Eurocurrency Market

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Lecture Notes for 15.436

International Financial Markets

Chapter 10

The international money and bond market

Fall 1999

Raman Uppal

10-2

International Finance: Chapter 10 – International bond market

Fall 1999

Road Map
1 Part A Part B Part C 10 11 Part D Part E Preliminaries: Conventions, notation, and basic concepts Currency markets and the behavior of the exchange rate Markets for exchange-rate derivatives and the hedging decision Markets for fixed income securities and the financing decision International money and bond markets Swap markets Markets for equities and the portfolio investment decision Foreign direct investment

Fall 1999

International Finance: Chapter 10 – International bond market

10-3

Contents
10.1 Main issues . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.2 Motivating problems . . . . . . . . . . . . . . . . . . . . . . 10.3 Introduction to euromarkets . . . . . . . . . . . . . . . . . . 10.3.1 History of euromarkets . . . . . . . . . . . . . . . . . . . . . . .

4 5 6
7

10.4 Eurobanking markets . . . . . . . . . . . . . . . . . . . . . . 10.4.1 Eurodeposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.4.2 Eurocredits and euroloans . . . . . . . . . . . . . . . . . . . . . . 10.4.3 Revolving or floating-rate loans . . . . . . . . . . . . . . . . . . . 10.4.4 Costs of a euroloan . . . . . . . . . . . . . . . . . . . . . . . . . 10.4.5 Credit lines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.4.6 Forward Forwards and Forward Rate Agreements . . . . . . . . . .

10
10 11 13 14 18 19

10.5 Eurosecurity markets . . . . . . . . . . . . . . . . . . . . . . 10.5.1 Reasons for growth of eurosecurity markets . . . . . . . . . . . . . 10.5.2 Institutional features of eurobonds . . . . . . . . . . . . . . . . . 10.5.3 Eurocommercial paper . . . . . . . . . . . . . . . . . . . . . . .

25
26 28 31

10.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.7 Recommended readings 10.8 Practice problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

34 35 35

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International Finance: Chapter 10 – International bond market

Fall 1999

10.1

Main issues

• Eurocurrency markets

– Eurodeposits, eurocredits and euroloans, FRAs
• Eurosecurity markets

– Eurobonds, eurocommercial paper
• Comparing bonds in the same currency but

– with different maturities, or – with different fee structures.

The study of euromarkets for fixed-income instruments serves as an introduction to the study of swaps. – Just as domestic and foreign money markets connect the spot and forward exchange rate (via the Covered Interest Rate Parity relation), – International bond markets will serve to connect the spot exchange market to the swap market.

Fall 1999

International Finance: Chapter 10 – International bond market

10-5

10.2

Motivating problems

Motivating Problem 10.1 (Upfront fees and equivalent spreads) A bank offers you the following rates: 10 percent fixed, or (when you borrow floating-rate) LIBOR + 2 percent. You prefer to borrow floating-rate, as you expect a drop in interest rates. Another bank offers you LIBOR + 1.5 percent, but asks a substantial up-front fee. How can you compare the terms offered by the two banks? Motivating Problem 10.2 (Forward rate agreements) On January 2, you sign a six-to-nine month forward rate agreements (FRA) for frf 50 m at 10 percent p.a. Six months later the three-month LIBOR rate turns out to be 8 percent p.a. What is the cash settlement on July 2? Motivating Problem 10.3 (Interest rate options—caps) You bought an option that limits the interest rate on a future six-month loan to at most 10 percent p.a. If the interest rate is 11 percent on the expiration date of the option, what is the value of this option on the expiration date?

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International Finance: Chapter 10 – International bond market

Fall 1999

10.3...
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