10.4 Summary

from three to ve years and so the risk for either borrower or investor is that the

shape of one or both yield curves will change more quickly than expected, turning

expected benets into losses. Diff swaps became common when US and European

interest rates diverged sharply. They involve correlation risk – an assumption that there

will be a correlation between an interest rate movement and that of the currency.

With a LIBOR-in-arrears swap, the borrower essentially takes a bet that implied

forward rates are wrong by having LIBOR set, say, six months in arrears.

It is also possible to combine a zero coupon bond with an interest rate swap

(known as a zero coupon swap). Then there are swaptions– options that give the right

to enter into a swap within a specied period. Because swaps are off-balance-sheet

business but carry risks for the swap bank, there was a concern in the past that

banks might take on more risk through swaps than was justied by the size of their

capital backing. As a consequence, as we shall see in Chapter 13, the rules adopted

by a number of countries (known as the Basel rules), which try to ensure that the

capital backing of banks is adequate for the type of business in which they are

engaged, make allowances for off-balance-sheet business. Because currency swaps

involve both default risk and exchange rate risk, they require higher capital back-

ing under the Basel rules and this has slowed down their expansion relative to

interest rate swaps.

There are yet other derivatives which do not t neatly under the futures, options

and swaps headings. One such are equity protected notes– zero-coupon, index-linked

notes that allow investors to protect themselves against potential losses without

giving up the possibility of gains. Dynamic hedging involves the buying and selling

of forward contracts in the market in order to replicate options. It became popular

in foreign exchange markets after the problems in the European Monetary System

in 1992, which caused options prices to rise sharply. Safes(synthetic agreements for

forward foreign exchange) are forward contracts that do not require an exchange

of principal. This means that banks need to devote less capital to them and are less

exposed to default risk. There are two types of safe: the Exchange Rate Agreement(ERA)

which protects the purchaser against a change in the forward foreign exchange

spread, and the Forward Exchange Agreement (FXA) which gives protection against a

change in the spot rate as well as the forward spread. Insurance risk contractsare futures

and options on catastrophe insurance, health, and home-owner’s and reinsurance

risk.

10.4Summary

Capital has become much more mobile internationally since the early 1960s. There

can now be said to be a world capital market, although barriers to capital mobility

still exist, and the poorer countries remain largely excluded from it. International

capital ows can be classied by purpose, borrower or lender. A major role in the

development of the world capital market was played by the euromarkets or offshore

markets – markets conducted outside the country in whose currency the transactions

are conducted. The earliest growth was in eurocurrencies, especially in eurodollars

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Chapter 10 • International capital markets

(US dollar bank deposits held outside the US). The market grew rapidly for economic

and institutional reasons, including the domestic restrictions on the expansion of

US banks at home, the growth of transnational corporations, US government policies

to counter pressure on the dollar, and the anonymity offered by many offshore banks

as well as political reasons associated with the Cold War. The markets grew particu-

larly rapidly in the 1970s, following the two large world oil price rises.

The operation of the market narrowed the spread between borrowing and lend-

ing rates in world markets, provided additional hedging facilities for international

companies and played an important role in the recycling of the large balance of

payments surpluses of OPEC countries after the oil price rises. On the other hand, it

may have added to world ination, it probably reduced the stability of the world

nancial system, and it certainly greatly limited the ability of open economies to

follow independent macroeconomic policies.

The growth of the market has been associated with the development of a wide range

of innovative techniques that have provided additional exibility for borrowers

and lenders and have assisted in the design of complex risk management strategies.

However, these techniques have also been much used for speculative purposes, and

like the markets in derivatives, have led to many large losses. The most interesting

techniques have been the various types of swap that have been practised.

Questions for discussion

1	How is money actually transferred from an account in one country to an account in another?

2	Has the growth of the euromarkets been, on balance, a positive development for the world economy?

3	How many reasons can you think up for preferring xed to oating rate loans and vice versa?

4	Find out as much as you can about: (a)the activities of the international credit rating agencies; (b)the role of the international banks in the international debt crisis of the developing countries.

5	What is: (a)EURIBOR? (b)a euroeuro? (c)a swaption? (d)a plain vanilla swap?

6	Look in the nancial press and nd examples of variations on plain vanilla swaps that are not mentioned in the text.

7	If you swapped a oating rate payment for a xed rate payment, would you gain or lose if interest rates unexpectedly rose? Why?

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	Answers to exercises
Further reading

B Eichengreen, J Tobin and C Wyplosz, ‘The case for sand in the wheels of international

nance’, Economic Journal, 105, 1995, 162–72

P Howells and K Bain, The Economics of Money, Banking and Finance: A European Text

(Harlow: Pearson Education, 3e, 2005) chs. 19, 20 and 24

K Pilbeam, Finance & Financial Markets (Basingstoke: Macmillan, 1998) chs. 6 and 16

J Podolski, Financial Innovation and the Money Supply(Oxford: Blackwell, 1986)

For current stories on international nancial markets see the Financial Times web site

http://www.ft.com

Answers to exercises

10.1

(a)In stage three in Box 10.1, A (the balance sheet of 1st Sunshine Bank) is unchanged. In B (the balance sheet of Lucky Chance Bank), the assets column now reads $1 million loan to Shanghai and Bristol Bank. The liabilities column is unchanged. We now need C (the balance sheet of Shanghai and Bristol Bank) which will have assets of $1 million loan to Weapons of Mass Destruction Inc and liabilities of $1 million loan from Lucky Chance Bank. The liabilities column of the balance sheet of Weapons of Mass Destruction Inc (now D) will be $1 million loan from Shanghai and Bristol Bank. (b)The German rm that sells goods to Weapons of Mass Destruction Inc will have as an asset a deposit with All Nippon Bank. Its matching liability will be a reduction in the value of its stock of goods. The deposit will feature as a liability in All Nippon’s balance sheet but we do not know what All Nippon does with the funds received. It could on-lend to another bank or lend to another end-user of funds.

10.2

(a)1.247. (b)Yes, although the re-deposit rate of 0.2 might be a little high. Features of importance include the fact that borrowing is in a currency different from that in use in the country in which the loan is made; euro markets are wholesale markets and are not subject to restrictions from domestic central banks. (c)See the discussion of the portfolio approach in Box 10.3.

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CHAPTER11

Government borrowing and

nancial markets

Objectives

What you will learn in this chapter:

lThe reasons for the existence of public sector decits and the public debt

l	The denition of the public sector net cash requirement (PSNCR) and other measures of government decits and government debt

l	The arguments against governments running high public sector decits and having high public debt

l	The nature of the links between the PSNCR, the interest rate and the growth of the money supply

l	The importance of government policy towards public sector decits and the public debt for nancial markets

l	The ways in which the attitudes of nancial markets inuence governments

l	The signicance of the management of the public debt for the interest rate structure

Public sector borrowing has been central to major parts of this book, since the trad-

ing of public sector debt instruments in the bond and bills markets is an important

element in the activities of nancial markets. They also act as the underlying asset

in some derivatives markets. The borrowing needs of the public sector are closely

scrutinised as analysts attempt to forecast changes in the interest rate policy of the

central bank, and these forecasts in turn affect the currency markets. Public sector

decits and debt also played a major part in decisions about the membership of the

euro area when it was established in January 1999 and have been much discussed in

relation to the terms of the Stability and Growth Pact of the European Union (EU).

Thus, we need here to consider some of the important relationships between public

sector borrowing and the nancial sector of the economy.

This chapter begins by explaining the terms currently used by the Ofce for

National Statistics (ONS) in the UK regarding public debt and discussing the British

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