What eurocurrency markets are not: – They are not markets limited to transactions in Europe; – They are not markets for transactions in the “euro,” the new common currency of the countries in the European Union. – They are not markets for foreign exchange transactions; instead these are markets for ? xed-income instruments. Fall 1999 International Finance: Chapter 10 – International bond market 10-7 10. 3. 1 History of euromarkets • The earliest activity in the euromarkets was in the deposit and loan segment, that is, the segment where banks act as intermediaries between investors and borrowers. The success of this unregulated, wholesale banking market was soon imitated in the bond section and the short-term securities part of the capital market (eurobonds, and eurocommercial paper, respectively). • The emergence or euromarkets was motivated by certain economic decisions and political factors; the growth of this market is mainly the result of low costs, thus enabling a narrower bidask spread. 10-8 International Finance: Chapter 10 – International bond market Fall 1999 • There are a number of historical factors that helped the initial development of euro-money markets: 1. As of the ? ties, the Cold War created political risks for communist depositors of US dollars. So the USSR and China shifted their dollar balances away from New York to London and Paris, out of reach of the US government.
2. After the second world war, the gbp was chronically overvalued, and the UK had serious balance of payments problems. So the UK government limited foreign borrowing in GBP. As a result, UK banks borrowed usd (that is accepted usd deposits), which were then used to extend usd loans instead of gbp loans. 3. Several regulations imposed by the US government imposed interest ceilings on domestic usd deposits; thus, US orporations and investors preferred to place usd deposits in Europe (where they obtained better rates); and these dollars were then re-lent to non-US borrowers, who were not allowed to borrow usd in the US. 4. Nixon’s “voluntary” (and, later on, mandatory) curbs on capital exports had the unexpected result that US multinationals stopped depositing their funds in the US, fearing that they would be blocked there. Instead, these funds were deposited in euro-markets. Fall 1999 International Finance: Chapter 10 – International bond market 10-9 • The explanation for the long-term success of these o? hore markets is their lower bid-o? er spread (that is, the di? erence between interest rates on loans and deposits), which in turn re? ect the lower costs of o? -shore banking as compared to domestic banking. There reasons for the low operating costs are: 1. The o? shore market is essentially a wholesale market, where large volumes of transactions allow narrow spreads. 2. Most euro-borrowers are sovereign states or high-grade corporations; this means that there are hardly any costs of credit evaluation, bonding, and monitoring. 3. There is no compulsory deposit insurance, which means that there are no insurance costs.
Nor are there any reserve requirements (which are, in fact, similar to taxes on deposits); and local monetary authorities tend to be far more lenient as far as credit restraints are concerned when borrowing does not involve their home currency. 4. Euro-banks are often located in tax havens or are part of a ? nancial network involving tax havens. Also, o? shore transactions may receive bene? cial tax treatment when compared with domestic businesses. 10-10 International Finance: Chapter 10 – International bond market Fall 1999 10. 4 10. 4. 1 Eurobanking markets Eurodeposits Initially, euro-deposits were mostly time deposits or term deposits, that is, non-negotiable, registered instruments with a ? xed life. • Later on, one could get a certi? cate of deposit (CD). – This is the tradable version of the traditional term deposit; – It is often a bearer security (that is, the owner is not registered with the issuing company or institution). • The bulk of the deposits have a very short duration: overnight, or one or two weeks, but mostly 1, 3 or 6 months. – These short-term deposits or CDs pay no interim interest but only one single payment at expiration. For long-term CD’s or long-term deposits (up to 7 years), there is either a ? xed- or ? oating-rate coupon.
