2. Global banking business
One clear trend in the evolution of financial
institutions and markets is the expansion of
activities across national boundaries.
Technology has made it possible to conduct
business around the world with relative ease
and minimal cost.
Producers recognize that export markets are
as important as domestic markets, and that
the range of competitors includes both
domestic and foreign operations.
3. Global banking activities
…involve both traditional commercial
banking and investment banking
operations.
U.S. commercial banks now accept deposits,
make loans, provide letters of credit, trade
bonds and foreign exchange, and underwrite
debt and equity securities in dollars and other
currencies.
With the globalization of financial markets, all
firms compete directly with other major
commercial and investment banks throughout
the world.
Foreign banks offer the same products and
services denominated in their domestic
currencies and in U.S. dollars.
Still, it was not always this way.
4. U.S. banks, although a dominant player in
some world markets, have not been
considered “large” by international
standards
Restrictive branching laws,
Restrictions on the types of activities U.S.
banks could engage in, and
Other regulatory factors generally meant that
U.S. banks were greater in number,
but smaller in size.
5. U.S. banks, although a dominant player in
some world markets, have not been
considered “large” by international
standards.
Rank
1
2
3
4
5
6
7
8
9
10
17
26
Company Name
Bank of Tokyo-Mitsubishi Ltd., Tokyo, Japan
Deutsche Bank AG, Frankfurt, Germany
Credit Agricole Mutual, Paris, France (2)
Credit Suisse Group, Zurich, Switzerland (1)
Dai-Ichi Kangyo Bank Ltd., Tokyo, Japan
Fuji Bank Ltd., Tokyo, Japan
Sanwa Bank Ltd., Osaka, Japan
Sumitomo Bank Ltd., Osaka, Japan
Sakura Bank Ltd., Tokyo, Japan
HSBC Holdings, Plc., London, United Kingdom
Chase Manhattan Corp., New York, United States
Citicorp, New York, United States (b)
12/31/1996
$648,161.00
575,072.00
479,963.00
463,751.40
434,115.00
432,992.00
427,689.00
426,103.00
423,017.00
404,979.00
333,777.00
278,941.00
Billions of dollars
Source: The AmericanBanker: http://www.americanbanker.com.
6. By the end of the 20th century, many
factors had changed in the U.S. banking
system.
The Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994 effectively eliminated interstate branching
restrictions in the U.S. such that:
by early 1994, there were 10 U.S. banks with 30 interstate
branches.
by June 2001, there were 288 U.S. banks with 19,298
interstate branches.
U.S. banks were also hampered in their ability to compete
internationally by the Glass-Steagall Act, which effectively
separated commercial banking from investment banking.
As such, U.S. commercial banks essentially provided two
products: loans and FDIC-insured deposits.
In November 1999, the U.S. Congress passed the GrammLeach-Bliley Act, which allowed U.S. banks to fully compete
with the largest global diversified financial companies by
offering the same broad range of products.
The Gramm-Leach-Bliley Act of 1999 repealed restrictions
on banks affiliating with securities firms and modified
portions of the Bank Holding Company Act to allow
affiliations between banks and insurance underwriters.
7. By the end of 2000, the largest banking
company in the world was Citigroup at just
under one-trillion dollars and three of the
largest ten banking companies in the world were
U.S. banks.
8. The merger between Citicorp and Travelers
created Citigroup, the first diversified financial
services company in the U.S.
The merger, however, was not completely
permissible at the time it was approved under
provisions of the Glass-Steagall Act.
The passage of the Gramm-Leach-Bliley Act, made
this merger permissible and thereby allowed
Citigroup to legally be the world’s largest banking
company.
Citigroup formed a financial holding company under
the provisions of the Gramm-Leach-Bliley Act and
became one of the first integrated financial services
companies engaged in investment services, asset
management, life insurance and property casualty
insurance, and consumer lending.
Its operating companies include Salomon Smith
Barney, Salomon Smith Barney Asset Management,
Travelers Life & Annuity, Primerica Financial Services,
Travelers Property Casualty Corp., and Commercial
Credit.
9. Today, the product offerings of Citigroup
are similar to that of Deutsche Bank in
Germany
Prior to the merger between Citibank and Travelers,
however, Citibank’s product line was more limited.
Outside the U.S., Citibank was able to offer a
diversified set of products using an Edge Act
corporation.
Edge Act corporations are domestic subsidiaries of
banking organizations chartered by the Federal
Reserve.
