office – this is a small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent company in dealings with the bank’s correspondents.

• Foreign branch bank – this operates like a local bank, but legally is a part of the parent bank. It is subject to both the banking regulation of its home country and the country in which it operates. The primary reason to establish such a bank is that the bank organization can provide a much fuller range of services for its MNC customers through a branch office than it can through a representative office. Also, with this approach it can compete on a local level with the banks of the host country.

• Subsidiary and affiliate banks – the subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major part by the foreign parent. The affiliate bank is one that is only partially owned but not controlled by its foreign parent. Bot operate under the banking laws of the country in which they are incorporated. Its advantage is that is allowed to underwrite securities.

• Edge act banks – these are federally chartered subsidiaries of US banks that are physically located in the US and are allowed to engage in a full range of international banking activities.

• Offshore banking centres – this is a country whose banking system is organized to permit external accounts beyond the normal economic activity of the country. The International Monetary Funds (IFM) recognized the Bahamas, Bahrain, the Cayman Island, Hong Kong, the Netherlands Antilles, Panama, and Singapore as major offshore banking centres. The principal features that make a country attractive for establishing an offshore banking operation are virtually total freedom from host-country governmental banking regulations – e.g. low reserve requirements and no deposit insurance, low taxes. Its primary activities are to seek deposits and grant loans in currencies other than the currency of the host government.

• International Banking Facilities (IBF) – is a separate set of asset and liability accounts that are segregated on the parent’s books; it is not a unique physical or legal entity. IBFs operate as foreign banks in the US; they seek deposits from non US-citizens; and can make loans only to foreigners. All nonbank deposits must be non-negotiable time deposits with a maturity of at least two business days and be of a size of at least $100,000. IBFs were established largely as a result of the success of offshore banking. However, offshore banking is not going to be eliminated, because IBFs are restricted from lending to US citizens, while offshore banks are not.

Bank capital adequacy refers to the amount of equity capital and other securities a bank holds as reserved against risky assets to reduce the probability of a bank failure. The Basel accord (1988), established by the Bank for International Settlements (BIS), is a framework for measuring bank capital adequacy for banks in the Group of Ten (G-10) countries and Luxembourg. The BIS is the central bank for clearing international transactions between national central banks, and also serves as a facilitator in reaching international banking agreements among its members. The Basel accord focus was on credit risk. However, the accord had its problems and critics. Even if the accord was satisfactory in safeguarding bank depositors from traditional credit risks, the capital adequacy requirements were not sufficient to safeguard against the market risk from derivatives trading. Given its shortcomings, an updated capital accord was needed. However, then additional shortcomings of the original accord were becoming evident: operational risk was becoming a significant risk. Basel II (2005) is based on three mutually reinforcing pillars: minimal capital requirements, a supervisory review process, and the effective use of market discipline. The second pillar is designed to ensure that each bank has a sound internal process in place to properly assess the adequacy of its capital based on a thorough evaluation of its risk. Basel III is being developed.

The Eurocurrency market is the core of the international money market. A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issued the currency. Deposits of dollars outside the US are called Eurodollars and banks accepting Eurocurrency deposits are called Eurobanks. The Eurocurrency market is an external banking system that runs parallel to the domestic banking system of the country that issued the currency. Unlike other deposits (in de US), Eurodollar deposits are not subject to arbitrary reserve requirements or deposit insurance; hence the cost of operations is less. The Eurocurrency market operates at the interbank and/or wholesale level. The rate charged by banks with excess funds is referred to as the interbank offered rate; they will accept interbank deposits at the interbank bid rate.

London has historically been, and remains, the major Eurocurrency financial centre. The London Interbank Offered Rate (LIBOR) is the reference rate in London for Eurocurrency deposits. It is starting to become common practice to refer to international currencies instead of Eurocurrencies and prime banks instead of Eurobanks. The Euro Interbank Offered Rate (EURIBOR) is the rate at which interbank deposits of the euro are offered by on prime bank to another in the Euro zone. In the wholesale money market, Eurobanks accept Eurocurrency fixed time deposits and issue negotiable certificates of deposit (NCDs): these are the preferable ways for Eurobanks to raise loanable funds, as the deposits tend to be for a lengthier period and the acquiring rate is often slightly less than the interbank rate. There is an interest penalty for the early withdrawal of funds from a fixed time deposit. On the other hand, NCDs are negotiable and can be sold in the secondary market if the depositor suddenly needs its funds prior to scheduled maturity.