For CDs with ? oating-rate coupons, – The life of the CD is divided into periods of usually six months. – The interest to be earned over each such period is ? xed at the beginning of the period, called the reset date, and – This interest rate is based on the then prevailing market interest rate, usually the London Interbank O? er Rate (LIBOR) or the Interbank O? er Rate in the currency’s domestic ? nancial center, but sometimes the US T-bill rate or the US prime rate. – Sometimes a ? oating-rate CD has a cap or a ? or, that is, the interest rate that the investor actually receives has an upper or lower bound. Fall 1999 International Finance: Chapter 10 – International bond market 10-11 10. 4. 2 Eurocredits and euroloans • Eurobanks o? er essentially the same products as domestic banks, namely loans and credit lines. • One di? erence is that euroloans tend to be of the ? oating-rate type, whereas many domestic loans have an interest rate that is ? xed over the entire life of the loan. • Another di? erence is that euro-loans tend to be extended by groups of banks (a consortium) rather than by single institutions. 10-12
International Finance: Chapter 10 – International bond market Fall 1999 10. 4. 2. 1 Bank syndicates A syndicate consists of many banks performing di? erent functions. • The lead bank (or lead manager) negotiates with the borrower for tentative terms and conditions, obtains a mandate, and looks for banks that provide the money or undertake to provide the money if there is any shortfall in funds. • The lead manager often contacts a smaller number of managing banks who underwrite the loan, that is, guarantee to make up for the funds if there is any shortfall. • Banks providing the funding are called participating banks. The paying agent is the bank receiving service payments from the borrower and distributing them to participating banks • Any given bank can play multiple roles. For instance, the lead bank is almost invariably also the largest underwriter (hence the name lead manager), and often also provides funding. • The main objective of syndication is to spread the risks. • It also avoids the moral hazard that the borrower might just pay o? the larger banks and ignore the small debt holders; because of the paying agent system, the borrower either defaults towards all banks, or to none. As is the case in domestic banking, the borrower often signs promissory notes (that is, I owe you documents), one for each payment, which makes the loan negotiable. Fall 1999 International Finance: Chapter 10 – International bond market 10-13 10. 4. 3 Revolving or ? oating-rate loans • Because euro-deposits have short maturities (mostly 1, 3, and 6 months), euro-bankers have a natural preference for shortterm loans. This allows them to match the duration of the loans with that of deposits. • Sometimes there is a cap and/or a ? oor to the e? ective interest rate. For instance, the contract may say that ? the interest rate will never exceed 10% p. a. (cap), ? or never fall below 7% p. a. (? oor). –
These caps and ? oors are like European-type options on T-bills or on euro-deposits or euro-loans. ? The ? oor is a call option on a promissory note, and the option is held by the lender and written by the borrower. ? The cap is a put option on a promissory note, and the option is held by the borrower and written by the lender. 10-14 International Finance: Chapter 10 – International bond market Fall 1999 10. 4. 4 Costs of a euroloan An upfront management fee and participation fee, usually of the order of 0. 5 to 1% . – The upfront feature means that this amount is deducted from the principal. That is, the borrower receives only 99. 599 • A (small) paying agent’s fee to cover the administrative expenses. • The risk-spread above the risk-free rate (that is, above LIBOR in the case of a ? oating-rate loan, or above the long-term ? xed rate paid by a government of excellent credit standing). – This spread depends on the quality of the borrower, the political risk of his country, the maturity and grace period, and the up-front fee. Also, the market situation a? ects the spread: at times, competition among banks drives down spreads to rockbottom levels. Fall 1999 International Finance: Chapter 10 – International bond market 10-15 • In principle, the fees are a compensation for the services of the intermediaries, while the spread is a compensation for default risk. – However, one can trade a higher upfront fee for a lower spread and vice versa. For instance, borrowers often accept a high up-front fee in return for a lower spread, because the spread is sometimes seen as a quality rating.
