CU-MBA-SEM-IV-International Banking and Forex

accounts, correspondent bank relationship facilitates transactions such as letters of credit, documentary collection, foreign exchange services and loan services for a bank’s international clients. Thus, the correspondent bank relationship gives the domestic bank a presence in overseas markets which permits international transactions to be concluded. Depending upon the extent of services that the institution wishes to offer, either a branch or an agency may be established. The basic definition of branch and agency be found in the U.S. International Banking Act of 1978. A branch is any office of a foreign bank at which deposits are received. On the other hand, an agency is any office at which deposits may not be accepted from citizens or residents of the U.S. if they are not engaged in international activities, but at which credit balance may be maintained. Thus, the principal difference between branches and agencies is that agencies cannot accept deposits for U.S citizens or residents and can only maintain credit balances related to their international activities. In addition, agencies cannot engage in either fiduciary or investment advisory activities with the exception of acting as custodians for individual customers. Agencies do engage in a variety of activities to finance international trade, such as the handling of letters of credit. Both agencies and branches are principally active in international market. As extensions of the foreign parent bank, branches are generally subject to more stringent state regulation than agencies due to the more extensive nature of their operations. The powers of a federal branch are similar in scope of those of a national bank; these branches possess full deposit-taking, loan, and commercial banking powers in addition to other trust powers. They are also subject to duties, restrictions, and limitations similar to those of a national bank organized in the same area. Foreign banks gain control of subsidiary banks by establishing new institutions or by acquiring existing domestic banking institutions and these subsidiaries generally may engage in a full line of banking activities. With respect to the designation of a foreign bank subsidiary, the term ban and subsidiary´ has the same meaning as those provides by section 2 of the Bank Holding Company Act (BHCA). A subsidiary bank of a foreign bank may be either a national or a state bank. State banks are governed by the laws of the state in which they are located, while national banks are chartered by the Comptroller of the Currency under the National Bank Act. In United States for example, although foreign ownership is not restricted, non-U.S. citizens may not form a majority of a national banks Board of Directors. Firms willing to gained access to international banking operations may also adopt the acquisition approach by acquiring indigenous or domestic banks. However, the acquisition process is guided by stringent conditions. For instance, Under the United States Bank Holding Company Act, the Federal Reserve Board must approve the acquisition of direct or indirect control of a U.S. bank by a domestic or foreign bank holding company. Various factors are considered in the approval or denial of a BHC application. These include analysis of the competitive effect of the acquisition acquires financial and managerial resources, and 151 CU IDOL SELF LEARNING MATERIAL (SLM)

future prospects of the bank being acquired, community needs, and the applicant’s organizational structure. The central bank functions as a banker, agent and financial adviser to the government. As a banker to government, the central bank performs the same functions for the government as a commercial bank performs for its customers. It maintains the accounts of the central as well as state governments. It receives deposits from government, it makes short-term advances to the government, it collects cheques and draft deposited in the government account. It provides foreign exchange resources to the government for repaying external debt, or purchasing goods or making other payments. As an agent to the government, the central bank collects taxes and other payments on behalf of the government. It raises loans from the public and thus manages public debt. It also represents the government in the international financial institutions and conferences. As a financial adviser to the government, the central bank gives advice to the government on economic, monetary, financial and fiscal matters such as deficit financing, devaluation, trade policy, foreign exchange policy, etc The central bank acts as the bankersRank in three capacities: custodian of the cash reserves of the commercial banks; as the lender of the last resort; and as clearing agent. In this way, the central bank acts as friend, philosopher and guide to the commercial banks. As a custodian of the cash reserves of the commercial banks, the central bank maintains the cash reserves of the commercial banks. Every commercial bank has to keep a certain percentage of its cash balances as deposits with the central banks. These cash reserves can be utilized by the commercial banks in times of emergency. At the Bretton Woods Conference in 1944 it was decided to establish a new monetary order that would expand international trade, promote international capital flows and contribute to monetary stability. The IMF and the World Bank were borne out of this Conference of the end of World War II. The World Bank was established to help the restoration of economies disrupted by War by facilitating the investment of capital for productive purposes and to promote the long-range balanced growth of international trade. On the other hand, the IMF is primarily a supervisory institution for coordinating the efforts of member countries to achieve greater cooperation in the formulation of economic policies. It helps to promote exchange stability and orderly exchange relations among its member countries. It is in this context that the present chapter reviews the purpose and working of some of the international financial institutions and the contributions made by them in promoting economic and social progress in developing countries by helping raise standards of living and productivity to the point of which development becomes self-sustaining. One major source of financing is international non-profit agencies. There are several regional development banks such as the Asian Development Bank, the African Development Bank and Fund and the Caribbean Development Bank. The primary purpose of these agencies is to finance productive development projects or to promote economic development in a particular region. The Inter-American Development Bank, for example, has the principal purpose of 152 CU IDOL SELF LEARNING MATERIAL (SLM)

accelerating the economic development of its Latin American member countries. In general, both public and private entities are eligible to borrow money from such agencies as long as private funds are not available at reasonable rates and terms. Although the interest rate can vary from agency to agency, these loan rates are very attractive and very much in demand. Of all the international financial organisations, the most familiar is the World Bank, formally known as the International Bank for Reconstruction and Development (IBRD). The World Bank has two affiliates that are legally and financially distinct entities, the International Development Association (IDA) and the International Finance Corporation (IFC). Exhibit 1 provides a comparison among IBRD, IDA and IFC in terms of their objectives, member countries, lending terms, lending qualifications as well as other details. 8.2 INTERNATIONAL EQUITY ISSUES This chapter studies the specific characteristics of national stock markets. National stock markets tend to have not only different legal and physical organization, but also different transaction and tend to have not only different legal and physical organization, but also different transaction and accounting methods. Recall that stock markets provide valuable information about publicly traded corporation. Different organizations and macroeconomic environments will affect the quality of the information disseminated by a stock market. The better a market is at disseminating information, the more attractive it becomes to international investors. This chapter begins with a general review of the major differences among international equity markets and market microstructure issues. Then, the chapter looks at some practical issues, relevant to international investors. We end this chapter analysing why international investors care about international markets. International equity markets are an important platform for global finance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper. To understand the importance of international equity markets, market valuations and turnovers are important tools. Moreover, we must also learn how these markets are composed and the elements that govern them. Cross-listing, Yankee stocks, ADRs and GRS are important elements of equity markets. In this chapter, we will discuss all these aspects along with the returns from international equity markets. Since the beginning of this decade, global output has grown by over 3 percent annually and inflation has slowed down in virtually all regions of the world. Although many countries have experienced rising incomes and living standards, this economic expansion has been shared unevenly by the regions of the world. Moreover, income inequality has risen in some of these same countries, leading to renewed concern that economic growth and equity do not necessarily go hand in hand. 153 CU IDOL SELF LEARNING MATERIAL (SLM)

The purpose of this conference is to explore the nexus between economic policy and equity. Perceptions of equity derive from social and cultural norms, and each society will emphasize its own values in forming policies to promote equity. Although there are no universally accepted criteria to judge equity, there is a consensus that equity is improved as the incomes of the least fortunate are raised, and especially as families are raised out of poverty. Views are more varied about the extent to which greater income equality is desired for its own sake. In short, there is general agreement that extreme inequality of income, wealth, or other determinants of individual opportunity is socially unacceptable, but little agreement on precisely what constitutes a fair distribution. These are difficult issues that strike at the core of societal values, but answers are necessary for informed policymaking and to assess whether policies are successful. Income inequality varies greatly among regions. It is currently the highest in Latin America and Sub-Saharan Africa and the lowest in Eastern Europe, with the other regions arrayed in between. In Latin America, the average Gini coefficient a commonly used measure of inequality--is almost 0.5, with most countries having a coefficient exceeding 0.4. In Africa, this coefficient is, on average, slightly below that in Latin America, although there is considerable variation among countries. Furthermore, in both Africa and Latin America, income inequality has a regional dimension: average incomes in urban areas are significantly higher than in rural areas. Income inequality has risen in recent years in a substantial number of countries. This trend has been most pervasive in the former centrally planned economies, where the transition to a market economy was accompanied by rising inequality. Until the late 1980s, transition economies had the most equal income distribution: the average Gini was in the mid-.20s. However, this had changed by the mid-1990s, by which time the average Gini coefficient rose to the low-.30s. Shrinking budgetary expenditures and public enterprise sectors have affected the relative income of public-sector workers. Rising informal sector activity, together with sectoral shifts, have also had an impact on the relative income shares of workers. The rising trend in income inequality has not been limited to transition economies, however. Inequality has also increased in several G-7 countries and is beginning to rise in some of the East Asian countries. These trends heighten the urgency for addressing equity issues. Much of the income distribution debate has centred on the distribution of wage earnings. But the distribution of labour income explains only part of the distribution of income. The limited data on wealth distribution indicate that wealth--and, by implication, capital income--is more concentrated than labour income. In Africa and Latin America, unequal ownership of land has been identified as an important factor in explaining the overall distribution of income. Furthermore, in many countries, particularly in transition countries, there has been a shift from labour to capital income in recent years. The fundamental change in asset distribution in transition countries occurred with the privatization of state-owned assets. The analysis of 154 CU IDOL SELF LEARNING MATERIAL (SLM)

trends in nonlabour income in other countries with well-developed capital markets and pension funds, however, is complicated. Pension funds and other financial institutions receive a sizable portion of capital income, and the share of capital income in total household income typically changes over the life cycle. Although most analyses of inequality focus on income, the case can be made that a more appropriate focus would be on the inequality of consumption. Because of both redistributive policies and the smoothing of consumption over the life cycle, the distribution of annual consumption is likely to exhibit substantially less inequality than the distribution of annual income. At least for some concepts of equity, the distinction between consumption and income can be important. Crucial to any discussion of economic policy and equity is the degree to which policies that promote equity might curtail growth. If these two social goals are in conflict, a fairer society may be achieved only at the cost of a less well-off society. The evidence on this issue is mixed. Large scale tax and transfer programs may, in fact, slow growth, but poverty alleviation and universal access to basic health care and education can simultaneously improve equity and enhance the human capital on which growth depends. Finally, an important issue is whether policymakers should focus on outcomes, such as the number of poor, or on creating conditions for equal opportunity for all participants in the economy. For some manifestations of income inequality, such as poverty, outcomes are clearly critical. For others, a level playing field may be all that is necessary, and greater emphasis can be placed on policies that facilitate mobility between income classes, and on ensuring that income and wealth are acquired justly and fairly. 8.2.1 General Overview and Differences Liquidity refers to the ability to transform a non-cash asset into its cash equivalent without a loss of principal. That is, liquid markets are markets where exit is relatively easy. Other things being equal, principal. That is, liquid markets are markets where exit is relatively easy. Other things being equal, international money managers will prefer to invest in liquid markets. Given the preference for liquid stocks, illiquid stocks should offer a higher compensation. This compensation is called the liquidity premium. In the U.S., Ang et al., in a comparison of listed stocks and OTC stocks, report an average estimated liquidity premium of 2.51% per year, but this return will be realized only if investors demand liquidity –i.e., can wait- once a year. But, if investors demand liquidity once a month, the liquidity premium is negative: -5.07%! In emerging markets, the liquidity premium has been estimated at 3.2% per year. not only how many people want their product, but also how many would actually be willing and able to buy it. A broad measure of liquidity -and easy to calculate- is total market capitalization. According to this measure, the largest equity market in the world is the U.S. market, with a market According to this measure, the largest equity market in the world is the U.S. market, with a 155 CU IDOL SELF LEARNING MATERIAL (SLM)

market capitalization of USD 26.2 trillion in 2014. For the same year, the second largest equity market was the Chinese market with a market capitalization of USD 4.0 trillion, while the third largest market was the Japanese market with a market capitalization of USD 3.8 trillion. The U.S. capital market is large compared to the U.S. economy. In 2014, the U.S. stock market capitalization represented roughly 150% of the U.S. GDP. During the same year, the market capitalization/GDP figure for Germany was only 44%, while the corresponding figure for Mexico was 38%. There are different reasons that explain these different ratios. In many European countries corporations are undercapitalized and rely heavily on bank financing. In Europe, banks tend to provide corporations with all financial services. They assist them in their Europe, banks tend to provide corporations with all financial services. They assist them in their commercial needs as well as in their long-term debt and equity financing. It is common for European banks to own shares of their clients. In Germany 15% of large German firms are bank controlled, while the percentage reaches 30% in Belgium. In the U.S., commercial banks were prohibited by the Glass-Stegall Act to participate in their clients' equity. Thus, U.S. companies, especially small ones, are used to go public to raise capital in the marketplace. In other countries, many large firms are state owned and some of them are not listed on the capital markets. In a recent study of corporate control of large firms in 27 countries, most of them industrial countries, La Porta, Lopez de Silanes, and Shleifer estimate that 18% of firms are state owned. In Italy, for example, a large part of arms- manufacturing, oil, chemical, electronic, automobile, banking, insurance, and transportation industries is owned by the government. Family ownership is another factor that influences market capitalization. Many family owned firms are reluctant to list their stock in an exchange for fear of losing family control. Family ownership of large firms is unusual in the U.S. In other countries, however, family ownership is extremely common. For example, in Israel 50% of large firms are considered family-controlled. In Hong Kong, the percentage of family-controlled large firms is 70%. As a final note regarding this measure, some analysts, including Warren Buffet, use the MC/GDP measure as a valuation metric to identify what markets are under over-valued. Under this view, the higher the ratio, the more overvalued the market. Another measure of liquidity and exchange activity is transaction volume. Not surprisingly, New York and Tokyo have the largest share turnover. Depending on market activity, these figures can York and Tokyo have the largest share turnover. Depending on market activity, these figures can vary widely from one year to the next, but in general most major markets enjoy a similar degree of liquidity in terms of transaction volume. In fact, the annual turnover ratio (TR) -i.e., the ratio of annual transactions in USD to year-end USD market capitalization- varies significantly over time. Therefore, comparison of national market liquidity based on the TR could lead to different conclusions if different years are taken into account. Example XI.1: From 1995 to 2002 the U.S. annual turnover varied from 65% to 156 CU IDOL SELF LEARNING MATERIAL (SLM)

