Page 1

International Finance

Lecture 4

Page 2

International Finance• Course topics

– Foundations of International Financial Management

– World Financial Markets and Institutions

– Foreign Exchange Exposure– Financial Management for a

Multinational Firm

Page 3

World Financial Markets and Institutions

• International Banking and Money Market

• International Bond Market• International Equity Markets• Futures and Options on Foreign

Exchange• Currency and Interest Rate Swaps• International Portfolio Investment

Page 4

International Banking and Money Market

• _____________ Banking• International Money Market• International Debt Crises

Page 5

International Banking• What are the main business activities of banks

and near banks? How do they make a profit?–

• International banks– Take deposits, issue loans denominated in

different ________, facilitate ___________trade, and trade currencies

• Rapid growth in international banking1.Rapid growth of international ___________2.Banks abroad can pursue activities not

___________in home country3.Tap into Eurodollar market

Page 6

Canadian banking industry• The banking industry includes 19

___________banks, 23 ___________bank subsidiaries and 21 foreign bank ___________operating in Canada.

• In total, these institutions manage almost $1.8 trillion in assets.

• More details at Canadian Bankers Association webpage, including how Schedule I, II, and III banks differ from each other.

Page 7

The big six• Bank of Montreal

– http://www.bmo.com/ • The Bank of Nova Scotia

– http://www.scotiabank.ca/ • CIBC

– http://www.cibc.com/ • National Bank of Canada

– http://www.nbc.ca • Royal Bank of Canada

– http://www.royalbank.com• Toronto-Dominion Bank

– http://www.td.com

Page 8

International focus of the Big Six

Page 9

Schedule II Banks in Canada

Page 10

Ten Largest U.S. Banks

Page 11

Types of International Banking Offices

• Correspondent bank• Representative office• Foreign branch• Subsidiary and affiliate bank• Edge Act Banks (in the USA)• Offshore banking center

Page 12

International Banking Offices• Correspondent bank

– i.e. two banks maintain a correspondent bank account with each other. Service: mostly currency conversions, additionally, _______________________________________ on the correspondent bank.

• Representative office– If one or more important clients for a domestic bank

are located overseas, the bank may send an ___________with a cell phone and a computer to work in that foreign country and offer service to the bank’s clients. Extra service: _______________________________________________.

Page 13

Foreign Branches• A foreign branch bank operates like a local

bank, but is legally part of the the parent.– Subject to both the banking regulations of

___________country and ___________country.– Can provide a much fuller range of services

than a representative office.– Foreign branches are not subject to Canadian

___________requirements or deposit insurance• Branch Banks are the most popular way for

Canadian banks to expand overseas. (USA, Europe, shell branches in offshore centers).

Page 14

International Banking Offices• Subsidiary and Affiliate Banks

– A ___________bank is a locally incorporated bank wholly or partly owned by a foreign parent.

– An ___________bank is one that is partly owned but not controlled by the parent.

– Canadian parent banks like foreign subsidiaries because they allow Canadian banks to underwrite securities.

• Edge Act Banks– In the U.S., Edge Act banks are federally

chartered subsidiaries of U.S. banks that are physically located in the U.S. that are ___________to engage in a full range of international banking activities.

Page 15

Offshore Banking Centers• An offshore banking

center is a country whose banking system is organized to permit external accounts beyond the ___________scope of local economic activity.

• The host country usually grants complete freedom from host-country governmental banking regulations.

• The IMF recognizes as

major _______ banking centers: – the Bahamas– Bahrain– the Cayman Islands– Hong Kong– the Netherlands

Antilles– Panama– Singapore

Page 16

Cost of Banking Crises in Other Countries

Page 17

International Banking Regulation

• International bank crises, along with the regulation (bad) experience in ___________, suggests that regulation often ___________.

• In many banking crises, the existence of government safety net increases moral ___________incentives and regulatory ___________makes things worse.

