Euro Currency Market

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EURO CURRENCY MARKETS:

EURO CURRENCY MARKETS

Learning objectives:

Learning objectives Euro Money Euro Deposits Euro Currency Euro Banking/ International Banking Loan Syndicate (Syndication)

Euro Money:

Euro Money Concept of money Why Euro money? How it is created? Reasons for growth of the market.

Concept of Money:

Concept of Money Capable of being used as medium of exchange Possible to store value through the asset Serves as unit of account It can be used as means of deferred payment.

Why Euro Money?:

Why Euro Money? The international operations in capital markets & the need to undertake foreign exchange transactions in order to consummate the transfer of financial claims & that there is absence of any unified world legal framework for settlement of such claims, the market came into existence.

How Euro money is created?:

How Euro money is created? A national currency becomes part of offshore currency market when it is transferred to a bank outside its own monetary system, i.e. transferred to a bank outside the nation in question. Ex-US dollar held in Paris qualifies as Euro currency.

Reasons for the growth of the Euro money market.:

Reasons for the growth of the Euro money market. Depositors receive better terms than they can otherwise obtain at home (i.e. better interest rates on deposits than home interest rates). Borrowers can borrow more , possibly at lower interest rates than they can at home ( on shore).

Slide 8:

Euro-money comprises of Euro deposits and Euro-currency.

Euro Deposits:

Euro Deposits Concept Nature Reasons for the growth of the market.

Euro Deposits:

Euro Deposits The deposits denominated in currencies made outside the domestic banking system operation are called as Euro deposits. Thus, when a currency deposit is made in a bank outside the jurisdiction of the central bank which issued the currency is termed as Euro deposit. More risky as beyond the control of domestic banking authority.

Nature of Euro deposits:

Nature of Euro deposits They are primarily conventional short term deposits (30 days or 90 days). Interest rates on such deposits are fixed. Term is short. They are non-negotiable (unless specified). Interest rates fluctuates in response to demand & supply pressures. Can be made in currencies like ECU / SDR.

Reasons for the growth of the Euro deposit market.:

Reasons for the growth of the Euro deposit market. Depositors receive better terms than they can otherwise obtain at home (i.e. better interest rates on deposits than home interest rates). Borrowers can borrow more , possibly at lower interest rates than they can at home ( on shore).

Euro Currency:

Euro Currency Concept Creation Growth Features Functions The Euro markets Attraction Drawbacks Difference between Domestic & Euro Currency markets Difference between Eurobonds & Eurocurrency loans.

WHAT IS EURO-CURRENCY?:

WHAT IS EURO-CURRENCY? Euro-currency is any currency banked outside its country of origin. Thus it is a non-domestic financial intermediary. It is extremely large & has grown rapidly in a short interval. It has received a bad press from Central Banks, which continuous to call it a major cause of inflation & an obstacle to their control of domestic monetary systems.

Creation of Euro Currency:

Creation of Euro Currency One can take the physical currency of a country & deposit it in a bank in another country. Banks do hold currency of other countries but mainly for the convenience of travelers. One can transfer deposits from within the country whose currency is in question to an offshore bank. This may well be an overseas subsidiary of the very same bank with which the original deposit was held.

Growth of Euro-Currency:

Growth of Euro-Currency Growth 1950s. Eastern Europeans, afraid US would seize deposits to reimburse claims for business losses as a result of Communist takeover of Eastern Europe. Currency deposited by national governments or corporations in banks outside their home market. This applies to any currency and to banks in any country.

Other Events ::

Other Events : Britain – 1957 prohibited banks from financing non-British trade. U.S. – 1960s discouraged banks from lending to non-US residents. Oil crisis – 1970s led to huge amount of dollars amassed by OPEC countries. They did not want them to be in the US because they were afraid that they would be confiscated by the US government. Gave opportunity to those who wanted to deposit or borrow dollars (later, other currencies, as well).

Growth of Euro-Currency:

Growth of Euro-Currency Growth depositors receive better terms than they can receive onshore. borrowers can borrow more, possibly at power rates, than they can onshore.

Features of Euro Currency Market:

Features of Euro Currency Market Points of difference between the Euro currency & Domestic currency market.