94%, while the same statistic ranged from 45% to 90% for Thailand. In contrast, for the same period, the TR changed from 101% to 235% for Korea. The main problem with transaction volume is that it is reported as an average, usually monthly or annual number. Some stocks may have a good average, say daily average turnover, but the average is not representative; there are many days with no trading. That is, the stock seems on average liquid, but in many days it would be very difficult to trade. Using this intuition, it is common to use the number of non-trading days as a liquidity measure. For example, the average proportion of non- trading days in U.S. listed stocks is 10%, while in Thailand the average proportion is 37%. If daily volume is not available, the number of zero return days can be used as a proxy. After all, if a stock price is unchanged, it should be the result of two events: no information, or no trading. The proportion of zero return days is an easy measure to calculate. Stock prices are the only input needed. Lang, Lins and Maffett, in a study of well-developed EAFE markets, report that the median listed stock has a zero return on 24.5% of the trading days per year and has a bid-ask spread of 1.9%. 8.2.2 Market Microstructure The typical organization for a stock market is the private stock exchange model. Private stock exchanges are founded by independent members for the purpose of trading securities. A typical exchanges are founded by independent members for the purpose of trading securities. A typical example of the private stock exchange is the New York Stock Exchange (NYSE). There might be several private stock exchanges in a country and they may compete with each other. The multiple private stock exchange structure is observed in the U.S., Japan, and Canada. In other countries, like the U.K., Mexico, and Taiwan, one leading exchange has emerged through either attrition or absorption of its leading competitors. The exchanges are private, but they are subject to public regulation. The mix of self-regulation and government supervision is oriented more toward self-regulation. Private exchanges often require members to perform all of their transactions on the floor of the exchange. Commissions are either set by the exchange or imposed by the public authority. In many countries, commissions are fully negotiable. Another organizational model for stock exchanges is the public stock exchange. This structure was created in France, using the Napoleon legal code. This structure gives the brokers, who are appointed by the government, a monopoly over all transactions. Brokerage firms are private and new brokers are proposed to the state for nomination by the broker's association. Many European stock exchanges were organized under this model. The stock exchanges of Paris, Athens, and Madrid, among others, used this model. Some countries have organized their stock exchanges around banks. Under the banker’s stock exchange, banks are the major securities traders. The SWX Swiss Exchange is a typical example of a banker’s exchange. The seventy-six members of the SWX are all banks, a quarter of them foreign. Some of the members are “remote members.” These remote members are foreign banks with no physical presence at the exchange. Banker’s exchanges may be either private or semi- public organizations. Banker’s exchanges are found in the German sphere of influence: 157 CU IDOL SELF LEARNING MATERIAL (SLM)

Austria, Switzerland, and Scandinavia. During the last twenty years, deregulation and competition from other stock exchanges have progressively affected all public exchanges. Today, the majority of the exchanges have been reorganized following the private stock exchange model. For example, the Borza Italian S.P.A., the group leader and responsible for the organization and management of the Italian stock exchange. The company, founded in 1997 following the privatization of the exchange, is responsible for defining and organizing the functioning of the markets; defining the rules and procedures for admission and listing on the market for issuing companies and brokers; managing and overseeing the market; supervising the listed companies' disclosure. The Borza Italian’s primary objective is to ensure the development of the managed markets, maximizing their liquidity, transparency and competitiveness and at the same time pursuing high levels of efficiency and profitability. A more recent development is the transformation of many exchanges --e.g., the Paris Bourse, Deutsche Börse, Athens Stock Exchange (ASE) and Australian Stock Exchange (ASX)-- into Deutsche Börse, Athens Stock Exchange (ASE) and Australian Stock Exchange (ASX)-- into business organizations. They are adopting corporate-type ownership and governance, segmented markets and performance-driven organizational structure and culture. For example, on March 15, 2000, the London Stock Exchange’s (LSE) shareholders voted to demutualize and, thus, enable the exchange to become a public company. A month later, shares of LSE started to be traded at the LSE. In March 2006, the NYSE also went public, trading under the tick symbol NYX. On December 6, 2002, the Chicago Mercantile Exchange (CME) -the largest U.S. futures exchange listed on the NYSE, becoming the first U.S. financial market to go public. Similarly, in 2005, the Chicago Board of Trade (CBOT), also went public. Exchanges are competing for listings with one another like businesses. Competition and technological change have created the conditions for consolidation and cooperation agreements in the stock exchange industry around the world. Since the late 1990s, there has been a big wave of consolidation among stock exchanges. In June 1999, the four French market operators merged to form a single entity, Paris Bourse. Later, in September 2000, the Amsterdam Exchange (AEX), the Brussels Exchange (BXS) and the Paris Bourse merged to form the first European exchange Euronext N.V. Euronext became the first fully integrated cross-border single currency stock, derivatives and commodities market. In January 2002, Euronext acquired the London International Financial Futures and Options Exchange. Almost immediately, in February 2002, Euronext merged with the Lisbon Stock Exchange (BVL). Years later, in May 2006, NYSE agreed to buy Euronext NV for USD 10 billion. This purchase created the first transatlantic stock market, which became NYSE Euronext. In 2008, NYSE Euronext but the old American Stock Exchanges for USD 260 million in stock. 158 CU IDOL SELF LEARNING MATERIAL (SLM)

8.3 FOREIGN LISTING AND EQUITY UNDERWRITING PROCESS The mortgage loan underwriting guidelines of Cirius Pacific Fund, LLC have been developed and refined based upon the experience of the Fund Managers, gained through underwriting and funding over 1,200 privately-funded loans totalling over $380 Million in combined direct funding since 2008, as well as multiple profitable joint venture equity investments. Mark Hanf, broker and president, of Pacific Private Money Loans, Inc., has more than 25 years of transactional real estate investing and eight years as an active hard money lender. Rick Culp, our Operations Manager, has 15 years of banking and 15 years of conventional mortgage origination experience. John Citrigno, CCIM, broker and president of Cirius Capital has over 30 years’ experience as an investment real estate broker, analyst, property manager, investor, joint venture manager and sponsor. For the past six years he has been an active hard money lender with a specialty underwriting and financing Fix & Flip transactions and equity investments ranging from quick cosmetic rehabs, to major renovations, room additions, and new construction. Having experience on both sides of the financing transaction makes the Fund Managers uniquely qualified to evaluate not only the borrower and collateral but also the investment strategy underlying the loan request and its plan for repayment. We place an emphasis on creating relationships with successful local real estate investors and value the repeat business it brings. Our combined real estate investment and construction experience assists in prompt and thorough underwriting and our Cirius Analysis software helps us quickly determine the profitability of a borrower or sponsor’s loan or equity funding request. These factors, along with our reputation for performance and certainty of funding once we commit to a loan or equity transaction, has assisted us in attracting some of the highest quality borrowers and joint-venture equity opportunities. And because of our profit sharing model, investors in the Fund will directly and additionally benefit from this experience and these opportunities. Cirius Pacific Fund, LLC maintains written underwriting guidelines which it uses to guide its lending and investment decisions. These guidelines are continually reviewed, discussed, revised and updated as the rules and markets change. We attend leading mortgage and real estate investment conferences on a quarterly basis to stay abreast of industry and marketplace changes and engage the industry’s top attorneys, accountants, and advisors to review our processes for compliance with new lending, real estate, and securities regulations. We shall, during the life of the Fund provide, upon request, copies of the most recent versions of the specific underwriting guidelines used for the various types of loan applications we receive. While we typically look at all three of the above in the underwriting process, the most weight is given primarily to the collateral when the loan-to-value ratio is especially conservative (i.e. 70% or less) using traditional “asset-based” criteria which focuses on determining the property’s current as-is value (regardless of purchase price) in order to make certain that an adequate “equity cushion” will exist at the time of funding. For the higher loan-to-value ratios (75% to 80% or more) of the purchase price (or Fair Market Value) and for all major 159 CU IDOL SELF LEARNING MATERIAL (SLM)

renovation, new construction, and joint-venture equity opportunities, we base our funding decision on how the combination of the underwriting variables work to create a sound funding opportunity, with the most weight is given to underwriting the borrower or sponsors, and more specifically, their track-record, experience. When underwriting the higher-leverage scenarios, which typical have a value-add component we take time do additional underwriting as to the scope of work, construction/renovation budget, timeline for completion, project team, and exit strategy with a focus on determining the project’s ultimate “profitability”. This is because from our experience the single most significant factor in achieving return of our investment and a positive outcome is the profitability (profit margin) of the borrower’s (or sponsor’s) value-add or exit strategy and their ability to reach a profitable exit based upon their track-record, experience, and team. 8.4 SUMMARY  We require the services of an independent third party appraiser for most of our higher- leverage loans, construction loans, and equity joint-venture opportunities. And, we will require independent third party appraisals on refinances and other cash-out loan requests. While we typically require independent third party appraisal valuations prior to funding there are circumstances wherein a third-party appraisal report is neither warranted nor possible in the particular situation. In some circumstances, particularly those of lower-leverage loans that must be underwritten and funded quickly, the Fund will rely on the experience and expertise of the Manager, its principals and employees, as well as research derived from its database  Many active, successful private companies consider an Initial Public Offering (IPO) at some stage in their development as a route to accelerate growth and to open up new opportunities for their business. In addition, foreign companies may look towards an ASX listing (whether as a primary or dual listing) to access the Australian capital markets and private equity investors may work towards an IPO as an exit mechanism for their investment.  Regardless of the stage in the company’s growth, it is important for the directors and owners of such businesses to weigh up the pros and cons of a listing, consider alternative methods of achieving their goals and understand the IPO process in advance of taking this significant step. This guide is not intended to be a blueprint for an IPO. Rather, it aims to assist companies in making an informed decision as to whether to seek a listing and to demystify the IPO process. The best advice we can give is to seek advice early. Once the decision to list has been made, a well-equipped team to help guide the listing process is vital.  While companies with a foreign exempt listing are only subject to minimal requirements under the ASX Listing Rules, any foreign company with a full ASX 160 CU IDOL SELF LEARNING MATERIAL (SLM)

listing will be subject to all of the ASX Listing Rules and related disclosure obligations except to the extent that ASX has waived the application of a particular Listing Rule. ASX will waive the requirement to comply with a particular Listing Rule in certain circumstances where it is confident that the rules of another stock exchange which apply to the company are at least as stringent as ASX requirements. As the trading of shares of foreign companies can generally not be settled through ASX’s electronic trading system, CHESS, the shares are instead traded in the form of depositary receipts known as CHESS Depositary Interests or CDIs.  It is very important for a company which intends to go public to engage experienced advisers. These advisers will help the company assess whether or not it is suitable for listing and, if it is, they ensure a smooth transition to the public arena. Meeting with experienced advisers at an early stage is the most effective way to identify the issues and minimise costs. 8.5 KEYWORDS  Intra-day Position – The size of spot or forward positions allowed for a dealer during the business day, which may be larger than that allowed for the end of the day. Also called daylight limits.  Latin American Integration Association (LAIA) – The purpose of the LAIA is to reduce tariff barriers between member countries. The member countries are Argentina, Bolivia, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela. LAIA is also known under ALADI.  Letter of Credit (Revocable) – A letter of credit that can be modified or revoked by the issuing bank up until the time payment is made.  Letter of Credit (Revolving) – A letter of credit issued for a specific amount that renews itself for the same amount over a given period. Usually, the unused renewable portion of the credit is cumulative as long as drafts are drawn before the expiration of the credit.  Letter of Credit (Standby) – A letter of credit or similar arrangement that represents an obligation to the beneficiary on the part of the issuer to repay money borrowed by or advanced to or for the account party, make payment on account of any indebtedness undertaken by the account party, or make payment on account of any default by the account party in the performance of an obligation. 8.6 LEARNING ACTIVITY 1. Create a survey on Market Microstructure. 161 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on General Overview and Differences. ___________________________________________________________________________ ___________________________________________________________________________ 8.7UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Equity? 2. What is Prepaid shareholder? 3. Define shareholder? 4. Define Microstructure? 5. What is Underwriting Process? Long Questions 1. Explain the advantages of International Equity Issues. 2. Explain the Disadvantages of International Equity Issues. 3. Illustrate the Market Microstructure. 4. Illustrate the Foreign Listing. 5. Illustrate the Equity Underwriting Process. B. Multiple Choice Questions 1. Where does futures contracts are regularly traded? a. Chicago Board of Trade. b. New York Stock Exchange. c. American Stock Exchange. d. Chicago Board of Options Exchange 2. What does hedge in the futures market does? 162 a. Eliminates the opportunity for gains b. Eliminates the opportunity for losses c. Increases the earnings potential of the portfolio d. Does both (a) and (b) of the above. CU IDOL SELF LEARNING MATERIAL (SLM)

