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Euro Currency Market Essay

Paper type: Essay
Pages: 9 (2219 words)
Downloads: 8
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The money market in which Eurocurrency, currency held in banks outside of the country where it is legal tender, is borrowed and lent by banks in Europe. The Eurocurrency market is utilized by large firms and extremely wealthy individuals who wish to circumvent regulatory requirements, tax laws and interest rate caps that are often present in domestic banking, particularly in the United States.

‘Eurocurrency Market’

Rates on deposits in the Eurocurrency market are typically higher than in the domestic market, because the depositor is not protected by domestic banking laws and does not have governmental deposit insurance.

Rates on loans in the Eurocurrency market are typically lower than those in the domestic market, because banks are not subject to reserve requirements on Eurocurrency and do not have to pay deposit insurance premiums. A.Eurocurrency market

Definition and background

The Eurocurrency market consists of banks (called Eurobanks) that accept deposits and make loans in foreign currencies. A Eurocurrency is a freely convertible currency deposited in a bank located in a country which is not the native country of the currency.

The deposit can be placed in a foreign bank or in the foreign branch of a domestic US bank. [Note of caution! The prefix Euro has little or nothing to do with the newly emerging currency in Europe.]

In the Eurocurrency market, investors hold short-term claims on commercial banks which intermediate to transform these deposits into long-term claims on final borrowers.

The Eurocurrency market is dominated by US $ or the Eurodollar. Occasionally, during weak dollar periods (latter part of 1970s and 1980s), the EuroSwiss franc and the EuroDM markets increased in importance. The Eurodollar market originated post WWII in France and England thanks to the fear of Soviet Bloc countries that dollar deposits held in the US may be attached by US citizens with claims against communist governments!

Thriving on government regulation

By using Euromarkets, banks and financiers are able to circumvent / avoid certain regulatory costs and restrictions. Some examples are:

a)Reserve requirements
b)Requirement to pay FDIC fees
c)Rules or regulations that restrict competition among banks

Continuing government regulations and taxes provide opportunities to engage in Eurocurrency transactions. However, ongoing erosion of domestic regulations have rendered the cost and return differentials much less significant than before. As a result, the domestic money market and Eurocurrency markets are closely integrated for most major currencies, effectively creating a single worldwide money market for each participating currency.

Illustration I

German firm sells medical equipment to institutional buyer in the US. It receives a US$ check drawn on Citicorp, NY. Initially this check is deposited in a checking account for dollar working capital use. But to earn a higher return (or rate of interest) on the $ 1 million the German firm decides to place the funds in a time deposit with a bank in London, UK.

One million Eurodollars have thus been created by substituting a dollar account in a London bank for the dollar account held in NY. Notice that no US $ left NY but ownership of the US deposit has moved from a foreign corporation to a foreign bank. The London bank would not like to leave the funds idle in NY account. If a government or commercial borrower is unavailable, the London bank will place the $ 1 million in the London interbank market. The interest rate at which such interbank loans are made is called the London interbank offer rate (LIBOR).

This example demonstrates that the Eurocurrency market is a chain of deposits and a chain of borrowers and lenders. The majority of Eurocurrency transactions involve transferring control of deposits from one Eurobank to another Eurobank. Loans to non-Eurobank borrowers account for less than half of all Eurocurrency loans.

The Eurocurrency market operates like any other financial market, but for the absence of government regulations on loans that can be made and interest rates that can be charged.

Eurocurrency loans

Eurocurrency loans are made on a floating – rate basis.

Interest rates on loans to governments, corporations and nonprime banks are set at a fixed margin above LIBOR for a given period and currency.

Example

If the margin is 75 basis points (b.p.) and the current LIBOR is 6%, the borrower is charged 6.75% for the relevant period. LIBOR is the underlying variable rate of interest, usually set for a 6 month period. —

The margin or spread between the lending bank’s cost of funds and the interest charged by the borrower is based on the borrower’s perceived creditworthiness / riskiness. The spreads can range from 15 b.p. to more than 300 b.p., the median of the range varying from 100 to 200 b.p.

