The International Capital Markets Prof. Ian Giddy New York University New York University/ING Barings

The InternationalCapital Markets

Prof. Ian GiddyNew York University

New York University/ING Barings

Copyright ©1999 Ian H. Giddy Capital Markets 2

Instruments and Markets

Corporate BondsCorporate Bonds

DomesticDomestic InternationalInternational


International Financial Markets

The Eurocurrency market Foreign exchange Covered interest arbitrage International portfolio investment returns Hedging international portfolios International diversification: passive vs

active


“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

Separation of currency, institution and jurisdiction

Why do people want Eurocurrency deposits and loans?

Why is LIBOR the world’s key benchmark rate?

The Eurocurrency Market


The Eurocurrency Market

“A Eurodollar is a dollar deposited in a bank within a jurisdication outside the United States”

Separation of currency, institution and jurisdiction

Why do people want Eurocurrency deposits and loans?

Why is LIBOR the world’s key benchmark rate?


Where the Eurocurrency Market Fits In

US Domestic German

Market EUR0CURRENCY MARKET Domestic Market

Euro-Deutsche Mark

Eurodollar Market

Market Foreign

Exchange

Market Japanese

Euro-Yen Domestic

Market Market

Euro-Commercial Euro-Floating Rate Straight

Paper Market Note Market Eurobond Market


The Global Bond Market

Domestic bonds Foreign bond

(Issued within country of currency, by non-resident issuers)

Eurobonds(Issued and sold in a jurisdiction outside the

country of the currency of denomination) Global Bonds(Issued in the domestic and the Eurobond

markets simultaneously)


Characteristics of Eurobonds

Issued outside country of currency Not subject to domestic registration or disclosure

requirements In most cases take form of private placements Placed through syndicates in many countries who sell

principally to nonresidents Bonds are structured so as to be free of withholding

tax Bearer formBut... Eurobonds usually influenced de facto by government

and banks of country of currency


International Bond Markets are Linked

Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps

BONDMARKETSWITHINCOUNTRYOFCURRENCY

BONDMARKETSOUTSIDECOUNTRYOFCURRENCY

CurrencySwaps

Long-datedForwardExchange

Domestic US

- Gov't- Corporate

ForeignBonds

"Yankee"

DomesticJapanese

- Gov't- Corporate

ForeignBonds

"Samurai"

EurodollarBond Market

EuroyenBond Market


Exchange Rate Risk

Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies


Policies and Exchange Rate Regimes

Exchange rate systems--fixed vs floating

Managed floating EMU-type currency blocs De facto blocs--the dollar


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

The Euromarket vs the Euro

C


Domestic Policies, Domestic Prices and Interest Rates, and Exchange Rates

Country A Country B

DOMESTIC DOMESTICECONOMIC ECONOMICPOLICIES POLICIES

INFLATION INFLATION RATE RATE

EXCHANGERATE

INTEREST INTEREST RATE RATE

FORWARDRATE


Foreign Exchange Mechanics and Calculations

“Money never leaves homes” Funds transfer, chips, and timing Relative interest rates

1. Forward premium or discount

2. Points

3. Spot and forward Spot and forward

1. Points

2. Forward premium or discount

3. Relative interest rates


Exchange Rates

CurrencyHowquoted

Spot(2 businessdays)

Forward(90 days)

Britishpounds(GBP)

US$perGBP

1.632 1.617

Japaneseyen (JPY)

Yen perUS$

117.5 116.3


A Typical Forward Contract

We agree today to pay a certain price for a currency in the future

SonySony B of AB of A

JPY


Foreign Exchange Quotations

Spot Forward points



Bid OfferSpotForward pointsRule:add if bid<offer,subtract if bid>offerOutright forward



Bid OfferSpotForward pointsRule:add if bid<offer,subtract if bid>offerOutright forward