3. What happens in future market when interest rates fall, a bank that perfectly hedges its portfolio of Treasury securities? a. Suffers a loss. b. Experiences a gain. c. Has no change in its income. d. None of these. 4. What has happened in futures markets have grown rapidly? a. Are standardized. b. Have lower default risk. c. Are liquid. d. All of these. 5. Which parties have bought a futures contract and thereby agreed to the bonds are said to have taken a position? a. Sell; short b. Buy; short c. Sell; long d. Buy; long Answers 1-a, 2-e, 3-c, 4-d, 5-d 8.8 REFERENCES References book  Kwan, Simon and Willard Carlton, 1993, The structure and pricing of private placement corporate loans, University of Arizona working paper.  Mester, Loretta, 1992, Traditional and non-traditional banking: An information theoretic approach, Journal of Banking and Finance.  Nassberg, Robert, 1981, Loan documentation: Basic, but critical, Business Lawyer. Textbook references  Pavel, Christine and David Phillis, 1987, Why banks sell loans: An empirical analysis, Economic Perspectives, Federal Reserve Bank of Chicago.  Pennachi, George, 1988, Loan sales and the cost of bank capital, Journal ofFinance. 163 CU IDOL SELF LEARNING MATERIAL (SLM)

 Petersen, Mitchell and Raghuram Rajan, 1994, The benefits of lending relationships: Evidence from small business data, Journal of Finance. Website  https://nou.edu.ng/sites/default/files/2018- 06/MBF%20845%20INTL%20BANKING%20COURSE%20MATERIAL.pdf  http://ciriuspacific.com/wp-content/uploads/2018/03/Investment-Parameters-and- Underwriting-Guidelines.pdf  https://www.tutorialspoint.com/international_finance/international_equity_markets.ht m 164 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 9 – FOREIGN EXCHANGE MARKETS STRUCTURE 9.0 Learning Objectives 9.1 Introduction 9.2 Main Characteristics of Forex Market 9.2.1 Most Liquid Market in the World 9.2.2 Most Dynamic Market in the World 9.2.3 It is a Twenty-Four Hour Market 9.2.4 Market Transparency 9.2.5 International Network of Dealers 9.2.6 Most Widely Traded Currency is the Dollar 9.2.7 “Over-The-Counter” Market with an “Exchange-Traded” Segment 9.3 Role of International Banks in Forex Markets 9.3.1 Speculators in Foreign Exchange Markets 9.3.2 Central Banks in Foreign Exchange Markets 9.4 Summary 9.5 Keywords 9.6 Learning Activity 9.7 Unit End Questions 9.8 References 9.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Illustrate the concept of Foreign Exchange Markets  Explain the Main Characteristics of Forex Market  Illustrate the Role of International Banks in Forex Markets 9.1 INTRODUCTION The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. 165 CU IDOL SELF LEARNING MATERIAL (SLM)

It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market. The main participants in this market are the larger international banks. Financial centres around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange market does not set a currency's absolute value but rather determines its relative value by setting the market price of one currency if paid for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc. The foreign exchange market works through financial institutions and operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as \"dealers\", who are involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the \"interbank market\". Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little supervisory entity regulating its actions. The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency. The modern foreign exchange market began forming during the 1970s. This followed three decades of government restrictions on foreign exchange transactions under the Bretton Woods system of monetary management, which set out the rules for commercial and financial relations among the world's major industrial states after World War II. Countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed per the Bretton Woods system. The foreign exchange market is the most liquid financial market in the world. Traders include governments and central banks, commercial banks, other institutional investors and financial institutions, currency speculators, other commercial corporations, and individuals. According to the 2019 Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average daily turnover was $6.6 trillion in April 2019 Of this $6.6 trillion, $2 trillion was spot transactions and $4.6 trillion was traded in outright forwards, swaps, and other derivatives. 166 CU IDOL SELF LEARNING MATERIAL (SLM)

Foreign exchange is traded in an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading centre is the United Kingdom, primarily London. In April 2019, trading in the United Kingdom accounted for 43.1% of the total, making it by far the most important centre for foreign exchange trading in the world. Owing to London's dominance in the market, a particular currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its special drawing rights every day, they use the London market prices at noon that day. Trading in the United States accounted for 16.5%, Singapore and Hong Kong account for 7.6% and Japan accounted for 4.5%. Turnover of exchange-traded foreign exchange futures and options was growing rapidly in 2004-2013, reaching $145 billion in April 2013. As of April 2019, exchange-traded currency derivatives represent 2% of OTC foreign exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are traded more than to most other futures contracts. Most developed countries permit the trading of derivative products on their exchanges. All these developed countries already have fully convertible capital accounts. Some governments of emerging markets do not allow foreign exchange derivative products on their exchanges because they have capital controls. The use of derivatives is growing in many emerging economies. Countries such as South Korea, South Africa, and India have established currency futures exchanges, despite having some capital controls. Foreign exchange trading increased by 20% between April 2007 and April 2010 and has more than doubled since 2004. The increase in turnover is due to a number of factors: the growing importance of foreign exchange as an asset class, the increased trading activity of high-frequency traders, and the emergence of retail investors as an important market segment. The growth of electronic execution and the diverse selection of execution venues has lowered transaction costs, increased market liquidity, and attracted greater participation from many customer types. In particular, electronic trading via online portals has made it easier for retail traders to trade in the foreign exchange market. By 2010, retail trading was estimated to account for up to 10% of spot turnover, or $150 billion per day. Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers. Within the interbank market, spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players outside the inner circle. The difference between the bid and ask prices widens as you go down the levels of access. This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the \"line\". The top-tier interbank market accounts for 51% of all 167 CU IDOL SELF LEARNING MATERIAL (SLM)

transactions. From there, smaller banks, followed by large multi-national corporations, large hedge funds, and even some of the retail market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size”. Central banks also participate in the foreign exchange market to align currencies to their economic needs. 9.2 MAIN CHARACTERISTICS OF FOREX MARKET Controversy about currency speculators and their effect on currency devaluations and national economies recurs regularly. Economists, such as Milton Friedman, have argued that speculators ultimately are a stabilizing influence on the market, and that stabilizing speculation performs the important function of providing a market for hedgers and transferring risk from those people who don't wish to bear it, to those who do. Other economists, such as Joseph Stiglitz, consider this argument to be based more on politics and a free market philosophy than on economics.Large hedge funds and other well capitalized \"position traders\" are the main professional speculators. According to some economists, individual traders could act as \"noise traders\" and have a more destabilizing role than larger and better informed actors. Currency speculation is considered a highly suspect activity in many countries. While investment in traditional financial instruments like bonds or stocks often is considered to contribute positively to economic growth by providing capital, currency speculation does not; according to this view, it is simply gambling that often interferes with economic policy. For example, in 1992, currency speculation forced Sweden's central bank, the Riksbank, to raise interest rates for a few days to 500% per annum, and later to devalue the krona. Mahathir Mohammad, one of the former Prime Ministers of Malaysia, is one well-known proponent of this view. He blamed the devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators. Gregory Millman reports on an opposing view, comparing speculators to \"vigilantes\" who simply help \"enforce\" international agreements and anticipate the effects of basic economic \"laws\" in order to profit. In this view, countries may develop unsustainable economic bubbles or otherwise mishandle their national economies, and foreign exchange speculators made the inevitable collapse happen sooner. A relatively quick collapse might even be preferable to continued economic mishandling, followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are viewed as trying to deflect the blame from themselves for having caused the unsustainable economic conditions. 168 CU IDOL SELF LEARNING MATERIAL (SLM)

9.2.1 Most Liquid Market in the World Currency spot trading is the most popular FX instrument around the world, comprising more than 1/3 of the total activity. It is estimated that spot FX trading generates about $1.5 trillion a day in volume, making it the largest most liquid market in the world. Compare that to futures $437.4bn and equities $191bn and you will see that foreign exchange liquidity towers over any other market. Even though there are many currencies all over the world, 80% of all daily transactions involve trading the G-7 currencies i.e. the “majors.” When compared to the futures market, which is fragmented between hundreds of types of commodities, and multiple exchanges and the equities market, with 50,000 listed stocks, it becomes clear that the futures and equities provides only limited liquidity when compared to currencies. Liquidity has its advantages, the primary one being no manipulation of the market. Thin stock and futures markets can easily be pushed up or down by specialists, market makers, commercials, and locals. Spot FX on the other hand takes real buying/selling by banks and institutions to move the market. Any attempted manipulation of the spot FX market usually becomes an exercise in futility. Among the various financial centres around the world, the largest amount of foreign exchange trading takes place in the United Kingdom, even though that nation’s currency the pound sterling—is less widely traded in the market than several others. The United Kingdom accounts for about 32 percent of the global total; the United States ranks a distant second with about 18 per cent and Japan is third with 8 percent. Thus, together, the three largest markets—one each in the European, Western Hemisphere, and Asian time zones account for about 58 percent of global trading. After these three leaders comes Singapore with 7 percent. The large volume of trading activity in the United Kingdom reflects London’s strong position as an international financial centre where a large number of financial institutions are located. In the 1998 foreign exchange market turnover survey, 213 foreign exchange dealer institutions in the United Kingdom reported trading activity to the Bank of England, compared with 93 in the United States reporting to the Federal Reserve Bank of New York. In foreign exchange trading, London benefits not only from its proximity to major Eurocurrency credit markets and other financial markets, but also from its geographical location and time zone. In addition to being open when the numerous other financial centres in Europe are open, London’s morning hours overlap with the late hours in a number of Asian and Middle East markets; London’s afternoon sessions correspond to the morning periods in the large North American market. Thus, surveys have indicated that there is more foreign exchange trading in dollars in London than in the United States, and more foreign exchange trading in marks than in Germany. However, the bulk of trading in London, about 85 percent, is accounted for by foreign-owned 169 CU IDOL SELF LEARNING MATERIAL (SLM)

institutions, with U.K.-based dealers of North American institutions reporting 49 percent, or three times the share of U.K owned institutions there. 9.2.2 Most Dynamic Market in the World Foreign exchange market is the most dynamic market in the world. Regardless of which instrument you are trading be it stocks, municipal bonds, U.S. treasuries, agricultural futures, foreign exchange, or any of the countless others the attributes that determine the viability of a market as an investment opportunity remain the same. Namely, good investment markets all possess the following characteristics liquidity, market transparency, low transaction costs, and fast execution. Based upon these characteristics, the spot FX market is the perfect market to trade. 9.2.3 It is a Twenty-Four Hour Market During the past quarter century, the concept of a twenty-four hour market has become a reality. Somewhere on the planet, financial centres are open for business, and banks and other institutions are trading the dollar and other currencies, every hour of the day and night, aside from possible minor gaps on weekends. In financial centres around the world, business hours overlap; as some centres close, others open and begin to trade. The foreign exchange market follows the sun around the earth. The International Date Line is located in the western Pacific, and each business day arrives first in the Asia-Pacific financial centres first Wellington, New Zealand, then Sydney, Australia, followed by Tokyo, Hong Kong, and Singapore. A few hours later, while markets remain active in those Asian centres, trading begins in Bahrain and elsewhere in the Middle East. Later still, when it is late in the business day in Tokyo, markets in Europe open for business. Subsequently, when it is early afternoon in Europe, trading in New York and other U.S. centres start. Finally, completing the circle, when it is mid- or late-afternoon in the United States, the next day has arrived in the Asia-Pacific area, the first markets there have opened, and the process begins again. The twenty-four hour market means that exchange rates and market conditions can change at any time in response to developments that can take place at any time. It also means that traders and other market participants must be alert to the possibility that a sharp move in an exchange rate can occur during an off hour, elsewhere in the world. The large dealing institutions have adapted to these conditions, and have introduced various arrangements for monitoring markets and trading on a twenty four hour basis. Some keep their New York or other trading desks open twenty-four hours a day, others pass the torch from one office to the next, and still others follow different approaches. However, foreign exchange activity does not flow evenly. Over the course of a day, there is a cycle characterized by periods of very heavy activity and other periods of relatively light 170 CU IDOL SELF LEARNING MATERIAL (SLM)