The maturity of the Eurocurrency loan can range from 3 to 10 years. Eurocurrency loans are made by bank syndicates. The bank originating the loan becomes the lead bank managing the syndicate, inviting one or two other banks to be co-managers of the loan. The borrower is charged a one-time syndication fee ranging from 0.25 % to 2 % of the loan value according to the size and type of the Eurocurrency loan.

The drawdown [period over which the borrower may use the loan] of the loan and the repayment period vary in accordance with the borrower’s needs. A commitment fee of about 0.5 % per annum is paid on the unused balance, and prepayments in advance of the agreed upon schedule are permitted but are sometimes subject to a penalty fee.

i) EAC of Eurocurrency loan

A corporate borrower has arranged a DM 500 million, five-year EuroDM loan with a bank syndicate led by two managing banks. The upfront syndication fee is 2 %.

Net proceeds to the borrower = $ 500 mn – 0.02 (US $ 500 mn) = DM 490 mn.

The interest rate on the EuroDM loan is LIBOR + 1.75 %, with LIBOR reset every 6 months. If the initial LIBOR6 rate for DM is 6 %, the first semiannual debt service payment is:

[(0.06 + 0.0175) / 2] * DM 500 mn = DM 19.3750 mn

Therefore the borrower’s effective annual rate (EAC) for the first six months is:

[DM 19.3750 mn / DM 490 mn] * 2 * 100 = 7.9082 %

This EAC changes in every reset period (in this case 6 months) with LIBOR6.

ii) Multicurrency loans

Though most Eurocurrency loans are Eurodollar loans, these often come with a multicurrency clause. This clause gives the borrower the right (subject to availability) to switch from one currency to another on any rollover (or reset) date. This option allows the borrower to match currencies with cash inflows and outflows (which is an effective way of managing exposure to currency risk, and thus an effective risk-management technique). The option also allows borrowers to take advantage of its own expectations regarding currency changes and search for funds with the lowest effective cost.

iii) Interest rates

Interest rates in national and Eurocurrency markets are closely linked through arbitrage.

US $ credit marketsSterling credit markets

US lending rateUK lending rate

Eurodollar lending rateEurosterling lending rate

Eurodollar deposit rateEurosterling deposit rate

US deposit rateUK deposit rate

The difference between the Euro$ deposit rate and the Eurosterling deposit rate is given by the forward discount or premium (which approximates the expected change in the dollar/pound exchange rate).

A.Eurobond markets

Eurobonds are bonds sold outside the country whose currency they are dominated in. They are similar in many ways to public debt sold in domestic capital markets. However, the Eurobond market is entirely free of official regulation and is self-regulated by the Association of International Bond Dealers.

Borrowers in the Eurobond market are typically well known and have impeccable credit ratings (for example, developed countries, international institutions, and large MNCs). The Eurobond market has grown rapidly in the last two decades, and it exceeds the Eurocurrency market in size.

i)Currency denomination

About 75 % of Eurobonds are dollar denominated. The most important nondollar currencies for Eurobond issues are DM and FF (now rapidly replaced by the euro), the JY and the BP [The Swiss central bank ban has led to the absence of SF Eurobonds].

ii)Fixed – rate Eurobonds

Fixed-rate Eurobonds pay coupons once a year, unlike the semiannual coupon, domestic bonds in the US market. Borrowers compare the all-in cost, that is, the effective interest rate, on Eurobonds and domestic bonds.

