CH-11 International Banking and Money Market – International Financial Management : Book Guide

CHAPTER 11 INTERNATIONAL BANKING AND MONEY MARKET ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS QUESTIONS 1. Briefly discuss some of the services that international banks provide their customers and the market place. Answer: International banks can be characterized by the types of services they provide that distinguish them from domestic banks. Foremost, international banks facilitate the imports and exports of their clients by arranging trade financing. Additionally, they serve their clients by arranging for foreign exchange necessary to conduct cross-border transactions and make foreign investments and by assisting in hedging exchange rate risk in foreign currency receivables and payables through forward and options contracts. Since international banks have established trading facilities, they generally trade foreign exchange products for their own account. Two major features that distinguish international banks from domestic banks are the types of deposits they accept and the loans and investments they make. Large international banks both borrow and lend in the Eurocurrency market. Moreover, depending upon the regulations of the country in which it operates and its organizational type, an international bank may participate in the underwriting of Eurobonds and foreign bonds. International banks frequently provide consulting services and advice to their clients in the areas of foreign exchange hedging strategies, interest rate and currency swap financing, and international cash management services. Not all international banks provide all services. Banks that do provide a majority of these services are known as universal banks or full service banks. 2. Briefly discuss the various types of international banking offices. Answer: The services and operations which an international bank undertakes is a function of the regulatory environment in which the bank operates and the type of banking facility established. A correspondent bank relationship is established when two banks maintain a correspondent bank account with one another. The correspondent banking system provides a means for a bank’s MNC clients to conduct business worldwide through his local bank or its contacts. A representative office is a small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in its dealings with the bank’s correspondents. It is a way for the parent bank to provide its MNC clients with a level of service greater than that provided through merely a correspondent relationship. A foreign branch bank operates like a local bank, but legally it is a part of the parent bank. As such, a branch bank is subject to the banking regulations of its home country and the country in which it operates. The primary reason a parent bank would establish a foreign branch is that it can provide a much fuller range of services for its MNC customers through a branch office than it can through a representative office. A subsidiary bank is a locally incorporated bank that is either wholly owned or owned in major part by a foreign subsidiary. An affiliate bank is one that is only partially owned, but not controlled by its foreign parent. Both subsidiary and affiliate banks operate under the banking laws of the country in which they are incorporated. U.S. parent banks find subsidiary and affiliate banking structures desirable because they are allowed to engage in security underwriting. Edge Act banks are federally chartered subsidiaries of U.S. banks which are physically located in the United States that are allowed to engage in a full range of international banking activities. A 1919 amendment to Section 25 of the Federal Reserve Act created Edge Act banks. The purpose of the amendment was to allow U.S. banks to be competitive with the services foreign banks could supply their customers. Federal Reserve Regulation K allows Edge Act banks to accept foreign deposits, extend trade credit, finance foreign projects abroad, trade foreign currencies, and engage in investment banking activities with U.S. citizens involving foreign securities. As such, Edge Act banks do not compete directly with the services provided by U.S. commercial banks. Edge Act banks are not prohibited from owning equity in business corporations as are domestic commercial banks. Thus, it is through the Edge Act that U.S. parent banks own foreign banking subsidiaries and have ownership positions in foreign banking affiliates. An offshore banking center is a country whose banking system is organized to permit external accounts beyond the normal economic activity of the country. Offshore banks operate as branches or subsidiaries of the parent bank. The primary activities of offshore banks are to seek deposits and grant loans in currencies other than the currency of the host government. In 1981, the Federal Reserve authorized the establishment of International Banking Facilities (IBF). An IBF is a separate set of asset and liability accounts that are segregated on the parent bank’s books; it is not a unique physical or legal entity. IBFs operate as foreign banks in the U.S. IBFs were established largely as a result of the success of offshore banking. The Federal Reserve desired to return a large share of the deposit and loan business of U.S. branches and subsidiaries to the U.S. 3. How does the deposit-loan rate spread in the Eurodollar market compare with the depositloan rate spread in the domestic U.S. banking system? Why? Answer: Competition has driven the deposit-loan spread in the domestic U.S. banking system to about the same level as in the Eurodollar market. That is, in the Eurodollar market the deposit rate is about the same as the deposit rate for dollars in the U.S. banking system. Similarly the lending rates are about the same. In theory, the Eurodollar market can operate at a lower cost than the U.S. banking system because it is not subject to mandatory reserve requirements on deposits or deposit insurance on foreign currency deposits. 4. What is the difference between the Euronote market and the Eurocommercial paper market? Answer: Euronotes are short-term notes underwritten by a group of international investment or commercial banks called a “facility.” A client-borrower makes an agreement with a facility to issue Euronotes in its own name for a period of time, generally three to 10 years. Euronotes are sold at a discount from face value, and pay back the full face value at maturity. Euronotes typically have maturities of from three to six months. Eurocommercial paper is an unsecured short-term promissory note issued by a corporation or a bank and placed directly with the investment public through a dealer. Like Euronotes, Eurocommercial paper is sold at a discount from face value. Maturities typically range from one to six months. 