activity. Most of the trading takes place when the largest number of potential counterparties is available or accessible on a global basis. Market liquidity is of great importance to participants. Sellers want to sell when they have access to the maximum number of potential buyers/ and buyers want to buy when they have access to the maximum number of potential sellers. Business is heavy when both the U.S. markets and the major European markets are open that is, when it is morning in New York and afternoon in London. In the New York market, nearly two thirds of the day’s activity typically takes place in the morning hours. Activity normally becomes very slow in New York in the mid- to late afternoon, after European markets have closed and before the Tokyo, Hong Kong, and Singapore markets have- opened. Given this uneven flow of business around the clock, market participants often will respond less aggressively to an exchange rate development that occurs at a relatively inactive time of day, and will wait to see whether the development is confirmed when the major markets open. Some institutions pay little attention to developments in less active markets. Nonetheless, the twenty-four hour market does provide a continuous “real-time” market assessment of the ebb and flow of influences and attitudes with respect to the traded currencies, and an opportunity for a quick judgment of unexpected events. The foreign exchange market provides a kind of never-ending beauty contest or horse race, where market participants can continuously adjust their bets to reflect their changing views. 9.2.4 Market Transparency Price transparency is very high in the FX market and the evolution of online foreign exchange trading continues to improve this, to the benefit of traders. One of the biggest advantages of trading foreign exchange online is the ability to trade directly with the market maker. A reputable forex broker will provide traders with streaming, executable prices. It is important to make a distinction between indicative prices and executable prices. Indicative quotes are those that offer an indication of the prices in the market, and the rate at which they are changing. Executable prices are actual prices where the market maker is willing to buy/sell. Although online trading has reached equities and futures, prices represent the LAST buy/sell and therefore represent indicative prices rather than executable prices. Furthermore, trading online directly with the market maker means traders receive a fair price on all transactions. When trading equities or futures through a broker, traders must request a price before dealing, allowing for brokers to check a trader’s existing position and ‘shade’ the price a few pips depending on the trader’s position. Online trading capabilities in FX also create more efficiency and market transparency by providing real time portfolio and account tracking capability. Traders have access to real time profit/loss on open positions and can generate reports on demand, which provide detailed 171 CU IDOL SELF LEARNING MATERIAL (SLM)

information regarding every open position, open order, margin position and generated profit/loss per trade. 9.2.5 International Network of Dealers The market is made up of an international network of dealers. The market consists of a limited number of major dealer institutions that are particularly active in foreign exchange, trading with customers and with each other. Most, but not all, are commercial banks and investment banks. These dealer institutions are geographically dispersed, located in numerous financial centres around the world. Wherever located, these institutions are linked to, and in close communication with, each other through telephones, computers, and other electronic means. There are around 2,000 dealer institutions whose foreign exchange activities are covered by the Bank for International Settlements’ central bank survey, and who, essentially, make up the global foreign exchange market. A much smaller sub-set of those institutions accounts for the bulk of trading and market-making activity. It is estimated that there are 100- 200 market- making banks worldwide; major players are fewer than that. At a time when there is much talk about an integrated world economy and “the global village,” the foreign exchange market comes closest to functioning in a truly global fashion, linking the various foreign exchange trading centres from around the world into a single, unified, cohesive, worldwide market. Foreign exchange trading takes place among dealers and other market professionals in a large number of individual financial centres— New York, Chicago, Los Angeles, London, Tokyo, Singapore, Frankfurt, Paris, Zurich, Milan, and many, many others. But no matter in which financial centre a trade occurs, the same currencies, or rather, bank deposits denominated in the same currencies, are being bought and sold. A foreign exchange dealer buying dollars in one of those markets actually is buying a dollar- denominated deposit in a bank located in the United States, or a claim of a bank abroad on a dollar deposit in a bank located in the United States. This holds true regardless of the location of the financial centre at which the dollar deposit is purchased. Similarly, a dealer buying Deutsche marks, no matter where the purchase is made, actually is buying a mark deposit in a bank in Germany or a claim on a mark deposit in a bank in Germany. And so on for other currencies. Each nation’s market has its own infrastructure. For foreign exchange market operations as well as for other matters, each country enforces its own laws, banking regulations, accounting rules, and tax code, and, as noted above, it operates its own payment and settlement systems. Thus, even in a global foreign exchange market with currencies traded on essentially the same terms simultaneously in many financial centres, there are different national financial 172 CU IDOL SELF LEARNING MATERIAL (SLM)

systems and infrastructures through which transactions are executed, and within which currencies are held. With access to all of the foreign exchange markets generally open to participants from all countries, and with vast amounts of market information transmitted simultaneously and almost instantly to dealers throughout the world, there is an enormous amount of cross border foreign exchange trading among dealers as well as between dealers and their customers. At any moment, the exchange rates of major currencies tend to be virtually identical in all of the financial centres where there is active trading. Rarely are there such substantial price differences among major centres as to provide major opportunities for arbitrage. In pricing, the various financial centres that are open for business and active at any one time are effectively integrated into a single market. Accordingly, a bank in the United States is likely to trade foreign exchange at least as frequently with banks in London, Frankfurt, and other open foreign centres as with other banks in the United States. Surveys indicate that when major dealing institutions in the United States trade with other dealers, 58 percent of the transactions are with dealers located outside the United States. Dealer institutions in other major countries also report that more than half of their trades are with dealers that are across borders; dealers also use brokers located both domestically and abroad. 9.2.6 Most Widely Traded Currency is the Dollar The dollar is by far the most widely traded currency. According to the 1998 survey, the dollar was one of the two currencies involved in an estimated 87 percent of global foreign exchange transactions, equal to about $1.3 trillion a day. In part, the widespread use of the dollar reflects its substantial international role as – “investment” currency in many capital markets, “reserve” currency held by many central banks, “transaction” currency in many international commodity markets, “invoice” currency in many contracts, and “intervention” currency employed by monetary authorities in market operations to influence their own exchange rates. In addition, the widespread trading of the dollar reflects its use as a “vehicle” currency in foreign exchange transactions, a use that reinforces, and is reinforced by, its international role in trade and finance. For most pairs of currencies, the market practice is to trade each of the two currencies against a common third currency as a vehicle, rather than to trade the two currencies directly against each other. The vehicle currency used most often is the dollar, although by the mid-1990s the Deutsche mark also had become an important vehicle, with its use, especially in Europe, having increased sharply during the 1980s and ’90s. Thus, a trader wanting to shift funds from one currency to another, say, from Swedish krona to Philippine pesos, will probably sell krona for U.S. dollars and then sell the U.S. dollars for pesos. Although this approach results in two transactions rather than one, it may be the preferred way, since the dollar/Swedish krona market, and the dollar/Philippine peso market 173 CU IDOL SELF LEARNING MATERIAL (SLM)

are much more active and liquid and have much better information than a bilateral market for the two currencies directly against each other. By using the dollar or some other currency as a vehicle, banks and other foreign exchange market participants can limit more of their working balances to the vehicle currency, rather than holding and managing many currencies, and can concentrate their research and information sources on the vehicle. Use of a vehicle currency greatly reduces the number of exchange rates that must be dealt with in a multilateral system. In a system of 10 currencies, if one currency is selected as vehicle currency and used for all transactions, there would be a total of nine currency pairs or exchange rates to be dealt with, whereas if no vehicle currency were used, there would be 45 exchange rates to be dealt with. In a system of 100 currencies with no vehicle currencies, potentially there would be 4,950 currency pairs or exchange rates [the formula is- n(n-1)/2].Thus, using a vehicle currency can yield the advantages of fewer, larger, and more liquid markets with fewer currency balances, reduced informational needs, and simpler operations. The U.S. dollar took on a major vehicle currency role with the introduction of the Bretton Woods par value system, in which most nations met their IMF exchange obligations by buying and selling U.S. dollar to maintain a par value relationship for their own currency against the U.S. dollar. The dollar was a convenient vehicle, not only because of its widespread use as a reserve currency, but also because of the presence of large and liquid dollar money and other financial markets, and , in time, the Euro-dollar markets where dollars needed for foreign exchange transactions could conveniently be borrowed. Changing conditions in the 1980s and 1990s altered this situation. In particular, the Deutsche mark began to play a much more significant role as a vehicle currency and, more importantly, in direct “cross trading.” As the European Community moved toward economic integration and monetary unification, the relationship of the European Monetary System (EMS) currencies to each other became of greater concern than the relationship of their currencies to the dollar. An intra-European currency market developed, centring on the mark and on Germany as the strongest currency and largest economy. Direct intervention in members’ currencies, rather than through the dollar, became widely practiced. Events such as the EMS currency crisis of September 1992, when a number of European currencies came under severe market pressure against the mark, confirmed the extent to which direct use of the DEM for intervening in the exchange market could be more effective than going through the dollar. Against this background, there was very rapid growth in direct cross rate trading involving the Deutsche mark, much of it against European currencies, during the 1980s and ’90s. 174 CU IDOL SELF LEARNING MATERIAL (SLM)

There are derived cross rates calculated from the dollar rates of each of the two currencies,- and there are direct cross rates that come from direct trading between the two currencies— which can result in narrower spreads where there is a viable market. In a number of European countries, the volume of trading of the local currency against the Deutsche mark grew to exceed local currency trading against the dollar, and the practice developed of using cross rates between the DEM and other European currencies to determine the dollar rates for those currencies. With its increased use as a vehicle currency and its role in cross trading, the Deutsche mark was involved in 30 percent of global currency turnover in the 1998 survey. That was still far below the dollar, but well above the Japanese yen, and the pound sterling. 9.2.7 “Over-The-Counter” Market with an “Exchange-Traded” Segment Until the 1970s, all foreign exchange trading in the United States was handled “over-the- counter,” (OTC) by banks in different locations making deals via telephone and telex. In the United States, the OTC market was then, and is now, largely unregulated as a market. Buying and selling foreign currencies is considered the exercise of an express banking power. Thus, a commercial bank or Securities & brokerage firms in the United States do not need any special authorization to trade or deal in foreign exchange. There are no official rules or restrictions in the United States governing the hours or conditions of trading. The trading conventions have been developed mostly by market participants. There is no official code prescribing what constitutes good market practice. However, the Foreign Exchange Committee, an independent body sponsored by the Federal Reserve Bank of New York and composed of representatives from institutions participating in the market, produces and regularly updates its report on Guidelines for Foreign Exchange Trading. These Guidelines seek to clarify common market practices and offer “best practice recommendations” with respect to trading activities, relationships, and other matters. Although the OTC market is not regulated as a market in the way that the organized exchanges are regulated, regulatory authorities examine the foreign exchange market activities of banks and certain other institutions participating in the OTC market. As with other business activities in which these institutions are engaged, examiners look at trading systems, activities, and exposure, focusing on the safety and soundness of the institution and its activities. Examinations deal with such matters as capital adequacy, control systems, disclosure, sound banking practice, legal compliance, and other factors relating to the safety and soundness of the institution. The OTC market accounts for well over 90 percent of total U.S. foreign exchange market activity, covering both the traditional products as well as the more recently introduced OTC products. On the “organized exchanges,” foreign exchange products traded are currency futures and certain currency options. 175 CU IDOL SELF LEARNING MATERIAL (SLM)

Steps are being taken internationally to help improve the risk management practices of dealers in the foreign exchange market, and to encourage greater transparency and disclosure. 9.3 ROLE OF INTERNATIONAL BANKS IN FOREX MARKETS Speculators and central banks are important participants in foreign exchange markets. Speculators invest in assets denominated in different currencies and, therefore, buy or sell currencies. Central banks may be engaged in foreign exchange markets to increase or decrease the value of their currency with respect to other currencies. 9.3.1 Speculators in Foreign Exchange Markets The generic term speculator includes a wide variety of market participants. Foreign exchange traders and brokers make up a relatively small segment among speculators; commercial banks, hedge funds, and other financial companies represent the most important group among speculators. Regardless of type, speculators in foreign exchange markets want to profit from buying currency low and selling it high. In other words, all speculators try to make a profit from fluctuations in exchange rates. The interbank market, which consists of large commercial banks and financial firms, is a major player in foreign exchange markets. Its activity helps determine the bid (buy) and ask (sell) price of currencies. This market has no trading floor, but banks can trade with each other directly or via electronic brokerage systems that connect market participants. 9.3.2 Central Banks in Foreign Exchange Markets Central banks have a unique place in foreign exchange markets. First, unlike the other groups involved in foreign exchange markets, the central banks’ involvement in foreign exchange markets doesn’t have a profit motive. Second, central banks’ decisions regarding monetary policy are extremely influential on exchange rate determination. Central banks indirectly affect exchange rates through their monetary policy decisions. In every country, central banks are responsible for conducting monetary policy, among their other roles. The main goals of monetary policy are to promote price stability and economic growth. Basically, a central bank addresses the domestic economy’s problems by changing the quantity of money and interest rates, which leads to changes in the exchange rate as well. Third, central banks can directly affect exchange rates through interventions into foreign exchange markets. A central bank can use its domestic currency and foreign currency reserves to buy or sell foreign currencies directly in the foreign exchange market. 176 CU IDOL SELF LEARNING MATERIAL (SLM)