This interest rate is calculated as the discount rate that equates the present value of the future interest and principal payments to the net proceeds received by the issuer, or as the IRR of the bond.

iii) Comparing Eurobond issue with a US domestic issue

To compare a Eurobond issue with a US domestic issue, therefore, the all-in cost of funds on an annual basis must be converted to a semiannual basis or vice versa. Thus,

Semiannual yield = [1 + Annual yield]^0.5 – 1, and(1)

Annual yield = [1 + Semiannual yield]^2 – 1.(2)

Illustration II

P & G plans to issue a 5-year bond with a face value of $ 100 million. Its investment banker estimates that a Eurobond issue would have to bear a 7.5 % coupon and that fees and other expenses will total $ 738,000 providing net proceeds to P & G of $ 99,262,000.

Exhibit 1 shows the cashflows associated with the Eurobond issue. The all-in cost (IRR) of this issue, which is an annual rate, is shown as 7.68 %. As a cross – check, the third column shows that the PV of the cashflows, using a discount rate of 7.68 %, sum to P & G ‘s net proceeds of $ 99,262,000.

Alternatively, P & G can issue a $ 100 million, 5-year bond in the US market with a coupon of 7.4 %. With estimated issuance costs of $ 974,000, P & G will receive net proceeds of $ 99,026,000.

Exhibit 2 shows the cashflows associated with this issue and its all-in cost (IRR) of 3.82 %. Note that the cashflows are semiannual, as is the all-in cost. Again, the third column does a cross-check to confirm the 3.82 % all-in cost.

According to Equation (1) above, the equivalent semiannual all-in cost for the Eurobond issue is (1.0768)^0.5 – 1 = 3.77 %. Thus, the all-in cost of the Eurobond is lower, making it preferable if all other terms and conditions on the two bonds are the same.

Alternatively, using Equation (2) above, we can convert the US bond yield to its annual equivalent and compare that figure to the Eurobond yield of 7.68 %. This computation would have yielded an annualized all-in cost of the US bond issue equal to (1.0382)^2 – 1 = 7.78 %. As before, the Eurobnd issue is preferable because its all-in cost is 10 basis points lower.

what is euro currency market:

A Eurocurrency Market is a money market that provides banking services to a variety of customers by using foreign currencies located outside of the domestic marketplace. The concept does not have anything to do with the European Union or the banks associated with the member countries, although the origins of the concept are heavily derived from the region. Instead, the Eurocurrency Market represents any deposit of foreign currencies into a domestic bank. For example, if Japanese yen is deposited into a bank in the United States, it is considered to be operating under the auspices of the Eurocurrency Market.

The Eurocurrency Market has its roots in the World War II era. While the war was going on, political challenges caused by the takeover of the continent by the Axis Powers meant that there was a limited marketplace for trading in foreign currency. With no friendly government operations within the European marketplace, the traditional economies of the nations were displaced, along with the currencies. To combat this, especially due to the fact that many American companies were tied to the well-being of business behind enemy lines, banks across the world began to deposit large sums of foreign currency, creating a new money market.

One of the factors that make the Eurocurrency Market unique compared to many other money market accounts is the fact that it is largely unregulated by government entities. Since the banks deal with a variety of currencies issued by foreign entities, it is difficult for domestic governments to intervene, particularly in the United States. However, with the establishment of the flexible exchange rate system in 1973, the Federal Reserve System was given powers to stabilize lending currencies in the event of a crisis situation. But one problem that arises is that these crises are not defined by the regulations, meaning that intervention must be established based on each case and the Federal Reserve must work directly with central banks around the world to resolve the matter. This adds to the volatility of the Eurocurrency Market.

Despite its name, the Eurocurrency Market is primarily influenced by the value of the American dollar. Nearly two-thirds of all assets around the globe are represented by U.S. currency. The challenge with foreign banks revolves around the fact that regulations enforced by the Federal Reserve are really only enforceable within the U.S. The taxation level and exchange rate of the American dollar varies depending on the nation. For example, an American dollar in Vietnam is worth more than it is in Canada, further influencing the market.

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Euro Currency Market. (2017, Jan 14). Retrieved from https://studymoose.com/euro-currency-market-essay

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