Eco Assignment Final

SRN
PARTICULARS
PAGE
O.
NO.
Introduction
Currency markets
Geographical Extent of the Foreign Exchange Market
Functions of foreign exchange market
Euro currency, euro currency market
Euro dollar, euro dollar market
Characteristics of euro dollar market
Benefits of euro dollar market
Effects of Euro Dollar Market on International Financial System
10
Shortcomings of the Euro-Dollar Market
11
The growth of the Eurocurrency markets
12
13
14
15
Issues relating to Eurocurrency markets

The economic significance of the Euro-currency market
The competitive advantages of the Euro-currency market

The Eurocurrency market and Inflation
Mcom16
SEM 2 (Economics)
Euro Bonds
17
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Pros and Cons of Euro Bonds
Introduction
Foreign-currency depositsthose denominated in a currency other than that of the host country
have risen spectacularly in recent years. The Eurocurrency system is now the focal point of the
international market for short-term capital (deposits and loans of a year or less), and
intermediate-term credits. Why then was this incredible growth virtually unforeseen by practical
bankers or by academic observers? In principle, the Eurocurrency market is unnecessary. The
clearing of international payments, hedging forward against exchange risk, and short term
credits for trade finance can all be provided by a system in which commercial banks in each
country accept deposit liabilities from foreigners and domestic nationals that are denominated
exclusively in the currency of that countryone in which only Dutch banks accept guilder
deposits and make guilder loans, only American banks accept dollar deposits and make dollar
loans, and so on. To finance foreign trade for their customers, these commercial banks can easily
obtain spot or forward foreign exchange in the interbank market that operates internationally or
draw on balances of foreign currency held with correspondent banks abroad. Let us define
traditional foreign-exchange banking (TFEB) to be this conceptually simple system of "-onshore"
banking supported by foreign correspondents. Traditional foreign-exchange banking arises
naturally from the role of domestic commercial banks as custodians of the national money supply
and intracountry payments mechanism. Historically, TFEB has dominated international finance,
including the twenty years of rapid growth in trade following the Second World War. For
understanding the causes of exchange-rate fluctuations at the present time or the invoicing and
hedging strategies of nonbank merchants and manufacturers engaged in foreign trade, the
implicit assumption of TFEB is sufficient. In a Eurocurrency market, by contrast, banks resident in
country A accept deposits and make loans in the currencies of countries B, C, D, and so on, and
depositors and borrowers are often nonresidents. Despite the semantic connotations, a
Eurocurrency system is not necessarily located in Europe. Major Eurocurrency markets exist in
Canada, Singapore, Japan, and the Caribbean. Because the U.S. dollar is usually the principal
Mcom SEM 2 (Economics)
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currency traded abroad. the expression "Eurodollar market" often connotes trading in many
convertible currencies. Here, however, the term "Eurodollar" is used narrowly to refer only to
deposits of U.S. dollars held outside the United States. The term "Euro guilders" refers to
deposits of guilders in banks not resident in the Netherlands: "offshore" markets exist in many
convertible currencies other than U.S. dollars. The rapid emergence in the 1960s of a worldwide
Eurocurrency market that coexists and competes with TFEB resulted from the peculiarly stringent
and detailed official regulations governing residents operating with their own national currencies.
These regulations contrast sharply with the relatively great freedom of nonresidents to make
deposits or borrow foreign currencies from these same constrained national banking systems. On
an international scale, offshore unregulated financial markets compete with onshore regulated
ones. Gurley and Shaw's (1960 ) standard analysis of unregulated versus regulated financial
intermediaries' shows why it is not surprising that the former grow rapidly at the expense of the
latter. The quirks in foreign-exchange controls and national regulations of commercial banking
that have created the huge Eurocurrency market remain to be spelled out. But their financial
consequences are striking: 1. There is an important foreign-exchange aspect: by trading with
each other in the Eurocurrency market, commercial banks can more conveniently cover the
forward foreign-currency obligations undertaken on behalf of their nonbank customers and
engage in covered interest.
The Eurocurrency market has a purely domestic intermediation aspect (within the confines of a
single national currency) it supplants financial intermediation between savers and investors that
might otherwise flow through a purely domestic capital market, as in the case of the United
States during the monetary "crunch" of 1969. 3. The Eurocurrency market is a great international
conduit for funneling short- and medium-term capital from surplus (net saver) countries to deficit
(net borrower) countries, as with the huge flow of funds arising from the formation of the OPEC
oil cartel in 1973-74. The competitive strength of the Eurocurrency market in all three roles
accounts for its astonishing growth and resiliency, on the one hand, and the great difficulty
academic economists have had in developing a single theoretical model to describe it, on the
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other. Freedom from restraint has created a paragon of international banking efficiency. Yet the
underlying asymmetry vis-a-vis domestic banks has also created an acute problem of secondbest optimization for any single monetary authority, and national central banks have responded
differently to this problem of regulating transactions in foreign currencies. Somewhat
surprisingly, however, the unregulated Eurocurrency market does not compete with TFEB in all
respects. TFEB continues to provide the actual means of payment in international commodity
trade and in capital-account transactions.
Currency markets
The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one
currency for another. Prior to 1996 the market was confined to large corporate banks and international
corporations. However it has since opened up to include all traders and speculators. The average daily turnover
in forex markets is US$4.0 trillion, according to the Bank of International Settlements Triennial Survey from
2010. The market is growing rapidly as investors gain more information and develop more interest.
In trading foreign exchange, investors bet that one currency will appreciate over another; they profit when they
bet correctly and collect the profit in the form of an interest rate spread when they return to the original
currency. The profit margins are low compared with other fixed-income markets. Large trading volumes can,
however, result in very high profits. Over half of all forex trading takes place in London and New York, with
London dominating the market at 37% of all transactions. New Yorks market share is 18%, with Tokyo ranked
third at 6%. Singapore, Switzerland, and Hong Kong are the next-largest forex markets globally with
approximately 5% market share each.
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One type of very short-term transaction is the spot transaction between two currencies, delivering over two days
and using cash as opposed to a contract.
In a forward transaction, the money is not exchanged until an arranged date and an exchange rate is agreed in
advance. The time period ranges from days to years. Currency swaps are a popular type of forward transaction;
these involve the exchange of currency by two parties for an agreed length of time and an arrangement to swap
currencies at an agreed later date. Another type is a foreign currency future, which is inclusive of interest. A
standard contract is drawn up and a maturity date arranged. The time schedule is about three months.
In a foreign exchange option (FX option), the most liquid and biggest options market in the world, the owner
may elect to exchange money in a designated currency for another currency at an agreed date in the future. This
type of transaction depends on the availability of option contracts on an organized exchange. Otherwise, such
forex deals may be carried out using an over-the-counter (OTC) contract.
The foreign exchange market provides the physical and institutional structure through which the money of one
country is exchanged for that of another country, the rate of exchange between currencies is determined, and
foreign exchange transactions are physically completed. A foreign exchange transaction is an agreement
between a buyer and a seller that a given amount of one currency is to be delivered at a specified rate for some
other currency.
Geographical Extent of the Foreign Exchange Market