5. Briefly discuss the cause and the solution(s) to the international bank crisis involving lessdeveloped countries. Answer: The international debt crisis began on August 20, 1982 when Mexico asked more than 100 U.S. and foreign banks to forgive its $68 billion in loans. Soon Brazil, Argentina and more than 20 other developing countries announced similar problems in making the debt service on their bank loans. At the height of the crisis, Third World countries owed $1.2 trillion! The international debt crisis had oil as its source. In the early 1970s, the Organization of Petroleum Exporting Countries (OPEC) became the dominant supplier of oil worldwide. Throughout this time period, OPEC raised oil prices dramatically and amassed a tremendous supply of U.S. dollars, which was the currency generally demanded as payment from the oil importing countries. OPEC deposited billions in Eurodollar deposits; by 1976 the deposits amounted to nearly $100 billion. Eurobanks were faced with a huge problem of lending these funds in order to generate interest income to pay the interest on the deposits. Third World countries were only too eager to assist the equally eager Eurobankers in accepting Eurodollar loans that could be used for economic development and for payment of oil imports. The high oil prices were accompanied by high interest rates, high inflation, and high unemployment during the 19791981 period. Soon, thereafter, oil prices collapsed and the crisis was on. Today, most debtor nations and creditor banks would agree that the international debt crisis is effectively over. U.S. Treasury Secretary Nicholas F. Brady of the first Bush Administration is largely credited with designing a strategy in the spring of 1989 to resolve the problem. Three important factors were necessary to move from the debt management stage, employed over the years 1982-1988 to keep the crisis in check, to debt resolution. First, banks had to realize that the face value of the debt would never be repaid on schedule. Second, it was necessary to extend the debt maturities and to use market instruments to collateralize the debt. Third, the LDCs needed to open their markets to private investment if economic development was to occur. Debt-for-equity swaps helped pave the way for an increase in private investment in the LDCs. However, monetary and fiscal reforms in the developing countries and the recent privatization trend of state owned industry were also important factors. Treasury Secretary Brady’s solution was to offer creditor banks one of three alternatives: (1) convert their loans to marketable bonds with a face value equal to 65 percent of the original loan amount; (2) convert the loans into collateralized bonds with a reduced interest rate of 6.5 percent; or, (3) lend additional funds to allow the debtor nations to get on their feet. The second alternative called for an extension the debt maturities by 25 to 30 years and the purchase by the debtor nation of zero-coupon U.S. Treasury bonds with a corresponding maturity to guarantee the bonds and make them marketable. These bonds have come to be called Brady bonds. 6. What were the weaknesses Basel II that became apparent during the global financial crisis that began in mid-2007? Answer: The crisis illustrated how quickly and severely liquidity risks can crystallize and certain sources of funding can evaporate, compounding concern related the valuation of assets and capital adequacy. Prior to the onset of the financial crisis, banks built up significant exposures to off-balance sheet market risks that were not adequately reflected in the capital requirements of Basel II. A number of banking organizations have experienced large losses, most of which were sustained in the banks’ trading accounts. These losses have not arisen from actual defaults, but rather from credit agency downgrades, widening credit spreads, and the loss of liquidity. 7. Discuss the regulatory and macroeconomic factors that contributed to the credit crunch of 2007-2008. Answer: The origin of the credit crunch can be traced back to three key contributing factors: liberalization of banking and securities regulation, a global savings glut, and the low interest rate environment created by the Federal Reserve Bank in the early part of this decade. The U.S. Glass-Steagall Act of 1933 mandated a separation of commercial banking from other financial services firms—such as securities, insurance, and real estate. The repeal of Glass-Steagall caused a blurring of the functioning of commercial banks, investment banks, insurance companies, and real estate mortgage banking firms. Since the repeal of GlassSteagall, commercial banks began engaging in risky financial service activities that they previously would not have and which contributed to the credit crunch. The Commodity Futures Trading Commission (CFTC) was created in 1974 to oversee futures trading to guard against price manipulation, prevent fraud among market participants, and to ensure the soundness of the exchanges. Credit default swaps (CDSs), a type of OTC credit derivative security, were not regulated by the CFTC. The CDS market grew from virtually nothing a half dozen years ago to a $58 trillion market that went largely unregulated and unknown. CDSs have played a prominent role in the credit crunch. In the years leading up to the crisis, the world was awash in liquidity in recent years, much of it denominated in U.S. dollars, awaiting investment. As a result, the United States was able to maintain domestic investment at a rate that otherwise would have required higher domestic savings (or reduced consumption) and also found a ready market with central banks for U.S. Treasury and government agency securities, helping keep U.S. interest rates low. The Fed Funds target rate fell from 6 ½ percent set on May 16, 2000 to 1.0 percent on June 25, 2003, and stayed below 3.0 percent until May 3, 2005. The decrease in the Fed Funds rate was the Fed’s response to the financial turmoil created by the fall in stock market prices in 2000 as the high-tech, dot-com, boom came to an end. Low interest rates created the means for first-time homeowners to afford mortgage financing and also created the means for existing homeowners to trade up to more expensive homes. Low interest rate mortgages created an excess demand for homes, driving prices up substantially in most parts of the country, in particular in popular residential areas such as California and Florida. 8. How did the credit crunch become a global financial Crisis? Answer: As the credit crunch escalated, many CDOs found themselves stuck with various tranches of MBS debt, especially the highest risk tranches, which they had not yet placed or were unable to place as subprime foreclosure rates around the country escalated. Commercial and investment banks were forced to write down billions of subprime debt. As the U.S. economy slipped into recession, banks also started to set aside billions for credit-card debt and other consumer loans they feared would go bad. The credit rating firms—Moody’s, S&P, and Fitch—lowered their ratings on many CDOs after recognizing that the models they had used to evaluate the risk of the various tranches were mis-specified. Additionally, the credit rating firms downgraded many MBS, especially those containing subprime mortgages, as foreclosures around the country increased. An unsustainable problem arose for bond insurers who sold credit default swap (CDS) contracts and the banks that purchased this credit insurance. As the bond insurers got hit with claims from bank-sponsored SIVs as the MBS debt in their portfolios defaulted, the credit rating agencies required the insurers to put up more collateral with the counterparties who held the other side of the CDSs, which put stress on their capital base and prompted credit-rating downgrades, which in turn triggered more margin calls. If big bond insurers, such as American International Group (AIG) failed, the banks that relied on the insurance protection would be forced to write down even more mortgage-backed debt which would further erode their Tier I Core capital bases. By September 2008, a worldwide flight to quality investments—primarily short term U.S. Treasury Securities—ensued. The demand for safety was so great, at one point in November 2008, the one-month U.S. Treasury bill was yielding only one basis point. The modern day equivalent of a ‘bank run’ was operating in full force and many financial institutions could not survive. 