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KU ECON 750 - CHAPTER 9 The Eurocurrency Market

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International Financial MarketsOverviewSlide 3Slide 4The Eurocurrency MarketSectors of the International Money MarketsThe Origins of Supply and Demand for Offshore BankingOnshore Banking Regulations Boost the Offshore MarketSlide 9Slide 10The Offshore Markets EndureGrowth of the Eurocurrency MarketPricing of Eurocurrency Deposits and LoansSlide 14Slide 15Slide 16Slide 17Can Offshore and Onshore Markets Coexist?The Impact of Capital Controls and TaxesMarket Share and Pricing in Competing Offshore CentersSlide 21The General Case with Many Currencies and Many Financial CentersArbitrage and Interest Rate ParityPolicy Matters - Private EnterprisesSlide 25Slide 26Slide 27Policy Matters - Public PolicymakersSlide 29Slide 30Slide 31Slide 32Slide 33The Eurocurrency Market9 Prices and PoliciesSecond Edition ©2001Richard M. LevichInternational Financial MarketsMcGraw Hill / Irwin9 - 2McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.OverviewHistorical OverviewThe Origins of Supply and Demand for Offshore BankingOnshore Banking Regulations Boost the Offshore MarketThe Offshore Markets EndureGrowth of the Eurocurrency Market9 - 3McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.OverviewPricing Of Eurocurrency Deposits and LoansPricing in the Case of One Currency and Two Financial CentersCan Offshore and Onshore Markets Coexist?The Impact of Capital Controls and TaxesMarket Share and Pricing in Competing Offshore CentersThe General Case with Many Currencies and Many Financial Centers9 - 4McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.OverviewPolicy Matters - Private EnterprisesConcerns of DepositorsConcerns of BorrowersPolicy Matters - Public PolicymakersOffshore Markets and Macroeconomic StabilityCould the Offshore Markets Expand Indefinitely?Approaches to Regulating Offshore MarketsCompeting for Markets: U.S. Policy InitiativesOffshore Markets: European Policy Concerns9 - 5McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Eurocurrency MarketThe Eurocurrency market is the market for deposits placed under a regulatory regime different from the regulations applied to deposits used to execute domestic transactions.It owes its existence to differences in national financial regulation combined with declining barriers to international capital movements.In effect, it is a parallel market in competition with the traditional domestic market.9 - 6McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Sectors of the International Money MarketsUS$ £OnshoreOffshore U.S. bank deposit U.S. Treasury billsand bonds U.S. corporate bonds U.K. bank deposit U.K. government bonds U.K. corporate bonds Euro-$ deposit Euro-$ bond(corporate andsovereignissuers) Euro-£ deposit Euro-£ bond(corporate andsovereignissuers)Currency DimensionRegulatoryDimension9 - 7McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Origins of Supply and Demand forOffshore BankingThe Eurocurrency market evolved through a combination of forces.The supply and demand for Eurodollars had always been present. The innovation came in the mid-1950s when banks elected to lend these funds within Europe rather than invest them in the U.S. money market.The demand for Eurodollars further multiplied when the Bank of England restricted the external use of sterling in 1957.9 - 8McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Onshore Banking RegulationsBoost the Offshore MarketUnder Regulation Q, the Federal Reserve established ceilings on the interest rate that banks could pay on deposits.To reduce the U.S. capital outflow, more regulations were imposed in the 1960s:The Interest Equalization Tax (IET) taxes U.S. purchases of foreign securities.The Foreign Credit Restraint Program limits the volume of bank lending with foreigners.9 - 9McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Onshore Banking RegulationsBoost the Offshore MarketHowever, these regulations only further encouraged borrowers to investigate the Eurocurrency markets.9 - 10McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Onshore Banking RegulationsBoost the Offshore MarketEuropean governments also experimented with capital controls in the 1970s.Both Germany and Switzerland imposed regulations to try to limit the nonresident demand for their currencies.Similarly, these regulations helped to promote the non-dollar segments of the Eurocurrency market.9 - 11McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.The Offshore Markets EndureEven though many of the regulations that initially fostered the market had since been abolished, the Eurocurrency markets have continued to grow and prosper.Today, we describe the innovation that permits the Eurocurrency market to sustain its existence as “unbundling” - taking the exchange risk of one currency and combining it with the regulatory climate and political risk of another financial center.9 - 12McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Growth of the Eurocurrency MarketAs in the onshore markets, funds are deposited, lent, re-deposited, and re-lent in the Eurocurrency market.The market has grown from essentially zero in 1960 to roughly $9.5 trillion on a gross basis and $5.5 trillion on a net basis in 1999.The U.S. dollar is the main currency, while Europe is the dominant region for Eurocurrency deposits.9 - 13McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.$$Pricing ofEurocurrency Deposits and LoansConsider the case of one currency (the U.S. dollar) and two financial centers (New York and London).9 - 14McGraw Hill / Irwin 2001 by The McGraw-Hill Companies, Inc. All rights reserved.Pricing ofEurocurrency Deposits and LoansIn the onshore market ...Quantityof FundsInterestRatesDThe demand (D ) for funds depends on the required rateof return on availableprojects,Swhile the supply (S )of funds depends on individuals’ ratesof time preference.AIn the absenceof transaction costs,the equilibrium is at A.XWhen banks incur costs X, RDRLQequilibrium deposit rate = RD, lending rate = RL,market size = Q.9 - 15McGraw


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