All “Edges” are located in the United States and may be
established by U.S. or foreign banks and bank holding
companies, but are limited to activities involving
foreign customers.
They can establish overseas branches and
international banking facilities (IBFs) and own foreign
subsidiaries.
10. 60.0%
10.0%
55.0%
5.0%
50.0%
0.0%
Domestic total assets
Foreign owned total assets
20
01
15.0%
19
99
65.0%
19
97
20.0%
19
95
70.0%
19
93
25.0%
19
91
75.0%
19
89
30.0%
19
87
80.0%
19
85
35.0%
19
83
85.0%
19
79
19
81
40.0%
19
77
90.0%
19
75
45.0%
19
73
50.0%
95.0%
Percent of total domestic
100.0%
Domestic total deposits
Foreign owned total deposits
Percent of total foreign owned
Foreign banks operating through their
American banking offices have also
aggressively pursued U.S. business.
11. The growth in market share of U.S. offices
of foreign banks in total loans and
business loans.
45.0%
90.0%
40.0%
85.0%
35.0%
80.0%
30.0%
75.0%
25.0%
70.0%
20.0%
65.0%
15.0%
60.0%
10.0%
55.0%
5.0%
50.0%
0.0%
Domestic total loans
Foreign owned total loans
Domestic business loans
Foreign owned business loans
Percent of total foreign owned
95.0%
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
19
97
19
99
20
01
50.0%
Percent of total domestic
100.0%
12. The largest U.S. banks with
significant international operations.
Total
Name
Assets
Citibank NA, New York NY
452,343
JPMorgan Chase Bk, New York NY
537,826
Bank of America NA, Charlotte NC 551,691
Fleet NA Bk, Providence RI
187,949
Bank of New York, New York NY
78,019
Bank One NA, Chicago IL
161,023
MBNA America Bk NA, Wilmington DE
43,066
First Union NB, Charlotte NC
232,785
State Street B&TC, Boston MA
65,410
Wachovia Bk NA, Winston-Salem NC1,555
7
Keybank NA, Cleveland OH
71,526
PNC Bk NA, Pittsburgh PA
62,610
Mellon Bk NA, Pittsburgh PA
27,813
Bank of Hawaii, Honolulu HI
10,493
Northern Trust Co, Chicago IL
32,758
National City Bk, Cleveland OH
39,214
Wells Fargo Bk NA, San Francisco140,675
CA
Wells Fargo Bk MN NA, Minneapolis MN
52,428
Deposits Held in:
Domestic Foreign Offices
Offices
$ Mill
% TA
98,899 208,024 46.0%
160,102 120,371 22.4%
334,909
56,634 10.3%
110,148
22,316 11.9%
28,786
27,024 34.6%
81,020
26,358 16.4%
26,187
1,448
3.4%
135,276
12,473
5.4%
12,137
26,718 40.8%
42,684
3,627
5.1%
40,010
2,721
3.8%
44,079
2,307
3.7%
9,947
4,949 17.8%
5,621
1,369 13.0%
10,380
9,424 28.8%
20,464
1,007
2.6%
73,644
5,433
3.9%
26,311
7,459 14.2%
Net Loans and leasses:
Domestic Foreign Offices
# of US
Offices
$ Mill
% TA Branches
121,901 157,462 34.8%
277
135,872
39,022
7.3%
612
287,364
20,867
3.8%
4,350
102,956
19,737 10.5%
1,709
19,822
16,879 21.6%
362
76,440
4,991
3.1%
804
18,733
4,123
9.6%
3
118,053
3,479
1.5%
2,143
4,519
1,402
2.1%
1
45,434
807
1.1%
790
54,047
785
1.1%
980
39,072
777
1.2%
735
6,269
548
2.0%
346
5,312
495
4.7%
78
11,331
397
1.2%
1
31,022
154
0.4%
353
93,799
20
0.0%
939
34,277
1
0.0%
169
13. The largest “foreign owned” banks
operating in the U.S.