9. What is a mortgage backed security? Answer: A mortgage-backed security is a derivative security because its value is derived from the value of the underlying mortgages that secure it. Conceptually, mortgage-backed securities seem to make sense. Each MBS represents a portfolio of mortgages, thus diversifying the credit risk that the investor holds. 10. What is a structured investment vehicle and what effect did they have on the credit crunch? Answer: A structured investment vehicle (SIV) is a virtual bank, frequently operated by a commercial bank or an investment bank, but which operates off balance sheet. Typically, an SIV raises short term funds in the commercial paper market to finance longer-term investment in mortgage-backed securities (MBSs). SIVs are frequently highly levered, with ratios of 10 to 15 times the amount equity raised. Structured investment vehicles have been one large investor in MBS. Since yield curves are typically upward sloping, the SIV might normally earn .25 percent by doing this. SIVs are subject to the interest rate risk of the yield curve inverting, that is, shortterm rates rising above long-term rates, thus necessitating the SIV to refinance the MBS investment at short-term rates in excess of the rate being earned on the MBS. Default risk is another risk with which SIVs must contend. If the underlying mortgage borrowers default on their home loans, the SIV will lose investment value. Nevertheless, SIVs predominately invest only in high-grade Aaa/AAA MBS. By investing in a variety of MBS, an SIV further diversifies the credit risk of MBS investment. The SIV’s value obviously derives from the value of the portfolio of MBS it represents. To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate at meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003 to 5 ¼ percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in this economic environment, especially when their adjustable-rate mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount of subprime MBS debt in structured investment vehicles was essentially unknown. While it was thought SIVs would spread MBS risk worldwide to investors best able to bear it, it turned out that many banks that did not hold mortgage debt directly, held it indirectly through MBS in SIVs they sponsored. To make matters worse, the diversification that investors in MBS and SIVs thought they had was only illusory. Diversification of credit risk only works when a portfolio is diversified over a broad set of asset classes. MBS and SIVs were diversified over a single asset class—poor quality residential mortgages! When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs and trading in the interbank Eurocurrency market essentially ceased as traders became fearful of the counterparty risk of placing funds with even the strongest international banks. Liquidity worldwide essentially dried up, creating the credit crunch. 11. What is a collateralized debt obligation and what effect did they have on the credit crunch? Answer: A collateralized debt obligation (CDO) is a corporate entity constructed to hold a portfolio of fixed-income assets as collateral. The portfolio of fixed-income assets is divided into different tranches, each representing a different risk class: AAA, AA-BB, or unrated. CDOs serve as an important funding source for fixed-income securities. An investor in a CDO is taking a position in the cash flows of a particular tranche, not in the fixed-income securities directly. The investment is dependent on the metrics used to define the risk and reward of the tranche. To cool the growth of the economy, the Fed steadily increased the Fed Funds target rate at meetings of the Federal Open Market Committee, from a low of 1.0 percent on June 25, 2003 to 5 ¼ percent on June 29, 2006. In turn, mortgage rates increased and home prices stopped increasing, thus stalling new housing starts and precluding mortgage refinancing to draw out paper capital gains. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in this economic environment, especially when their adjustable-rate mortgages were reset at higher rates. As matters unfolded, it was discovered that the amount of subprime MBS debt in CDOs and SIVs, and who exactly owned it, were essentially unknown, or at least unappreciated. The diversification that investors in CDOs and SIVs thought they had was only illusory. Diversification of credit risk only works when a portfolio is diversified over a broad set of asset classes. MBS, SIVs and CDOs, however, were diversified over a single asset class—poor quality residential mortgages! When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs and trading in the interbank Eurocurrency market essentially ceased as traders became fearful of the counterparty risk of placing funds with even the strongest international banks. Liquidity worldwide essentially dried up, creating the credit crunch. PROBLEMS 1. Grecian Tile Manufacturing of Athens, Georgia, borrows $1,500,000 at LIBOR plus a lending margin of 1.25 percent per annum on a six-month rollover basis from a London bank. If sixmonth LIBOR is 4 ½ percent over the first six-month interval and 5 3/8 percent over the second six-month interval, how much will Grecian Tile pay in interest over the first year of its Eurodollar loan? Solution: $1,500,000 x (.045 + .0125)/2 + $1,500,000 x (.05375 + .0125)/2 = $43,125 + $49,687.50 = $92,812.50. 2. A bank sells a “three against six” $3,000,000 FRA for a three-month period beginning three months from today and ending six months from today. The purpose of the FRA is to cover the interest rate risk caused by the maturity mismatch from having made a three-month Eurodollar loan and having accepted a six-month Eurodollar deposit. The agreement rate with the buyer is 5.5 percent. There are actually 92 days in the three-month FRA period. Assume that three months from today the settlement rate is 4 7/8 percent. Determine how much the FRA is worth and who pays who--the buyer pays the seller or the seller pays the buyer. Solution: Since the settlement rate is less than the agreement rate, the buyer pays the seller the absolute value of the FRA. The absolute value of the FRA is: $3,000,000 x [(.04875-.055) x 92/360]/[1 + (.04875 x 92/360)] = $3,000,000 x [-.001597/(1.012458)] = $4,732.05. 