Financial Markets

Assess the importance of LIBOR to the world’s financial/credit markets. Your response should be at least 200 words in length. All sources used, including the textbook, must be referenced; paraphrased and quoted material must have accompanying citations.

Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2012). Fundamentals of multinational finance. (IV ed., pp. 131-134). New York: Pearson.

In-text citation

(Moffett, Stonehill& Eiteman, 2012)

No Wiki, no dictionary.com, please cite all work

t.l A ir I F lrt i; current Multinational Financial challenges: The credit crisis of
2oo7-20o9

the shadow banking Process

The problem, however, is that securitization may degrade
credit quality. As long as t

he

Iender, the originator, was
.istuck,, with the r””r, trr” i”nolr was keen to assure the quality of

theloanandthecapabilityoftheborrowertorepayin.atimely’mannel.Thelenderlr.ada
vested interest in .orrtinuirg to monitor borrow”, teiavior over

the life of the debt’

Securitization, however, severed that link. Norv the originator
could originate and sell’

not being held accountable for the ultimate *puUifity of the-borrower
to fulfill the loan obli-

gation. Critics argue that securitization p.ouid”, incentives
for rapid and possibly sloppy

credit quality urr”rrrn”n,. O,igtnu’o” could now focus on generating
more and more fees

through more loans, o.l;;”;;;, *hile not being concerned over the actual loan
performance

over time. The originatJ-to-Olrtril.rte (OTD) riodel was nol fragmenting
traditional bank-

ingrisksandreturns.UndertheoTDframework,oncetheloan-wasmadeandresold,the
ability for any lnrtitrrtion truOitg 1t” portfolio of loans to

track and monitor borrower behav-

ior was negligible.
Proponents of securitization acknowledge that it did allow more

subprime mortgages

and loans to be written. But those same .riit, allowed more and more
home buyers and

commercial op”ru,orr’io\v”r-.ori firrun”ing, making home
ownership and small business

activities more affordable and more accessift”. naorleover,
although there was ciearly abuse

in the origination of subprime moftgages, *uny t”ti”ue that the
U’S’ system was particularly

vulnerable, not having sufficient ‘”quir”-“nt,
or principles in place over key credit quality

criteria like credit hiJtories. Proponlnts of securitization
argue that if these errors are cor-

rected, securitization would have the ability to truly reach
its objectives of creating more liq-

uid and efficient markets without degrading the quality
of the instruments and obligations’

Of course, securitization alone did not u”rrur” u murt”t for the
obligations’ Securitization

simplychangedtheirform,buttherewasstilltheneedforamarketforthenonconforming
obirgations.

*€ rq:*t:-: r*ci E r”lv*sin”l*:tt Vf fu ie i*s

Th” orgurriration that filled that market niche, the buyer of
much of the securitized noncon-

forming debt, was the strucntre(t investme;r- rrnirit isry;. Thrl_was
the ultimate financial

intermediation device: it borrowed short anJ invesred iong.tr”
SIV.was *

“ff-?:]11te
sheet

entity first created uy citigroup in 1988′ It was designed to allow
a bank to create an invest-

ment entity that would invest in iong-term ancl tri”gher yielding
assets such as speculative

grade bonds, mortgage-backed securities (MBSS;’ and -collateralized
debt obiigations

(CDOs), while fundin! itsem through commercial paper (CP)
issuances’ CP has long been

one ol the lowest-cost funding soulces fo, uny bn.’lrr”rr’ The
problem, of course’ is that the

buyers of Cp issuan””, -urtftiue full faith in tiie credit quality
of the business unit’ And that’

in ihe end, was the demise of the SIV’
Exhibit S.+ proviJ”s a brief overview of the SIV’s basic structure’

The funding of the typ

ical SIV was fairly simple: using minimal equity, the SIV borrowed
very short-commercial

paper, interbank, o, *ial,r*-tJrm-notes. sp”ttrti”g uanks p’ovided backup
lines of credit

to assure th” rrig6″rt ;r”dii ratings for CP irrru.t.”r.*The SIV then
used the proceeds to pur-

chase portfolios of d;;tyi;;t”g securities that held investment grade credit ratings’
The

SIV then generated an interest margin, roughly 0’25% on
average, acting as a middleman

in

119

i?iru:ffi;J;;;r;; many of rhe purchased assers-for exampre, c:|1,:”:1::1^1″::

‘bd;”r’# rcil;i, ^’I #1# ;’ ;;
i;ili;t :”‘:i,,y:l* l.:’^ :::1′ 5 ;,1”;:l :I”;;:;”;’;”##1;:;;;ilot,urp,im”-!1teue3′,’ll’-1P1,1,:t,L’ii”::::”1?Tj

ill:1,#f,?#”;;nn,”ir,r,*””‘”,rt”,’,*-o”ornieitmente’rd:.?ii11v^?:..”?T::::::
$.