This implies that – the spread that borrower X pays may be a poor indicator of the creditworthiness of borrower X. – A reliable comparisons between o? ers from competing banks can be made only if there is single measure of cost. This measure is called the “all-in cost” or the “equivalent yield. ” – Thus, when comparing o? ers from competing syndicates one should convert their upfront fees into equivalent spreads, or their spreads and paying agent fees into equivalent upfront costs. – At a more fundamental level, it is important to identify the economic factors that give rise to di? erences in ? nancing costs across di? rent instruments. 10-16 International Finance: Chapter 10 – International bond market Fall 1999 Example 10. 2 (Equivalent spread) Suppose an upfront fee of usd 3,700 is asked on a 5-year loan of usd 100,000 with an annual interest payment of 10% (including spreads) and one single amortization at the loan’s maturity. – The e? ective proceeds of the loan are, therefore, usd 100, 000 ? 3, 700 = usd 96, 300. – The e? ective interest rate can be estimated by computing the internal rate of return or yield, denoted by y : 10, 000 10, 000 10, 000 110, 000 10, 000 + + + = 96, 300 + (1 + y) (1 + y)2 (1 + y)3 (1 + y)4 (1 + y)5 The solution is, approximately, y = 11%. – Thus, the upfront fee is equivalent to a spread of 1 % p. a. Fall 1999 International Finance: Chapter 10 – International bond market 10-17 10. 4. 4. 1 Spread on ? oating rate loan • In the above example, the future payments are known because the loan had a ? xed interest rate. • If the loan is a ? oating-rate deal, one can no longer compute the yield, because the future cash? ows are unknown. • However, the upfront fee can still be translated into an equivalent annuity, using the interest rate on a ? xed-rate loan with the same life and the same default risk. The equivalent annuity can then be converted into an equivalent percentage spread by dividing the annuity by the nominal value of the loan. Example 10. 3 (Equivalent spread on ? oating rate loan) If the normal market rate on a ? xed-rate loan with the same life and default risk is 11%, the equivalent annuity (EqAn) of usd 3,700 upfront is determined as follows. 3700 = EqAn EqAn EqAn EqAn EqAn + + + + 1. 11 1. 112 1. 113 1. 114 1. 115 1 1 1 1 1 = EqAn ? + + + + 1. 11 1. 112 1. 113 1. 114 1. 115 = EqAn ? 3. 6959 – It follows that: EqAn = 3,700 3. 695 = usd 1001. Thus, the upfront fee is equivalent to a spread of about 1001/100,000 = 1% p. a. 10-18 International Finance: Chapter 10 – International bond market Fall 1999 10. 4. 5 Credit lines • In addition to outright loans, euro-banks also o? er standby credits. These come in two forms: – A standard line of credit of, say, gbp 10 m gives the bene? ciary the right to borrow up to gbp 10 m, at the prevailing interest rate plus a pre-set spread. ? The di? erence between a credit line and a loan is that with a credit line the company is not forced to actually borrow the money.
Interest is payable only on the portion actually used, while on the unused funds only a commitment fee of 0. 25 to 1% p. a. needs to be paid. ? A credit line is, in principle, a short-term commitment. In practice, a credit line tends to get extended, but it can be revoked by the bank if there are su? ciently important changes in the creditor’s credit standing. – A revolving commitment is similar to a credit line, except that it cannot be revoked during its life. • A credit line is like an option on the pre-set spread, and the revolving commitment is like a series of such options. The contract is an option, not a forward contract, because the bene? ciary can always borrow elsewhere if the marketrequired spread drops. – The credit line and the revolving commitment di? er from caps in the sense that the contract imposes a ceiling on the spread, not on the interest. Fall 1999 International Finance: Chapter 10 – International bond market 10-19 10. 4. 6 Forward Forwards and Forward Rate Agreements • Forward contracts on interest rates come in two forms: – the forward-forward (FF), and – the forward rate agreement (FRA). Like any forward contract, a FRA can be used either for hedging or for speculation purposes. Banks, for example, use FRA’s, along with T-bill futures and bond futures, to reduce problems with maturity mismatches. • FRAs have some advantages as compared to T-bill futures and bond futures, and these advantages are basically similar to the advantages of forward exchange contracts over currency futures contracts. • For ? nancial institutions, and even for corporations, FRAs (and interest futures) are superior when compared to synthetic FRA’s in the sense that they do not in? ate the balance sheet. A limitation of these contracts is that there is no organized secondary market. • But, as in the case of swaps, long-term FRA contracts are often collateralized or periodically recontracted.