3. Assume the settlement rate in problem 2 is 6 1/8 percent. What is the solution now? Solution: Since the settlement rate is greater than the agreement rate, the seller pays the buyer the absolute value of the FRA. The absolute value of the FRA is: $3,000,000 x [(.06125-.055) x 92/360]/[1 + (.06125 x 92/360)] = $3,000,000 x [.001597/(1.015653)] = $4,717.16. 4. A “three-against-nine” FRA has an agreement rate of 4.75 percent. You believe six-month LIBOR in three months will be 5.125 percent. You decide to take a speculative position in a FRA with a $1,000,000 notional value. There are 183 days in the FRA period. Determine whether you should buy or sell the FRA and what your expected profit will be if your forecast is correct about the six-month LIBOR rate. Solution: Since the agreement rate is less than your forecast, you should buy a FRA. If your forecast is correct your expected profit will be: $1,000,000 x [(.05125-.0475) x 183/360]/[1 + (.05125 x 183/360)] = $1,000,000 x [.001906/(1.026052)] = $1,857.61. 5. Recall the FRA problem presented as Example 11.2. Show how the bank can alternatively use a position in Eurodollar futures contracts (Chapter 7) to hedge the interest rate risk created by the maturity mismatch it has with the $3,000,000 six-month Eurodollar deposit and rollover Eurocredit position indexed to three-month LIBOR. Assume that the bank can take a position in Eurodollar futures contracts that mature in three months and have a futures price of 94.00. Solution: To hedge the interest rate risk created by the maturity mismatch, the bank would need to buy (go long) three Eurodollar futures contracts. If on the last day of trading, three-month LIBOR is 5 1/8%, the bank will earn a profit of $6,562.50 from its futures position. This is calculated as: [94.875 - 94.00] x 100 bp x $25 x 3 contracts = $6,562.50. Note that this sum differs slightly from the $6,550.59 profit that the bank will earn from the FRA for two reasons. First, the Eurodollar futures contract assumes an arbitrary 90 days in a threemonth period, whereas the FRA recognizes that the actual number of days in the specific threemonth period is 91 days. Second, the Eurodollar futures contract pays off in future value terms, or as of the end of the three-month period, whereas the FRA pays off in present value terms, or as of the beginning of the three-month period. 6. The Fisher effect (Chapter 6) suggests that nominal interest rates differ between countries because of differences in the respective rates of inflation. According to the Fisher effect and your examination of the one-year Eurocurrency interest rates presented in Exhibit 11.3, order the currencies from the eight countries from highest to lowest in terms of the size of the inflation premium embedded in the nominal ask interest rates for June 5, 2013. Solution: According to the Fisher effect, the one-year Eurocurrency interest rates suggest that the inflation premiums for the countries representing the eight currencies ordered from highest to lowest are: Canadian dollar, British pound, U.S. dollar, Singapore dollar, euro, Japanese yen/Swiss franc, Danish krone. 7. George Johnson is considering a possible six-month $100 million LIBOR-based, floating-rate bank loan to fund a project at terms shown in the table below. Johnson fears a possible rise in the LIBOR rate by December and wants to use the December Eurodollar futures contract to hedge this risk. The contract expires December 20, 2009, has a US$ 1 million contract size, and a discount yield of 7.3 percent. Johnson will ignore the cash flow implications of marking to market, initial margin requirements, and any timing mismatch between exchange-traded futures contract cash flows and the interest payments due in March. Loan Terms September 20, 2009 December 20, 2009 March 20, 2010 • Borrow $100 million at • Pay interest for first three • Pay back principal September 20 LIBOR + 200 months plus interest basis points (bps) • Roll loan over at • September 20 LIBOR = 7% December 20 LIBOR + 200 bps Loan First loan payment (9%) Second payment initiated and futures contract expires and principal    • 9/20/09 • 12/20/09 • 3/20/10 a. Formulate Johnson’s September 20 floating-to-fixed-rate strategy using the Eurodollar future contracts discussed in the text above. Show that this strategy would result in a fixed-rate loan, assuming an increase in the LIBOR rate to 7.8 percent by December 20, which remains at 7.8 percent through March 20. Show all calculations. Johnson is considering a 12-month loan as an alternative. This approach will result in two additional uncertain cash flows, as follows: Loan First Second Third Fourth initiated payment (9%) payment payment payment and principal      • 9/20/09 • 12/20/09 • 3/20/10 • 6/20/10 • 9/20/10 b. Describe the strip hedge that Johnson could use and explain how it hedges the 12-month loan (specify number of contracts). No calculations are needed. CFA Guideline Answer a. The basis point value (BPV) of a Eurodollar futures contract can be found by substituting the contract specifications into the following money market relationship: BPV FUT = Change in Value = (face value) x (days to maturity / 360) x (change in yield) = ($1 million) x (90 / 360) x (.0001) = $25 The number of contract, N, can be found by: N = (BPV spot) / (BPV futures) = ($2,500) / ($25) = 100 OR N = (value of spot position) / (face value of each futures contract) = ($100 million) / ($1 million) = 100 OR N = (value of spot position) / (value of futures position) = ($100,000,000) / ($981,750) where value of futures position = $1,000,000 x [1 – (0.073 / 4)]  102 contracts Therefore on September 20, Johnson would sell 100 (or 102) December Eurodollar futures contracts at the 7.3 percent yield. The implied LIBOR rate in December is 7.3 percent as indicated by the December Eurofutures discount yield of 7.3 percent. Thus a borrowing rate of 9.3 percent (7.3 percent + 200 basis points) can be locked in if the hedge is correctly implemented. A rise in the rate to 7.8 percent represents a 50 basis point (bp) increase over the implied LIBOR rate. For a 50 basis point increase in LIBOR, the cash flow on the short futures position is: = ($25 per basis point per contract) x 50 bp x 100 contracts = $125,000. However, the cash flow on the floating rate liability is: = -0.098 x ($100,000,000 / 4) = - $2,450,000. Combining the cash flow from the hedge with the cash flow from the loan results in a net outflow of $2,325,000, which translates into an annual rate of 9.3 percent: = ($2,325,000 x 4) / $100,000,000 = 0.093 This is precisely the implied borrowing rate that Johnson locked in on September 20. Regardless of the LIBOR rate on December 20, the net cash outflow will be $2,325,000, which translates into an annualized rate of 9.3 percent. Consequently, the floating rate liability has been converted to a fixed rate liability in the sense that the interest rate uncertainty associated with the March 20 payment (using the December 20 contract) has been removed as of September 20. b. In a strip hedge, Johnson would sell 100 December futures (for the March