$s
ffi
ffi’ffi*g

belief in portfolio th”;;y.fh:,; tL,”ory held that whereas a single large
subprime borrower con-

stituted significant risk, a portfolio of subprime botrowe” *hith was
securitized (chopped up

124
pAll-r i Global Financial Environment

StructureO lnvestment Vehicles (SlVs)

SlVs, born in 1998 and
essentiallY dead bY the
end of 2008, were Pure
fee/sPread devices for
pure “shadow banklng”
in which the bank
borrowed short and
invested long.

Sellers of asset-backed
and mortgage-backed
portfolios

Bank

Purchases
+– securtized

asset Portfolios
iike CDOs

\ ,j
\./

R”trrn

Structured lnvestment
Vehicle (SlV)

:-,jr- – :: :1.:j:::::’;’ :::=:

Assets Liabilities

SIV is off -balance’sheet
of the s7onsoring bank

lssues Commercial
Paper (CP) “—–>
to raise funds

The SlVs had to be
reabsorbed bY their
banks when the CP

market seized-uP
at the end of 2008.

Buyers of Commercial
Paper (CP)

“\- -,)
– LIBOR = SPread ot O 25%

pieces in a sense), Iepresented significantiy less
risk of credit default and could therefore be

;*’ff”o,TJ;ilT::15;lnXXtnever.
As the housing boom corapsed in 2007, the subprime

mortgages underiving these CDOs failed’
t””-t-d**::::JV’s asset portfolios to be

instantly written down in value (mark-to-market
accounting required real-time revaluation

of the assets). As the asset values feil, uuyers
of SlV-based cP disappeared’ Because the

sponsoringbanksofmanySlVshad-top.o’ia”u*tuplinesofcreditfortheirSlVstoobtain
A1lp1 credit quality to begin with, the sant<,

were foiced to step back in and fund their own

SIVs. In the second ft”U.iTOOZ and the
first half of 2008, most SIVs were either closed

dorvn or

re.consolidatedwiththeirsponsoringbanks.Byo-ctober2008,SIVsweleathingofthepast.
In rhe end, both ,ir”-uitrr and ieath of the SIV

were somewhat symbolic of the three

major forces many believe were behind ,t,” “,”4i’
crisis of 2007 and2008: complex financial

instruments,off-balancesheetaccountingentities,andincreaseduseofleverage.

SlVsareonlyonepartofthestoryofcreditproblemsin200Tand200s,buttheyare
instructive because they include tlrr”, 1″otu”‘ that contributed

disturbance elsewhere’ First’

they involved the useLf inrovativ, ,”rurit-rr, which
were hsrd to value in the best of cir-

cumstancesandwhichhadlitttehistorytoindicatehowtheymightbehaveinaseveremar.
ket rlownturn. second, risks were underestimated:

the sIVs weri a form of highty leveraged

spec,lation, *niri’*o, i”pendent on the assuntption tkat the
marLets would always supply

Iiquidity. Finally, they were off balance sir”t ,ntitirt’ few
in the markets (or perhaps in the

regulatory og”nri’;ri’noi on ogrurote idea of the scope
or natur.e of their activities until the

trouble came. The result of tlte interact:lo”‘”f in”” f”ctuts-with
a sharp ltousing market

dow,nturn x ,n, *,ori ,ustqine(t prrioct of iirtt”aliiiy in
u.S- financial markets since’ the

Great Depression’
_,.Averting Financial crisis,,, cRS Report for congress,

by Mark Jickling,
‘-^ –

Congressiona’l Research Service’ October
8′ 2008′

,+

C 1-l A p T E F S Current Multinational Financial Challenges: The Credit Crisis of 2OO7-2OO9 721

As the credit crisis of 2008 deepened into the recession of 2009, many lawmakers and

regulators in a variety of countries and continents debated the possible regulation of
financial derivatives tirat may have contributed to the crisis. Both the European Union

and the United States governments looked hard and close at two specific derivatives-

collateralized ttebt oblilgations (CDOs) and credit rlefautt swaps (CDSs)-to determine
what role they played itt ttt” crisis, and if and how they might be brought under greater
control.

Collateralized Debt Obligations {CEOs}
One of the key instruments in this new growing securitization was the collateralized debt ohli-

gation,or cDO, pictured in Exhibit 5.5. Banks originating mortgage loans, and colporate

Ioans and bonds, iould now cteate a portfolio of these debt instruments and package them as

an asset-backed security. Once packaged, the bank passed the security to a special purpose

vehicle(sPv) (not to be confused with the previously described SIV), often 1:::l* in an off-
shore financial center tike the Cayman Islands for legal and tax advantages’) SPVs offered a

number of distinct advantages,.rr”h ut the ability to remain off-balance sheet if financed and

operated properly. From thire the CDO was sold into a growing market through underwrit-

eis. This fieed up the bank’s financial resources to originate more and more loans, earning a

variety of fees. A typical fee was 1.1% upfront to the CDO underwriter. The collateral in the

CDO was the real estate or aircraft or heavy equipment or other property the loan was used

to purchase.

