Euro Currency and Bonds

Introduction…..5

1. Euro Currency……..5
2. Euro Currency Market
3. Institutional Settings
4. First Principle
5. Deposit Rates
6. Euro Deposit Risk
7. Euro Bonds Market Dimension and Currency Composition
8. Dimensions
9. Currency Composition
10. Regulatory and Institutional Features
11. Primary Market
12. Competitive Market
13. Grey Market
14. Pricing of Euro Bonds
15. Problems and Risk
16. Arbitrage Opportunity
17. Global Bond Firms with and without Currency Hedging
18. References

Introduction

Financial crisis is one of the most if not the most disruptive shock to an economy. It results into a steep and rapid devaluation in asset prices and failures of financial institutions. Financial crises can be caused by both internal (political instability) and external shocks (increase in the price of oil) to the economy. It leads to a negative impact on different parts of the financial system and the economy. To a great extent, they are hard to predict and tackle due to their complexity especially when it comes to liquidity or insolvency issues. Financial crises have instigated and/or fuelled many of the worst recessions around the world. In the short-term, monetary and fiscal policies often are insufficient for ending these crises. The financial crisis of 2007-2009 has brought into light the risk of disproportionately relying on solely one currency (USD) for international trade and investment. So investment in offshore market can prevent the crisis because of its huge trading volume representing the largest asset class in the world leading to high liquidity. For example, investment in offshore market allows a business in the United Kingdom to trade or invest in the United States and pay euro dollars, even though its income is in Euros. Hence without the help of offshore market, the US dollar would not have attained the superior position that it takes over today in international trade and investment.

1. Euro Currency

A euro currency is a time-deposit of money in an International Bank located in a country different from the country that issued the currency. For e.g. Euro yen or the deposits of Japanese Yen located in a bank outside Japan. As the Yen deposited outside the Japan is called Euro Yen. The banks accepting the Euro currency deposits are called Euro banks.

The euro currency market is an external banking system that works by coordinating to the Domestic Banking System of a country that issued the currency. Both, Euro and Domestic Banking System seek deposits and give loan to the customers from the deposited funds in their bank. Euro dollar deposits for e.g., are not subject to arbitrage reserve requirements or deposit insurance, hence marking their cost of operations less. Because of the reduced cost structure the euro currency market has grown significantly in recent years. The Euro currency market operates at the inter-bank and/or wholesale level. Euro banks with surplus funds and no retail customers will lend funds to euro banks that have borrowers but need ‘loanable’ funds. The rate charged by banks with excess funds is referred to as the interbank offered rates.

In simple words Euro currency market can be defined as the short term borrowing or lending of a currency away from the Country which has originally issued that currency. So far the most important euro currency is Euro Dollar which is accounted in almost 60-65% of all the Euro Currency operations.

1. Eurocurrency Market

The market where Euro currency is often borrowed from seller and lends to buyer is Eurocurrency Market.

1. Euro Currency Market Size

The Euro currency market has experienced a rapid growth since 1960s. In 1963 the overall total value of Euro bank’s assets was estimated to be $12.4 billion. But by the end of December 1985 the Eurocurrency market was approximately calculated by Morgan Guaranty bank to have a gross size of $ 1,668 Billion, out of which 75% were Eurodollars. In 2003 the Eurodollar market was around $15,929 billion, which was maintaining at an average growth of 19.6% per annum over a period of 4 decades. The Eurodollar market has since then been the back bone of global finance source. In year 1997, almost 90% of all loans at international level were carried out on a similar basis. Difference between net and gross size of Eurocurrency market makes accurate measurement of the actual size of the Eurocurrency market tricky. The growth of Eurocurrency market is equally difficult to estimate because the market is not accountable to any government institution . Both non-Euro bank and inter-bank deposits have the gross measure, while an interbank deposit excludes the net measure. The overall evaluation gives an idea about the gross activity in the Euromarkets whereas the net measure gives a better clue related to the ability of generating credit of the Euro banking system.