payment), 100 March futures (for the June payment), and 100 June futures (for the September payment). The objective is to hedge each interest rate payment separately using the appropriate number of contracts. The problem is the same as in Part A except here three cash flows are subject to rising rates and a strip of futures is used to hedge this interest rate risk. This problem is simplified somewhat because the cash flow mismatch between the futures and the loan payment is ignored. Therefore, in order to hedge each cash flow, Johnson simply sells 100 contracts for each payment. The strip hedge transforms the floating rate loan into a strip of fixed rate payments. As was done in Part A, the fixed rates are found by adding 200 basis points to the implied forward LIBOR rate indicated by the discount yield of the three different Eurodollar futures contracts. The fixed payments will be equal when the LIBOR term structure is flat for the first year. 8. Jacob Bower has a liability that: • has a principal balance of $100 million on June 30, 2008, • accrues interest quarterly starting on June 30, 2008, • pays interest quarterly, • has a one-year term to maturity, and • calculates interest due based on 90-day LIBOR (the London Interbank Offered Rate). Bower wishes to hedge his remaining interest payments against changes in interest rates. Bower has correctly calculated that he needs to sell (short) 300 Eurodollar futures contracts to accomplish the hedge. He is considering the alternative hedging strategies outlined in the following table. Initial Position (6/30/08) in 90-Day LIBOR Eurodollar Contracts Strategy A Strategy B Contract Month (contracts) (contracts) September 2008 300 100 December 2008 0 100 March 2009 0 100 a. Explain why strategy B is a more effective hedge than strategy A when the yield curve undergoes an instantaneous nonparallel shift. b. Discuss an interest rate scenario in which strategy A would be superior to strategy B. CFA Guideline Answer a. Strategy B’s Superiority Strategy B is a strip hedge that is constructed by selling (shorting) 100 futures contracts maturing in each of the next three quarters. With the strip hedge in place, each quarter of the coming year is hedged against shifts in interest rates for that quarter. The reason Strategy B will be a more effective hedge than Strategy A for Jacob Bower is that Strategy B is likely to work well whether a parallel shift or a nonparallel shift occurs over the one-year term of Bower’s liability. That is, regardless of what happens to the term structure, Strategy B structures the futures hedge so that the rates reflected by the Eurodollar futures cash price match the applicable rates for the underlying liability-the 90day LIBOR-based rate on Bower’s liability. The same is not true for Strategy A. Because Jacob Bower’s liability carries a floating interest rate that resets quarterly, he needs a strategy that provides a series of three-month hedges. Strategy A will need to be restructured when the three-month September contract expires. In particular, if the yield curve twists upward (futures yields rise more for distant expirations than for near expirations), Strategy A will produce inferior hedge results. b. Scenario in Which Strategy A is Superior Strategy A is a stack hedge strategy that initially involves selling (shorting) 300 September contracts. Strategy A is rarely better than Strategy B as a hedging or risk-reduction strategy. Only from the perspective of favorable cash flows is Strategy A better than Strategy B. Such cash flows occur only in certain interest rate scenarios. For example Strategy A will work as well as Strategy B for Bower’s liability if interest rates (instantaneously) change in parallel fashion. Another interest rate scenario where Strategy A outperforms Strategy B is one in which the yield curve rises but with a twist so that futures yields rise more for near expirations than for distant expirations. Upon expiration of the September contract, Bower will have to roll out his hedge by selling 200 December contracts to hedge the remaining interest payments. This action will have the effect that the cash flow from Strategy A will be larger than the cash flow from Strategy B because the appreciation on the 300 short September futures contracts will be larger than the cumulative appreciation in the 300 contracts shorted in Strategy B (i.e., 100 September, 100 December, and 100 March). Consequently, the cash flow from Strategy A will more than offset the increase in the interest payment on the liability, whereas the cash flow from Strategy B will exactly offset the increase in the interest payment on the liability. MINI CASE: DETROIT MOTORS’ LATIN AMERICAN EXPANSION It is September 1990 and Detroit Motors of Detroit, Michigan, is considering establishing an assembly plant in Latin America for a new utility vehicle it has just designed. The cost of the capital expenditures has been estimated at $65,000,000. There is not much of a sales market in Latin America, and virtually all output would be exported to the United States for sale. Nevertheless, an assembly plant in Latin America is attractive for at least two reasons. First, labor costs are expected to be half what Detroit Motors would have to pay in the United States to union workers. Since the assembly plant will be a new facility for a newly designed vehicle, Detroit Motors expects minimal resistance from its U.S. union in establishing the plant in Latin America. Secondly, the chief financial officer (CFO) of Detroit Motors believes that a debt-forequity swap can be arranged with at least one of the Latin American countries that has not been able to meet its debt service on its sovereign debt with some of the major U.S. banks. The September 10, 1990, issue of Barron’s indicated the following prices (cents on the dollar) on Latin American bank debt: Brazil 21.75 Mexico 43.12 Argentina 14.25 Venezuela 46.25 Chile 70.25 The CFO is not comfortable with the level of political risk in Brazil and Argentina, and has decided to eliminate them from consideration. After some preliminary discussions with the central banks of Mexico, Venezuela, and Chile, the CFO has learned that all three countries would be interested in hearing a detailed presentation about the type of facility Detroit Motors would construct, how long it would take, the number of locals that would be employed, and the number of units that would be manufactured per year. Since it is time-consuming to prepare and make these presentations, the CFO would like to approach the most attractive candidate first. He has learned that the central bank of Mexico will redeem its debt at 80 percent of face value in a debt-for-equity swap, Venezuela at 75 percent, and Chile 100 percent. As a first step, the CFO decides an analysis based purely on financial considerations is necessary to determine which country looks like the most viable candidate. You are asked to assist in the analysis. What do you advise? Suggested Solution for Detroit Motors’ Latin American Expansion Regardless in which LDC Detroit Motors establishes the new facility, it will need $65,000,000 in the local currency of the country to build the