:be

Lme

rbe
ion
the
ain
rWn

tor
ast.

ree
:ial

are
rst,

:ir-
ar-

aed
ply
the
the

ket
the

tEffi+*
U.nderling Asset or
Credii lnstrument

– Mortgage ,t
Loan :j

,@

\

Corporate i:

‘ Loan !-,#i: ,/

I

Corporate i

‘ Bond ‘.r
.l

:.w@

,/
:

Underwriter :___*
Lehman, Bear Stearns’,
.:..;:::,:.ri,.::::r. ::tr:;t:: i.i:r,r1,-r;..:i:::::l

\

Buyers or
lnvestors

Pension
Fund .;

l-Bank/ :
House t,

€sffi’:iffi

Hedge
Fund l

.*”*”#

The Collateralized Debt Obligation (CDO)

Bank :
l

!::i:::::;, !1:::rlJiirilri-j

cDo ,–,>
:l

i:ii,’:ji::;!:*l!;:;:-:i I
I

I

Special Purpose Credit Rating from
Vehicle (SPV) I Moody’s, S&P’ Fitch

‘:!i:!=j:::::*:.a+.rii:.,1::;:1i.i::::*:i-j -i’!:i::::i.::::::it::l:l:’:irit’:r:r’::i_:]r’:::’

The collateralized Debt obligation, cDo, is a derivaiive instrument created from bank-origrnated mortgages and

loans, combined with similar?ebt obligations into a portfolio, and then re-sold through investment banking

underwriters to a variety of investors. ihe credit rating of the CDO, based on its constituent components, is critical
to the salability to investors.

SSome readers may remernber the ignominious past of the SPV from its widespread use by Enron in acquiring

more and more debt-off-balance sheet-to feed its continuously failing business model in the late 1990s.ng,
08.

C H A PT E R 5 Current Multinational Financial Challenges: The Credit Crisis of 2OA7-20O9

plans were underway in Australia, Belgium, Canada, France, Germany, Iceland, Ireland, Italy,
Luxembourg, Spain, Sweden, the United Kingdom, and the United States.

The credit crisis, which had first started in the summer of 2007, now moved to a third
stage. The first stage had been the failure of specific mortgage-backed securities. These had
caused the fall of specific funds and instruments. The second stage had seen the crisis spread
to the very foundations of the organizations at the core of the global financial system, the
commercial and investment banks on all continents. This third new stage had been feared
from the beginning-a credit-induced global recession of potential depression-like depths.
Not only had lending stopped, but also in many cases, borrowing and investing had ceased.
Although interest rates in U.S. dollar markets hovered little above zero,the price was not the
issue. The prospects for investment returns of all types were now dim. The corporate sector
did not see economic opportunities and returns to new investment. Budgets were slashed,
layoffs continued, and the economies of the industrial world retrenched.

What’s Wrong with LIBOH?
Toclay’s failure of confidence is based on three related issaes.’ the solvency of banks, their
ability to fund themselves in illiquid markets and the health of the real economy.

-“The Credit Crunch: Saving the System,” The Economisr, October 9,2008.

The global financial markets have always depended upon commercial banks for their core
business activity. In turn, the banks have always depended on the interbank market for the
liquid linkage to all of their nonbank activity, their loans and financing of multinational busi-
ness. But throughout 2008 and early 2009,the interbank market was, in one analyst’s words,
“behaving badly.” LIBOR was clearly the culprit.

The interbank market has historically operated, on its highest levels, as a “no-name” mar-
ket. This meant that for the banks ai the highest level of international credit quality, inter-
bank transactions could be conducted without discriminating by name. Therefore, they
traded among themselves at no differential credit risk premiums.A major money center bank
trading on such a level was said tobe trading on the run.Banks that were considered to be of
slightly less credit quality, sometimes reflecting more country risk than credit risk, paid
slightly higher to borrow in the interbank market.The market itself still preferred not to price
on an individual basis, often categorizingmany banks by tier.

But much of this changed in the summer of 20A7 as many subprime mortgages began t

o

fait. As they fell, the derivatives that had fed on those mortgages fell, the Collateralized Debt
Obligations (CDOs), and with them a number of hedge funds. As individual financial institu-
tions, commercial and investment banks alike, started suffering more and more losses related
to bad loans and credits, the banks themselves became the object of much debate.

LIBOR’s Flole
In the spring of 2008, the British Bankers Association (BBA), the organization charged with
the daily tabulation and publication of LIBOR Rates, became worried about the validity of its
own published rate.The growing stress in the financial markets had actually created incentives
for banks surveyed for LIBOR calculation to report lower rates than they were actually pay-
ing. A bank that had historically been considered to be on the run,bur now suddenly reported
having to pay higher rates in the interbank market, would be raising concerns that it no longer
was of the same steadfast credit quality. The BBA collects quotes from 16 banks of seven dif-
ferent countries daily, including the United States, Switzerland, and Germany. Rate quotes
are collected for 15 different maturities, ranging from one day to one year across 10 dilferent
currencies.9 But the BBA has become concerned that evenits survey wording- “at what rate

eAfter collecting the 16 quotes by matu fity and currency, the BBA eiiminates the four highest and four lowest rafes
reported, and averages the rcmaining ones to determine various published LIBOR rates.