Geographically, the foreign exchange market spans the globe, with prices moving and currencies traded
somewhere every hour of every business day.
The market is deepest, or most liquid, early in the European afternoon, when the markets of both Europe and the
U.S. East coast are open.
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The market is thinnest at the end of the day in California, when traders in Tokyo and Hong Kong are just getting
up for the next day.
In some countries, a portion of foreign exchange trading is conducted on an official trading floor by open
bidding. Closing prices are published as the official price, or 'fixing' for the day and certain commercial and
investment transactions are based on this official price.
The Size of the Market

In April 1992, the Bank of International Settlements (BIS) estimated the daily volume of trading on the foreign
exchange market and its satellites (futures, options, and swaps) at more than USD 1 trillion. This is about 5 to
10 times the daily volume of international trade in goods and services.
The market is dominated by trading in USD, DEM, and JPY respectively. The major markets are London (USD
300 billion), New York (USD 200 billion), and Tokyo (USD 130 billion).
Hours Market
The markets are situated throughout the different time zones of the globe in such a way that when one market is
closing the other is beginning its operations. Thus at any point of time one market or the other is open.
Therefore, it is stated that foreign exchange market is functioning throughout 24 hours of the day. However, a
specific market will function only during the business hours. Some of the banks having international network
and having centralized control of funds management may keep their foreign exchange department in the key
centre open throughout to keep up with developments at other centers during their normal working hours In
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India, the market is open for the time the banks are open for their regular banking business. No transactions take
place on Saturdays.
Efficiency
Developments in communication have largely contributed to the efficiency of the market. The participants keep
abreast of current happenings by access to such services like Dow Jones Telerate and Teuter. Any significant
development in any market is almost instantaneously received by the other market situated at a far off place and
thus has global impact. This makes the foreign exchange market very efficient as if the functioning under one
roof.
Currencies Traded
In most markets, US dollar is the vehicle currency, Viz., the currency used to denominate international
transactions. This is despite the fact that with currencies like Euro and Yen gaining larger share, the share of US
dollar in the total turn over is shrinking.
Physical Markets
In few centers like Paris and Brussels, foreign exchange business takes place at a fixed place, such as the local
stock exchange buildings. At these physical markets, the banks meet and in the presence of the representative of
the central bank and on the basis of bargains, fix rates for a number of major currencies. This practice is called
fixing. The rates thus fixed are used to execute customer orders previously placed with the banks. An advantage
claimed for this procedure is that exchange rate for commercial transactions will be market determined, not
influenced by any one bank. However, it is observed that the large banks attending such meetings with large
commercial orders backing up, tend to influence the rates.
Participants
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The participants in the foreign exchange market comprise;