plant. The analysis involves a comparison of the dollar cost of enough LDC debt from a creditor bank to provide $65,000,000 in local currency upon redemption with the LDC central bank. If Detroit Motors builds in Mexico, it will need to purchase $81,250,000 (= $65,000,000/.80) in Mexican sovereign debt in order to have $65,000,000 in pesos after redemption with the Mexican central bank. The cost in dollars will be $35,035,000 (= $81,250,000 x .4312). If Detroit Motors builds in Venezuela, it will need to purchase $86,666,667 (= $65,000,000/.75) in Venezuelan sovereign debt in order to have $65,000,000 in bolivars after redemption with the Venezuelan central bank. The cost in dollars will be $40,083,333 (= $86,666,667 x .4625). If Detroit Motors builds in Chile, it will need to purchase $65,000,000 (= $65,000,000/1.00) in Chilean sovereign debt in order to have $65,000,000 in pesos after redemption with the Chilean central bank. The cost in dollars will be $45,662,500 (= $65,000,000 x .7025). Based on the above analysis, Detroit Motors should consider approaching Mexico about the possibility of a debt-for-equity swap to build an assembly facility. Of course, there are many other factors, such as tax rates, shipping costs, and labor costs that also should be considered. Assuming all else is equal, however, Mexico seems to be the most attractive candidate. APPENDIX 11A QUESTION 1. Explain how Eurocurrency is created. Answer: The core of the international money market is the Eurocurrency market. A Eurocurrency is a time deposit of money in an international bank located in a country different from the country that issues the currency. For example, Eurodollars are deposits of U.S. dollars in banks located outside of the United States. As an illustration, assume a U.S. Importer purchases $100 of merchandise from a German Exporter and pays for the purchase by drawing a $100 check on his U.S. checking account (demand deposit). If the funds are not needed for the operation of the business, the German Exporter can deposit the $100 in a time deposit in a bank outside the U.S. and receive a greater rate of interest than if the funds were put in a U.S. time deposit. Assume the German Exporter deposits the funds in a London Eurobank. The London Eurobank credits the German Exporter with a $100 time deposit and deposits the $100 into its correspondent bank account (demand deposit) with the U.S. Bank (banking system) to hold as reserves. Two points are noteworthy. First, the entire $100 remains on deposit in the U.S. Bank. Second, the $100 time deposit of the German Exporter in the London Eurobank represents the creation of Eurodollars. This deposit exists in addition to the dollars deposited in the U.S. Hence, no dollars have flowed out of the U.S. banking system in the creation of Eurodollars. International Banking and Money Market Chapter Eleven Chapter Outline • International Banking Services – The World’s Largest Banks • Reasons for International Banking • Types of International Banking Offices – Correspondent Bank – Representative Offices – Foreign Branches – Subsidiary and Affiliate Banks – Edge Act Banks – Offshore Banking centers – International Banking Facilities • Capital Adequacy Standards Chapter Outline (continued) • International Money Market – Eurocurrency Markets – Eurocredits – Forward Rate Agreements – Euronotes – Euro-Medium-Term Notes – Eurocommercial Paper – Eurodollar Interest Rate Futures Contracts • International Debt Crisis – History – Debt-for-Equity Swaps – The Solution: Brady Bonds • Japanese Banking Crisis • The Asian Crisis • Global Financial Crisis International Banking Services • International banks do everything domestic banks do and: – Arrange trade financing. – Arrange foreign exchange. – Offer hedging services for foreign currency receivables and payables through forward and option contracts. – Offer investment banking services (where allowed). The World’s 10 Largest Banks 1. Deutsche Bank Germany 2. HSBC Holdings United Kingdom 3. BNP Paribas France 4. Mitsubishi UFI Financial Group Japan 5. Barclay’s United Kingdom 6. JPMorgan Chase United States 7. Bank of America United States 8. ICBC China 9. Mizuho Financial Japan 10. Citigroup United States Reasons for International Banking • Low marginal costs – Managerial and marketing knowledge developed at home can be used abroad with low marginal costs. • Knowledge advantage – The foreign bank subsidiary can draw on the parent bank’s knowledge of personal contacts and credit investigations for use in that foreign market. • Home nation information services – Local firms in a foreign market may be able to obtain more complete information on trade and financial markets in the multinational bank’s home nation than is obtainable from foreign domestic banks. • Prestige – Very large multinational banks have high perceived prestige, which can be attractive to new clients. • Regulatory advantage – Multinational banks are often not subject to the same regulations as domestic banks. Reasons for International Banking • Wholesale defensive strategy – Banks follow their multinational customers abroad to avoid losing their business at home and abroad. • Retail defensive strategy – Multinational banks also compete for retail services such as travelers checks and the tourist and foreign business market. • Transactions costs – Multinational banks may be able to circumvent government currency controls. • Growth – Foreign markets may offer opportunities for growth not found domestically. • Risk reduction – Greater stability of earnings with diversification. Types of International Banking Offices • Correspondent bank • Representative offices • Foreign branches • Subsidiary and affiliate banks • Edge Act banks • Offshore banking centers • “Shell” branches • International banking facilities Correspondent Bank • A correspondent banking relationship exists when two banks maintain deposits with each other. • Correspondent banking allows a bank’s MNC client to conduct business worldwide through his local bank or its correspondents. Representative Offices • A representative office is a small service facility staffed by parent bank personnel that is designed to assist MNC clients of the parent bank in dealings with the bank’s correspondents. • Representative offices also assist with information about local business customs and credit evaluation of the MNC’s local customers. Foreign Branches • A foreign branch bank operates like a local bank, but is legally part of the parent. – Subject to both the banking regulations of home country and foreign country. – Can provide a much fuller range of services than a representative office. • Branch banks are the most popular way for U.S. banks to expand overseas. Subsidiary and Affiliate Banks • A subsidiary bank is a locally incorporated bank wholly or partly owned by a foreign parent. • An affiliate bank is one that is partly owned but not controlled by the parent. • U.S. parent banks like foreign subsidiaries because they allow U.S. banks to underwrite securities. Edge Act Banks • Edge Act banks are federally chartered subsidiaries of U.S. banks that are physically located in the U.S. and are allowed to engage in a