‘:i1

ril

:i
t?l

*;.
i,!,

€
&

r32 PAFT 1 Global Financial Environment

i,- ,-:; ::”e la:rk borrow a reasonable amount?” *was leading to some reportingirregulari

ties.

1.:=;:: :*rre increasing differences in the interpretation of “reasonable.”

–1< lhe crisis deepened in September and October 2008, many corporate borrowers began to ;::*e publicly that LIBOR rates published were in fact understating their problems. Many loan *sreements with banks have market disruption clauses that allow banks to actually charge cor- parate borrowers their "real cost of funds," not just the published LIBOR. When markets are under stress and banks have to pay more and more to fund themselves, they need to pass the higher costs on to their corporate clients. Of course, this is only for corporate borrowers with pre- existing loan agreements with the banks. Corporate borrowers attempting to arrange new ioan agreements were beilg quoted ever-higher prices at considerable spreads over LIBOR.

LIBOR, although only one of several key interest rates in the global marketplace, has
been the focus of much attention and anxiety of late. In addition to its critical role in the
interbank market, it has become widely used as the basis for all floating rate debt instruments
of all kinds. This includes mortgages, corporate loans, industrial development loans, and the
multitudes of financial derivatives sold throughout the global marketplace. The BBA
recently estimated that LIBOR was used in the pricing of more than $360 trillion in assets
globally. LIBOR’s central role in the markets is illustrated in Exhibit 5.7Z.Itwas therefore a
source of much concern when LIBOR rates literally skyrocketed in September 2008.

In principle, central banks around the world set the level of interest rates in their curren-
cies and economies. But these rates are for lending between the central bank and the banks of
the banking system.The result is that although the central bank sets the rate it lends at, it does
not dictate the rate at which banks lend either between themselves or to non-bank borrowers.
As illustrated in Exhibit 5.13, in July and August prior to the September crises, 3-month
LIBOR was averaging just under 80 basis points higher than the 3-month interest rate swap
index-the difference being terme d the TED Spread.TED is an acronym for T:bilt and ED
(the ticker symbol for the Eurodollar futures contract). In September and October 2008,

LIBOR and the Crisis in Lending

Step 2. Since banks no longer could “trust” the credit quality of other banks,
lnterbank lending, priced on LIBOR, became a focal point of anxiety.

\
Bank

,i
;:ga€!:Gs*i

//

Step 1. As the loans and investments
made by banks began to fail, the banks
were iorced to write off the losses under
mark-to-market regulatory requirements
The banks then needed to draw upon
new funds, like the interbank market.

Bank debt
., began to dry up

Bank ‘.<-

lnterbank
Market

<_*->–
(LTBOR)

Corporaie
Borrowers

5C

Atr

4.0

Q

g 2.5(
c)
o-

0.5c

0.0c

“o(1t\i
Scurce: E

Slep 3, Corporate borrowers who
found bank lending shui off, now
went directiy to the market,
issuing commercial paper. Atler
only a few weeks, however,
that market too shut down.

Commercial l
Paper {CP} Marker ;

,-..:a:€!*j1i5!:jdr: jii rr::,:::.i :1,

+
I

Mutual
Funds

Step 4. Mutual funds and other
nonbank investors were no longer
willing to invest in CP as corporate
borrowers began to suffer from falling
business condltions and failure to pay

2.4(

t.Jt

1.0c

Mortgage
Loan

Corporate
Loan

Corporate
Bond

C lt A p T E Ft 5 Current Multinational Financial Challenges: The Credit Crisis of 2OO7-2O49

The U.S. Dollar TED Spread {July 2008-January 2009)

however, the spread rose to more than 350 basis points,3.57o, as the crisis caused many banks

to question the credit quality of other banks. Even this spread proved misleading’The fact was

that many banks were “o-pl”t”ly
“locked-out” of the interbank market’ Regardless of what

they mayor may not have been willing to pay for funds, they could not get them.-Whit
is also apparent from Exhibit 5.t3, ls the impact of the various U’S’T?easury and

Federal Reserve actions to “Ie-float” the market. As banks stopped lending in mid- 1e late-

September, and many interbank markets became illiquid, the U’S’ financial authorities

*ork.d feverishly to inject funds into the marketplace. The result was the rapid reduction in

the 3-month Interest Rate Swap Index. The TED Spread remained relatively wide only a

short period of time, wittr LtgbR actually falling to under 1.5o/” by the end of 2008′ In
January 2009, the TED Spread returned to i more .i*rno., spread of under 80 basis points’10