Functions of Euro Currency Market:

Functions of Euro Currency Market Foreign exchange hedging Domestic intermediation International inetrmediation

The Euro Markets:

The Euro Markets - The most important international financial markets today. A) The Eurocurrency Market 1. Composed of Euro-banks who accept/maintain deposits of foreign currency 2. Dominant currency: US$

Slide 22:

B) Growth of Eurodollar Market caused by restrictive US government policies, especially 1. Reserve requirements on deposits 2. Special charges and taxes 3. Required concessionary loan rates 4. Interest rate ceilings 5. Rules which restrict bank competition.

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C) Eurodollar Creation involves 1. A chain of deposits 2. Changing control/usage of deposit 3. Eurocurrency loans a. Use London Inter-bank Offer Rate- LIBOR as basic rate b. Six month rollovers c. Risk indicator: size of margin between cost and rate charged. 4.Multicurrency clause Clause gives borrower option to switch currency of loan at rollover. Reduces exchange rate risk

Euro Dollar:

Euro Dollar Thus euro dollars are bank deposit liabilities denominated in U.S. dollars but not subject to U.S banking regulations. For the most part, banks offering Euro dollar deposits are located outside the U.S.

Slide 25:

D) Eurobonds Bonds sold outside the country of currency denomination. 1. Recent Substantial Market Growth -due to currency swaps, a financial instrument which gives 2 parties the right to exchange streams of income over time. 2. Links to Domestic Bond Markets arbitrage has eliminated interest rate differential. 3. Placement underwritten by syndicates of banks

ATTRACTION:

ATTRACTION Lack of government regulation. Pay higher interest rates. Charge lower rates. Reserve restrictions are less costly. Gave opportunity to those who wanted to deposit or borrow dollars (later, other currencies, as well).

DRAWBACKS:

DRAWBACKS Probability of bank failure (low). Foreign exchange risk. Unregulated system could result in loss of deposits.

Difference between Euro currency market & Domestic money market.:

Difference between Euro currency market & Domestic money market. 1) The absence of reserve requirements in Euro currency market means the absence of direct control by Central Banks. Central banks are gradually feeling their way towards some partial solutions of this problem, but the situation is certainly not as clear-cut as in each country's domestic markets.

Difference between Euro currency market & Domestic money market.:

Difference between Euro currency market & Domestic money market. 2) The absence of international character means that like the foreign exchange market, the Euro market does not exit in any particular location. It consists of participants all around the world linked together by telephones, telexes & increasingly by computerized information systems. Thus, it is a continuous market.

Difference between Euro currency market & Domestic money market.:

Difference between Euro currency market & Domestic money market. 3) There are number of problems in euro currency market as compared to domestic market such as jurisdiction, the acceptability of a freeze on deposits in one country by another country whose currency is being traded in the first country, booking a loan in one centre rather than another is merely legitimate tax planning or tax evasion etc.s

Difference between Euro currency market & Domestic money market.:

Difference between Euro currency market & Domestic money market. 4) The Euro currency market is purely wholesale market as compared to domestic market which is retain banking market. Thus it is got relative freedom from regulations as compared to domestic markets.

Difference between Euro currency market & Domestic money market.:

Difference between Euro currency market & Domestic money market. 5) The Euro currency market is almost exclusively concerned with matched deposit dealing. That is, each deposit (liability) of an international bank will tend to be matched by an asset (usually a deposit in another bank) of the same currency & of similar maturity.

Difference between Euro currency market & Domestic money market.:

Difference between Euro currency market & Domestic money market. 6) In Euro currency market loans are typically made for specific period & funded by a deposit of a similar period. This is very different from a domestic market where typically large amounts of lending are done on the basis of a prime (or base) rate, with these loans being funded day to day in the domestic overnight or short-date money market or from normal customer deposits.

Difference between Euro currency market & Domestic money market.:

Difference between Euro currency market & Domestic money market. 7) In Euro currency market as compared to domestic deposits are time deposits at fixed interest rates, usually of short maturity. Many of these deposits are on call , thus these can be withdrawn without notice.

Difference between Eurobond vs. Eurocurrency loans:

Difference between Eurobond vs. Eurocurrency loans Five Differences a. Eurocurrency loans use variable rates b. Loans have shorter maturities c. Bonds have greater volume d. Loans have greater flexibility e. Loans obtained faster

Euro Banking:

Euro Banking Concept Features Risk in Euro Banks Euro Banking & the Central Bank

Concept of Euro Banking:

Concept of Euro Banking Euro Bank is a financial intermediary that bids for time deposits & makes loans in the offshore market. Usually, this will also mean that it deals in currencies other than those of the country in which it is located.