This reduces credit risk, so a fairly lively over-the-counter market has emerged. 10-20 International Finance: Chapter 10 – International bond market Fall 1999 De? nition 10. 2 (Forward forward) A Forward Forward (FF) contract ? xes an interest rate at t for a deposit or loan starting at a future time T1 and expiring at T2, where t < T1 < T2. Receive interest + principal Sign FF contract T1 t ? t ? t=0 Deposit principal ? T2 time Example 10. 4 (Forward forward) Consider a 6-to-9-month forward forward contract for jpy 100 m at 4% p. a. (simple interest). This contract guarantees that the return on a three-month deposit of jpy 100 m, to be made six months from now, will be 4%/4=1%. At time T1, the jpy 100 m will be deposited, and principal plus the agreed-upon interest will be received at time T2. Fall 1999 International Finance: Chapter 10 – International bond market 10-21 De? nition 10. 3 (Forward Rate Agreement) A Forward Rate Agreement (FRA) contract ? es an interest rate at t for a notional deposit or loan starting at a future time T1 and expiring at T2, where t < T1 < T2. • The Forward Rate Agreement or FRA is a variant of the forward-forward. • In contrast to the FF, under a FRA the deposit is notional— that is, the contract is for a hypothetical deposit rather than an actual deposit. – Instead of actually making the deposit, the holder of the contract will settle the gain (or loss) in cash, and receive (or pay) the present value of the di? erence between the contracted forward interest rate and market rate that is actually prevailing at time T1. In practice, – the reference interest rate on which the cash settlement is based is computed as an average of many banks’ quotes, two days before T1. – The contract stipulates how many banks will be called from what list, and how the averaging is done. – In the early eighties, FRAs were quoted for short-term maturities only. Currently, quotes extend up to 10 years. 10-22 International Finance: Chapter 10 – International bond market Fall 1999 Example 10. 5 (Forward Rate Agreement) Consider a nine-to-twelve-month fim 5 m notional deposit at a forward interest rate of 12% p. a. (a forward return of 3%).
If the Helsinki Interbank O? er Rate (HIBOR) at time T1 turns out to be 10% p. a. (implying a return of 2. 5%), the forward contract has a positive value equal to the di? erence between the promised interest (3% on fim 5 m) and the interest in the absence of the FRA, 2. 5% on fim 5 m. Thus, in nine months the investor will receive the present value of this contract, which amounts to fim 5m ? 0. 030 ? 0. 025 = fim 24, 3902. 1. 025 Fall 1999 International Finance: Chapter 10 – International bond market 10-23 10. 4. 6. 1 Valuation of FFs and FRAs 1. How should one value an outstanding contract? . How should one set the forward interest rate? Receive 1 + rF 1,2 Find value at t t Sign FF contract t T1 t ? t ? 0 t Deposit 1 unit ? T2 time • The value of the contract at t depends on: – The value at t of the deposit (out? ow) at T1 is: – The value at t of the return on the loan at T2 is: – Thus, the value of the contract is: F 1 + r1,2 ?1 . 1+rt,1 1+rF 1,2 . 1+rt,2 Vt = 1 + rt,2 ? 1 . 1 + rt,1 10-24 International Finance: Chapter 10 – International bond market Fall 1999 • At time 0, the value of the contract is 0, which implies that F r1,2 is set in such a way that: V0 = F 1 + r1,2 + r0,2 ? 1 = 0, 1 + r0,1 which implies that: F (1 + r1,2 ) ? (1 + r0,1 ) = 1 + r0,2 . Example 10. 6 (Valuation of an FRA) Suppose that the current 3- and 6-month chf interest rates are 9% and 9. 125% p. a. Then, ? nding the value of a 3-to-6 months FRA loan for chf 10 m at 10% p. a. is equivalent to ? nding the value of the following portfolio: – a 3-month loan with face value 10 m at time T1 (3 months from now) – a 6-month deposit with face value 10. 25 m at T2 (six months from now) Vt = PV(in? ows) ? PV(out? ows) = chf 10. 25m chf 10m ? 1 + (6/12) ? . 09125 1 + (3/12) ? 0. 09 = chf22, 798. Fall 1999 International Finance: Chapter 10 – International bond market 10-25 10. 5 Eurosecurity markets • Almost simultaneously with the emergence of euro-money markets, ? rms and governments also started issuing usd bonds outside the US (eurodollar bonds), and sold them to non-US residents.