full range of international banking activities. • The Edge Act was a 1919 amendment to Section 25 of the 1914 Federal Reserve Act. Offshore Banking Centers • An offshore banking center is a country whose banking system is organized to permit external accounts beyond the normal scope of local economic activity. • The host country usually grants complete freedom from host-country governmental banking regulations. • The IMF recognizes the following as major offshore banking centers: – The Bahamas, Bahrain, the Cayman Islands, Hong Kong, the Netherlands Antilles, Panama, and Singapore. “Shell” Branches • Shell branches need to be nothing more than a post office box. • The actual business is done by the parent bank at the parent bank. • The purpose was to allow U.S. banks to compete internationally without the expense of setting up operations “for real.” International Banking Facilities • An international banking facility is a separate set of accounts that are segregated on the parents books. • An international banking facility is not a unique physical or legal identity. • Any U.S. bank can have one. • International banking facilities have captured a lot of the Eurodollar business that was previously handled offshore. Capital Adequacy Standards • Bank capital adequacy refers to the amount of equity capital and other securities a bank holds as reserves. • Three pillars of capital adequacy: – Minimum capital requirements – Supervisory review process – Effective use of market discipline • While traditional bank capital standards protect depositors from traditional credit risk, they may not be sufficient protection from derivative risk. – Barings Bank, which collapsed in 1995 from derivative losses, looked good on paper relative to the capital adequacy standards of the day. Capital Adequacy Standards • The Basel II Accord has been endorsed by central bank governors and bank supervisors in the G10 countries. • Sets out the details for adopting a more risk sensitive minimum capital requirements. – The key variables the bank must estimate are the probability of default and the loss given default for each asset on their books. International Money Market • Eurocurrency is a time deposit in an international bank located in a country different than the country that issued the currency. – For example, Eurodollars are U.S. dollardenominated time deposits in banks located abroad. – Euroyen are yen-denominated time deposits in banks located outside of Japan. – The foreign bank doesn’t have to be located in Europe. Eurocurrency Market • Most Eurocurrency transactions are interbank transactions in the amount of $1,000,000 and up. • Common reference rates include: – LIBOR (London Interbank Offered Rate) – PIBOR (Paris Interbank Offered Rate) – SIBOR (Singapore 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) Eurocredits • Eurocredits are short- to medium-term loans of Eurocurrency. • The loans are denominated in currencies other than the home currency of the Eurobank. • Often the loans are too large for one bank to underwrite; a number of banks form a syndicate to share the risk of the loan. • Eurocredits feature an adjustable rate. – On Eurocredits originating in London the base rate is LIBOR Forward Rate Agreements • An interbank contract that involves two parties, a buyer and a seller. • The buyer agrees to pay the seller the increased interest cost on a notational amount if interest rates fall below an agreed rate. • The seller agrees to pay the buyer the increased interest cost if interest rates increase above the agreed rate. Forward Rate Agreements: Uses • Forward rate agreements can be used to: – Hedge assets that a bank currently owns against interest rate risk. • For example, a bank that has made a three-month Eurodollar loan against an offsetting six-month Eurodollar deposit could protect itself by selling a “three against six” FRA. – Speculate on the future course of interest rates. Forward Rate Agreements: Example • A three against nine FRA is a 3-month forward contract on a six-month interest rate for a sixmonth period beginning three months from now. 0 1 2 3 4 5 6 7 8 9 Cash Settlement of FRA Settling a Forward Rate Agreement • At the end of the agreement period, the loser pays the winner an amount equal to the present value of the difference between the settlement rate (SR) and the agreement rate (AR), sized according to the length of the agreement period and the notational amount. days Notational Amount × (SR – AR) × 360 days 1 + SR × 360 Settling a FRA • A €5,000,000, 4%, 3 against 9 FRA entered into January 1, 2014 has the following terms: If on 3/1/14 the SR = 5% the seller pays the buyer €24,918.74. If on 3/1/14 the SR = 3% the buyer pays the seller €25,169.62. Forward Rate Agreements • FRAs are designed so the buyer will have the same future value of interest expense (i.e., a perfect hedge at the agreed-up rate) for any value of LIBOR at maturity of the FRA. • Calculate the FV of interest expense – If LIBOR at expiration is 3 percent: €5,025,169.62 x (1 + .03 x ) = €5m x ( 1 + .04 x ) €5,102,222.22 = €5,102,222.22 – If LIBOR at expiration is 5 percent: (€5m - €24,918.74)x(1 + .05 x ) = €5m x ( 1 + .04 x ) €5,102,222.22 =€5,102,222.22 Euronotes • Euronotes are short-term notes underwritten by a group of international investment banks or international commercial banks. – They are sold at a discount from face value and pay back the full face value at maturity. – Maturity is typically three to six months. Eurocommercial Paper • Unsecured short-term promissory notes issued by corporations and banks. • Placed directly 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 higher. Eurodollar Interest Rate Futures Contract • Widely used futures contract for hedging shortterm U.S. dollar interest rate risk. • The underlying asset is a hypothetical $1,000,000 90-day Eurodollar deposit—the contract is cash settled. • Traded on the CME and the Singapore International Monetary Exchange. • The contract trades in the March, June, September, and December cycle. Reading Eurodollar Futures Quotes OPEN OPEN HIGH LOW SETTLE CHG YLD CHG INT Eurodollar (CME)—1,000,000; pts of 100% Jun 96.56 96.58 96.55 96.56 - 3.44 - 1,398,959 Eurodollar futures prices are stated as an index number of three-month LIBOR calculated as F = 100 – LIBOR. The closing price for the June contract is 96.56, thus the implied yield is 3.44 percent = 100 – 96.56. Since it is a 3-month contract one basis point corresponds to a $25 price change: .01 percent of $1 million represents $100 on an annual basis. International Debt Crisis • Some of the largest banks in the world were endangered when loans were made to sovereign governments of some less-developed countries. • At the height of the crisis, Third World countries owed $1.2 trillion. • Like many calamities, it is easy to see in retrospect that, it’s a bad idea to put too many eggs in one basket, especially if you don’t know much about that basket. Debt-for-Equity Swaps • As part of debt rescheduling agreements among the bank lending syndicates and the debtor nations, creditor banks would sell their loans for U.S. dollars at discounts from face value to MNCs desiring to make equity investment