Concept of Euro Banking:

Concept of Euro Banking It can be created in two ways- 1) One can take the physical currency of a country out of the country & deposit it in a bank of another country. 2) A national currency deposit becomes part of the offshore currency market when it is transferred to a bank outside the controlled national monetary system.

Features of Euro Banking:

Features of Euro Banking Unregulated institutions Not subject to interest rates ceilings. Advantage of low tax location Margins are low & overheads cost low. Are subject to greater risk than domestic banks. Unprofitable in nature. Less subject to pressures from government.

Risks of Euro Banking:

Risks of Euro Banking Exchange Rate Risk-due to assets & liabilities denominated in different foreign currencies. Interest Rate Risk-mismatch of maturity between assets & liabilities as deposits are short term & lending is long term. Default Risk-default in payments-especially in case of MNCs & governments.

Euro Banking & the Central Bank.:

Euro Banking & the Central Bank. The central banks often voice their concern about the offshore markets. They are- While the central banks have a stronger control on credit creation but this control is lost when the banking business slips to offshore markets.

Euro Banking & the Central Bank.:

Euro Banking & the Central Bank. The central banks often voice their concern about the offshore markets. They are- As the euro markets are still viewed by the press & the public as mysterious & omnipotent, they make convenient scapegoats for failures of nerve in the handling of domestic monetary policy.

Euro Banking & the Central Bank.:

Euro Banking & the Central Bank. The central banks often voice their concern about the offshore markets. They are- The central bank has control over the allocation of credit if there is no euro banking. With the Euro banking in place, they have no control over allocation of credit in the offshore capital market. Thus, as the banking business slips to offshore markets , the control on money supply declines.

Euro Banking & the Central Bank.:

Euro Banking & the Central Bank. The central banks often voice their concern about the offshore markets. They are- There exits a strong arbitrage connection between the domestic & offshore markets because the interest rate differentials exist between these two markets. It will be possible only when the deposit rate of one market is greater than the lending rate of the other market.

Euro Banking & the Central Bank.:

Euro Banking & the Central Bank. The central banks often voice their concern about the offshore markets. They are- Suppose CRR is changed for controlling credit by impounding a larger portion of fresh deposits, to avoid this regulation the funds may be siphoned to offshore markets. Similarly, to avoid these regulations , the funds may be shifted from the domestic markets to offshore markets.

Loan Syndicate (syndication):

Loan Syndicate (syndication) Concept Nature Advantages & Disadvantages Participants Charges on these loans Quoting spreads in syndication Loan syndication procedure in India

Concept of Loan Syndicate:

Concept of Loan Syndicate A loan syndicate is a high structured group of financial institutions (primary banks), formed by a manager (or a group of co-managers), which agree to lend a specific amount of loan or money on common terms & conditions to a borrower. It involves a small group of knowledgeable & well capitalised banks that agree initially to provide the entire loan.

Nature of Loan Syndicate:

Nature of Loan Syndicate It is a term loan It has drawndown period. Repayment of the loan are made in accordance with an amortisation schedule. Loan attached with grace period. It is a major negotiating point between the borrowers & the lead bank. Are of revolving credit type. Flexibility.

Advantages of Loan Syndicate:

Advantages of Loan Syndicate Highly profitable & positive impact on the earnings of the banks-ex-Citicorp, BOA. Improved risk-return performance because can diversify loans by country & type of customer. High credit standing Safeguards such as credit insurance programmes, guarantees by parent company & host Government on loans to affiliates etc. reduces risk of international lending.

Disadvantages of Loan Syndicate:

Disadvantages of Loan Syndicate Risk analysis is highly complex It did not anticipate dramatic increase in country risk Some bankers have relaxed their credit standards to compensate for weak domestic demand & commercial demand for loans. Many loans are short term variable loans –raise the question of the ability of debtor country to service their external debt. Advantages of Loan Syndicate

Disadvantages of Loan Syndicate:

Disadvantages of Loan Syndicate If borrowings countries ae unable to meet their obligations on time, the banks will be forced to roll over their loans indefinitely. The ultimate purpose of some loans is to finance balance of payments deficit. This type of loan does not improve the debtors country’s ability to generate foreign exchange earnings.

Participants of Loan Syndicate:

Participants of Loan Syndicate Lead Banks Managing Banks Participating Banks There is a separate group called co-managers.