(i)
Corporates
(ii)
Commercial banks
(ii)
(iii)
Exchange brokers
Central banks
Corporates
The business houses, international investors, and multinational corporations may operate in the
market to meet their genuine trade or investment requirements. They may also buy or sell currencies
with a view to speculate or trade in currencies to the extent permitted by the exchange control
regulations. They operate by placing orders with the commercial banks. The deals between banks
and their clients form the retail segment of foreign exchange market. In India the foreign Exchange
Management (Possession and Retention of Foreign Currency) Regulations, 2000 permits retention,
by resident, of foreign currency up to USD 2,000. Foreign Currency Management (Realisation,
Repatriation and Surrender of Foreign Exchange) Regulations, 2000 requires a resident in India who
receives foreign exchange to surrender it to an authorized dealer: (a) Within seven days of receipt in
case of receipt by way of remuneration, settlement of lawful obligations, income on assets held
abroad, inheritance, settlement or gift: and (b) Within ninety days in all other cases. Any person who
acquires foreign exchange but could not use it for the purpose or for any other permitted purpose is
required to surrender the unutilized foreign exchange to authorized dealers within sixty days from
the date of acquisition. In case the foreign exchange was acquired for travel abroad, the unspent
foreign exchange should be surrendered within ninety days from the date of return to India when the
foreign exchange is in the form of foreign currency notes and coins and within 180 days in case of
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travellers cheques. Similarly, if a resident required foreign exchange for an approved purpose, he
should obtain from and authorized dealer.
Commercial Banks
are the major players in the market. They buy and sell currencies for their clients. They may also
operate on their own. When a bank enters a market to correct excess or sale or purchase position in a
foreign currency arising from its various deals with its customers, it is said to do a cover operation.
Such transactions constitute hardly 5% of the total transactions done by a large bank. A major
portion of the volume is accounted buy trading in currencies indulged by the bank to gain from
exchange movements. For transactions involving large volumes, banks may deal directly among
themselves. For smaller transactions, the intermediation of foreign exchange brokers may be sought.
Exchange brokers
facilitate deal between banks. In the absence of exchange brokers, banks have to contact each other
for quotes. If there are 150 banks at a centre, for obtaining the best quote for a single currency, a
dealer may have to contact 149 banks. Exchange brokers ensure that the most favorable quotation is
obtained and at low cost in terms of time and money. The bank may leave with the broker the limit
up to which and the rate at which it wishes to buy or sell the foreign currency concerned. From the
intends from other banks, the broker will be able to match the requirements of both. The names of
the counter parities are revealed to the banks only when the deal is acceptable to them. Till then
anonymity is maintained. Exchange brokers tend to specialize in certain exotic currencies, but they
also handle all major currencies. In India, banks may deal directly or through recognized exchange
brokers. Accredited exchange brokers are permitted to contract exchange business on behalf of
authorized dealers in foreign exchange only upon the understanding that they will conform to the
rates, rules and conditions laid down by the FEDAI. All contracts must bear the clause subject to
the Rules and Regulations of the Foreign Exchanges Dealers Association of India. Central Bank
may intervene in the market to influence the exchange rate and change it from that would result only
from private supplies and demands. The central bank may transact in the market on its own for the
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above purpose. Or, it may do so on behalf of the government when it buys or sell bonds and settles
other transactions which may involve foreign exchange payments and receipts. In India, authorized
dealers have recourse to Reserve Bank to sell/buy US dollars to the extent the latter is prepared to
transact in the currency at the given point of time. Reserve Bank will not ordinarily buy/sell any
other currency from/to authorized dealers. The contract can be entered into on any working day of
the dealing room of Reserve Bank. No transaction is entered into on Saturdays. The value date for
spot as well as forward delivery should be in conformity with the national and international practice
in this regard. Reserve Bank of India does not enter into the market in the ordinary course, where the
exchages rates are moving in a detrimental way due to speculative forces, the Reserve Bank may
intervene in the market either directly or through the State Bank of India.
Settlement of Transactions
Foreign exchange markets make extensive use of the latest developments in telecommunications for
transmitting as well settling foreign exchange transaction, Banks use the exclusive network SWIFT
to communicate messages and settle the transactions at electronic clearing houses such as CHIPS at
New York.
SWIFT:
SWIFT is a acronym for Society for Worldwide Interbank Financial Telecommunications, a co
operative society owned by about 250 banks in Europe and North America and registered as a co
operative society in Brussels, Belgium. It is a communications network for international financial
market transactions linking effectively more than 25,000 financial institutions throughout the world
who have been allotted bank identified codes. The messages are transmitted from country to country
via central interconnected operating centers located in Brussels, Amsterdam and Culpeper, Virginia.
