INTERNATIONAL FINANCIAL MANAGEMENT 3

Where the Eurocurrency Market Fits In Market EUR0CURRENCY MARKET Domestic Market Euro-Deutsche Mark Eurodollar Market Market Foreign Exchange Market Japanese Euro-Yen Domestic Mar

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Ian Giddy

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FINANCIAL MANAGEMENT

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 www.stern.nyu.edu

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 www.stern.nyu.edu/~igiddy/ifmx.htm

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 www.giddy.org

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International Financial Management

Prof Ian Giddy

Stern School of Business,

New York University

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International Financial Management

 Management of international assets

 Management of international liabilities

 Management of cross-border financial

risks

 Cross-border funds transfers

These depend on the environmental

features of international notably, the global financial markets

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What is Special about Corporate Finance

in the International Environment?

 Financial markets are partially linked, partially

separated by national jurisdications

 Exchange rate fluctuations affect revenues,

costs and valuation of firms

 The competitive international financial

markets offer special tools, opportunities and risks

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What are the Global Financial

Markets?

 The Foreign Exchange Market

 The Derivatives

 Domestic and International Money Markets

 Domestic and International Capital Markets

 Beyond the Money and Bond Markets:

International Equity and Commodity Markets

 Using the Global Capital Markets: Investors’

and Issuers’ Perspectives

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The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank

within a jurisdication outside the United States”

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The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank

within a jurisdication outside the United States”

 Separation of currency, institution and

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US Domestic German

Market EUR0CURRENCY MARKET Domestic

Market

Euro-Deutsche Mark Eurodollar Market

Market

Japanese Euro-Yen Domestic

Market Market

Where the Eurocurrency Market Fits In

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Where the Eurocurrency Market Fits In

Market EUR0CURRENCY MARKET Domestic

Market

Euro-Deutsche Mark Eurodollar Market

Market Foreign

Exchange Market Japanese

Euro-Yen Domestic

Market Market

Euro-Commercial Euro-Floating Rate Straight

Paper Market Note Market Eurobond Market

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Interest Rate Linkages in the

International Money Market

Two stories to tell:

 Domestic vs Euro

 Eurocurrency A vs Eurocurrency B

Domestic Market A The Euromarkets Domestic Market B

Bank Euro Euro Bank

sury Deposit Deposit Deposit Deposit sury

Bill Market Market Bill

Corp- Euro Euro Corp-

sury orate Bond Bond orate sury

Bond Bond Market Market Bond Bond

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Domestic versus Euro

The Eurodollar Premium

Market price of risk

versus Cost of regulation

 Eurodollar vs U.S Interest Rate

Effective cost of domestic deposit

= (interest rate + FDIC fees)

(1 - reserve requirement)

 Capital controls and divided credit markets

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Covered Interest Arbitrage

Money market 1

Money market 2

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Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

The Dealing Room

CUS- FOR- Foreign TOMER SPOT WARD Exchange

Dealing

FUNDING EUROCURRENCY Market

Diagram of a Dealing Room

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Foreign exchange and Eurocurrency dealing are interrelated activities and so are done on the same trading floor.

CUS- FOR- Foreign TOMER SPOT WARD Exchange

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Linkages Between Eurocurrency Rates

Interest rate differential

Forward premium

Expected

% change in exchange rate

Expected

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Forward premium

Expected

Covered interest

rate parity

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Forward premium

Expected

Covered interest

rate parity

Uncovered interest

rate parity

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Forward premium

Expected

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Example: Anglo’s Funding

 Anglo-American, the natural resources

conglomerate, is seeking 3-month US$

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Anglo’s Answer

It’s cheaper for Anglo-American to borrow

in the US CP market Reason:

 US: simply borrow for 3 months

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of actual exchange rate

Unbiased Forward Rate Theory

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Unbiased Forward Rate

Forward premium or discount

= Expected annual rate of change

of the exchange rate That is,

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of actual exchange rate

months

International Fisher Effect

INTEREST RATE DIFFERENTIAL

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International Fisher Effect

/ E$ = / EDM + E(R $/DM ) That is,

Interest-rate differential

equals

Expected annual rate of change of exchange rate

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Cost of Hedging

Money Market Hedge

(Borrow to match

assets)

Do nothing Expected rate of

change of exchange rate

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Corporate Hedging Decisions:

Frutas Amazonas

Exporting bananas to Spain, get paid in

Spanish pesetas Funding is in U.S

dollars

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Corporate Hedging Decisions:

Frutas Amazonas

 Continue funding in U.S dollars The

peseta might get stronger in the next three months, from $1=128 pesetas to

$1=126 pesetas This could be the cheapest

 Switch funding to pesetas, despite the

slightly higher cost

 Borrow in dollars, but hedge the

exchange risk in the forward market.

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Frutas Amazonas

Eurodollar 3-month loan rate

5 9/16%

Europeseta month loan rate

3-7 15/16%

Spot exchange rate today

Pta128.210 per USD

Forward exchange rate today

Pta129.005 per USD

Forward discount,

% per annum

-2.5

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Law of One Price

p=Sp*

The Price of Tin

In New York On the Kuala On the

Exchange 273c per lb 15.37 ringgit US$5830 per

per kilogramb per kilogramc

a1 avoirdupois pound = 0.45359 kilograms

bUS$1 = 2.6965 Malaysian ringgit on the date of calculation

c 1 tonne = 1000 kilogram.

All data taken from the Commodities section

of the London Financial Times.

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RELATIVE INFLATION

Purchasing Power Parity:

Theory and Evidence

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Deviations from

Purchasing Power Parity

60 70 80 90 100 110 120 130 140

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Deviations from

Purchasing Power Parity

Source: JP Morgan Index of real effective exchange rate versus 18 industrial country currencies,

60 70 80 90 100 110 120 130 140

UK

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US Expected Inflation Rate 2%

Inflation & Interest Rates

Canadian Expected Inflation Rate 7%

US Interest Rate 5%

Canadian Interest Rate 10%

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US Expected Inflation Rate 2%

Canadian Expected Inflation Rate 7%

US Interest Rate 5%

Canadian Interest Rate 10%

Expected Rate of Change

of the Exchange Rate

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Borrow at US Interest Rate 5%

Invest at Canadian Interest Rate 10%

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Buy Canadian Dollars Forward

(at discount of 5%)

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The Linkages Again

Relative excess money supply

Relative inflation rates

Forward exchange premium

or discount

Exchange rate change

Relative interest rates

6 5

4

1

3 2

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A Framework

Country A Country B

DOMESTIC DOMESTIC ECONOMIC ECONOMIC POLICIES POLICIES

INFLATION INFLATION RATE RATE

EXCHANGE RATE INTEREST INTEREST

RATE RATE

FORWARD RATE

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Conclusion:

Corporate Exchange Rate Risk

 Exchange Rate Risk is the risk arising from

fluctuating exchange rates between two

currencies

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Corporate Exchange Rate Risk

 Exchange Rate Risk is the risk arising from

fluctuating exchange rates between two

currencies; but it’s tied to prices and to

business risk.

Relative monetary and fiscal policies

Relative inflation

Exchange

rate change

Exchange

rate change

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Turkey, 1995

Turkish Lira:

Down 33.5%

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