Charges on Loan Syndicates:

Charges on Loan Syndicates Front end fees Agents annual fees

Charges on Loan Syndicates:

Charges on Loan Syndicates Front end fees They are one off charges negotiated in advance & imposed when the loan agreement is signed. These fees are usually in the range of 0.5%-1% of the value of the loan. The fee may be higher if the borrower insists upon obtaining funds at a lower spread than warranted by market conditions & creditworthiness.

Charges on Loan Syndicates:

Charges on Loan Syndicates Front end fees It consists of participation fees & management fees. Each of these amount to 0.25%-0.5% of the entire amount of loan. Participation fees are divided between the underwriting bank & the lead bank (takes the premium on the entire loan). The rest is of the management fees is divided among the managing banks in proportion to the amount each agrees to underwrite prior to sysdication.

Charges on Loan Syndicates:

Charges on Loan Syndicates Front end fees = Lead bank premium (TL) + Participation fee + management fee + initial agents fee (if any) Where- TL= Total loan UDL= undrawn loan

Charges on Loan Syndicates:

Charges on Loan Syndicates Agents annual fees Annual payments= (LIBOR + spread) ( TL)+ commitment fee (UDL) + annual agents fee (if any) + tax adjustment (if any) + reserve requirement adjustment (if any). Where- TL= Total loan UDL= undrawn loan

Quoting Spreads in Loan Syndicate:

Quoting Spreads in Loan Syndicate Spreads & maturities are heavily influenced by market conditions. In period when market conditions are relatively easy, spreads decline and maturities become lengthier. Converse is true when market conditions are tight.

Quoting Spreads in Loan Syndicate:

Quoting Spreads in Loan Syndicate Factors that need consideration- The present level of interest rates The banks capital / asset ratios The volatility of interest rates Liquidity considerations attributable to the amount of non-bank deposits entering the euro market. Relative loan demand pressures in domestic markets Changes in the competitive structure of the syndicated credit market The borrowers risk.

Quoting Spreads in Loan Syndicate:

Quoting Spreads in Loan Syndicate Spreads if widen over time, lenders are locked into a long maturity loan at the old spread. Is the spread narrow, the borrower can refinance & therefore should not object to accepting higher spreads for longer maturities. The high level of nominal interest rate implies a narrower absolute spread.

Quoting Spreads in Loan Syndicate:

Quoting Spreads in Loan Syndicate There may be inverse relationship between interest rates & Spreads. The 2 reasons are- If borrowers are sensitive to the total interest cost on syndicated loans banks may be forced to lower spreads to compensate for higher LIBOR when faced with an expected fall in demand. Banks are expected to equate marginal cost of all the sources of funds. In period of high nominal interest rates , the opportunity cost of reserve requirements if higher.

Loan syndication procedure in India:

Loan syndication procedure in India Step-1 To begin with the borrowing company starts with working out the investment proposal along with details of financing plans & obtain government approval for both. The financing plans are approved with a broad set of parameters so that some flexibility is left for the borrower.

Loan syndication procedure in India:

Loan syndication procedure in India Step-2 The borrower then calls for quotations from leading foreign banks & usually also from the major domestic banks (such as SBI in India) for overseas component of financing plan. Based on the quotations , the borrower than gives ‘mandate’ to the bank which has quoted the best overall terms. Suppose this bank is Hong Kong Bank.

Loan syndication procedure in India:

Loan syndication procedure in India Step-3 Hong Kong Bank then prepares a document for examination by a set of banks to be associated as managing banks. This document is called the ‘placement memorandum’, which presents in details, the project for which the loan is being sought, the viability of the project, cash flows & other relevant information. The idea of this memorandum is to get a relatively large number of Euro banks interested in loan proposal. The loan is then marketed to a large number of participating banks who wish to commit funds & time to a project if they find it attractive enough.

Loan syndication procedure in India:

Loan syndication procedure in India Step-4 Once the syndicate group is formed & the necessary commitments are obtained from the group members, the lead banks prepares the necessary legal documents & gets them signed by company officials.

Loan syndication procedure in India:

Loan syndication procedure in India Step-5 Once the fourth step is completed the disbursement of the funds starts to the client in accordance with the mutually agreed conditions.

Loan agreement:

Loan agreement It is signed by all participating banks & the borrower. It describes the basic transactions, the purpose of the loan, maturity, various types of fees & their payments, warranties & undertakings, amortization, drawdown arrangements, interest rate & its determination, ,default circumstances, financial covenants, laws & jurisdiction & finally the relationship between the agent bank & the paticipating banks.