9.4 SUMMARY  Although foreign exchange may be confusing, in today’s global marketplace, there is a critical need for almost everyone to understand foreign exchange like never before. As the world shrinks, there is an ever-increasing likelihood that we will be required to address the risks associated with the fact that there are different currencies used all around the world and that these currencies will have an immediate impact on our world.  We must be able to evaluate the effects of, and actively respond to, changes in exchange rates with respect to our consumption decisions, investment portfolios, business plans, government policies, and other life choices. Moreover, there is an ever-increasing probability that we will have to transact in these foreign exchange markets—in our personal or professional life. This book has been intended to assist with this potentially new and doubtlessly confusing milieu.  The words that were written by Claude Tygier some 20 years ago are as true today as they were then:  To most people, the arena where the world’s major currencies fluctuate against each other remains very much of a mystery.1  Perhaps that is why I enjoy teaching foreign exchange. It is gratifying to empower people with a new language and to assist them in entering and actively participating in a world that I believe is truly fascinating.  Foreign exchange risk exposure refers to changes in the currency rate that influences the firms’ value, which is represented by stock return in this study. This is what increases the business’ risks. The expected and unexpected fluctuation in foreign exchange rate movement affects stock return and has created concern among firms and investors. This motivates the research to investigate the significant effect of foreign exchange exposure towards stock return and assesses any significant changes in the foreign exchange exposure during the pre- and post-crisis period.  After examining the coefficient in the lag regression of a two factor market model, the analysis findings establish that stock return is not significantly exposed to foreign exchange rate changes but the exposure changes as time evolves because the foreign exchange exposure effect is likely to be stronger during the crisis compared to before the crisis. The evidence obtained is not enough to conclude that there is a significant relationship but this study definitely contributes to the understanding that larger firms should be aware of the exposure and protect themselves against it, if needed. 177 CU IDOL SELF LEARNING MATERIAL (SLM)

9.5 KEYWORDS  Multi-currency Line – A line of credit giving the borrower the option of using any readily available major currency.  Multilateral Exchange Contract – An exchange contract involving two foreign currencies against each other, for example, a contract for U.S. dollars against British pounds made in London. Also called an arbitrage exchange contract.  Nationalization – A process where a nation’s central government assumes ownership and operation of private enterprises within its territory.  Loro Accounts – An account that a bank in one country maintains for a bank in another country. It usually holds foreign currency on behalf of the owner-bank’s customers.  Maquiladoras – A program where imports are shipped duty and license free to Mexican firms for assembly and then exported back to the U.S. 9.6 LEARNING ACTIVITY 1. Create a survey on Main Characteristics of Forex Market. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on Most Dynamic Market in the World. ___________________________________________________________________________ ___________________________________________________________________________ 9.7UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Forex Market? 2. Define the term Forex? 3. What is Dynamic Market? 4. What is International Network? 5. Who are Speculators? Long Questions 1. Explain the Most Liquid Market in the World. 178 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Explain the Main Characteristics of Forex Market. 3. Illustrate the Role of International Banks in Forex Markets. 4. Illustrate the Speculators in Foreign Exchange Markets. 5. Examine the Central Banks in Foreign Exchange Markets. B. Multiple Choice Questions 1. What does the exchange rate mean? a. The price of one currency relative to gold. b. The value of a currency relative to inflation. c. The change in the value of money over time d. The price of one currency relative to another. 2. How does exchange rates are determined? a. The money market. b. The foreign exchange market. c. The stock market. d. The capital markets. 3. Where does most trades involve the buying and selling of although market trades are said to involve the buying and selling of currencies? a. Bank deposits denominated in different currencies. b. SDRs c. Gold d. ECUs 4. Which among the following is the immediate (two-day) exchange of one currency for another? a. Forward transaction b. Spot transaction. c. Money transaction. d. Exchange transaction 5. What is an agreement to exchange dollar bank deposits for euro bank deposits in one month?. a. Spot transaction. 179 CU IDOL SELF LEARNING MATERIAL (SLM)

b. Future transaction c. Forward transaction d. Monthly transaction Answers 1-d, 2-b, 3-a, 4-b, 5-c 9.8 REFERENCES References book  Preece, Dianna and Donald Mullineaux, 1994, Monitoring by financial intermediaries: Banks versus nonbanks, Journal of Financial Services Research.  Preece Dianna and Donald Mullineaux, 1996, Monitoring, loan negotiability and firm value, Journal of Banking and Finance.  Rajan, Raghuram and Andrew Winton, 1995, Covenants and collateral as incentives to monitor, Journal of Finance. Textbook references  Rajan, Raghuram, 1992, Insiders and outsiders: The choice between informed and arm’s length debt, Journal of Finance.  Simons, Katerina, 1993, Why do banks syndicate loans?, New England Economic Review, Federal Reserve Bank of Boston.  Wake man, Lawrence, 1981, The real function of bond rating agencies, Chase Financial Quarterly. Website  http://studentsrepo.um.edu.my/2693/8/Chap_5.pdf  https://www.oreilly.com/library/view/foreign-exchange- a/9781118046210/weit_9781118046210_oeb_c15_r1.html  https://onlinelibrary.wiley.com/doi/10.1002/9781119201601.ch15 180 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 10 – INTERNATIONAL MONEY MARKET INSTRUMENTS STRUCTURE 10.0 Learning Objectives 10.1 Introduction 10.2 GDRs 10.2.1 Structure 10.2.2 Types 10.3 ADRs 10.4 IDRs 10.5 Euro Bonds 10.6 Repos 10.7 CPs 10.8 Derivatives 10.9 Floating Rate Instruments 10.10 Euro Deposits 10.11 Summary 10.12 Keywords 10.13 Learning Activity 10.14 Unit End Questions 10.15 References 10.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Illustrate the concept of Euro Bonds.  Explain the concept of ADRs.  Illustrate the concept of Euro Bonds. 181 CU IDOL SELF LEARNING MATERIAL (SLM)

10.1 INTRODUCTION The money market is a component of the economy which provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less. As short-term securities became a commodity, the money market became a component of the financial market for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in money markets is done over the counter and is wholesale. There are several money market instruments in most Western countries, including treasury bills, commercial paper, banker's acceptances, deposits, certificates of deposit, bills of exchange, repurchase agreements, federal funds, and short-lived mortgage- and asset-backed securities. The instruments bear differing maturities, currencies, credit risks, and structures. A market can be described as a money market if it is composed of highly liquid, short-term assets. Money market funds typically invest in government securities, certificates of deposit, commercial paper of companies, and other highly liquid, low-risk securities. The four most relevant types of money are commodity money, fiat money, fiduciary money, and commercial bank money. Commodity money relies on intrinsically valuable commodities that act as a medium of exchange. Fiat money, on the other hand, gets its value from a government order. Money markets, which provide liquidity for the global financial system including for capital markets, are part of the broader system of financial markets. The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods, typically up to twelve months. Money market trades in short-term financial instruments commonly called \"paper\". This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity. The core of the money market consists of interbank lending—banks borrowing and lending to each other using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to the London Interbank Offered Rate (LIBOR) for the appropriate term and currency. Finance companies typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP), which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Some large corporations with strong credit rating issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf. The money market enables commercial banks to use their excess reserves in profitable investments. The main objective of commercial banks is to earn income from its reserves as 182 CU IDOL SELF LEARNING MATERIAL (SLM)

well as maintain liquidity to meet the uncertain cash demand of its depositors. In the money market, the excess reserves of commercial banks are invested in near money assets, which are easily converted into cash. Thus, commercial banks earn profits without sacrificing liquidity. As per the Reserve Bank of India, the term ‘Money Market’ is used to define a market where short-term financial assets with a maturity up to one year are traded. The assets are a close substitute for money and support money exchange carried out in the primary and secondary market. In other words, the money market is a mechanism which facilitate the lending and borrowing of instruments which are generally for a duration of less than a year. High liquidity and short maturity are typical features which are traded in the money market. The non- banking finance corporations (NBFCs), commercial banks, and acceptance houses are the components which make up the money market. Money market is a part of a larger financial market which consists of numerous smaller sub- markets like bill market, acceptance market, call money market, etc. Besides, the money market deals are not out in money / cash, but other instruments like trade bills, government papers, promissory notes, etc. But, the money market transactions can’t be done through brokers as they have to be carried out via mediums like formal documentation, oral or written communication. In environmental law and policy, market-based instruments (MBIs) are policy instruments that use markets, price, and other economic variables to provide incentives for polluters to reduce or eliminate negative environmental externalities. MBIs seek to address the market failure of externalities by incorporating the external cost of production or consumption activities through taxes or charges on processes or products, or by creating property rights and facilitating the establishment of a proxy market for the use of environmental services. Market-based instruments are also referred to as economic instruments, price-based instruments, new environmental policy instruments (NEPIs) or new instruments of environmental policy. Examples include environmentally related taxes, charges and subsidies, emissions trading and other tradeable permit systems, deposit-refund systems, environmental labelling laws, licenses, and economic property rights. For instance, the European Union Emission Trading Scheme is an example of a market-based instrument to reduce greenhouse gas emissions. Market-based instruments differ from other policy instruments such as voluntary agreements and regulatory instruments. However, implementing an MBI also commonly requires some form of regulation. Market-based instruments can be implemented systematically, across an economy or region, across economic sectors, or by environmental medium (e.g. water). Individual MBIs are instances of environmental pricing reform. According to Kete, \"policymaking appears to be in a transition towards more market-oriented instruments, but it remains an open-ended experiment whether we shall successfully execute 183 CU IDOL SELF LEARNING MATERIAL (SLM)

a long-term social transition that involves the private sector and the state in new relationships implied by the pollution prevention and economic instruments rhetoric 10.2 GDRS The trend towards the internationalization of financial markets has gained impetus during the last two decades, driven mainly by the sophistication in IT and capital market participants borrowers, investors decades, driven mainly by the sophistication in IT and capital market participants, greater co-operation between financial regulators, the lowering of capital barriers across national boundaries and the liberalization of capital markets in emerging economies2. Many companies are looking beyond their domestic financial markets to develop an investor base and to raise international capital3. By the end of December 2001, there were 2465 foreign companies listed on the major stock exchanges of the world. A vast majority of foreign firms choose to cross-list their stock through the use of depositary receipts (DRs), which have become the popular mode of financing. The 1990s saw an increased flow of DR Programmes, especially from the emerging markets. In April 1992, the government permitted Indian companies to raise equity capital by issuing DR programme in the international financial markets and of all the emerging markets, India has the maximum number of DR programme. This aims at understanding the conceptual framework of DR programme and studying the evolution of DR markets, including the introduction and development of DR programme issued by Indian firms. The remaining is organized as follows: Section I provides a conceptual framework for the DR programs. Section II traces the historical evolution and growth of DR markets, including the developments pertaining to the Indian DR programs. Finally, summary and conclusions of this chapter are presented in the Section III. A depositary receipt is a negotiable instrument denominated in US dollars or Euro, which is issued to the investors in one or more than the domestic currency of the issuer company), which is issued to the investors in one or more foreign countries. depicts the mechanism for floatation of a DR program. DRs are issued by the overseas depositary bank to the international investors either against the issuer’s local currency shares registered in depositary’s name in the shareholder books of the company or against the physical delivery of local currency shares of the issuer company to the depositary or, more commonly, to a domestic custodian bank appointed by the depositary. The depositary in respect of a DR program is located in a foreign country, where as the custodian is located in a home country of the issuer company. 10.2.1 Structure Each DR represents a certain number of underlying local currency equity shares of the issuer traded in the home market of the issuer. The depositary sets the ratio of a single issuer traded in the home market of the issuer. The depositary sets the ratio of a single DR to per local currency equity share of the issuer. This ratio can be less than, equal to or greater than 1 184 CU IDOL SELF LEARNING MATERIAL (SLM)

