Download Euromarkets (Ch. 13)

Euromarkets
These can broadly be classified as Eurocurrency and Eurobond markets. We want to
focus on how MNCs can use these international markets to meet their financing
requirements.
A. Eurocurrency market
Definition and background
The Eurocurrency market consists of banks (called Eurobanks) that accept deposits and
make loans in foreign currencies. A Eurocurrency is a freely convertible currency
deposited in a bank located in a country which is not the native country of the currency.
The deposit can be placed in a foreign bank or in the foreign branch of a domestic US
bank.
[Note of caution! The prefix Euro has little or nothing to do with the newly emerging
currency in Europe.]
In the Eurocurrency market, investors hold short-term claims on commercial banks which
intermediate to transform these deposits into long-term claims on final borrowers.
The Eurocurrency market is dominated by US $ or the Eurodollar. Occasionally, during
weak dollar periods (latter part of 1970s and 1980s), the EuroSwiss franc and the
EuroDM markets increased in importance. The Eurodollar market originated post WWII
in France and England thanks to the fear of Soviet Bloc countries that dollar deposits held
in the US may be attached by US citizens with claims against communist governments!
Thriving on government regulation
By using Euromarkets, banks and financiers are able to circumvent / avoid certain
regulatory costs and restrictions. Some examples are:
a) Reserve requirements
b) Requirement to pay FDIC fees
c) Rules or regulations that restrict competition among banks
Continuing government regulations and taxes provide opportunities to engage in
Eurocurrency transactions. However, ongoing erosion of domestic regulations have
rendered the cost and return differentials much less significant than before. As a result,
the domestic money market and Eurocurrency markets are closely integrated for most
major currencies, effectively creating a single worldwide money market for each
participating currency.
Illustration I
German firm sells medical equipment to institutional buyer in the US. It receives a US$
check drawn on Citicorp, NY. Initially this check is deposited in a checking account for
dollar working capital use. But to earn a higher return (or rate of interest) on the $ 1
million the German firm decides to place the funds in a time deposit with a bank in
London, UK.
One million Eurodollars have thus been created by substituting a dollar account in a
London bank for the dollar account held in NY. Notice that no US $ left NY but
ownership of the US deposit has moved from a foreign corporation to a foreign bank.
The London bank would not like to leave the funds idle in NY account. If a government
or commercial borrower is unavailable, the London bank will place the $ 1 million in the
London interbank market. The interest rate at which such interbank loans are made is
called the London interbank offer rate (LIBOR).
--This example demonstrates that the Eurocurrency market is a chain of deposits and a
chain of borrowers and lenders. The majority of Eurocurrency transactions involve
transferring control of deposits from one Eurobank to another Eurobank. Loans to nonEurobank borrowers account for less than half of all Eurocurrency loans.
The Eurocurrency market operates like any other financial market, but for the absence of
government regulations on loans that can be made and interest rates that can be charged.
Eurocurrency loans
Eurocurrency loans are made on a floating – rate basis.
Interest rates on loans to governments, corporations and nonprime banks are set at a fixed
margin above LIBOR for a given period and currency.
Example
If the margin is 75 basis points (b.p.) and the current LIBOR is 6%, the borrower is
charged 6.75% for the relevant period. LIBOR is the underlying variable rate of interest,
usually set for a 6 month period.
--The margin or spread between the lending bank’s cost of funds and the interest charged
by the borrower is based on the borrower’s perceived creditworthiness / riskiness. The
spreads can range from 15 b.p. to more than 300 b.p., the median of the range varying
from 100 to 200 b.p.
The maturity of the Eurocurrency loan can range from 3 to 10 years. Eurocurrency loans
are made by bank syndicates. The bank originating the loan becomes the lead bank
managing the syndicate, inviting one or two other banks to be co-managers of the loan.
The borrower is charged a one-time syndication fee ranging from 0.25 % to 2 % of the
loan value according to the size and type of the Eurocurrency loan.
The drawdown [period over which the borrower may use the loan] of the loan and the
repayment period vary in accordance with the borrower’s needs. A commitment fee of
about 0.5 % per annum is paid on the unused balance, and prepayments in advance of the
agreed upon schedule are permitted but are sometimes subject to a penalty fee.
i) EAC of Eurocurrency loan
A corporate borrower has arranged a DM 500 million, five-year EuroDM loan with a
bank syndicate led by two managing banks. The upfront syndication fee is 2 %.
Net proceeds to the borrower = $ 500 mn – 0.02 (US $ 500 mn) = DM 490 mn.