Deposits Held in: Loans in
%
# of
Total Domestic Foreign
Frgn
Foreign # of US
Foreign
Top Holding Company
Name
Assets Offices Offices Offices
Owned Branches Branches
HSBC Bank USA, Buffalo NY
84,230 37,067 21,153
3,194 HS BC Holdings PLC, LONDON NA
100
440
19
Lasalle Bank NA, Chicago IL
54,731 24,963
4,226
0 ABN Amro, AMS TERDAM NA
100
122
2
Taunus Corporation, NEW YORK NY
Bankers Trust Co, New York NY
42,678 11,423 10,000
253
100
4
14
Standard Federal Bk NA, Troy MI
42,088 19,702
624
0 ABN Amro, AMS TERDAM NA
100
385
2
Bank of Tokyo-Mitsubishi, TOKYO NA
Union Bk of CA NA, San Francisco CA
35,591 26,518
3,305
1,041
66
286
6
Banco Popular De PR, San Juan PR
20,477 11,459
190 10,306 Popular Inc., S AN JUAN PR
100
2
204
Harris T&SB, Chicago IL
19,673
9,498
1,708
151 Bank of Montreal, MONTREAL NA
100
57
2
Allfirst Bk, Baltimore MD
17,762 12,758
545
249 Allied Irish Banks Limited, DUBLIN NA
100
270
2
RBC Centura Bk, Rocky Mount NC
13,732
7,388
273
0 Royal Bank of Canada, MONTREAL NA
100
241
1
Bank of The West, San Francisco CA
13,412
9,212
N/A
0 Bancwest Corporation, HONOLULU HI
44
193
0
United CA Bk, San Francisco CA
10,524
8,285
428
0 S anwa Bank, Limited, OS AKA NA
100
121
1
First Hawaiian Bk, Honolulu HI
8,682
5,691
463
364 Bancwest Corporation, HONOLULU HI
44
56
6
Firstbank PR, San Juan PR
8,143
4,117
N/A
0 First Bancorp, S AN JUAN PR
100
1
49
Banco S antander S .A., S ANTANDER NA
Banco Santander PR, Hato Rey PR
7,656
4,811
0
0
80
1
72
TD Waterhouse Bk NA, Jersey City NJ
6,069
5,546
N/A
0 TD Waterhouse Holdings, Inc., NEW YORK NY 80
2
0
Israel Discount Bank Limited, TEL-AVIV NA 100
Israel Discount Bk of NY, New York NY
6,021
2,112
2,094
415
7
1
Westernbank Puerto Rico, Mayaguez PR
5,887
3,214
N/A
0 W Holding Company, Inc., MAYAGUEZ PR
100
1
35
Banco Popular North America, New York City NY
5,606
4,761
0
0 Popular Inc., S AN JUAN PR
100
98
0
Safra NB, New York NY
5,010
2,548
320
875 S NBNY Holdings Limited, MARINA BAY NA 99
2
1
Banco Bilbao Vizcaya Argenta, San Juan PR 4,801
2,971
N/A
0 BBVAPR Holding Corporation, S AN JUAN PR 100
1
61
Bank of Tokyo Mitsubishi TC, New York NY 4,337
1,491
1,310
46 Bank of Tokyo-Mitsubishi, TOKYO NA
100
1
1
Bank Leumi USA, New York NY
4,082
1,496
1,800
169 Bank Leumi Le-Israel B.M., TEL-AVIV NA
99
8
1
R-G Premier Bk of PR, San Juan PR
3,963
2,115
N/A
0 R&G Financial Corporation, S AN JUAN PR 100
1
25
Doral Bk, San Juan PR
3,486
1,528
N/A
0 Doral Financial Corporation, S AN JUAN PR 100
1
26
Incus Co. Ltd., ROAD TOWN NA
Laredo NB, Laredo TX
2,349
2,029
N/A
0
71
24
0
14. Universal banking model
Universal banking is the conduct of a variety
of financial services such as:
trading of financial instruments; foreign
exchange activities; underwriting new debt
and equity issues; investment management,
insurance; as well as extension of credit and
deposit gathering
Universal banks have long dominated
banking in most of continental Europe.
Universal banks engage in everything from
insurance to investment banking and retail
banking—
similar to U.S. banks prior to the enactment of
the Banking Act of 1933 and Glass-Steagall
provisions and now post the passage of the
Gramm-Leach-Bliley Act of 1999
15. Three events changed the historical
development of banking in the united states.
1.
The first was the stock market crash of 1929 and
the following Great Depression.
2.
3.
Many people blamed the banks and the universal
banking activities for the problems although there is
no strong evidence to link the speculative activities
of banks with the crash.
The second was the enactment of the Banking Act
of 1933 and the Glass-Steagall provision, which
separated commercial banking from investment
banking activities.
The third was the rising importance of the federal
government in financial markets.
Prior to these events, the U.S. banking
system operated more of less under a
universal banking system.
16. The advantages of universal banking
…risk diversification and expanded business
opportunities.