Eurocredits are short- to medium-term loans of Eurocurrency extended by Eurobanks to corporations, sovereign governments, nonprime banks, or international organizations. The loans are denominated in currencies other than the home currency of the Eurobank. Because these loans are frequently too large for a single bank to handle, Eurobanks will band together to form a bank lending syndicate to share the risk. The credit risk on these loans is bigger than on leans to other banks in the interbank market. Consequently, the interest rate on Eurocredits must compensate the bank, or banking syndicate, for the added credit risk. A Eurocredit may be viewed as a series of shorter-term loans, where at the end of each time period (generally 3/6 months), the loan is rolled over and the base-lending rate is again priced to current LIBOR over the next time interval of the loan.

A major risk Eurobanks face in accepting Eurodeposits and in extending Eurocredits is interest rate risk, resulting from a mismatch in the maturities of the deposits and credits. If deposit maturities are longer (shorter) than the credit maturities, and interest rates fall (rise), credit (deposit) rates will be adjusted downward (upwards) while the bank is still paying (receiving) a higher (lower) rate on deposits (credits). Only when deposit and credit maturities are perfectly matched will the rollover feature of Eurocredits allow the bank to earn the desired deposit-loan rate spread. A forward rate agreement (FRA) is an interbank contract that allows the Eurobank to hedge the interest rate risk in mismatched deposits and credits. An FRA involves two parties: a buyer and a seller, where:

1. The buyer agrees to pay the seller the increased interest cost on a notional amount if interest rates fall below an agreement rate, or

2. The seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreement rate.

FRAs are structures to capture the maturity mismatch in standard-length Eurodeposits and credits. See also exhibit 7.6. The payment amount under an FRA is calculated as the absolute value of:

Appendix 12

where days denotes the length of the FRA period.

Euronotes are short-term notes underwritten by a group of international investment or commercial banks called a ‘facility’. A client-borrower makes an agreement with a facility to issue Euronotes in its own name for a period of time, generally 3 to 10 years. The Euronotes are sold at a discount from face value and pay back the full face values at maturity (from three to six months in general). Borrowers find Euronotes attractive because the interest expense is slightly less – typically LIBOR plus 1/8 percent – in comparison to syndicated Eurobank loans. The bank prefers them because they earn a small fee from the underwriting of supply the funds and earn the interest return.

Eurocommercial paper is an unsecured short-term promissory note issued by a corporation or a bank and placed directly with the investment public through a dealer. Also, this paper is sold at a discount from the face value and they range from 1 to 6 months.

The Eurodollar contract has become most widely used futures contract for hedging short-term US dollar interest rate risk. The international debt crisis (sometimes called the Third World debt crisis; 1982) was caused by lending to the sovereign governments of some less-developed countries (LCDs). The lending process became circular and known as the petrodollar recycling: Eurodollar loan proceeds were used to pay for new oil imports; some of the oil revenues from developed and LDCs were redeposited, and the deposits were re-lent to Third World borrowers. In the midst of the LDC crisis, a secondary market developed for LDC debt at prices discounted significantly from face value. The debt was purchased for use in debt-for-equity swaps (exhibit 7.10). As part of debt rescheduling agreements among the bank lending syndicates and the debtor nations, creditor banks would sell their loans for US dollars at discounts from face value to MNCs desiring to make equity investment in subsidiaries or local firms in the LDCs. A LDC bank would buy the bank debt from a MNC at a smaller discount than the MNC paid, but in local currency. The MNC would use the local currency to make preapproved new investment in the LDC that was economically or socially beneficial to the LDC and its populace. Brady bonds were the loans converted into collateralized bonds with a reduced interest rate (of 6.5%) devised to resolve the international debt crisis in the late 1980s and is named after the US Treasury Secretary Nicholas Brady.