1. Reasons for the Development and Growth of the Eurocurrency Market

• Euro currency market provides higher interest rates on short-term deposits in established offshore market.
• Multi-national corporations with major focus on international trade finds it very viable to keep balances abroad for short periods in the currency in which they do most of their transactions.
• Domestic credit restraints can be overcome by International firms just by borrowing within the Eurocurrency market.

1. Institutional Settings

• Due to explicit corporate situation, the offshore market gains some unique features. Preponderantly the market is liable to obvious drivers because it is not attached from its domestic correspondent. These are realistic just in case of market division of government bonds. This driver basically takes into account appreciation and therefore explains why the offshore and onshore yield curves deviate from each other.

1. Credit Creation in Eurocurrency Market
   1. Multiplier effect

The multiplier factor results within the Eurodollar market which comes from the observation of partial preserve banking. For every $1000 deposit, if a bank holds 10% of the initial amount, it can lend $900 in the market of the initial deposit. This $900 deposit will generate a $90 reserve in the next bank and an $810 loan. This generates another $810 deposit, an $81 reserve in the next bank and a $729 loan. The sum of $1000 + $900 +810 + $729 + … eventually reaches $10,000, or $1000 divided by the percentage reserve. The process of lending and re-depositing could continue until Euromarkets deposits reaches:

D = R/r

R= initial injection of funds into the Euromarkets,

r = fraction of reserves held against deposits,

1/r = deposit-reserve multiplier.

1. Competitive Response to Offshore Markets

• Knowledge Advantage

The offshore funds can draw on the domestic funds knowledge of personal contact and credit investigation for use in that offshore market.

• Regulation Advantage

The Offshore market may not be subject to the same regulations as domestic market.

• Growth

Growth prospects in a home nation may be limited by a market largely saturated with services offered by domestic funds.

• Risk Reduction

Greater stability of earning is possible with offshore investment. Offsetting business and monetary policy cycles across nations reduces the domestic specific risk in that offshore market.

• Tax benefit

Advantage of less tax can be enjoyed in offshore market.

• Higher Returns

Depending on the interest rate, offshore market may result in higher returns as compared to onshore market.

• Flexibility

With investing in offshore market comes the freedom to choose. An investor in Bangladesh will get more trading or investment opportunities in Europe than in its domestic market.

• Uncertainty in Exchange Rate

Exchange rates vary due to numerous factors. Some may be strictly political events but financial activities can also affect the exchange rates.

1. Operation and Effects of Eurocurrency Markets
   1. Operation

• In general Euro banks do not produce capital, but they are fundamentally financial mediators which brings together borrowers and lenders. Euro bank is related to commercial bank deposits which are done in the offshore market. E.g. A deposit denominated in the British Pounds in an American Commercial Bank (or even in an American branch of a British bank) is termed as Eurodollar.

1. Risk of Eurocurrency deposits

• The Eurocurrency deposits within the offshore market can create great fluctuations in exchange and other financial markets.
• The Eurocurrency market reduces the efficiency of domestic stabilization efforts of national governments.
• Eurocurrency deposits in any markets are mostly not controlled. It may result in a severe global recession that could turn some of the system’s banks insolvent. This probably would lead internationally to the kind of bank chaos that affected capitalist nations during the 19th century.

1. Euro Bonds

Any corporate or government which issues bonds in a currency not native to their home currency is called Euro Bonds. In other words, Euro bonds are those bonds which are in a different currency from the Country or the Market issuing them. For e.g. An Indian Company issuing Euro pound bonds denominated in the UK currency in Singapore. The Indian Company in this example can issue pounds denominating Euro bonds in any country other than the U.K.

Euro bonds have always been attractive to the investors because it gives investor flexibility to choose the currency in which they want to denominate their euro bonds. Euro bond is desirable tool for financing facilities as it gives issuer pliability to select the currency in which to offer their bonds according to country’s systematic obligations. Also Euro bonds owner do not need to be registered with the issuer of the bonds.

1. Eurobond Markets

Eurobond markets are long-term debt securities sold outside the borrower’s country to raise long-term capital in a currency other than the currency of the nation where the bonds are sold.