A universal bank can spread its costs over a
broader base of activities and generate more
revenues by offering a bundle of products.
Diversification, in turn, reduces risk.
insurance companies, investment banks and
other suppliers of financial services are
moving toward building financial
conglomerates
The GLB Act repealed Glass-Steagall and
allows U.S. banks to operate in the business
of commercial banking, investment banking,
and insurance.
Although there are many restrictions, U.S.
banks are allowed to compete with foreign
banks on an equal footing for the first time
since the passage of the Glass-Steagall Act,
17. Disadvantages of universal banking
…inherent conflict of interest
A universal bank might use pressure tactics
to coerce a corporation into using its
underwriting services or buy insurance from
its subsidiary by threatening to cut off credit
facilities.
It could force a borrower in financial
difficulties to issue risky securities in order
to pay off loans.
A universal bank could also abuse
confidential information supplied by a
company issuing securities as well.
One area of the new GLB Act that has
received significant attention is that of privacy
protection
18. Formation and development of the
European Community (EC) will provide
new opportunities for U.S. Banks.
By abolishing trade restrictions, the EC
exposes European banks to outside
competition.
In order to increase their competitive
advantage, many banks are looking into
merging with banks from other countries.
Today, most of Europe uses a unified
currency, the Euro.
19. Organizational structures in
international markets
Head office
International divisions or departments are
operated as a part of the head office's
organizational structure, with the division
managers reporting to senior management
(supervisory function).
Representative office
International office which does not conduct
normal banking business but simply
represents the corporation, with the purpose
of promoting the corporation's name and
developing business to be funneled to the
home office (exploratory function).
20. Foreign offices
Foreign branch
A legal part of the home bank which is subject
to the laws and regulations of the host nation
Shell office
Does not conduct business with local
individuals; serves as a conduit for Eurodollar
activities that originate in the head office
Full-service branch
Performs all the activities of domestic banks
Foreign Subsidiary
Foreign banks or non-bank corporations
acquired by domestic commercial banks or
bank holding companies; distinct from the
parent bank and performs the same functions
as the domestic banks
21. Edge act and agreement corporations
Edge Act corporations:
Domestic subsidiaries of banks chartered by
the Federal Reserve which may be
established by U.S. or foreign banks and are
limited to activities involving foreign
customers.
Agreement corporations:
State-chartered equivalents of Edge Act
Corporations.
22. International banking facilities
Subparts of banks that are created to
conduct international business without the
cost and effort of avoiding regulatory
requirements through shell units.
Exist as a set of accounting entries on the
books of the parent company.
23. Export trading companies
Companies that are acquired by banks and
are organized and operated principally for
purposes of exporting goods and services
produced in the U.S. by unaffiliated persons.
24. Agencies of foreign banks
Parts of foreign banks that can offer only a
limited range of banking services (cannot
accept transactions deposits from U.S.
residents or issue CDs) with the primary
purpose of financing trade originating from
firms in their own country.
25. International financial markets
International markets have evolved to
facilitate funds flow in international
exchange of goods and services and to
reduce the risk of doing business outside the
home country.
26. The Eurocurrency market
Eurocurrency:
A deposit liability in any currency except that
of the country in which the bank is located.
Eurobank:
Bank that issues Eurocurrency claims.
27. Eurodollars
Arise when a Eurobank accepting the deposit
receives a dollar claim on the U.S. bank from
which the funds were transferred.
Eurobanks will redeposit the Eurodollar
proceeds in another bank until the funds are
given out as a loan by one of the banks.
The initial Eurodollar deposit is accepted at
the base rate called LIBOR (London
Interbank Offer Rate).
Each redeposit and the final loan will then be
priced at a markup over LIBOR.
28. The Eurobond market
Bonds issued in the international
Euromarket, underwritten by an international
banking syndicate, not subject to any one
country's securities laws, and denominated
in any major national currency.
Floating-rate Note:
Issued in denominations as low as $5,000
with maturities ranging from two to five years,
carrying interest rates that vary with LIBOR.
29. Eurocredits
…term loans priced at a premium over
LIBOR, with the rate floating every three or
six months in most cases, thereby reducing
the mismatch between asset and liability
maturities
Eurocredits are created to overcome interest
rate risk.
30. International lending
International operations generate a
considerable portion of earnings for money
center banks
Citigroup earns about two-thirds of their
earnings globally.
International lending, however, carries risks
not associated with domestic lending
Country risk
…default risk associated with loans to
borrowers outside the home country
Foreign exchange risk
…the current and potential volatility in
earnings and stockholders’ equity due to
changes in foreign exchange rates.