The interest rate on the EuroDM loan is LIBOR + 1.75 %, with LIBOR reset every 6
months. If the initial LIBOR6 rate for DM is 6 %, the first semiannual debt service
payment is:
[(0.06 + 0.0175) / 2] * DM 500 mn = DM 19.3750 mn
Therefore the borrower’s effective annual rate (EAC) for the first six months is:
[DM 19.3750 mn / DM 490 mn] * 2 * 100 = 7.9082 %
This EAC changes in every reset period (in this case 6 months) with LIBOR6.
ii) Multicurrency loans
Though most Eurocurrency loans are Eurodollar loans, these often come with a
multicurrency clause. This clause gives the borrower the right (subject to availability) to
switch from one currency to another on any rollover (or reset) date. This option allows
the borrower to match currencies with cash inflows and outflows (which is an effective
way of managing exposure to currency risk, and thus an effective risk-management
technique). The option also allows borrowers to take advantage of its own expectations
regarding currency changes and search for funds with the lowest effective cost.
iii) Interest rates
Interest rates in national and Eurocurrency markets are closely linked through arbitrage.
US $ credit markets
US lending rate
Sterling credit markets
UK lending rate
Eurodollar lending rate
Eurosterling lending rate
Eurodollar deposit rate
Eurosterling deposit rate
US deposit rate
UK deposit rate
The difference between the Euro$ deposit rate and the Eurosterling deposit rate is given
by the forward discount or premium (which approximates the expected change in the
dollar/pound exchange rate).
B. Eurobond markets
Eurobonds are bonds sold outside the country whose currency they are dominated in.
They are similar in many ways to public debt sold in domestic capital markets. However,
the Eurobond market is entirely free of official regulation and is self-regulated by the
Association of International Bond Dealers.
Borrowers in the Eurobond market are typically well known and have impeccable credit
ratings (for example, developed countries, international institutions, and large MNCs).
The Eurobond market has grown rapidly in the last two decades, and it exceeds the
Eurocurrency market in size.
i)Currency denomination
About 75 % of Eurobonds are dollar denominated. The most important nondollar
currencies for Eurobond issues are DM and FF (now rapidly replaced by the euro), the JY
and the BP [The Swiss central bank ban has led to the absence of SF Eurobonds].
ii)Fixed – rate Eurobonds
Fixed-rate Eurobonds pay coupons once a year, unlike the semiannual coupon, domestic
bonds in the US market. Borrowers compare the all-in cost, that is, the effective interest
rate, on Eurobonds and domestic bonds.
This interest rate is calculated as the discount rate that equates the present value of the
future interest and principal payments to the net proceeds received by the issuer, or as the
IRR of the bond.
iii) Comparing Eurobond issue with a US domestic issue
To compare a Eurobond issue with a US domestic issue, therefore, the all-in cost of funds
on an annual basis must be converted to a semiannual basis or vice versa. Thus,
Semiannual yield = [1 + Annual yield]^0.5 – 1, and
(1)
Annual yield = [1 + Semiannual yield]^2 – 1.
(2)
Illustration II
P & G plans to issue a 5-year bond with a face value of $ 100 million. Its investment
banker estimates that a Eurobond issue would have to bear a 7.5 % coupon and that fees
and other expenses will total $ 738,000 providing net proceeds to P & G of $ 99,262,000.
Exhibit 1 shows the cashflows associated with the Eurobond issue. The all-in cost (IRR)
of this issue, which is an annual rate, is shown as 7.68 %. As a cross – check, the third
column shows that the PV of the cashflows, using a discount rate of 7.68 %, sum to P &
G ‘s net proceeds of $ 99,262,000.
Alternatively, P & G can issue a $ 100 million, 5-year bond in the US market with a
coupon of 7.4 %. With estimated issuance costs of $ 974,000, P & G will receive net
proceeds of $ 99,026,000.
Exhibit 2 shows the cashflows associated with this issue and its all-in cost (IRR) of 3.82
%. Note that the cashflows are semiannual, as is the all-in cost. Again, the third column
does a cross-check to confirm the 3.82 % all-in cost.
According to Equation (1) above, the equivalent semiannual all-in cost for the Eurobond
issue is (1.0768)^0.5 – 1 = 3.77 %. Thus, the all-in cost of the Eurobond is lower,
making it preferable if all other terms and conditions on the two bonds are the same.
Alternatively, using Equation (2) above, we can convert the US bond yield to its annual
equivalent and compare that figure to the Eurobond yield of 7.68 %. This computation
would have yielded an annualized all-in cost of the US bond issue equal to (1.0382)^2 – 1
= 7.78 %. As before, the Eurobnd issue is preferable because its all-in cost is 10 basis
points lower.