International Financial Management

P G Apte

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P.G.Apte International Financial Management
 6.1 The Global Financial Market
• The last two decades have witnessed the
emergence of a vast global financial market
enabling massive cross-border capital flows
• Geographical integration and functional
integration of financial markets
• The early part of eighties saw the process of
disintermediation get under way
• The process of liberalization and integration
continued into the 1990s with many of the
developing countries carrying out substantive
reforms and opening up their financial markets

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P.G.Apte International Financial Management
 6.1 The Global Financial Market
• Domestic and offshore markets
• Eurocurrencies Market
• Differences between offshore and domestic
markets
• Are domestic and offshore markets really two
distinct markets or should we view the entire
global financial market as a single market ?
– Arbitrage will ensure that they will be closely
linked together in terms of costs of funding and
returns on assets
– They do differ significantly on the regulatory
dimension
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 6.3 Euromarkets
• It is mainly an interbank market trading in time
deposits and various debt instruments
• A "Eurocurrency Deposit" deposit is a deposit
in the relevant currency with a bank outside the
home country of that currency
• Similarly a Eurodollar Loan
• The prefix "Euro" is now outdated
• These markets have evolved a variety of
instruments
• The key difference between Euromarkets and their
domestic counterparts is one of regulation

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 6.3 Euromarkets
• Eurodollar market originated in 1950’s
• Growth of the eurodollar market was due to a number of
other factors
– Supply side
• US restrictions on domestic banks and capital
markets throughout the 60's and 70's (Regulation Q,
Int.Equlization tax)
• The importance of the dollar as a vehicle currency
in international trade and finance
• European companies’ preference for dealing with
European banks
– Demand side
• Demand for Eurodollar loans by non-US entities and by US
multinationals to finance their foreign operations
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 6.3 Euromarkets

• Like any other fractional reserve banking system,

eurobanks can generate multiple expansion of
eurodeposits on receiving a fresh injection of cash
• The "modern" approach rejects the idea of a fixed
reserve ratio and emphasizes the fact that supply
of Eurodeposits on one hand and the demand for
Euroloans on the other are both dependent upon
the rate of interest
• Also relevant are risks – mainly political – as
perceived by depositors and borrowers.

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 6.3 Euromarkets (contd.)

• Concerns about Euro and offshore markets

– The market facilitates short term speculative
capital flows - the so called "hot money"
– National monetary authorities lose effective
control over monetary policy since domestic
residents can frustrate their efforts by
borrowing or lending abroad
– The market is based on a tremendously large
volume of interbank lending

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P.G.Apte International Financial Management
 6.3 Euromarkets (contd.)

– Euromarkets create “private international

liquidity”
– The markets allow central banks of deficit
countries to borrow for balance of payments
purposes thus enabling them to put off needed
adjustment measures

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 6.3 Euromarkets (contd.)

• The advantages of Euro and offshore markets

– More efficient allocation of capital worldwide
– Smoothing out the effects of sudden shifts in balance of
payments imbalances
– The spate of financial innovations that have been
created by the market which have vastly enhanced the
ability of companies and governments to better manage
their financial risks

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6.4 Interest Rates in the Global Money
Markets
• The linkages between interest rates in the
domestic and offshore markets and between
interest rates for different currencies in the
offshore market
• The spectrum of interest rates existing in an
economy at any point of time is the result of
the complex interaction between several
forces as shown in figure 6.1
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6.4 Interest Rates in the Global Money
Markets (contd.)

Figure 6.1
Determinants of Interest
Rates

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6.4 Interest Rates in the Global Money
Markets (contd.)

• Interbank deposit market, the benchmark is

provided by the interbank borrowing and lending
rates in the Eurocurrency market e.g. LONDON
INTER-BANK OFFER RATE abbreviated
LIBOR
• The relationship between interest rates in the
domestic and euro segments of the money market

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6.4 Interest Rates in the Global Money
Markets (contd.)
– Arbitrage by borrowers and investors with access to
both the markets should serve to keep the rates close
together
– Why are the rates not identical?
• Demand side and supply side factors
• Linkages between interest rates for different
currencies in the euromarket
– Forward contract: Under this contract, a depositor
agrees to deliver a particular currency six months later
in return for another currency, at an exchange rate
specified now. This is the forward exchange rate.
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6.4 Interest Rates in the Global Money
Markets (contd.)
– Effective interest rate
– Covered Interest Arbitrage
• The relationship between the domestic and
offshore market interest rates for a currency
are governed by risk premia, reserve
requirements and other regulations that
apply to domestic deposits and the presence
of capital controls
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6.4 Interest Rates in the Global Money
Markets (contd.)
• The differences in interest rates between
currencies in the euromarket are explained
by the differences in the spot-forward
margins.
• In equilibrium, effective returns on all
currencies would be equal

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 6.5 An Overview of Money Market
Instruments
• During the decade of the eighties the markets have
evolved a wide array of funding instruments
• Commercial Paper
– Commercial paper is a corporate short-term, unsecured
promissory note issued on a discount to yield basis
– It can be regarded as a corporate equivalent of CD
(Certificate of Deposit) which is an interbank
instrument

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 6.5 An Overview of Money Market
Instruments (contd.)
• Certificates of Deposit
– A Certificate of Deposit (CD) is a negotiable
instrument evidencing a deposit with a bank
– Unlike a traditional bank deposit which is non-
transferable, a CD is a marketable instrument so that
the investor can dispose it off in the secondary market
when cash is needed
• Banker’s Acceptance
– This is an instrument widely used in the US money
market to finance domestic as well as international
trade
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 6.5 An Overview of Money Market
Instruments (contd.)
– In a typical international trade transaction, the
seller(exporter) draws a time or “usance” draft on the
buyer's (importer's) bank. On completing the shipment,
the exporter hands over the shipping document and the
letter of credit issued by the importer's bank to its bank.
The exporter gets paid the discounted value of the draft.
The exporter's bank presents the draft to the importer's
bank which stamps it as "accepted“.

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 6.6 Summary
• Examine the interest rate linkages between
the different segments of the global money
markets
• Close link between interest rates in the
domestic and offshore markets in a
particular currency
• Brief survey of common short-term funding
instruments in global money markets

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