1. Euro Bonds Market Dimension and Currency Composition

Eurobonds dominates over 80 percent of the international bond market. The euro bond market has developed drastically after 2001. The major cause of fall of Dollar denominated Euro bonds was the growth of the Euro as an international trade and investment currency which has made the market more attractive for investor as well as issuer for euro denominated bonds. The impressive boost of the European bond market can be explained by an enhanced and more liquid market. Another reason was the greater range of novel products, such as index-linked bonds, real-time bond indices; fixed income exchange traded funds, credit derivatives and structured products. Companies issuing dollar-denominated Eurobonds pay a slightly lower interest rate than they would pay in the U.S... Prior to the EMU set up about 75% of Eurobonds was in U.S. dollars but today’s market is conquered by the Euro denominated bonds. The latter now tops with more than 45% of the entire Euro Bonds market (and it is still growing) while the former has declined to only 36%.

1. Institutional Feature of Euro Bonds

Euro bonds mainly consist of Bearer bonds where the possessor is also the proprietor. No data is kept whatsoever by the issuer stating the actual holder of the bonds. On the other hand, registered bonds clearly specify the holder’s name which appears on the front of the bond. The issuer also keeps track of owner and allocates the bond serial number on holder’s name. The name of each new holder of the registered bond is allocated to the serial number of the bond.

The Euro bond market consists of 80% of the international bond market comprising mainly large Financial Institutions.

The Euro bonds are not regulated by any Government authority or private sector.

1. Primary Market
   1. Competitive Market

Euro bonds are highly competitive compared to any other International Bonds market. The main factor responsible for this feature of Euro bond is the easy entry into the underwriting business. The Concentration ratios of Euro Bonds represents that it has reached the numerous important players in the underwriting business market. In the case of Euro bonds, underwriter shares big risk. In some cases it is difficult for the underwriter to even cover its cost, let alone profit making.

1. Gray market

Issuer and buyer get the information through gray market even before issuing of the bond in the market. For instance when an issued bonds is priced at 1000 pounds, in the gray market price can be estimated at 980 pounds, financier and underwriter syndicate can deduce that the bond is over-priced. In Gray market interest rates are higher and small bonds are issued. The opposite can take place if bonds perform above par in gray market.

1. Risk and problems associated with Eurobonds

• Moral Hazard

Joint issuance of debt through Eurobonds brings in a major moral hazard. If European Union accepts the Euro Bonds, it would be allowing unscrupulous activities and providing access to unauthorized agencies.

• No Political Backing

Eurobonds would be insufficient for the good executing of the fiscal unions. Monetary transfers would be required from the countries with plenty of capital to underdeveloped countries. Eurobonds alone are not universal remedy – and there is no political eagerness on the part of body of voters for the kind of drastic federalism that would be required.

• Anonymous Bond Holder

Most of the Eurobonds are bearer bonds. The issuer does not keep any record of the firm to which bond is issued.. Eurobonds are attractive to investors who want to remain anonymous (to avoid taxes or for other reasons).

• Credit Risk

Euro bonds are highly risky because of credit risk. Some assets may result in higher yield but some may not. The investor should have good knowledge of the market and consider doing research about the Euro bonds it is going to invest in.

1. Pricing of Euro bonds

The issuer of Eurobonds calculate price with the help of EURIBOR (Euro Interbank Offered Rate), LIBOR (London Interbank Offered Rate) and the United States Treasury Bonds market. Usually brokers and banks help the financier to invest in the Euro bonds. Investor should have good knowledge of market and should consider the expertise and credit quality of the issuer.

1. Arbitrage Opportunity

In an incorporated capital market the evaluation of bonds are done under certain terms and conditions. It fluctuates the price of a bond equally in both Eurobond and domestic market. Arbitrage between the offshore and onshore bond markets guides the markets toward integration. As Euro bonds are bearer bonds and the issuer do not have track of the buyer which makes investment an arbitrage opportunity. Also the investor is anonymous so there is not tax. No data is kept whatsoever by the issuer stating the actual holder of the bonds. The holder of the physical bonds is the owner of the Eurobonds.

1. References

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