The Eurocurrency Market

A Eurocurrency is a currency that is deposited in a bank located outside of the country of origin. Eurocurrencies are created when, for example, a U.S. firm transfers dollars from a bank in the United States to a bank outside of the United States. Also, someone outside of the U.S. may receive dollars in connection with a business transaction or because of a purchase in the foreign exchange market. When these dollars are deposited in a bank outside of the United States they become Eurodollars. The bank may either be a foreign bank, such as Deustche Bank, or a foreign branch of a U.S. bank, such as Chase Manhattan, that is located in Frankfurt. Other important Eurocurrencies include Euromarks, Euroyen and Eurosterling (Deutsche marks, Japanese yen, and British pounds), deposited outside of their country of origin The gross size of the Eurocurrency market is in excess of $5 trillion. About two-thirds of the Eurocurrencies outstanding are U S dollar-denominated.

As an illustration, consider the following example: BMW sells a car to an American dealer for $60,000. The American dealer pays BMW with a check for $60,000 drawn on Chase Manhattan Bank. BMW must then decide what to do with this check. BMW could immediately sell the dollars (buy Deutsche marks). However, BMW wants to retain the dollars for use later on (perhaps to pay for goods purchased from U.S. firms), so it buys a Eurodollar deposit by depositing the check in Deutsche Bank in Germany. The typical Eurocurrency deposit is a nonnegotiable time deposit with a fixed term to maturity. Maturities range from overnight to as long as five years.

The Eurocurrency market provides an important alternative to domestic sources of funds for multinational firms. For example, in the United States, large, well-established multinational corporations can borrow funds either in the domestic financial market, or in the international financial marketplace, such as the Eurocurrency market. If General Motors chooses to borrow in the Eurodollar market it would receive a Eurodollar loan from a foreign bank, such as Barclays Bank in London or Deutsche Bank in Frankfurt. The interest rate in the Eurodollar market is usually related to the London interbank offer rate, or LIBOR. LIBOR is the interest rate at which banks in the Eurocurrency market lend lo each other. The cost to borrow in the Eurocurrency market is usually stated as a margin above LIBOR. Typically, Eurodollar borrowing rates are between 0.5% and 3% over LIBOR, with a median of about 1.5%. Eurocurrency loans range in maturity up to ten years for the best quality borrowers.

Factors that affect exchange rates

Exchange rates between currencies vary over time, reflecting supply and demand considerations for each currency. For example, the demand for British pounds comes from a number of sources, which include foreign buyers of British exports who must pay for their purchases in pounds, foreign investors who desire to make investments in physical or financial assets in Britain, and speculators who expect British pounds to increase in value relative to other currencies. The British government may also be a source of demand if it attempts to keep the value of the pound (relative to other currencies) from falling by using its supply of foreign currencies or gold to purchase pounds in the market.

Sources of supply include British importers who need to convert their pounds into foreign currency to pay for purchases, British investors who desire to make investments in foreign countries, and speculator who expect British pounds to decrease in value relative to other currencies.

Exchange rates also are affected by economic and political conditions that influence the supply of, or demand for a country's currency. Some of these conditions include differential inflation and interest rates among countries, the government's trade policies, and the government's political stability. A high rate of inflation within a country tends to lower the value of its currency with respect to the currencies of other countries experiencing lower rates of inflation. The exchange rate will tend to decline as holders sell or exchange the country's currency for other currencies whose purchasing power is not declining at as high a rate. In contrast, relatively high interest rates within a country tend to increase the exchange rate as foreign investors seek to convert their currencies and purchase these higher yielding securities.

Government trade policies that limit imports—such as the imposition of tariffs, import quotas and restrictions on foreign exchange transactions— reduce the supply of the country's currency in the foreign exchange market. This, in turn, tends to increase the value of the country's currency with respect to other currencies and thus increase exchange rates.

Finally, the political stability of the government affects the risks perceived by foreign investors and companies doing business in the country These risks include the possible expropriation of investments or restrictions on the amount of funds (such as returns from investments) that may be taken out of the country.

In the following sections we develop the important relationships between spot rates, forward rates, interest rates, and inflation rates as they impact foreign currency exchange rates.