• Problems in regulating international banking1. Lack of knowledge or ability to closely monitor bank

operations in other countries2. Hard to identify which agency is responsible

• Trend: cooperation and standardization of regulatory ___________ (i.e. Basel Accord)

Page 18

Capital Adequacy Standards• Bank capital adequacy refers to the amount of

equity ___________and other securities a bank holds as reserves.

• The Bank for International Settlements (BIS) and the 1988 and 2003 Basel Accords are a key part of the international institutions and standards that govern how much bank capital is “enough” to ensure the safety and soundness of the banking system.

www.bis.org

Page 19

Calculating capital requirements

First Bank Assets Liabilities

Reserves $3 m Chequable deposits $20 m Canada securities $10 m Nontransactions

deposits $60 m

Loans to other banks $7 m Borrowings $11 m Municipal bonds $10 m Loan loss reserves $2 m Residential mortgages $10 m Bank capital $7 m Commercial loans $20 m Consumer loans $35 m Fixed assets $5 m

Page 20

Calculating capital requirements

• We will introduce two forms of Bank Capital requirements

• The first type is based on the so-called leverage ratio:

Leverage Ratio = Equity Capital/Assets

Well ___________: a bank’s leverage ratio must exceed 5%.

Is First Bank well capitalized?

• Risk-based capital requirements (from the Basel 1988 Accord): assets are allocated into four categories, each with a different weight to reflect the degree of credit risk

Page 21

Calculating capital requirements

1st category: zero weight, reserves and government securities in OECD countries2nd category: 20% weight, claims on banks in OECD countries3rd category: 50% weight, municipal bonds and residential mortgages4th category: 100% weight, debts of consumers and corporationsOff-balance-sheet activities are treated in a similar mannerBanks must hold as capital at least 8% of their risk-weighted assets.

Page 22

Calculating capital requirements• Is First Bank well-capitalized according to

Risk-based capital requirements?

Page 23

Capital Adequacy Standards

• While traditional bank capital standards may be enough to protect depositors from traditional credit risk, they may not be sufficient protection from derivative risk.

• For example, Barings Bank, which collapsed in 1995 from derivative losses, looked good on paper relative to capital adequacy standards.

• Value at Risk (VaR) models provide a ___________ measurement of capital adequacy.

www.riskmetrics.com • We will deal with VaR later in the course. Idea of

using value at risk: compare VaR with bank capital

Page 24

International Money Markets• Money Markets Defined

1. Money market ___________are usually sold in large denominations

2. They have ___________default risk3. They mature in one year ___________from their

issue date• Investors in Money Market: Provides a place for

warehousing surplus funds for short periods of time

• Borrowers find that money market provides low-cost source of temporary funds

Page 25

Money Market Instruments• Treasury ___________

• ___________Funds

• Repurchase ___________

• ___________Certificates of Deposit

• Commercial Paper

• Banker’s ___________

• International Money Market Instruments

Page 26

International Money Market

• Eurocurrency Market• ___________• Forward Rate Agreement• ___________• Eurocommercial paper

Page 27

International Money Market• Eurocurrency is a ___________deposit in an

international bank located in a country different than the country that issued the currency.– For example, Eurodollars are U.S. dollar-

denominated time deposits in banks located ___________.

– Euroyen are ___________-denominated time deposits in banks located outside of Japan.

– A deposit ___________ have to be located in Europe.

Page 28

Eurocurrency Market• Most Eurocurrency transactions are interbank

transactions in the amount of $1,000,000 and up.• Common reference rates include

– LIBOR the London Interbank ___________Rate– PIBOR the Paris Interbank ___________Rate– SIBOR the ___________Interbank Offered Rate

• A new reference rate for the new euro currency– EURIBOR the rate at which interbank time

deposits of € are offered by one prime bank to another.

• View Eurodollar deposit rates the Federal Reserve

Page 29

Eurocredits• Eurocredits are ___________to medium-term loans

of Eurocurrency by Eurobanks to corporations, sovereign governments, and nonprime banks.

• The loans are denominated in currencies other than the ___________currency of the Eurobank.