The Asian crisis started with the devaluation of the Thai Baht, which lead to other Asian countries devaluating their currencies by letting them float – ending their pegged value with the US dollar. Interestingly, the Asian crisis followed a period of economic expansion in the region financed by record private capital inflows. Domestic price bubbles in East Asia, particularly in real estate, were fostered by these capital inflows. The simultaneous liberalization of financial markets contributed to bubbles in financial asset prices as well. The close interrelationships common among commercial firms and financial institutions in Asia resulted in poor investment decision-making.

The credit crunch, or the inability of borrowers to easily obtain credit, began in the US in the summer of 2007. The origin of the credit crunch was caused by: the liberalization of banking and securities regulations, a global savings glut, and the low interest rate environment created by the Federal Reserve Bank in the early part of this decade. Credit default swaps (CDS) played a prominent role in the credit crunch. The low interest rate mortgages created an excess demand for homes, driving prices up substantially in most parts of the US, in particular in popular residential areas such as California and Florida. Many homeowners refinanced and withdrew equity from their home, which was frequently used for the consumption of consumer goods. Many of these goods were produces outside the US, and were therefore contributing to US current account deficits. During this time, many banks and mortgage financers lowered their credit standards to attract new home buyers who could afford to make mortgage payments at current low interest rates, or at ‘teaser’ rates that were temporarily set at a low level during the early years of an adjustable-rate mortgage, but would likely to be reset to a higher rate later on. These so-called subprime mortgages were typically not held by the originating bank making the loan, but instead were repacked into mortgage-backed securities (MBSs) to be sold to investors. To cool the growth of the economy the Fed steadily increased the fed funds target rate at meetings of the Federal Open Market Committee, which lead to increases in the mortgage rates and home prices stopped increasing. It was discovered that the amount of subprime MBS debt in structured investment vehicles (SIVs) and collateralized debt obligations (CDOs), and who exactly owned it, was essentially unknown, or at leas unappreciated. An SIV is a virtual bank, frequently operated by a commercial bank or an investment bank, but which operates off the balance sheer. A CDO is a corporate entity constructed to hold a portfolio of fixed-income assets as collateral. While it was thought SIVs and CDOs would spread MBS risk worldwide to investors best able to bear it, it turned out that many banks that did not hold mortgage debt directly held it indirectly through MBSs in SIVs they sponsored. Diversification of credit risk in MBSs, SIVs, and CDOs thought they had was only illusory, because the portfolio was only diversified over a single asset class – poor-quality residential mortgages! When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs, and trading in the interbank Eurocurrency market essentially ceased as traders became fearful of the counterparty risk of placing funds with even the strongest international banks. Liquidity worldwide essentially dried up. Eventually, the credit crunch leads to a financial crisis. Credit rating firms lowered their ratings on many CDOs after discovering that they were mis-specified and they also downgraded many MBSs, especially those containing subprime mortgages, as foreclosures around the world increased. Sustainable problems arose for bond insures who sold credit default swaps (CDS) contracts and the banks that purchased this credit insurance. As the bond insurers got hit with claims from bank-sponsored SIVs as the MBS debt in their portfolios defaulted, the credit rating agencies required the insurers to put up more collateral with the counterparties who held the other side of the CDSs, which put stress on their capital base and prompted credit-rating downgrades, which in turn triggered more margin calls. Many lessons should be learned from these experiences. One lesson is that bankers seem not to scrutinize credit risk as closely when they serve only as mortgage originators and then pass it on to MBS investors rather than hold the papers themselves. New banking regulations and financial regulations are currently being implemented to try and prevent or mitigate future financial crisis.

Chapter 10: currency swaps and interest rates

In interest rate swap financing, two parties, called counterparties, make a contractual agreement to exchange cash flows at periodic intervals. There are two types of interest rate swaps:

1. Single-currency interest rate swap: shortened: interest rate swap. It has many variants; however, all involve swapping interest payments on debt obligations that are denominated in the same currency. The simplest is the (‘plain vanilla’) fixed-for-floating rate interest rate swap, one counterparty exchanges the interest payments of a floating-rate debt obligation for the fixed-rate interest payments of the other counterparty. Reasons for using this swap are to better match cash inflows and outflows and/or to obtain a cost savings.