• Starting in the sixties and especially the seventies, eurobonds were also denominated in other currencies than the usd. • As of the seventies, corporations and governments also started issuing short-term commercial paper. These markets are the tradable-security versions of the banking products we discussed in the preceding section. 10-26 International Finance: Chapter 10 – International bond market Fall 1999 10. 5. 1 Reasons for growth of eurosecurity markets • The explanations for the long-term success of o? -shore securities markets are largely similar to the ones cited for eurocurrency markets: • Fewer regulations for o? -shore public issues because monetary authorities and capital market regulators are less concerned with issues that do not involve their own currency and are not (or not primarily) targeted at local investors. Swift and e? cient private placement – By traditional US standards, publication requirements in Europe were never very stringent; and no rating is required for euro-issues. – But even these comparatively lax requirements can be largely or entirely avoided if the issue is private rather than public. – For loans privately placed with a limited number of professional investors, there is no queuing and few disclosure requirements. • As borrowers are generally of good credit standing, eurobonds tend to be unsecured, so that legal costs as well as the expenses of bonding and monitoring are avoided. Fall 1999
International Finance: Chapter 10 – International bond market 10-27 • Euro-bonds, being anonymous bearer bonds, make it easier to evade income taxes. Withholding taxes can be avoided by issuing the bonds in tax havens; and most OECD countries have recently waived withholding taxes for non-residents. • Issues below usd 100 m are rare. The relatively large size of these issues allows low issuing costs. • Another impetus for the growth of the euro-securities market came from the general disintermediation movement since the mid-70’s. This evolution was the result of two forces. – First, many banks lost their ? st-rate creditworthiness when parts of their loan portfolios turned sour (due to the international debt crisis and the collapse of the real-estate markets). As a result, these banks were no longer able to fund at the AAA rate, which meant that top borrowers could borrow at a lower cost than banks by tapping the market directly. – Second, as a response to the lower pro? ts from lending and borrowing and to the sti? ened capital adequacy rules, banks preferred to earn fee income from bond placements or commercial paper issues. 10-28 International Finance: Chapter 10 – International bond market
Fall 1999 10. 5. 2 Institutional features of eurobonds • Bearer securities – Euro-bonds are bearer bonds. – In many countries, an investor can cash in coupons and principal paid out by bearer securities without having to reveal his or her identity. • Interest payments – Euro-bonds originally carried (and to a large extent still carry) ? xed coupons. – Floating-rate notes (FRN) are a more recently introduced instrument, in which case every six months the interest rate is reset on the basis of the then prevailing three- or six-month LIBOR plus a pre-set spread. • Amortization Amortization of the bond’s principal amount typically occurs at maturity; such bonds are known as bullet bonds. – Alternatively, the borrower may commit to buy back predetermined amounts of bonds in the open market every year, which is called a purchase fund provision. – Under a variant provision, the borrower does not have to buy back the bonds if market prices are above par, and instead has a right to call a predetermined part of the issue every year. This is called a sinking-fund provision. Fall 1999 International Finance: Chapter 10 – International bond market 10-29 • Currency of denomination The currency of denomination of the bonds is most often a single currency (especially the usd, dem, jpy, chf). – Also the private ECU is becoming increasingly popular as the currency of denomination; other currency baskets, such as the SDR or the European Unit of Account, have never really caught on. – Some bonds have currency options attached to them. • Stripped bonds. – Bond stripping essentially means that the coupons and the principal components of the bond are sold separately. – The main consequence of stripping is that the principal can be sold separately, as a zero-coupon bond. The motivation for stripping is that zero coupon bonds, o? ering capital gains rather than interest, get favorable tax treatment in many countries. ? In some countries, including Japan and Italy, capital gains are even entirely exempt from personal taxation. ? Thus, the principal is sold to Japanese or Italian investors, and the (taxable) coupons are sold to low-tax investors. 10-30 International Finance: Chapter 10 – International bond market Fall 1999 • Issuing Procedures – Placement of euro-bonds is most often via a syndicate of banks or security houses.