31. Short-term foreign trade financing
…international trade and international trade
financing are considerably more complex than
simply dealing with trading partners within the
same country
To facilitate trade, someone must enter the transaction
and assume the risk that the importer may not pay.
Commercial banks fulfill this role through bankers
acceptance financing.
Trading partners must also have the opportunity to
convert one currency into another, which creates a
demand for foreign exchange services as well.
Bankers acceptance
…A time draft that represents a guarantee under which
the accepting bank agrees to remit the face value of
the draft at maturity.
Acceptances are attractive because a bank substitutes
its credit rating for that of the importer.
33. Direct international loans
…originate from international departments of
domestic banks, Edge Act corporations, credit
offices of foreign branches and subsidiaries.
Credit extended to less-developed countries
(LDCs) has exhibited a poor repayment history
and many of the banks have chosen to
withdraw from lending to these countries after
a large number of default incidents that took
place in the 1980s.
Banks prefer to have foreign exposure
in the form of equity investments rather
than long-term, constantly renegotiated
loans to foreign central banks.
34. Credit analysis of foreign loans
Credit analysis for international loans
follow the same procedures adopted
frequently for domestic loans:
evaluation
of the required loan amount,
use of proceeds,
source and timing of expected payment,
availability of secondary collateral
sources.
35. Foreign exchange activities
Because different countries use
different monetary units, traders must
be able to convert one unit into
another.
Foreign exchange markets are where
these monetary units are traded.
Foreign
exchange
…currency other than the monetary unit
of the home country
Exchange rate
…the price of one currency in terms of
another currency.
36. Risks unique to international lending:
Foreign exchange risk
…the current and potential risk to earnings and
stockholders’ equity arising from changes in
foreign exchange rates
Country risk
…default risk associated with loans to
borrowers outside the home country
Economic risks
…quantifiable economic and business risks
(mostly examined under regular credit analysis).
Political (sovereign) risks
…the likelihood that foreign governments will
unilaterally alter their debt service payments,
regardless of the formal repayment schedule
37. Foreign Exchange:
…currency other than the monetary unit of
the home country
Exchange Rate
…price of one currency in terms of another
currency.
Spot Market:
…market for exchange of currencies for
immediate delivery.
Forward Market
…market for transactions that represent a
commitment to exchange currencies at a
specified time in the future at an exchange rate
determined at the time the contract is signed.
38. Foreign exchange risk
…current and potential risk to earnings and
stockholder’s equity arising from changes
in foreign exchange rates
Found when changing exchange rates affect
a bank’s cash inflows differently than cash
outflows associated with positions
denominated in different currencies
Changes in values of foreign currency
positions (buying and selling foreign
currencies for their own account) due to
changing foreign exchange rates is price risk
39. Example: Foreign exchange risk
Commerce Bank’s (CB) home country is
Poland and home currency is the zloty.
current (spot) exchange rate is $1 = 150 zlotys.
2. Commerce Bank:
1.
1.
2.
3.
4.
$1,000 in loans
$250 in liabilities denominated in U.S. dollars
assets are worth 150,000 zlotys
liabilities are worth 37,500 zlotys at the
prevailing exchange rate.
If the exchange rate moved to $1 = 160 zlotys,
1. assets increase in value by 10,000 zlotys,
2. liabilities increase by 2,500 zlotys.
3. the bank’s equity would rise by 7,500 zlotys.
40. Example (continued): Foreign exchange risk
If the exchange rate moved to $1 = 140 zlotys,
1. assets decrease in value by 10,000 zlotys,
2. liabilities decrease by 2,500 zlotys
3. the bank’s would see stockholders’ equity
decrease by 7,500 zlotys
These same exposures exist for off-balance
sheet commitments and guarantees when
counterparties effect the at risk transactions
or activities.
41. Managing foreign exchange rate risk
A bank’s risk managers analyze aggregate
foreign exchange risk by currency.
A bank’s net balance sheet exposure in
currency j (NEXPj) is the amount of assets
minus the amount of liabilities denominated
in currency j:
NEXPj = Aj – Lj
where
Aj = assets denominated in currency j,
Lj = liabilities denominated in currency j.
If NEXPj > 0, the bank is long on currency j
and if NEXPj < 0, the bank is short currency j.