• Often the loans are too large for one bank to underwrite; a number of banks form a ___________to share the risk of the loan.

• Eurocredits feature an adjustable rate. On Eurocredits originating in London the base rate is LIBOR.

Page 30

Eurocredits

Comparison of US lending and borrowing rates with Eurodollar rates on August 19, 2002

Page 31

Rolling over debt

• Short-term financing = exposure to interest rate risk. • Teltrex International borrows $3,000,000 at LIBOR

plus a lending margin ¾ percent per annum on a 3-month rollover basis. Current LIBOR is 5 17/32 percent. What is the effective annual interest rate on borrowing?

Page 32

Rolling over debt• If LIBOR stays the same for the first 3 months and then

changes to 5 1/8 percent, what is the new effective annual rate, and what is the cost of financing for Teltrex International during the first six months?

Page 33

Forward Rate Agreements

• Recall, short-term financing/investment = exposure to ___________rate risk. Banks use FRA to hedge this risk.

• FRA is an interbank ___________ that involves two parties, a buyer and a seller.

• The buyer agrees to pay the seller the excess interest rate on a notional amount above a floating rate (e.g., LIBOR).

• The seller agrees to _____ the buyer the excess interest rate on a notional amount above the agreed rate, Rfix .

• Forward Rate Agreements can be used to: – Hedge assets that a bank currently owns against

interest rate risk.– Speculate on the future course of interest rates.

Page 34

Forward Rate Agreements

Time line

Inte

rest

Rat

e

Page 35

Forward Rate Agreements• In theory ___________could be made at time T2. At

that time, based on the notional amount L and number of days T2 - T1: – If RT1T2 < Rfixed, Bank 1 could pay to Bank 2 the

agreed ___________rate Rfixed, and receive from Bank 2 the variable rate RT1T2.

– This never happens; instead Bank 1 just pays the __________ (Rfixed - RT1T2) to Bank 2.

– If RT1T2 > Rfixed, Bank 2 could pay to Bank 1 the agreed fixed rate Rfixed, and receive from Bank 2 the variable rate RT1T2.

– This never happens; instead Bank 2 just pays the difference (RT1T2 - Rfixed) to Bank 1.

Page 36

Forward Rate Agreements• In practice • Payment L*|Rfixed - RT1T2|*(T2 - T1)/360 is _________ to

time T1 and paid at time T1, since the rate is known at T1 and no real need to wait until T2, unless the contract allows for reference rate variability between T1 and T2

• Payment under standard FRA is calculated as follows

360/)(1

360/)(

1221

1221fixed

TTR

TTRRLPAYOFF

TT

TTFRA

Page 37

Forward Rate Agreements• The reference rate Rfixed is normally set at today’s

level of forward rate FT1T2.

• Continuously compounded Forward rate, ___________ FT1T2 = (RT2*T2-RT1*T1)/(T2-T1)

• For example, you observe 6-month LIBOR=5.39% and 3-month LIBOR=5.36%, both continuously compounded, you know that there are 91 days to maturity for 3-month rate and 182 days until maturity for 6-month LIBOR

• Forward rate F91182 =

Page 38

Forward Rate Agreements• Assume that today Bank 1 buys a FRA with

notional amount $3,000,000 from Bank 2 and fixed rate 5.42% per annum. The FRA starts in 3 months (91 days) and will last for 3 more month, until day 180.

• No payments are made at this point, but Bank 1 has a binding agreement to pay 5.42% p.a. to Bank 2 for 3 months, and Bank 2 has a binding agreement to pay the 3-month LIBOR rate for 3 months between day 91 and 180 to Bank 1, the rate to be determined on Day 91.

Page 39

Forward Rate Agreements• If on day 91 the actual 3-month LIBOR=5%, then• 5%<5.42% Bank 1 (buyer) pays to Bank 2

(seller) the difference:

• If on day 91 the actual 3-month LIBOR=6%, then• 6%>5.42% Bank 2 pays to Bank 1 the difference:

Page 40

Forward Rate Agreements• Value of the FRA• If forward rate = reference rate, the value is zero • If forward rate ≠ reference rate, the value is the

discounted payoff assuming the forward rate is realized

• You need to check whether Rfixed < or > FT1T2 to detrmine profit/loss for long/short position in the FRA.