The lead bank or lead manager negotiates with the borrower, brings the syndicate together, makes a market (at least initially), and supports the price during and immediately after the selling period. – There are often, but not always, managing banks that underwrite the issue and often buy part of the bonds for their own account. – The ? scal agent takes care of withholding taxes. – Prospective customers can ? nd information about the issuing company and about the terms and conditions of the bond in a prospectus. – Often an uno? cial version of the prospectus is already circulating before the actual prospectus is o? ially approved; this preliminary prospectus is called the red herring. – On the basis of the red herring, investors can already buy forward the bonds for a few weeks before the actual issuing period starts. This period of uno? cial trading is called the gray market period. • Secondary Market The secondary market for euro-bonds is not very active. Fall 1999 International Finance: Chapter 10 – International bond market 10-31 10. 5. 3 Eurocommercial paper • Commercial paper refers to short-term securities (from seven days to a few years) issued by private companies. Just as euro-bonds are the disintermediated version of longterm euro-bank loans, euro commercial paper (ECP) forms the disintermediated counterpart of short-term bank loans. • ECP markets have existed in an embryonic form ever since banks drew promissory notes on their borrowers as a way to con? rm loan agreements. But the market became important only in the eighties, when, as part of the general disintermediation movement, large corporations with excellent credit standing started issuing short- or medium-term paper, which is placed with institutional investors. The volume of the market remains low relative to the bond and bank-loan market. 1
0-32 International Finance: Chapter 10 – International bond market Fall 1999 10. 5. 3. 1 Features of eurocommercial paper • The market consists of notes, promissory notes, and CD’s. – Notes are medium-term paper with maturities from 1 to 7 years, usually paying out coupons. – Promissory notes have shorter lives (sometimes as short as 7 days), and are issued on a discount basis, that is, without interim interest payments and with par value. • Although an ECP issue can be a one-time a? air, many issuers have an ECP-program contract with a syndicate. A bare-bones ECP program just eliminates the bother of getting a syndicate together each time commercial paper needs to be placed; • But many program contracts also o? er some form of underwriting commitment (for issues up to a given amount and within a given period). Fall 1999 International Finance: Chapter 10 – International bond market 10-33 • Such a commitment can stipulate the following terms: – A ? xed spread (for example 0. 5% above LIBOR); this is called a Note Issuing Facility (NIF). – A capped spread; this is called a Revolving Underwritten Facility (RUF). • The di? rence between a NIF and a RUF is less important than what it may seem at ? rst sight. – A NIF is an also an option on a spread, not a forward contract on a spread, because the borrower is under no obligation to use the facility. – That is, if spreads go down in the market, the borrower can choose not to use the NIF and issue paper via a new syndicate or under a new agreement. – Under such circumstances the advantage of the RUF to the borrower is only that it avoids the cost and complications of setting up a new issuing program. 10-34 International Finance: Chapter 10 – International bond market Fall 1999 10. 6
Summary • The main di? erences between euromarkets and domestic money markets is that transactions in euromarkets are in currencies other than that of the country where the transaction takes place. • Euromarkets are unregulated markets, often o? ering more attractive bid-ask spreads. • Other than this di? erence, the transactions one can make in euromarkets are not fundamentally di? erent from the transaction in domestic markets • Arbitrage relations link: – Interest rates (spot interest rates, forward interest rates, and yields at par); – Interest rates in various currencies and the spot and forward currency markets. Yields-at-par across currencies and swap markets (discussed in the next chapter). Fall 1999 International Finance: Chapter 10 – International bond market 10-35 10. 7 Recommended readings • Chapter 9 of Sercu and Uppal, “International Financial Markets and the Firm. ” • Appendix to Chapter 9 of Sercu and Uppal, “International Financial Markets and the Firm. ” 10. 8 Practice problems Quiz questions • Multiple-choice questions 1–3 on pages 309 of SU Chapter 9. Exercise questions • Questions 1-7 on pages 310 of SU Chapter 9.