111.35 111.450.52 0.517

110.83 110.933


110

115

120

125

130

135

140

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

EXCHANGERATE, YENPER US$

FORWARDPREMUIM,PERCENTPER ANNUM

FORWARD(LEFT SCALE)

SPOT (LEFT SCALE)

FORWARD PREMIUM(RIGHT SCALE)

MONTHLY DATA, 1987-1989

FORWARD PREMIUM = [(SPOT-FORWARD)/SPOT]*(12/3)*100

The Forward Rate Tracks the Spot Rate


Covered Interest Arbitrage

Moneymarket 1

Moneymarket 2

Spot Forward


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

The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing

Money

FUNDING EUROCURRENCY Market

Dealing

In the Dealing Room

The Dealing Room


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

The Dealing RoomCUS- FOR- Foreign TOMER SPOT WARD Exchange Dealing

Money

FUNDING EUROCURRENCY Market

Dealing

Diagram of a Dealing Room


Interest-Rate Parity

$1 (1 + / E$) = ($1/ S t )(1 + /EBP) Fnt

where St is the spot exchange rate (dollars per British

Pound) and Fnt is the forward rate.

to a close approximation,

(/E$ - /EBP) = [(Ft n - St)/St] (365/n) 100

Interest-rate differential = forward

premium or

discount


Example: Guidant’s Cash

Guidant, the medical instruments company, is seeking to invest 3-month US$ money.Guidant can invest in the US CP market at

5.5%Or in the Eurosterling market at 6.7%The BP is:

spot $1.5484, 3-mo forward $1.5454 Which is better?


Guidants’s Answer

It’s better for Guidant to invest in the GBP instrument and hedge. Reason:US: simply invest for 3 months

Result: $1(1+5.5%/4) = 1.01375

UK: take the US dollars, change into British pounds at spot rate, cover by selling sterling at 3-mo forward rate to convert the money back into dollars

Result: ($1/1.5484)(1+6.7%/4)1.5454 = 1.01478


TIME

EXCHANGE RATE Spot

Forward

Actual

Today In three

months

What if Guidant didn’t hedge?


TIME

EXCHANGE RATE Spot

Forward

Actual

Probabilitydistributionof actualexchange rate

Today In three

months

Unbiased Forward Rate Theory


Issues

What are the risks involved in investment in foreign securities?

How do you measure benchmark returns on foreign investments?

Are there benefits to diversification in foreign securities?


International Equity Investments

Equity returns in local currency Exchange rate changes Other factors?


Equity Returns: Domestic vs Global

Yardeni.com

International charts


Int’l Investment Choices

Direct Stock Purchases ADRs Mutual Funds

Open endClosed end

Global companies


Obstacles to International Investment Might Include:

Information barriers. Political and capital control risks. Foreign exchange risks. Restrictions on foreign investment and

control. Taxation. Higher costs.


Foreign Exchnage Risk in International Investing

Foreign Exchange Risk Variation in return related to changes in

the relative value of the domestic and foreign currency

Total Return = Investment return plus return on foreign exchange

Not possible to completely hedge a foreign investment


Returns with FX

Return in US is a function of two factors

1. Return in the foreign market

2. Return on the foreign exchange


Returns with FX

(1 + rUS) = (1 + rFM) (1 + rFX)

rUS = return on the foreign investment in US Dollars

rFM = return on the foreign market in local currency

rFX = return on the foreign exchange


Return Example: Dollar Appreciates

Initial Investment : $100,000

Initial Exchange: $2.00/ Pound Sterling

Final Exchange:$2.10/ Pound Sterling

Return in British Security: 10%

Return in US Dollars

(1 + rUS) = (1.10) (1.05) = (1.155)

rUS = 15.5%


Return Example: Dollar Depreciates

Initial Investment : $100,000

Initial Exchange: $2/ Pound Sterling

Final Exchange: $1.85/ Pound Sterling

Return in British Security: 10%

Return in US Dollars

(1 + rUS) = (1.10) (.9250) = (1.0175)

rUS = 1.75%


Exchange Rate Risk

Exchange Rate Risk is the risk arising from fluctuating exchange rates between two currencies; but it’s tied to prices and hence to nominal equity returns.