based on the market value of the local currency shares of the issuer and is decided in a manner so as to make the price of a single DR trade in a range comfortable to the foreign investors. When each underlying domestic share in the home country is priced considerably low in terms of its equivalent value in dollars, then each DR may represent several underlying domestic shares. However, if each underlying domestic share is priced equivalent to several hundred dollars, then each DR may be only a fraction of a normal share. While most DR programs have been established with a 1:1 ratio, some of DR programs have ratios ranging from 100,000:1 to 1:100. 100,000:1 to 1:100. Appropriate ratio is decided by the depositary bank at the inception of the DR program with counselling from the issuer, investors, brokers, investment bankers and underwriters. The ratio can be adjusted at a future date to address changes in market conditions. Alternately, the issuer may undertake a stock split of the underlying domestic shares so as to keep the market price of a single DR within a comfortable price range for the foreign investors. In setting the ratio, three factors are decisive. First, the issuer decides the ratio in a manner so that DR prices conform to the price range at which most securities of companies in the issuer's industry generally trade. Second, issuer wants to conform to the average price range at which most shares listed on the stock exchange trade. Finally, ratio is decided to give a sense of ‘just pricing’ to the prospective investors. In order to establish a DR program, issuer selects a depositary, a custodian bank and an advisory team constituted of lawyers, accountants, and investment bankers. While the advisory team plays a crucial role during the initial floatation and listing process of the DR program, the role of the depositary and the custodian bank is crucial even after the initial floatation and listing process gets over. They are responsible for managing the issue on an on-going basis. The issuer appoints custodian bank in consultation with the depositary bank. The issuer and the depositary bank enter into a depositary agreement that sets forth the terms of the DR program. The agreement stipulates the rights and responsibilities of the issuer, depositary and the investors investing in the DR program. The issuer, on an on-going basis, deals only with the depositary bank in regards to payments, notices or rights/bonus issues related to the DR issues. The depositary agreement, as a general rule, sets forth an obligation of the depository to provide notice of shareholder meetings and other information about the issuer company to the investors so as to enable them to exercise their shareholders rights. While for GDR investors voting rights rests with the depository bank, ADR investor are allowed to exercise their voting rights in individual capacity. Depositary bank is also responsible for secondary market transfers / cancellations of DR’s. The depositary agreement also set out the amount payable as administration fee from the issuer for the services offered by the depositary. When investors want to sell their DRs, they notify their broker. The broker can either sell the DRs in the market where they are initially issued or sell the shares into the sell the DRs in the market where they are initially issued or sell the shares into the issuer company’s home market. Secondary market trading in DRs is constituted of two types of market transactions, 185 CU IDOL SELF LEARNING MATERIAL (SLM)

viz., the intra-market transaction and the cross-border transaction. The intra-market transactions follow the settlement procedures set out for the trading in domestic securities of the country where DRs are issued. In a typical intra-market transaction, DR certificates are transferred from the seller’s account to the buyer’s account. A high liquidity level is necessary for intra-market transaction to get executed. Most secondary market transactions in ADRs are settled via intra-market trading due to the high liquidity levels in the ADR markets. In a cross-border transaction, brokers, either through their own international offices or through a local broker in the issuer company’s home market, will sell the shares back into the home market. In order to settle the trade, the broker will surrender the DRs to the depository bank with instructions to deliver the shares to the buyer in the home market. The depository bank will cancel the DRs and instruct the custodian to release the underlying shares and deliver them to the local broker who purchased the shares. The broker will arrange for the foreign currency to be converted into the appropriate currency for payment to the DR holder. The cross-border transactions in DRs are, typically, executed to take advantage of the price differentials between the DR prices and the prices of equivalent underlying domestic shares. Besides, lack of liquidity in DR markets also prompts the cross-border transactions. Most transactions in the Indian GDRs are executed as cross-border transactions. 10.2.2 Types Issuer Company has the option of issuing one or more types of the available choices of DR programs. A broader classification of DR programs is on the basis of the countries DR programs. A broader classification of DR programs is on the basis of the countries where DR programs are issued and or listed. While American Depositary Receipts (ADRs) are issued and or listed only in the US markets, Global Depositary Receipts (GDRs) are simultaneously issued and or listed in the more than one market, typically in the European and US markets. DR programs can also be classified into the following four categories based on the regulatory complexity of the issuance process, purpose and the post issuance reporting requirements of the program. Unsponsored American Depositary Receipts These are issued by one or more depositaries in response to market demand but without a formal agreement with the depositaries in response to market demand but without a formal agreement with the issuer company. Unsponsored DRs are created in order to satisfy the investors’ demand for the securities of a particular foreign company. When investors show their buying interest in the shares of a particular foreign company, broker’s purchase those shares listed on the company's home market and request the delivery of the shares to the depositary bank’s custodian operating in that country. The broker then converts the US dollars or Euro received from the investor into the corresponding foreign currency in order to make payment for the purchased shares from the company’s home market. On the same day custodian notifies the depositary bank that the delivery of the shares has been received. Upon such notification, DRs are issued and delivered to the initiating brokers who then delivers the 186 CU IDOL SELF LEARNING MATERIAL (SLM)

DRs to the investor. If the DR facility is established without the active participation of the issuer company, then the fee payable to the depositary bank is borne by the holders of unsponsored DR’s. For seeking the exemption from the full reporting requirements of the SEC, depositary bank must apply under Rule 12g3-2(b). The obligation to file a bank must submit an application under Rule 12g3-2(b). The obligation to file a registration statement under the Securities Exchange Act of 1933 is imposed on the depository. After obtaining the exemption from the full reporting requirements of the SEC, the depository bank files a Securities Act Form F-6. The SEC has adopted Form F-6 for the registration of ADRs under the 1933 Act. Form F-6 is composed primarily of the depositary agreement pursuant to which the depositary bank agrees to issue ADRs and hold the deposited securities. The SEC adopts the fictional entity theory in making it mandatory for the depositary to file Form F-6. Under this theory the depositary bank assumes the issuers responsibility to file a registration documents with the SEC and is required to sign Form F-6 on behalf of issuer. However, the depositary and its officers remain shielded from any liability arising from the content of the registration document. The filing of Form F-6 is obligatory even in case of the sponsored DR programs. However, the issuer is a party to the depositary agreement of the sponsored programs, and hence is liable for any liability arising from the content of the registration document. Unsponsored ADR programs are exempted from the SEC’s reporting requirements and can only be traded on the over-the-counter market5 and listed in the pink sheets. Unsponsored ADR programs have several advantages over the sponsored ADR programs. First, they are relatively inexpensive and easier way for expanding the investor base in the US. Second all costs associated with establishment of an unsponsored ADR program are borne by the investor. Third, SEC registration and reporting requirements are minimal. Fourth, the issuer is not a party to the depository agreement, or a registration applicant and therefore is not subject to any US liability arising in connection with the ADR program. Some examples of the unsponsored DR programs, which have their origination in the recent past are – the Telephones de Mexico’s DR program listed on NASDAQ and the Wal-Mart de Mexico’s DR program traded on OTC market of U.S.A. However, unsponsored DR programs have become a rarity in the recent years. Foreign companies, which are popular amongst the investors, most willingly sponsor their DR program. The main reasons for the gradual obsolescence of unsponsored DR programs in the recent years are: the issuer being not a party to the depository agreement has little control over the unsponsored DR program; the unsponsored programs can easily be duplicated by other depository banks as there is no need of any consent from the issuer company; conversion of a unsponsored DR program into a sponsored DR program Sponsored American Depositary Receipts Issuer takes the initiative of launching a sponsored DR program by appointing the depositary and other intermediaries involved sponsored DR program by appointing the depositary and 187 CU IDOL SELF LEARNING MATERIAL (SLM)

other intermediaries involved in a DR program. Sponsored DR programs offer several advantages to the issuer. First, issuer has complete control over the sponsored DR facility. Second, issuer can choose from the several types of sponsored DR programs, some of which can be used for raising the fresh capital and for listing on the foreign stock exchange. Sponsored DRs to be issued in the US markets must be registered with SEC using the Form F-6. The filing in the Form-6 is made pursuant to provisions of the Securities Act 1933. It incorporates by reference various provisions of the depositary agreement. Typically, the Form F-6 for a sponsored DR program is executed by the depository bank, but must also be signed by a majority of the issuer’s board of directors, who undertake, if necessary, to make the required future disclosures. Level-I ADR programs are exempted from the reporting requirements of the SEC under the Rule 12g3-2(b). It is not necessary for the level-I issuers to recast or reconcile the Rule 12g3- 2(b). It is not necessary for the level-I issuers to recast or reconcile their financial statements as per the US Generally Accepted Accounting Principles (GAAP). Moreover, level-I issuers do not have to file a Form 20-F7 with the SEC. However, Rule 12g3-2(b) requires that the issuers of level-I ADR programs must provide the SEC on Form 6-K with English translations or summaries of information that is: sent to shareholders, made public in the home market, or provided to a local exchange(s). Due to relatively easy regulatory framework for the level-I issuers, SEC does not allow the level-I ADR programs to list on the US stock exchanges. Similarly, level-I ADR programs cannot be used as a means of raising fresh capital from the US capital markets. However, a level-I ADR program offer an easy and relatively inexpensive way for the issuers to gauge the interest of US investors in their securities and to familiarize their name to the US investors. Many well-known multinational companies have established level-I programs viz. Roche Holding, ANZ Bank, South African Brewery, Guinness, Cemex, Jardine Matheson Holding, Dresdner Bank, Mannesmann, RWE, CS Holding, Shiseido, Nestle, Rolls Royce, Volkswagen etc. Privately Placed - Rule 144A Depositary Receipts (RADRs) Private placement of ADRs is a comparatively cheaper and faster mode of raising the capital than the level- ADRs is a comparatively cheaper and faster mode of raising the capital than the level- III ADR offerings. Issuers, therefore, often raise the capital through the private placement of sponsored DRs in the foreign markets. A non-US issuer can privately place its ADRs with the US investors pursuant to the Regulation D and Rule 144A. Regulation D, adopted by SEC in 1982, establishes certain conditions under which a securities offering made in US territory is considered a private offering, and is therefore not subject to the requirements of advance filing with the SEC and provision of a prospectus. Under Rule 144A, adopted by SEC in April 1990, non-US firms are allowed to privately place their ADRs for trading among the qualified institutional buyers (QIBs) in US. As per Rule 144A, a QIB is any institution that owns and invests on a discretionary basis not less than US $100 million in securities of issuers that are not affiliated to it or an entity entirely owned by the 188 CU IDOL SELF LEARNING MATERIAL (SLM)

QIBs. Rule 144A greatly increased the liquidity of privately placed securities by allowing QIBs to resell the RADRs privately to the other QIBs without any holding period requirement. RADRs offerings are exempted from certain disclosure and reporting requirements designed to protect individual investors, such as prospectus delivery and periodic financial reporting. Securities offered in the Rule 144A market do not have to be registered under the Securities Act and issuers do not have to comply with the periodic reporting requirements of the Exchange Act. To float ADRs under Rule 144A it is necessary that the same class of securities have not been listed on a US securities exchange or quoted on NASDAQ, at the time of issuance of securities under Rule 144A. This condition is applied to prevent the development of dual markets for the same security 10.3 ADRS United States investors have dramatically increased their investment in foreign securities over the years. As technological advances and regulatory initiatives securities over the years. As technological advances and regulatory initiatives facilitate more global securities markets, investments in foreign securities should continue to grow.' Foreign equity securities are traded in the United States in three forms: Ordinary Shares as issued in the country of incorporation; American Shares as issued specifically for use in the United States, frequently with different procedural rights; and American Depositary Receipts (ADRs), the most common form.' Foreign companies seeking to expand trading of their equity securities traditionally have established ADR programs, and the vast majority of foreign issuers, excluding Canadian companies, use ADRs when they list their securities in the United States.3 In recent years, new applications for ADRs have been developed. ADRs have been used in mergers and acquisitions, restructurings, foreign government debt offerings, employee benefit and compensation plans, and offerings under Rule 144A of the Securities Act.4 Unless otherwise indicated, references throughout this to \"foreign company\" or \"foreign issuer\" refer to \"foreign private issuer,\" defined in Securities Act Rule 405 and Exchange Act Rule 3b-4 to mean any foreign issuer (other Act Rule 405 and Exchange Act Rule 3b-4 to mean any foreign issuer (other than a foreign government), except an issuer that meets the following conditions: more than 50 percent of its outstanding voting securities are held by U.S. residents, and any of the following: the majority of its executive officers or directors are residents or citizens of the United States, more than 50 percent of its assets are located in the United States, or its business is administered principally in the United States. Since 1983 the regulations of the Securities and Exchange Commission (SEC) distinguished ADRs from American Depositary Shares (ADSs). ADRs were the physical certificates that evidenced ADSs, similar to the way a stock certificate evidences shares of stock. An ADS was the security that represented an ownership interest in the deposited securities, in the way a share of stock represents an ownership interest in a corporation. Because of the resulting confusion and because market participants did not differentiate between ADRs and ADSs, the SEC abandoned this distinction in a release reviewing the ADR market. The SEC release and 189 CU IDOL SELF LEARNING MATERIAL (SLM)

