Drawbacks of the Eurocurrency Market

The eurocurrency market has two drawbacks. First, when depositors use a regulated banking system, they know that the probability of a bank failure that would cause them to lose their deposits is very low. Regulation maintains the liquidity of the banking system. In an unregulated system such as the eurocurrency market, the probability of a bank failure that would cause depositors to lose their money is greater (although in absolute terms, still low). Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a system and are willing to pay the price.

Second, borrowing funds internationally can expose a company to foreign exchange risk. For example, consider a US company that uses the eurocurrency market to borrow euro-pounds--perhaps because it can pay a lower interest rate on euro-pound loans than on dollar loans. Imagine, however, that the British pound subsequently appreciates against the dollar. This would increase the dollar cost of repaying the euro-pound loan and thus the company's cost of capital. This possibility can be insured against by using the forward exchange market (as we saw in Chapter 9) but the forward exchange market does not offer perfect insurance. Consequently, many companies borrow funds in their domestic currency to avoid foreign exchange risk, even though the eurocurrency markets may offer more attractive interest rates.

The Global Bond Market

The global bond market grew rapidly during the 1980s and 1990s (see Figure 11.5). Bonds are an important means of financing for many companies. The most common kind of bond is a fixed-rate bond. The investor who purchases a fixed-rate bond receives a fixed set of cash payoffs. Each year until the bond matures, the investor gets an interest payment and then at maturity he gets back the face value of the bond.

International bonds are of two types: foreign bonds and eurobonds. Foreign bonds are sold outside of the borrower's country and are denominated in the currency of the country in which they are issued. Thus, when Dow Chemical issues bonds in Japanese yen and sells them in Japan, it is issuing foreign bonds. Many foreign bonds have nicknames; foreign bonds sold in the United States are called Yankee bonds, foreign bonds sold in Japan are Samurai bonds, and foreign bonds sold in Great Britain are bulldogs.

Eurobonds are normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated. For example, a bond may be issued by a German corporation, denominated in US dollars, and sold to investors outside of the United States by an international syndicate of banks. Eurobonds are routinely issued by multinational corporations, large domestic corporations, sovereign governments, and international institutions. They are usually offered simultaneously in several national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency they are denominated. Eurobonds account for the lion's share of international bond issues.

Attractions of the Eurobond Market

Three features of the eurobond market make it an appealing alternative to most major domestic bond markets; specifically,

• An absence of regulatory interference.

• Less stringent disclosure requirements than in most domestic bond markets.

• A favorable tax status.

Regulatory Interference

National governments often impose tight controls on domestic and foreign issuers of bonds denominated in the local currency and sold within their national boundaries. These controls tend to raise the cost of issuing bonds. However, government limitations are generally less stringent for securities denominated in foreign currencies and sold to holders of those foreign currencies. Eurobonds fall outside of the regulatory domain of any single nation. As such, they can often be issued at a lower cost to the issuer.

Disclosure Requirements

Eurobond market disclosure requirements tend to be less stringent than those of several national governments. For example, if a firm wishes to issue dollar-denominated bonds within the United States, it must first comply with SEC disclosure requirements. The firm must disclose detailed information about its activities, the salaries and other compensation of its senior executives, stock trades by its senior executives, and the like. In addition, the issuing firm must submit financial accounts that conform to US accounting standards. For non-US firms, redoing their accounts to make them consistent with US standards can be very time consuming and expensive. Therefore, many firms have found it cheaper to issue eurobonds, including those denominated in dollars, than to issue dollar-denominated bonds within the United States.