in subsidiaries or local firms in the LDCs. • The LDC central bank would buy the bank debt from a MNC at a smaller discount than the MNC paid, but in local currency. • The MNC would use the local currency to make pre-approved new investment in the LDC that was economically or socially beneficial to the LDC. Debt-for-Equity Swap Illustration International Bank Sell $100m LDC firm or MNC subsidiary $60m LDC debt at local Equity 60% of face $80m in currency Investor or MNC $80m in local Redeem LDC currency debt at 80% of LDC Central face in local Bank currency Japanese Banking Crisis • The history of the Japanese banking crisis is a result of a complex combination of events and the structure of the Japanese financial system. • Japanese commercial banks have historically served as the financing arm and center of a collaborative group know as keiretsu. • Keiretsu members have cross-holdings of one another’s equity and ties of trade and credit. Japanese Banking Crisis • The collapse of the Japanese stock market set in motion a downward spiral for the entire Japanese economy and in particular Japanese banks. • This put massive amounts of bank loans to corporations in jeopardy. • It is unlikely that the Japanese banking crisis will be rectified anytime soon. – The Japanese financial system does not have a legal infrastructure that allows for restructuring of bad bank loans. – Japanese bank managers have little incentive to change because of the Keiretsu structure. The Asian Crisis • 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 bubbles in East Asia, particularly in real estate. • Additionally, the close interrelationships common among commercial firms and financial institutions in Asia resulted in poor investment decision making. • The Asian crisis is only the latest example of banks making a multitude of poor loans—spurred on by competition from other banks to make loans in the “hot” region. Global Financial Crisis • Officially began in the United States in December of 2007. • The origin of the credit crunch can be traced back to the low interest rate environment created by the Federal Reserve Bank in the early part of this century. – The fed funds target rate fell from 6.5 percent set on May 16, 2000, to 1.0 percent on June 25, 2003, and stayed below 3.0 percent until May 3, 2005. • Many banks and mortgage lenders lowered their credit standards to attract new home buyers who could afford to make mortgage payments at the current low interest rates, or “teaser” rates that were temporarily set at a low level during the early years of an adjustable-rate mortgage, but would likely reset to a higher rate later on. • Many of these home buyers would not have qualified for mortgage financing under more stringent credit standards, nor could they afford the loan at the eventual higher rates of interest. Global Financial Crisis • These so-called subprime mortgages were typically not held by the originating bank making the loan, but instead were resold for packaging into mortgage-backed securities (MBSs). – Between 2001 and 2006, the value of subprime mortgages increased from $190 billion to $600 billion. • Conceptually, mortgage-backed securities make sense. Each MBS represents a portfolio of mortgages, thus diversifying the credit risk that the investor holds. • Structured Investment Vehicles (SIVs) have been one large investor in MBS. An SIV is a virtual bank, frequently operated by a commercial bank or an investment bank, but which operates off the balance sheet. Global Financial Crisis • Typically, an SIV raises short-term funds in the commercial paper market to finance longer-term investment in MBSs and other assetbacked securities. – SIVs are frequently highly levered, with ratios of 10 to 15 times the amount of equity raised. – Since yield curves are typically upward sloping, the SIV might earn .25 percent by doing this. Obviously, SIVs are subject to the interest rate risk of the yield curve inverting (that is, short-term rates rising above long-term rates), thus necessitating the SIV to refinance the MBS investment at short-term rates in excess of the rate being earned on the MBS. • SIVs must contend with default risk. If the underlying mortgage borrowers default on their home loans, the SIV will lose investment value. Global Financial Crisis • Collateralized Debt Obligations (CDOs) have been another big investor in MBS. • A CDO is a corporate entity constructed to hold a portfolio of fixedincome assets as collateral. The portfolio of fixed-income assets is divided into different tranches, each representing a different risk class: AAA, AA-BB, or unrated. • CDOs serve as an important funding source for fixed-income securities. An investor in a CDO is taking a position in the cash flows of a particular tranche, not in the fixed-income securities directly. – The investment is dependent on the metrics used to define the risk and reward of the tranche. Investors include insurance companies, mutual funds, hedge funds, other CDOs, and even SIVs. MBSs and other asset-backed securities have served as collateral for many CDOs. Global Financial Crisis • To cool the growth of the economy, the Fed steadily increased the fed funds target rate at meetings of the Federal Open Market Committee, from a low of 1.00 percent on June 25, 2003, to 5.25 percent on June 29, 2006. • In turn, mortgage rates increased. Many subprime borrowers found it difficult, if not impossible, to make mortgage payments in a cooling economy, especially when their adjustable-rate mortgages were reset at higher rates. Global Financial Crisis • When subprime debtors began defaulting on their mortgages, commercial paper investors were unwilling to finance SIVs. Liquidity worldwide essentially dried up. • The spread between the three-month Eurodollar rate and threemonth U.S. Treasury-bills (the TED spread), frequently used as a measure of credit risk, increased from about 30 basis points in March 2007 to 200 basis points in November 2007, as investors became fearful of placing funds in even the strongest international banks. • Additionally, many CDOs found themselves stuck with the highest risk tranches of MBS debt, which they had not yet placed or were unable to place as subprime foreclosure rates around the country escalated. • Commercial and investment banks have been forced to write down over $170 billion of subprime debt to date, with as much as $285 billion expected. Global Financial Crisis • At this point, the story of the global financial crisis is still unfolding. Many lessons should be learned from it: – Credit rating agencies need to refine their models for evaluating esoteric credit risk created in MBSs and CDOs. – Borrowers must be more wary of putting complete faith in credit ratings. – Bankers seem to scrutinize credit risk less closely when they serve only as mortgage originators rather than the paper holders themselves. • As things have turned out, when the subprime mortgage crisis hit, commercial and investment banks found themselves exposed, in one fashion or another, to more mortgage debt than they realized they held. Solution Manual for International Financial Management Cheol S. Eun, Bruce G. Resnick 9780077861605