this do not use the term \"ADS,\" and \"ADR\" may, depending on its context, refer to either the physical certificate or the security evidenced by such certificate.5 An ADR is a substitute certificate that facilitates trading of foreign securities by enabling the holder to transfer title to the underlying foreign securities simply by enabling the holder to transfer title to the underlying foreign securities simply by transferring the ADR. An ADR is a negotiable certificate, a receipt issued by a U.S. depositary that represents ownership of shares of securities of a foreign private issuer. These shares are deposited by the holder of those securities and held overseas by the depositary.6 Typically, equity securities of a foreign issuer are deposited with a foreign affiliate or correspondent of a U.S. bank or trust company.7 The affiliate is usually located in the country of incorporation of the foreign issuer. The ADR is issued by the U.S. bank or trust company, and the certificates then trade in the U.S. securities market.8 An ADR holder can exchange ADRs for the underlying foreign securities at any time, and additional foreign securities can be deposited for issuance of additional ADRs. 9 An ADR may represent one foreign security or, to compensate for the different pricing levels between U.S. and foreign markets, a fraction or multiple of the security. 0 Once between U.S. and foreign markets, a fraction or multiple of the security. 0 Once an ADR program is established, the ADRs trade freely in the United States just like any other U.S. security. 10.4 IDRS Attention of Authorised Dealer Category-I banks is invited to Companies (Issue of Indian Depository Receipts) Rules, 2004 (IDR Rules) notified by the Ministry of Corporate Affairs and subsequent amendments made thereto and Circular No. SEBI / CFD / DIL / DIP / 20 /2006 / 3 / 4 dated April 3, 2006 issued by the Securities and Exchange Board of India (SEBI) regarding issue of Indian Depository Receipts by foreign companies in India and the SEBI (Disclosure and Investor Protection) Guidelines, 2000. In order to facilitate the eligible company’s resident outside India to issue Indian Depository Receipts (IDRs) through a Domestic Depository and to permit persons resident in India and outside India to purchase, possess, transfer and redeem IDRs, it has been decided to operationalise the IDR Rules, notified by the Government of India, as amended from time to time, with immediate effect. 2. In order to facilitate the eligible company’s resident outside India to issue Indian Depository Receipts (IDRs) through a Domestic Depository and to permit persons resident in India and outside India to purchase, possess, transfer and redeem IDRs, it has been decided to operationalise the IDR Rules, notified by the Government of India, as amended from time to time, with immediate effect. 3. Accordingly, eligible company’s resident outside India may issue Indian Depository Receipts (IDRs) through a Domestic Depository. The permission has been granted subject to compliance with the Companies (Issue of Depository Receipts) Rules, 2004 and subsequent amendments made thereto and the SEBI - 2 - (DIP) Guidelines, 2000, as amended from time to time. In case of raising of funds through issuance of IDRs by 190 CU IDOL SELF LEARNING MATERIAL (SLM)

financial/banking companies having presence in India, either through a branch or subsidiary, the approval of the sectoral regulator(s) should be obtained before the issuance of IDRs. Investment by Persons resident in India / FIIs / NRIs in IDRs 4. The FEMA Regulations shall not be applicable to persons resident in India as defined under section 2(v) of FEMA, 1999, for investing in IDRs and subsequent transfer arising out of transaction on a recognized Stock Exchange in India. Foreign Institutional Investors (FIIs) including SEBI approved sub- accounts of the FIIs, registered with SEBI and Non-Resident Indians (NRIs) may also invest, purchase, hold and transfer IDRs of eligible companies’ resident outside India and issued in the Indian capital market, subject to the Foreign Exchange Management Regulations, 2000 notified vide Notification No. FEMA 20 / 2000-RB dated May 3, 2000, as amended from time to time. Further, NRIs are allowed to invest in the IDRs out of funds held in their NRE / FCNR(B) account, maintained with an Authorised Dealer / Authorised bank. 10.5 EURO BONDS First, Eurobonds would be a decisive step towards a necessary medium term fiscal union and a first step towards a longer term political union. Second, they could reduce and even stop the present series of self-fulfilling attacks to fiscally vulnerable Member States and contagion to other Member States with less fiscal vulnerability. Third, they could, eventually, bring back financial stability to the euro area, given that joint guaranties or liabilities could convince markets that its Member States are really serious about achieving a proper fiscal union and a stable euro. Fourth, they could reduce the cost of debt of most euro area Member States and eventually of all of them through the much larger size, depth, liquidity and diversification of such a market which could reach the same status than the US Treasury bond market. Fifth, lower cost of debt and very large attraction to large government and private investors that need to diversify their investments beyond US dollars could help the euro area Member States to achieve earlier sustainable debt levels, faster recovery of economic activity and higher economic growth potential by returning faster to more normal levels of public investment. First, a Eurobond, jointly guaranteed by euro area Member States, contains an implicit insurance for all participating Member States and some of them may have an incentive to issue too much debt to profit from such an implicit guarantee creating a ‘moral hazard’ issue and its consequent rejection by the most fiscally responsible Member States. Second, some AAA rated Member States, such as Germany, may have temporarily to pay a slightly higher interest rate on its debt, given the inclusion in the jointly guaranty of other Member States with lower ratings. Third, the same Member States rightly claim that Eurobonds require as a prerequisite to their issuance to achieve a very high harmonization of fiscal policies by all euro area Member States. The first proposal of a bond-issuing EU stability fund was made by Daniel Gros and Stefano Micossi in the Spring 2009 issue of Europe’s World. Both economists where the first to argue that investors had developed a strong preference for public debt, because governments can 191 CU IDOL SELF LEARNING MATERIAL (SLM)

always force their central banks to print the money needed to meet their obligations, but this was not the case in Europe where no national government can force the ECB to print money. They realized that, on one side, there was a very strong demand for European bonds from investors to diversify away from the US dollar, and on the other side, Europe needed massive government capital infusions to prevent the crisis getting worse, mainly in the banking sector and in the euro area periphery. This is the reason why they were the first to propose the creation of a massive European Financial Stability Fund (EFSF) that would be at least on the scale of the US TARP, around EUR 500-700 billion which will issue bonds on the international markets with the explicit guarantee of Member States to face the necessary crisis management and would be wound down after a pre-determined period, perhaps of five years. For global investors, EFSF bonds would be practically riskless as they would have the backing of all Member States. They both affirmed that until the EU does not develop a unified market for bonds denominated in euro, backed jointly by EU Member States, the euro cannot become a leading reserve currency with the present privileges of the dollar. Setting up this fund with a common guarantee would not imply that stronger Member States would have to pay for the mistakes of the others, because at the end of its operations, losses could be distributed across Member States according to where they arose. In all likelihood, though, the fund would not lose, but rather make money because its funding costs would be much lower than those of individual Member States’ fiscal stimulus and because its existence would stabilize European financial markets. They were in favour of using the EIB as the agency hosting the EFSF because its board of governors included the finance ministers of the EU Member States. At 24 May 2010, more than one year later, an EFSF, with the same name and with a similar size to that proposed by the two economists, was created, but late, on an early morning of a Monday, after long urgent meetings over the weekend and under huge pressure from financial markets. They consider the EIB the institution better suited to issue them or even alternatively, directly by the euro area governments. In order to avoid that countries with lower spreads, especially Germany, object to Eurobond issues, they make the following proposals: First, each euro area government would participate in the issue on the basis of its equity shares in the EIB. Second, the coupon on the Eurobond would be a weighted average of the yields observed in each government bond market at the moment of the issue weighted also by their equity shares in the EIB. Third, the proceeds of the bonds would be channelled to each member government according to the same EIB share weights. Fourth, each government would pay the yearly interest rate on its part of the bond, using the same national interest rate used to compute the average interest of the euro bond. Greece, for instance, would have to pay a yearly interest rate on its part of the outstanding bond of 5.7% while Germany would have to pay only 3.1%. The advantage of this scheme is that Greece would pay the interest rate it faces today in the market, thus the incentive to free ride Germany would be very small or zero and Germany would pay the same interest it pays when issuing its own bonds, so it would not be penalized by a potentially higher interest rate. Why then Greece would participate if it keeps paying the 192 CU IDOL SELF LEARNING MATERIAL (SLM)

same interest rate? Because it would avoid being shut out of the market and can continue to have access to funding without imposing a burden on other participants in the scheme. Both economists alert about this system having two practical problems. The first is how to share the collective responsibilities underlying the bond issue. They would be the same that they already share when the EIB issues today in the markets. The second is that the yield of the euro common bond may differ from the weighted average of the yields of national bonds constituting the common bond as it happened with the ECU-bonds in the past. Nevertheless, given that the liquidity of the common euro bond would be much higher than in the individual national bond markets, the Eurobond would have a lower yield than the weighted average, so Member States with lower liquidity in their national bond markets will benefit from the lower yields that the higher liquidity of the euro bond produces. 10.6 REPOS Repo is a money market instrument, which enables collateralized short term borrowing and lending through sale/purchase operations in debt instruments. Under a repo transaction, a and lending through sale/purchase operations in debt instruments. Under a repo transaction, a holder of securities sells them to an investor with an agreement to repurchase at a predetermined date and rate. In the case of a repo, the forward clean price of the bonds is set in advance at a level which is different from the spot clean price by adjusting the difference between repo interest and coupon earned on the security. In the money market, this transaction is nothing but collateralized lending as the terms of the transaction are structured to compensate for the funds lent and the cost of the transaction is the repo rate .In other words, the inflow of cash from the transaction can be used to meet temporary liquidity requirement in the short term money market at comparable cost. Repo rate is nothing but the annualized interest rate for the funds transferred by the lender to the borrower. Generally, the rate at which it is possible to borrow through a repo is lower than the same offered on unsecured interbank loan for the reason that it is a collateralized transaction and the credit worthiness of the issuer of the security is often higher than the seller. Other factors affecting the repo rate include, the credit worthiness of the borrower, liquidity of the collateral and comparable rates of other money market instruments. A reverse repo is the mirror image of a repo. For, in a reverse repo, securities are acquired with a simultaneous commitment to resell. Hence whether a transaction is a repo or a reverse repo is determined only in terms of who initiated the first leg of the transaction. When the reverse repurchase transaction matures, the counterparty returns the security to the entity concerned and receives its cash along with a profit spread. One factor which encourages an organization to enter into reverse repo is that it earns some extra income on its otherwise idle cash.. A repo is also sometimes called a ready forward transaction as it is a means of funding by selling a security held on a spot basis and repurchasing the same on a forward basis.. When an entity sells a security to another entity on repurchase agreement basis and simultaneously purchases some other security from the same entity on resell basis it is called a double ready forward transaction. 193 CU IDOL SELF LEARNING MATERIAL (SLM)

In a repo transaction where there are two legs of transactions viz. selling of the security and repurchasing of the same, in the first leg of the transaction for a nearer date, sale price is and repurchasing of the same, in the first leg of the transaction for a nearer date, sale price is usually based on the prevailing market price for outright deals. In the second leg, which is for a future date, the price will be structured based on the funds flow of interest and tax elements of funds exchanged. This is on account of two factors. First, as the ownership of securities passes on from seller to buyer for the repo period, legally the coupon interest accrued for the period has to be passed on to the buyer. Thus, at the sale leg, while the buyer of security is required to pay the accrued coupon interest for the broken period, at the repurchase leg, the initial seller is required to pay the accrued interest for the broken period to the initial buyer. Transaction-wise, both the legs are booked as spot sale/purchase transactions. Thus, after adjusting for accrued coupon interest, sale and repurchase prices are fixed so as to yield the required repo rate. The excess of the coupon at the first leg of repo would represent the coupon interest for the repo period. Thus, the price adjustment depends directly upon the relationship between the net coupon and the repo amount worked out on the basis of the repo interest agreed upon the total funds transferred. When repo rate is higher than current yield repurchase price will be adjusted upward signifying a capital loss. If the repo rate is lower than the current yield, then the repurchase price will be adjusted downward signifying a capital gain. If the repo rate and coupon are equal, then the repurchase price will be equal to the sale price of security since no price adjustment at the repurchase stage will be required. If the repo rate is greater than the coupon, then the repurchase price is adjusted upward to the extent of the difference between the two. And, if the repo rate is lower than the coupon then, the repurchase price is adjusted downward. Specifically, in terms of repo rate, there will be no price adjustment when the current yield on security calculated on the basis of sale value is equivalent to repo rate. 10.7 CPS A commercial paper (CP) is an unsecured promissory note issued by very large private companies and financial companies having a short and fixed maturities. Majority private companies and financial companies having a short and fixed maturities. Majority of CPs have 30 days or less of original maturity; while most of the CPs have 270 days of the original maturity. The securities and exchange commission (SEC) may rarely permit some companies to issue CPs of more than 270 days. If companies are very popular, they will issue CPs directly without the involvement of Banks. The financial companies generally issue CPs directly to the investor while others make use of investment dealers. The discount rate (at which it is soled) depends on factors like reputation of issuer, maturity (remaining) and the sum. Due to higher default risk and lesser liquidity, they fix higher rates of discount. The preceding section we have seen some important money market instruments (of U.S.A.) and their basic features. Let us now turn to the instruments dealt in the international market. International money market is technically the “Euro – Currency” market. The prefix “Euro” 194 CU IDOL SELF LEARNING MATERIAL (SLM)

is used for historical reason because of the U.S. Dollar were largely deposited outside 122 U.S.A. in Europe particularly in London, Again the currency which is forming the larger share in the Euro – Currency markets happens to be the U.S. Dollar. Although in the recent past, other currencies have started becoming significant. Deutsete mark and Swiss francs), still the dollar continues to be the single most important currency. The Euro-currency market is operated by foreign banks called Euro Banks and U.S. Bank’s foreign branches. Generally, there is some amount of ambiguity between the 2 markets namely, the Euro – currency and Euro – Bank markets. The Euro – currency markets enable the investors to hold short – term claims are commercial banks. Normally, loans are advanced on “floating rate” basis, calculated as a fixed percentage over the London Inter Bank Offer Rate (LIBOR). Most of the loans are of 6 months duration. Shorter periods are also possible. These commercial Banks, in turn, function as intermediaries between investors and final borrowers. Banks transform the short-term claims into long – term claims on the final borrowers. While in Euro – Bond market, banks play a significant role, Basically “Euro Bonds” are directly issued by the financial borrowers. These Euro – Bonds are traded outside the country in whose currency, the bond is denominated (i.e. Euro – Dollar Bonds, for example, will be sold outside U.S.A. since such bonds are denominated in U.S.s currency). 10.8 DERIVATIVES The derivations account for approximately 80% of the financial market activity in the developed world – North America, Europe, and East Asia. Derivatives are almost like the developed world – North America, Europe, and East Asia. Derivatives are almost like insurance. The difference is that the insurance protects against the firm – specific “risks” whereas the derivatives take care of the market risks. It is widely used as an instrument of risk management. Investors are increasingly making use of derivatives to hedge against the risk of losses and enhance the value of their risks. According to Mr. J.P. Morgan, the derivatives do not make risks disappear but they make it possible to exchange a risk, you would rather not take for one, you are more willing to accept. Derivatives are dynamic. The risk profile of derivatives transaction changes constantly as markets and prices move up or down. In to-day’s contest of open economics with floating exchange rates being the order of the day, the world is a riskier place now than what it was 20 years ago. All business firms face an ever growing exposure to risk from all sides – volatility beyond a certain degree can put a firm out of business, in spite of it being efficient otherwise. Taxonomically, derivatives can be classified as options, futures, swaps and of course, the forward exchange contracts. There are hybrids like swaptions, option and futures etc., But we confine ourselves to the recent but emerging as the dominant instruments or products to manage risk in the arena of international finance. 195 CU IDOL SELF LEARNING MATERIAL (SLM)