Of course, the largei, more creditworthy companies do not have to borrow exclusively

from banks, but may [sue debt directly to itre market in the form of commercial paper’In

September 2008, when many commercial banks wele no longer answering the phone, many

coiporate borrowers did jusi that. The commercial paper market, however, also quickly fell as

many of the market’s tiaditional buyers of commercial paper-other commercial banks’

hedge funds,private equity funds, and even the SIVs discussed earlier-all now shied away

frori buying ifr” pup”i. By mid-October, the commercial paper market saw issuances fall

from an already low $f .Zi Uilio.t weekly to just above $1’4 billion’ Even CP sold by the

traditionally ,””ur” General Electric jumped 40 basis points. Many of the buyers of CP now
worried that the declining economy would result in an increasing default rate by CP issuers’

As the CP market locked–up, the corporate sectol saw another door to capital close’

133

ties.

nto
oan
lor-
are
the
lre-
oan

has
the
:nts

the
BA
;ets
‘ea

en-
;of
les
)rs.

rth
rap

]D
08,

5.00

450

4.00

3.50

_ 3.00
p zso
c)
o-

200

1.50

1.00

0.50

0.00

“.tltt-$S$-{l,stS$*$S.g-*Sl”E-t'”g”g’r
Source: British Bankers Association, Bloomberg

The TED Spread is the dilference
betlveen LIBOR and some measure
of risk-less interest (either the U S.
Treasury Bill rate or in thls case, the
Interest Rate SwaP lndex rate).

3-month USD LIBO

F

TED SPread

3-month lnterest Rate Swap lndex

thhe TED Spread is often calculated using the maturity equivalent to LIBOR in U.S. Tieasuries, in this case, the

3-month U.S. Tieasury Bill yield. In fact, in late 2008 the U.S. 3-month Tieasury Bitl yield hovered around zero’

734 f r A l-i -f I Global Financial Environment

Financial Fra*d and Financial te*cvery
The purported frauduient activity behind much of the gtobal
credit crisis involved ihe raiher compiex relationships
between financial instilutions and their customers and
partners of all kinds. Simply put, much of it involved the
abuse of trust.

ln the spring of 2O1j, the American ,nternational
Group (AlG), filed a series of lawsuits against other Wall
Streei investment banking and financial services {irms. AIG
had been the recipient of enormous quantities of bailout
capital at the height of the September 2008 crisis. As a
result, although still a possession of the U.S. government,
any funds recouped from fraudulent investing or lending
activities would go toward repaying taxpayers.

One example of this financial pursuit was in AIG s filing
in the Supreme Coud of the State of New york against lCp
Asset management.* ln its complaint, AIG asserted that ,,the

scheme perpetrated by the lOp Defendants involved numer-
ous breaches of their contractuai and fiduciary duties ic
AIG-FP.” lt also noted that most of the facts, circumstances.
and allegations were the same as those filed by ihe Secur!-
ties and Exchange Commission (SEC) jn its complaint filed
against ICP

ICP was the underwrjter of several large failed CDOs
called Triaxx-l and Triaxx-2. The proceeds earned from ihe
sale of the CDOs were used to purchase residentiaj
mortgage-backed securities. AIG asserts ihat lCp then nct
only entered into a series of credit default swaps ensurinE
against the faiiure of the underiying notes, but also purchased
hundreds of millions of dollars of the senior notes themselves.
ultimately exposing AIG to significant loss.

.Technically,
the listed defendanis were lCp Asset Management, LLC, lcp

Securities, LLC, lnstiiutional Credit padners, LLC, Tnax< piime C D)O ZOOt_i . Lld., Triaxx Funding High Grade l, Ltd. Moore Capital Management, Lp andJohnDoes 1-i0.

). 1

The credit crisis was worsened by the destabilizing effects of speculators betting that par-ticular CDos would faii. The trick was to create and sell cDos with enough risky mortgagesthat the cDO was likely to fail. The speculator bought credit default sw;ps lcbss; ri,rrictrshould repay what was lost when the cbo lalteo.ThJinvestors lost their morrey.rr
Although legal suits like these will most likely rvind their way through tire American

court system for many years, the basic questio n of fiduciury ,rrporribitity-ih” ,”rporrsibility
to act in the best interests of the client. to carr1, out their responsibilities with goodiaith, hon-esty, integrity, loyalty and undivided service-versus individual profit motives, is in manyways at the heart of the dilemma.

“Ftrre i{.emrccly: I}rcsc;”ig:tirx:s fcn ;*l fnfi:a:{e.aE
{itrs:F:al Filraqlcial $rg*,};st?:

Put crudely, the bright new finance is the higlilt, leveraged, tightly regulate;, msrket-based
system of allocating capital dominatecl bt’lYoll Street.”It is tie spivvy sLtccessor to ,,tradi-
tional bonking,” in which regulated contnterciol bqnks lent money to trusted clients and helcl
the debt on their books. The new systellt et’oh’ed ot’er the past three decades and saw explo-
sive growth in the past few years thanks b three simriltaneous but distinct developments:
deregulation, technological innovcttion atttl rhe growing international mobility of cipitat.