42. Gain/Loss in a position
The bank will lose if:
it is long a currency (NEXPj > 0) and the
currency depreciates in value (the currency
buys less of another currency).
if it is short a currency (NEXPj < 0) and the
currency appreciates in value (the currency
buys more of another currency).
The gain/loss in a position with a currency is
indicated by:
Gain/Loss in a Position With Currency j
= NEXPj x [spot exchange rate at time t
– spot exchange rate at time t-1]
43. Example: gain/loss in a position
Current (spot) exchange rate is $1 = 150
zlotys.
Commerce Bank’s (CB) would lose if
long U.S. dollars
the dollar depreciates as indicated by a
movement in the exchange rate to $1 = 140
zlotys.
Loss = [1,000 - 250] x [140 - 150]
= -7,500 zlotys
CB would gain if
the dollar appreciates as indicated by a
exchange rate change to $1 = 160 zlotys.
44. Example: forward markets
A bank commits to buy 1 million yen, 90 days
forward for $9804.
This means that after 90 days, the bank pays
$9804 and receives 1 million yen, regardless
of movements in exchange rates during the
90-day period.
45. Forward markets: forward premium.
Forward premium
…the forward price of a currency is higher
than its spot price, the foreign currency is
priced at a premium.
Example:
a bank agrees to buy 1 million yen 90 days
forward for 102 yens per dollar.
If the spot rate is 105 yens per dollar, the yen
is priced at a forward premium against the
dollar.
46. Forward markets: forward discount.
Forward discount
…the forward price of a currency is lower
than its spot price, the foreign currency is
priced at a discount.
Example:
a bank agrees to buy 1 million yen 90 days
forward for 102 yens per dollar.
if the spot rate is 100 yens per dollar, the yen
is priced at a forward discount against the
dollar.
47. Relationship between foreign exchange
rates and interest rates.
Arbitrage transactions between countries
guarantee that interest rate changes produce
changes in foreign exchange rates, and vice
versa.
If the interest rate differential between
securities in two countries falls out of line
with the spot-to-forward exchange rate
differential, a covered interest arbitrage will
take place and investors will make net profits
from the series of transactions.
48. Continuing arbitrage will go on until prices
move back into line to eliminate the riskless
return from covered interest arbitrage.
Covered interest arbitrage
2. Convert dollars to francs at $1 = 1.7 francs
$1,090,000
1 + 0.09 (1.7) = 1.7 million francs
$1,009,000
= $1,000,000
+ 0.09
1
1. Borrow dollars at 9%
3. Invest in Swiss securities yielding 10%
$1,090,000
1 + 0.09 (1.7)(1.10) = 1.87 million francs
$1,090,000 (1.7)(1.10)
= $1,121,776
+ 0.09
1
(1.667)
4. Sell francs for dollars 1 year forward at $1
= 1.667 francs
Sample Transaction: Borrow $1,000,000
1. Borrow $1,000,000 at 9%; agree to repay $1,090,000 in one year.
2. Convert $1,000,000 to 1.7 million francs in spot market at $1 = 1.7 francs.
3. Invest 1.7 million francs in 1-year security yielding 10%; will receive 1.87 million francs after 1 year.
4. Sell 1.87 million francs 1 year forward for $1,121,776 at $1 = 1.667 francs.
Net profit = $1,121,776 - $1,090,000 = $ 31,776
49. Foreign exchange rates and interest rates
Covered interest arbitrage
…exists when the interest rate differential
between securities in two countries is out of
line with the spot-to-forward exchange rate
differential.
Interest rate parity
…exist when covered interest arbitrage profit
potential is eliminated.
50. Interest rate parity implies:
1 + i 2 s1,2
= 1,
=
1 + i1 f1,2
or
i 2 − i1 f1,2 − s1,2
=
1 + i1 s1,2
Where
i1: Annual interest rate in
Country 1.
i2: Annual interest rate in
Country 2.
s1,2: Spot exchange rate
equal to the number of
units of Country 2's
currency for one unit of
Country 1's currency.
f1,2: One-year forward
exchange rate equal to
the number of units of
Country 2's
currency
for one unit of Country
1's currency.
51. The interest rate parity equilibrium
condition suggests that:
The forward exchange rate differential, as a
fraction of the spot rate, should equal the
interest rate differential relative to 1 plus an
interest factor to eliminate arbitrage profits.
Example:
i1 is 9%,
i2 is 10%, and
s1,2 is 1.7 as in the previous example,
then f1,2 should be equal to 1.7156:
0.10 − 0.09 f1,2 − 1.7
=
1 + 0.09
1.7