10.9 FLOATING RATE INSTRUMENTS A floating rate fund is a fund that invests in financial instruments that pays a variable or floating interest rate. A floating rate fund, which can be a mutual fund or an exchange-traded fund (ETF), invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest rate level. Typically, a fixed-rate investment will have a stable, predictable income. However, as interest rates rise, fixed-rate investments lag behind the market since their returns remain fixed. Floating rate funds aim to provide investors with a flexible interest income in a rising rate environment. As a result, floating-rate funds have gained in popularity as investors look to boost the yield of their portfolios. Although there is no formula to calculate a floating rate fund, there can be various investments that comprise a fund. Floating rate funds can include preferred stock, corporate bonds, and loans that have maturities from one month to five years. Floating rate funds can include corporate loans and mortgages as well. Floating rate loans are loans made by banks to companies. These loans are sometimes repackaged and included in a fund for investors. Floating rate loans are similar to mortgage- backed securities, which are packaged mortgages that investors can buy into and receive an overall rate of return from the numerous mortgage rates in the fund. Floating rate loans are considered senior debt, meaning they have a higher claim on a company's assets in the event of default. However, the term \"senior\" doesn't represent credit quality, only the pecking order of claiming a company's assets to pay back the loan if the company defaulted. Floating rate funds can include floating rate bonds, which are debt instruments whereby the interest paid to an investor adjusts over time. The rate on a floating rate bond can be based on the fed funds rate, which is the rate set by the Federal Reserve Bank. However, the return on the floating rate bond is typically the fed funds rate plus a set spread added to it. As interest rates rise, so does the return on the floating rate bond fund. The biggest advantage of a floating rate fund is its lower degree of sensitivity to changes in interest rates, compared with a fund or instrument with a fixed payment rate or fixed bond coupon rate. Floating rate funds appeal to investors when interest rates are rising since the fund will yield a higher level of interest or coupon payments. 10.10 EURO DEPOSITS A euro deposit is a deposit of foreign funds into a bank that operates within the European banking system. These banks function on the consolidated European currency—the euro. When an external investor deposits foreign currency into one of these banks, they are effectively depositing in euros. By putting money into a European bank account, the account 196 CU IDOL SELF LEARNING MATERIAL (SLM)

holder may expect to accrue interest at the floating interest rate determined by the European Central Bank (ECB) A euro deposit can be a method for a foreign citizen, or company, to protect their money if their home currency sharply loses value. Banks can stipulate minimums for these foreign deposits. European banks have historically paid customers generous interest rates for \"parking\" their money in these accounts. This practice encourages wealthy customers and large companies to keep a more considerable amount of money in these European accounts. However, in 2014, the European Central Bank (ECB) lowered interest rates to below zero for the first time. The rate has steadily fallen since then, now at its lowest rate ever—a negative 0.5% as of November 27, 2020. This lower interest rate meant imposing negative interest rates on deposits. Many international banks deposit their funds in the ECB. When the ECB initiated negative interest rates, those foreign banks, in essence, began paying to park funds in the ECB. Since negative interest rates resulted in a loss of revenue for the banks, many opted to pass those costs on to their customers Banks in the U.S., such as JPMorgan Chase and Bank of New York Mellon, started charging customers for euro deposits earlier this decade.4 In early 2017, the Swiss bank UBS began imposing a charge for deposits over one million Euros. UBS said the move reflected “the increasing costs seen across the industry of reinvesting cash from deposits in money and capital markets, the continued extraordinarily low interest rates in the euro area and increased liquidity regulations.” Many central banks around the world have lowered interest rates to below zero. Japan’s central bank, the Bank of Japan (BOJ), decided in 2016 to lower its interest rate to negative 0.1%, which is where it stands as of October 2020.6 7 Though Japanese banks were initially reluctant to pass the costs onto customers, many have imposed fees for larger customers to make up for shrinking profit margins.8 According to the Japanese bank, customers would not be charged without their consent, but the bank would refuse to allow further deposits if the customer refused to pay the fee. Some banks have opted not to pass the costs of negative interest rates onto customers. Some have said they feared a backlash from customers, which could result in lost accounts. The term euro dollar refers to U.S. dollar-denominated deposits at foreign banks or at the overseas branches of American banks. Because they are held outside the United States, euro dollars are not subject to regulation by the Federal Reserve Board, including reserve requirements. Dollar-denominated deposits not subject to U.S. banking regulations were originally held almost exclusively in Europe. Now, they are also widely held in branches located in the Bahamas and the Cayman Islands. 197 CU IDOL SELF LEARNING MATERIAL (SLM)

The fact that the euro dollar market is relatively free of regulation means such deposits can pay higher interest. Their offshore location makes them subject to political and economic risk in the country of their domicile; however, most branches where the deposits are housed are in very stable locations. The eurodollar market is one of the world's primary international capital markets. They require a steady supply of depositors putting their money into foreign banks. These eurodollar banks may have problems with their liquidity if the supply of deposits drops. Deposits from overnight out to a week are priced based on the fed funds rate. Prices for longer maturities are based on the corresponding London Interbank Offered Rate (LIBOR). Eurodollar deposits are quite large; they are made by professional counterparties for a minimum of $100,000 and generally for more than $5 million. It is not uncommon for a bank to accept a single deposit of $500 million or more in the overnight market. A 2014 study by the Federal Reserve Bank showed an average daily volume in the market of $140 billion. Most transactions in the eurodollar market are overnight, which means they mature on the next business day. With weekends and holidays, an overnight transaction can take as long as four days. The transactions usually start on the same day they are executed, with money paid between banks via the Fedwire and CHIPS systems. Eurodollar transactions with maturities greater than six months are usually done as certificates of deposit (CDs), for which there is also a limited secondary market. 10.11 SUMMARY  The Blue and Red Eurobond proposal by Jacques Delpla and Jacob von Wei sacker, published in May 2010 by Bruegel, is the most elaborated proposal known up to date. Both economists have come up with a design which avoids most if not all the Eurobond potential cons. Their main idea is to have both a senior and a junior debt tranche in the euro area Eurobonds. They call them Blue and Red Eurobonds. The Blue or senior bond tranche will be constructed by pooling up to 60% of GDP of the national sovereign debt of the euro area Member States (which is considered, according to the Treaty, the maximum level up to which debt is sustainable or not excessive) under joint and several liability of all its members to ensure that it will be a triple A asset.  This Eurobond will have a substantially lower yield than the weighted average of the national bond yields, given that the size and the liquidity of its market will be similar to those of the US Treasury bond. This Blue bond will strengthen the confidence in the euro and will help to end the actual sovereign debt crisis.  Moreover, interest rates on these Blue bonds will be even lower than those of the German Bunds today. From an investor’s perspective, their joint and several liability will reduce the risk even further because defaults risks tend not to be perfectly 198 CU IDOL SELF LEARNING MATERIAL (SLM)

correlated, lowering even more the yields on the Blue or senior tranche bond. The Blue bond market would reach an amount of around EUR 5,600 billion which is about five times the current market size of the German Bund and close in size to the US Treasury bond market which is around USD 8,300 billion.  Greater size and liquidity bring down borrowing costs given that large public investors, such as central banks and sovereign wealth funds, greatly value safety and liquidity. Only the increase in liquidity could reduce the debt cost of the Blue Bond by 10%, which is equivalent to reducing the net present value of the debt stock by 10% as well. Assuming a legacy debt stock of 60% of GDP, the liquidity advantage generated could amount to an average net present value of 6% of GDP of the euro area Member States. Government and public investors and large private investors in public debt, such as banks, insurance companies and pension funds not only invest in very deep and highly liquid bond markets but they also try to invest in highly diversified debt, so that the pooling of the debt of 17 quite different Member States reduces the default correlation risk and may win another added reduction to debt costs.  Moreover, most of these investors need to diversify their investments away from the US Treasury bond market and away from the US dollar, so they can get a natural exchange rate hedge, given the very high inverse correlation between both currencies movements. These are the main reasons why the euro will never be able to compete with the US dollar as a leading world reserve currency if such a Blue bond market is not created.  The Red or junior bond tranche is constructed by the excessive debt above the 60% level of debt to GDP and it will be issued by the Member States themselves. In this way, the junior tranche would pay a much higher interest rate than the present weighted average, because of its higher risk of default and its larger illiquidity. The average cost of borrowing for each Member State would be higher, the higher its amount of debt rises above 60% of GDP and the more worrying its borrowing path. By disentangling sovereign debt responsibilities within the euro area, the ‘no-bailout’ clause of the Treaty would become more credible not only de jure, but de facto since the higher rates of the Red bonds will send a warning signal to those Member States on an unsustainable fiscal path, discouraging them from reaching excessive debt levels above 60% of GDP and avoiding a situation like the present one, with high negative externalities and contagion to other Member States with a lower debt levels.  At the same time, it would be also less disruptive for a Member State issuing Eurobonds to default on its Red junior tranche, because the borrowing capacity of its senior Blue tranche would not be destroyed, as it would happen today. But from an investor’s perspective the prospects of a less disruptive default on the junior tranche increases the risk of default, thereby calling for an additional risk premium, thus 199 CU IDOL SELF LEARNING MATERIAL (SLM)

maintaining the Member State’s incentive to avoid a level of debt close to default. Moreover, the ECB will, most probably, take a prudent stance regarding the eligibility of Red bonds for its repo facility and, in order to qualify for the Blue bond tranche, national governments could be obliged to introduce a standardised collective action clause (CAC) in their Red bond borrowing, which would make any debt default or restructuring simpler and shorter. Debt discipline would be encouraged because this model would bring down the cost of debt servicing at the margin, bringing down overall debt and reducing the cost of debt on the Red tranche and on the overall debt. It would also encourage Member States not to reach the 60% of GDP debt levels because they borrow much cheaper and therefore they can keep their debt levels more sustainable and lower than in today’s situation.  Finally, Jean Claude Juncker’s and Giulio Tremonti’s proposal was published on 6 December 2010 by the Financial Times. The importance of their proposal, which is similar to the Blue and Red bond above, is that it has been the only one which was officially rejected by Germany and France at the bilateral summit on 10 December 2010 in Freiburg, even if the President of the Euro-Group was one of the two proponents. Nevertheless, European Commission President Barroso promised to defend it speaking at the plenary of the European Parliament in Luxembourg on 15 December 2010 after knowing about its rejection by the heads of both leading euro area Member States.  Both important ministers propose to launch Eurobonds issued by a European Debt Agency (EDA), as a successor of the EFSF, to be created within one month by the European Council. The EDA should have a mandate to issue Eurobonds gradually up to reaching an amount of outstanding debt equivalent to 40% of the total GDP of the European Union and of each Member State’s GDP. First, the EDA should finance up to 50% of issuances by EU Member States to create a deep and liquid market.  In exceptional circumstances, for Member States whose access to markets is impaired, it could finance up to 100% of issuances. Second, the EDA should offer a switch between Eurobonds and existing national bonds. The conversion rate would be at par, but the switch would be made through a discount option, where the discount is likely to be higher the more a bond is undergoing market stress. Knowing in advance the evolution of such spreads, Member States would have a strong incentive to reduce their deficits. These Eurobonds would halt the disruption of sovereign debt markets and stop present negative spill overs across national markets. In the absence of well- functioning secondary markets, investors are weary of being forced to hold their bonds to maturity and therefore ask for increasing prices when underwriting primary issuances. 200 CU IDOL SELF LEARNING MATERIAL (SLM)