-“The world Economl’: Tanrin.-e the Beast,” The Econonisr, october g,200g.
So rvhere now for the global financial markets.r Disrrissing the absolute extremes, on one endthat capitallsm has failed, and on the other end thar

“”trJ*” regulation is the only solution,what practical soiutions fall in between? \\trat if u,e return to tie sequence of events which
has led to the most recent global credit crisis?

i lTwo recommencled books chronicling the risk-v” practices of some wall Street firms and their executives are TheE-ttd-of wall Stt’eer by Roger Lowenstein (Penguin Press. \e $ Ybrk.2010) and The Big shortby Michaei Lervis(WW. Norton and Company, New york and London.2010).

F?e

2h?

eOLn

:cmI
SOUTC

fr-e s;
‘!c mt
exien,

I
lata,

158 P A R T 2 Foreign Exchange Theory and Markets

American terms are used in quoting rates for most foreign currency opti.ons and futures,

as well as in retail markets that deal with tourists and personal remittances. Foreign exchange

traders may also use nicknames for major currencies. “Cable” means the exchange rate
between U.S. dollars and U.K. pound sterling, the name dating from the time when transac-

tions in dollars and pounds were carried out over the ?ansatlantic telegraph cabie. A Cana-
dian dollar is a “loonie,” named after the water fowl on Canada’s one-dollar coin. “Kiwi”
stands for the New Zealand dollar,’Aussie” for the Australian dollar, “Swissie” for Swiss
francs, and “Sing dollar” for the Singapore dollar.

There are two major exceptions to this rule of using European terms: the euro and the

U.K.’s pound sterling. Th” “rrio
and the U.K. pound sterling are both normally quoted in

Ameriian terms;the U.S. dollar price of one euro and the U.S. dollar price of one pound ster-

ling. Additionally, Australian dollars and New Zealand dollars are normally quoted on Amer-

ican terms. Sterling is quoted as the foreign currency price of one pound for historical
reasons. For centuries, the British pound steriing consisted of 20 shillings, each of which

equaled 12 pence. Muitiplication and division with the nondecimal currency were difficult.

The custom evolved for foreign exchange prices in London, then the undisputed financiai

capitalof the world, to be stat;d in foreign currency units per pound. This practice remained

even after sterling changed to decimals in 7971.
The euro was first introduced as a substitute or replacement for domestic currencies like

the Deutsche mark ancl French franc. To make the transition simple for the residents and
users of these hrstorical currencies, ali quotes rvere made on a “domestic currency per euro”
basis. This held true for its quotation against the U.S. doilar; hence, “U.S. dollars per euro”
being the common quotation used today.

Direct and lndirect Quotations. A direct quote is the price of a foreign currency in domestic
currency units. An indirect quote is the price of the domestic currency in foreign currency uni

ts.

In retail exchange in many countries (such as currency exchanged in hotels or airports) it
is common practice to quote the home currency as the price and the foreign atrrency as the
ttnit. A woman walking down the Avenue des Champs-Elysdes in Paris might see the follow-
ing quote:

EUR0.8214 = USD1.00
In France, the home currency is the euro and the foreign currency is the dollar. This quotation
in France is termed a direct quote on the dollar or a price quote on the dollar.Yerbally, she might
say to herselt*0.8214 euros per dollar,” or “it will cost me 0.8274 euros to get one dollar.”

At the same time a man walking down Broadway in New York City may see the follow-
ing quote in a bank window:

U5D1.2174 = EUR1.00
The home curuency is the dollar (the price),lhe foreign currency is the euro (the unit).In New
York, this would be a direct qltote on the ettro (the home currency price of one unit of foreign
currency) and an indirect quote on the dollar (the foreign currency price of one unit of home
currency). Again, verbally, he would probably say “I will pay $L.2174 dollars per euro.” These
are Anterican terms.

The two quotes are obviously equivalent (at ieast to four decimal places), one being the
reciprocal of the other:

: USD1.2174IEUR
EURO.8214lUSD

Bid and Ask Rates. Aithough a newspaper or magazine article will state an exchange rate as
a single value, the market for buying and selling currencies, whether it be retail or wholesale,

he
in

tlC

ts.

,it
he
w-

fn
hr

rV-

AS

e,

CHAPTEn 6 The Foreign Exchange Market 159

uses two different rates, one for buying and one for selling. Exhibit 6.8 provides a sample of

how these quotations may be seen in the market for the dollarleuro’
A bid 1; the price (i.e., exchange rate) in one currency at which a dealer will buy another

currency. An ask is the price (i.e., exchange rate) at which a dealer will sell the other currency.