)360/(1

360/)(

22

1221fixed

TR

TTFRLV

T

TTFRA

Page 41

Forward Rate Agreements• Example. Now it is day 0 and the FRA specifies that

Rfixed=4%.

Since forward rate > reference rate, expected

discounted value of the payoff = ___________To buy FRA with such specifications, the buyer would

have to pay to the seller ___________as the seller is facing the discounted expected need to make a payment of this amount of money to the buyer

Page 42

Euronotes• Euronotes are ___________ notes underwritten by a

group of international investment banks or international commercial banks.– They are sold at a ___________from face value and

pay back the full face value at maturity.– Maturity is typically three to six months.

• Euro-Medium-Term Notes– Typically fixed rate notes issued by a corporation.– ___________range from less than a year to about ten

years.– Euro-MTNs is partially sold on a continuous basis –

this allows the borrower to raise funds as they are needed.

Page 43

Eurocommercial Paper• ___________short-term promissory notes

issued by corporations and banks.• Placed ___________with the public

through a dealer.• Maturities typically range from one

month to six months.• Eurocommercial paper, while typically

U.S. dollar denominated, is often of lower quality than U.S. commercial paper—as a result yields are ___________.

Page 44

Discount basis• Discount securities are quoted on bank discount

basis.

• rBD= quoted rate

• D – discount, D = ___________• t – days to maturity• F – face value• P - current price

tF

DrBD

360

Page 45

Discount basis• You observe that the quoted bankers acceptance

rate is 4.8% and you are considering investment in BA with face value of US$100,000. How much do you have to pay for the BA if it has 150 days to maturity? What is the effective annual rate on this investment?

Page 46

International Debt Crisis• Governments issue bonds, just like companies• If a foreign company defaults on a bond, what can

you do as a Canadian investor?

• At most you could ___________in that country and

try to sue the company managers. And you will probably never buy that company’s bonds again.

Page 47

International Debt Crisis• In 1970s major world banks wre accepting

deposits from the OPEC countries and Russia (oil dollars that gave rise to the whole Eurodollar market)

• Large sums of money were invested in bonds or other debt obligations issued by governments of less developed countries LDCs

Page 48

International Debt Crisis

Ten Biggest American Bank Lenders to Mexico($bn, September 30th, 1987)

Page 49

Debt-for-Equity Swaps

• As part of debt ___________agreements among the bank lending syndicates and the debtor nations, creditor banks would sell their loans for U.S. dollars at ___________from face value to MNCs desiring to make equity investment in subsidiaries or local firms in the LDCs.

• A LDC central bank would buy the ___________ from a MNC at a smaller discount than the MNC paid, but in local currency.

• The MNC would use the ___________to make pre-approved new investment in the LDC that was economically or socially beneficial to the LDC.

Page 50

Debt-for-Equity Swap Illustration

International Bank

Equity Investor or MNC

LDC Central Bank

LDC firm or MNC

subsidiary

Page 51

Recent Banking Crises• Japan. The collapse of the Japanese ___________set

in motion a downward spiral for the entire Japanese economy and in particular Japanese banks.

• This put in jeopardy massive amounts of bank loans to corporations.

• Asia. This crisis followed a period of economic expansion in the region financed by record private capital inflows.

• Bankers from the G-10 countries actively sought to finance the growth opportunities in Asia by providing businesses with a full range of products and services.

• This led to domestic price ___________in East Asia, particularly in ______________________.

Page 52

Financial Crises

• Factors Causing Financial Crises1. Increase in interest rates2. Increases in uncertainty3. Asset market effects on balance sheets

• Stock market effects on net worth• Unanticipated deflation• Cash flow effects

4. Bank panics