2. Cross-currency interest rate swap: shortened: currency swap. One counterparty exchanges the debt service obligations of a bond denominated in one currency for the debt service obligations of the other counterparty that are denominated in another currency. The simplest version is the exchange of fixed-for-fixed rate debt service. Reasons for using currency swaps are to obtain debt financing in the swapped denomination at a cost savings and/or to hedge long-term foreign exchange rate risk.

Notional principal, a reference amount of principal for determining interest payments, measures the size of the swap market. A swap bank describes a financial institution that facilitates swaps between counterparties; it serves as either a swap broker or swap dealer. A swap bank will typically quote a fixed-rate bid-ask spread versus three-month or six-month dollar LIBOR flat, that is, no credit premium. The quality spread differential (QSD) is the difference between the fixed interest rate spread differential and the floating interest rate spread differential of the debt of two counterparties of different creditworthiness. The former is generally greater than the latter since the yield curve for lower-quality debt tends to be steeper than the yield curve for higher-rated debt. A positive QSD is a necessary condition for an interest swap to occur that ensures that the swap will be beneficial to both parties.

In an interest swap, the principal sums the two counterparties raise are not exchanged, since both counterparties have borrowed in the same currency. The amount of interest payments that are exchanged are based on a notional sum, which may not equal the exact amount actually borrowed by each counterparty.

In a zero-coupon-for-floating rate swap where the floating-rate payer makes the standard periodic floating-rate payments over the life of the swap, but the fixed rate payer makes a single payment at the end of the swap. A variation is the floating-for-floating interest rate swap, in which each side is tied to a different floating rate interest index (e.g. LIBOR and Treasury bills) or a different frequency of the same index (e.g. the three-month and six-month LIBOR). For a swap to be possible, a QSD must still exist. Additionally, interest rate swaps can be established on an amortizing basis, where the debt services exchanges decrease periodically through time as the hypothetical notional principal is amortized.

Interest-rate risk refers to the risk of interest rates changing unfavourably before the swap bank can lay off on an opposing counterparty the other side of an interest rate swap entered into with a counterparty. Basis risk refers to a situation in which the floating rates of the two counterparties are not pegged to the same index. Any difference in the indexes is known as the basis. Exchange-rate risk refers to the risk the swap bank faces from fluctuating exchange rates during the time it takes for the bank to lay off a swap it undertakes with one counterparty wit an opposing counterparty. Credit risk is the major risk faced by a swap dealer and refers to the probability that the counterparty will default. The swap bank that stands between the two counterparties is not obligated to the defaulting counterparty, only to the non-defaulting counterparty. The mismatch risk refers to the difficulty of finding an exact opposite match for a swap the bank has agreed to take. The mismatch may be with respect to the size of the principal sums the counterparties need, the maturity dates of the individual debt issues, or the debt services dates. Sovereign risk refers to the probability that a country will impose exchange restrictions on a currency involved in a swap. This makes it very costly, or even impossible, for a counterparty to fulfil its obligation to the dealer. In this case, provisions exist for terminating the swap, which results in a loss of revenue for the swap bank.

Two primary reasons for a counterparty to use a currency swap are to obtain debt financing in the swapped currency at an interest cost reduction brought about through comparative advantages each counterparty has in its national capital market, and/or the benefit of hedging long-run exchange rate exposure. The two primary reasons for swapping interest rates are to better match maturities of assets and liabilities and/or to obtain a costs savings via the quality-spread differential. In an efficient market without barriers to capital flows, the costs savings argument through a QSD is difficult to accept. It implies that an arbitrage opportunity exists because of some mispricing of the default risk premium on different types of debt instruments. If the QSD is one of the primary reasons for the existence of interest rate swaps, one would expect arbitrage to eliminate it over time and that the growth of the swap market would decrease. However, growth in interest rate swaps has been extremely large in recent years. Therefore, the arbitrage argument does not seem to have much merit. Consequently, one has to rely on an argument of market completeness for the existence and growth of interest rate swaps – that is, all types of debt instruments are not regularly available for all borrowers.

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