Dealers bid (bty) at one price and ask (sell) at a slightly higher price, making their profit
from the spread between the buying and selling prices. The bid-ask spread may be quite large

for currencies that are traded infrequently, in small volumes, or both’

Bid and ask quotations in the foreign exchange markets are superficially complicated by

the fact that the bid for one curency is also the offer for the opposite currency.A trader seek-

ing to buy dollars with euros is simultaneously offering to sell euros for dollars.

As illustrated in Exhibit 6.8, however, the full outright quotation (the full price to all of

its decimal points) is typically shown only for the bid rate. Tiaders, however, tend to abbrevi-

ate when tait

of a spot quotat-ion maybe givenln full: that is,”1,.2170.” However. the second term’ the ask,

will piobably be expreised only as the digits that differ from the bid. Hence, the bid and ask

for ipot euros would probably be shown “1..2flAfi8″ on a video screen’ In some cases
between professional traders, they may only quote the last two digits of both the bid and ask,
,,JA-78′,b””uur” they know what the other figures are. Closing rates for 47 currencies (plus

the sDR) as quoted by the wsll steet Journal are presented in Exhibit 6.9.
T11e Watt Street Jiurnal gives American terms quotes under the heading “USD equiva-

lent” and European terms quotes under the heading “Currency per USD.” Quotes are given

on an outright tasis for spoi, with forwards of one, three, and six months provided for a few

select currencies. Quotes are for trading among banks in amounts of $1 million or more, as

quoted at 4 p.w. EST by Reuters. The Journal does not state whether these are bid, ask, or

mid-rate quotations.

Bid, Ask, and Mid-Point Quotations

rLrRluso “!.21?s11.2178 er 1.21?StrS

Quote
Currencv’ Base Yor: can sell You can buY

CurrencY I euro for I euro for
(‘target currency’) $1 2170 $1 .2178

‘Bid” “Ask”

Traders may quote
only the last lwo
drgits on a rate

)W

ln
1e

SE

ln text documents of any kind, the exchange rate may be slated as mid-paint
quote,lhe average of brd and ask, ot $1.21741€.

!r:-;::::;r::.:.-::r:::;::=:i:j. :i: i.::j:i:::j::;,*:::.i::i;’!:_j;:-l:ir::l!ji;i.*:;r:::iS!x*:

For example, lhe Wall Street Journal would quote the following
currencies as followsl

Last Bid

Euro (EUR/USD) 1.2170 Brazilian Reai (USD/BRL) 16827
Japanese Yen (USD/JPY) 83. 16 Canadian Dollar (USD/CAD) 0’9930

U.K. Paund (GBPIUSD) 1.5552 Mexican Peso (USD/MXN) 12’2365

$1F,!r{::Ei..@it*::4

Last Bid

Exchange Rates: New York Closing Snapshot

U.S.-dollar foreign-exchange rates in late New York trading, Tuesday, January 4′ 2011

Country

Argentina*
Brazrl

Canada

1 month forward
3-months foruuard
6-months lorward

Chile

Colombia
Ecuador
Mexicoi’
Peru
Uruguayi
Venezuela
isi;:,-Fctc;!!ir:
Australia
China
Hong Kong
lndia
lndonesia

Japan

‘1 -month forward

6-months foMard
Malaysia 5

Ne\ry Zealand
Pakistan
Philipp jnes

Singaoore
Sou’ih Korea
Taiwan

Thailand
Vietnam
L+::*!;tt
Czech Republic**
Denmark
Euro area
Hungary
Norway
Poland
Rornania
HUSSJA ‘