Relativemonetaryand fiscalpolicies

Relativemonetaryand fiscalpolicies

Relativeinflation

Relativeinflation

Exchangerate

change

Exchangerate

change


Turkey, 1995

Turkish Lira:Down 33.5%


Turkey, 1995

Turkish Lira:Down 33.5%

Turkish prices:up 83.8%!


Hedging International Equity Investments

Buy foreign equity and hedge the anticipated future value, P+E(r)?

Use short-term, value-adjusted, roll-over hedges?

Do nothing, because equities bear no currency sign?

AnticipatedAnticipatedActualActualInitialInitial


Measuring Benchmark Returns

Indexes EAFE Index Issues in Measuring Performance

WeightingCross-Holdings

Other PossibilitiesCountry and Region Funds


Diversification Benefits

Evidence shows international diversification is beneficial

Possible to expand the efficient frontier above domestic only frontier

Possible to reduce the systematic risk level below the domestic only level


Systematic Risk Level with International Diversification

RiskRisk

SecuritiesSecurities

Int’lDomDom


The Minimum-Variance Frontier

Efficient frontier

Individual assets

Global minimum-variance portfolio

E(r)


Efficient Frontier with International Diversification

ReturnReturn

RiskRisk

* *

*

**

* *

*DomDom

Int’lInt’l


The Global Efficient Frontier

10 15 20 25 30 5

5

10

15

20

25

30

STOCKSANDBONDS

STOCKSONLY

EAFESTOCKS& BONDS

EAFE STOCKS

WORLD STOCKS & BONDS

WORLD STOCKS

US STOCKS & BONDSUS STOCKS

US BONDS

AVERAGE RETURN% PA

RISK, % PA


International Portfolio Optimization: Passive vs Active Portfolios

(Let the proportions of all possible assets vary until the optimal proportions are found.)

The results of

letting the

computer

find the best

proportions for

various levels

of return:

0.1

0.11

0.12

0.13

0.14

0.15

0.16

0.17

0.18

0.19

0.2

0.21

0.22

0.23

0.05 0.1 0.15 0.2 0.25 0.3 0.35

RETURN

RISK(STANDARD DEVIATION)

Same risk as 100% USA,but higher return

100% USA portfolio

100% Japan

Minimum riskportfolio Market capitalization

weighted portfolio


Evidence Suggests Index Funds are Not for the International Investor

For the international investor the capitalization-weighted portfolio may not be the optimal one. The reason is market segmentation. The world stock market is not efficient yet, the evidence suggests, at least not in the "mean-variance efficiency" sense that is required by the CAPM.

Because of real exchange risk (deviations from PPP), what is the optimal portfolio for an investor in one country may not be the optimal portfolio for an investor in another, even if there were a single risk-free asset acceptable to both.

Studies confirm these propositions


Emerging Equity Markets


Can globally mobile investors capture value & control?

MacroFactors

• Currency overvaluation• Capital restrictions

StructuralFactors

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

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

Firm-levelFactors


www.bankofny.com/adr

adr.com


Brady Bonds

Origin? Types? Ecuador’s Bradies

DiscountParPast due interestInterest equalization

What next?


Correlations: Domestic vs Global

creditmetrics.com

correlation engine


Summary

The Eurocurrency market is most closely tied to the foreign exchange market

Covered interest arbitrage links spot-forward differential to interest rates

Foreign portfolio returns = equity + FX International diversification pays Hedging international portfolios is tricky


Ian H. Giddy

Ian Giddy

NYU Stern School of Business

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

[email protected]

http://giddy.org

Documents

The International Capital Markets Prof. Ian Giddy New York University New York University/ING Barings