Sweden

Switzerland

1-monlh Jomard
3-monlhs forward
6-monihs forward

TurkeyE’l
United Kingdom

I -monlh tonryard
3-monihs forward
6-months forward

i.; :.i.: ! t ; a tti A ii;i:r
Bahrain

Egypt*
israei
Jordan
Kenya
KuY./ait

Lebanon
Saudi Arabla
South Airica
United Arab Emirates
IMF.-

peso Ps
EO

dollar C$

peso $
peso Col$

U.S. dollar $
new peso $
new sol S/.
peso $u

boliviar fuede Bs

dollar AS
yuan Y
dollar HKS
rupee Fs
rupiah Fp
yen Y

ARS 0.252
BRL 0.602
cAD 1 .0015

1,0009
0.9995
0.9s68

cLP 0.00205
coP 0.0005276
USD 1
MXN

0.0818

PEN 0,3568
UYU 0.0502
vND 0.23285056

AUD 1.0055
cNY 0.1514
HKG 0.1287
INR 0.02226
tDR 0.0001113
JPY C.012189

0.012193
tJ.,J t ZZ\J I

4.o12215
0.3263
0.7666

0.01 166
0.023

o.77A5
0.0008885

0.03428
0.03324
0.00005

0.05343
0.1 784

1.3297

0.00482
0. 1 705
4.342

0.31 12

0.03268
o.1487
1.053/
1.0541
1.0548

LUCO

0.6483

1.5585

r.5581
1.5573

z.aaz+
0.1727
0.2841
1 ,4109

Q.O1234
3.5564

0.000666
o.2667
0.1 498
o.2723
1,5464

r -cyl”n:Y p-“I u9P:
3,9683
1.661 1

0.9985
0,9991
1.0005
1.0032
4a7.B

1895.38
1

12.2324
2.8027

19,92

4.2946

0.9945
6.607

7.7695
44.9236

8985
82.04
82,41

dr.9d
81.87

3.0647
1.3045
85.763
43.554
1.2478

1125.49
29.172
30.084

1 9499

18.716
5,6054

A 1Fa

247.47
5.8651
2.924

.).2 t .) I

30,6
6.7249
0,s49

o.9447
0.948
0.947

1.5426
o.6416
0.6418
0.8421
4.6428

0.377
5.7921
? <100

0.2088
81.05

0.2812
1501 .5
3.7495
6.6756
3.6724
o.6467

Currency symbol c9d9 u99 lq{Yalent

ringglt
doi ar
rupee
peso
dollar
won
dollar
baht
dong

koruna
krone
euro
forinl
krone
zloly
leu

ruble

krona
franc

dinar
pound

shekel
dinar

shilling
dinar

pound
riyal
rand

dirham
special drawing righl

Rivl MYF
NZ$ NZD
Rs, PKR
P PHP
SS SGD
W KRW
T$ T\ryD
B THB
d VND

Kc
Dkr

Ft

NKr

L
R

SKr
Fr.

YIL
I

o

shk

KSh

CZK
DKK
EUR
HUF
NOK
PLN
RON
RUB

SEK

CHF

TRY
GBP

BHD
EGP

ILS
JOD
KES

KWD
LBP
SAB
ZAR
AED
SDR

F

A/otes: ,r.Floating rate
rFinancial sGovernment rate and iBussian Central Bank rate *+Commercial rate ilspecial Drawing Rights (SDR)j from lhe lnterna-

tional Monetary Fund; based on exchange rates for u.s., British and Japanese currencies Based on trading among banks of $1 million and more’ as quoted

at 4 p,m. ET by Reuters. Rates are drawn fromlhe Wall Street Journalfor January 5 2011

CHAPTEn 6 The Foreign Exchange Market

A final note.The order of currencies in quotations used by traders can be quite confusing (at

least the authors of this book think so). As not”d by one major international banking pubLicatjon:

The notation EUR/USD is the system used by traders, although mathematically it would be

more correct to express the exchange rate the other way around, as it shows how many

USD have to be paid to obtain EUR 1.

This is why the culrency quotes in Exhibit 6.8-EUR/USD, USD/JPX or GBP/USD-are

quoted ani used in business and the rest of this text as $1.2170l€, Y83.161$, and $1’5552/f’
International finance is not for the weak of heartl

eross ffiates
Many currency pairs are only inactively traded, so their exchange rate is determined through

their relationship to a widely traded third currency. For example, a Mexican importer needs

Japanese yen to pay for pur”hur”, inTokyo. Both the Mexican peso (MXN) and the Japanese

yen (JPY) ur”
“o*-oniy

quoted against the U.S. dollar (USD). Using the foilowing quotes

from Exhibit 6.9:

JPY82.O4lUSD

]|/’){N12.2324lUSD

the Mexican importer can buy one U.S. dollar for MXNL2’2324, and with that dollar can buy

JPY 82.04.The cross rate calculation would be as follows:

Japanese yen/U.S. dollar JPY82.O4|USD : JPY6.7O68/MXN
Mexican pesos/U.S. dollar MXN12.2324ruSD

The cross rate could also be calculated as the reciprocal:

Mexican peso/U.S. dollar MXN12.2324lUSD : MXN0.1491.|IPY
Japanese yen/U.S. dollar JPY82’04/USD

161.

Japanese Yen

Mexican peso

cross rates often appear in financial publications in the form of a matrix, as shown rn

Exhibit 6.10 from the Wall Street Journal (same day quotes as in Exhibit 6’9)’ This matrix

shows the amount of each currency (rows) needed to buy a unit of the currency -bid rates -of

ffio’
Snapshot of forejgn exchange cross rates at 4 p v. EST.

_ Douar__ Euro _Pr!1l.-_sjfn”___j””o___
Y”n-_-cin9l’–

Canada
Japan

Mexico

Switzerland

U.K,

Euro

u.s.

0.9985 1.3277
a2.o41 109.09
12.232 16.265
0,949 1 .2619

0.6416 0.8532
4.752

1.3297

1.5562

127.86

19.064

1.4791

1.1721

1.5585

I .UCZ r

86.447

12.889

0.6761

o.7924

1,0537

o.o816

6.7069

0.0776

0.0525

0.0615

0.0818

o.0122

82j64
0.’1491 12.251
0.01 16 0.9505
0.0078 0.6426
0,0092 a.7532
0.0122 1.0015

Source: Thomson Reuters

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