The member countries are connected to the centre through regional processors in each country. The
local banks in each country reach the regional processors through the national net works. The
SWIFY System enables the member banks to transact among themselves quickly (i) international
payments (ii) Statements (iii) other messages connected with international banking. Transmission of
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messages takes place within seconds, and therefore this method is economical as well as time saving.
Selected banks in India have become members of SWIFT. The regional processing centre is situated
at Mumbai.
The SWIFT provides following advantages for the local banking community:
1. Provides a reliable (time tested) method of sending and receiving messages from a vast number of
banks in a large number of locations around the world.
2. Reliability and accuracy is further enhanced by the built in authentication facilities, which has
only to be exchanged with each counterparty before they can be activated or further
communications.
3. Message relay is instantaneous enabling the counterparty to respond immediately, if not prevented
by time differences.
4. Access is available t a vast number of banks global for launching new cross border initiatives.
5. Since communication in SWIFT is to be done using structure formats for various types of banking
transactions, the matter to be conveyed will be very clear and there will not be any ambiguity of any
sort for the received to revert for clarifications. This is mainly because the formats are used all ove3r
the world on a standardized basis for conducting all types of banking transactions. This makes the
responses and execution very efficient at the receiving banks end thereby contributing immensely to
quality service being provided to the customers of both banks (sending and receiving).
6. Usage of SWIFT structure formats for message transmission to counterparties will entail the
generation of local banks internal records using at least minimum level of automation. This will
accelerate the local banks internal automation activities, since the maximum utilization of SWIFT a
significant internal automation level is required.
CHIPS:
CHIPS stands for Clearing House Interbank Payment System. It is an electronic payment system
owned by 12 private commercial banks constituting the New York Clearing House Association. A
CHIP began its operations in 1971 and has grown to be the worlds largest payment system. Foreign
exchange and Euro dollar transactions are settled through CHIPS. It provides the mechanism for
settlement every day of payment and receipts of numerous dollar transactions among member banks
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at New York, without the need for physical exchange of cheques/funds for each such transaction.
The functioning of CHIPS arrangement is explained below with a hypothetical transaction: Bank of
India, maintaining a dollar account with Amex Bank, New York, sells USD 1 million to Canara
Bank, maintaining dollar account with Citibank.
1. Bank of India intimate Amex Bank debuts the account of Bank through SWIFT to debit its
account and transfer USD 1 million to Citibank for credit of current account of Canara Bank. 2.
Amex Bank debits the account of Bank of India with USD 1 million and sends the equivalent of
electronic cheques to CHIPS for crediting the account of Citibank. The transfer is effected the same
day.
3. Numerous such transactions are reported to CHIPS by member banks and transfer effected at
CHIPS. By about 4.30 p.m, eastern time, the net position of each member is arrived at and funds
made available at Fedwire for use by the bank concerned by 6.00 p.m. eastern time.
4. Citibank which receives the credit intimates Canara Bank through SWIFT.
It may be noted that settlement of transactions in the New York foreign exchange market takes place
in two stages, First clearance at CHIPS and arriving at the net position for each bank. Second,
transfer of fedfunds for the net position. The real balances are held by banks only with Federal
Reserve Banks (Fedfunds) and the transaction is complete only when Fedfunds are transferred.
CHIPS help in expediting the reconciliation and reducing the number of entries that pass through
Fedwire.
CHAPS:
is an arrangement similar to CHIPS that exists in London. CHAPS stands for Clearing House
Automated Payment System. Fedwire The transactions at New York foreign exchange market
ultimately get settled through Fedwire. It is a communication network that links the computers of
about 7000 banks to the computers of federal Reserve Banks. The fedwire funds transfer system,
operate by the Federal Reserve Bank, are used primarily for domestic payments, bank to bank and
third party transfers such as interbank overnight funds sales and purchases and settlement
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transactions. Corporate to corporate payments can also be made, but they should be effected through
banks. Fed guarantees settlement on all payments sent to receivers even if the sender fails.
Functions of the Foreign Exchange Market

The foreign exchange market is the mechanism by which a person of firm transfers purchasing power form one
country to another, obtains or provides credit for international trade transactions, and minimizes exposure to
foreign exchange risk.
Transfer of Purchasing Power:

Transfer of purchasing power is necessary because international transactions normally involve parties in
countries with different national currencies. Each party usually wants to deal in its own currency, but the
transaction can be invoiced in only one currency.
Provision of Credit:
Because the movement of goods between countries takes time, inventory in transit must be financed.
Minimizing Foreign Exchange Risk:

The foreign exchange market provides "hedging" facilities for transferring foreign exchange risk to someone
else.
Market Participants
The foreign exchange market consists of two tiers: the interbank or wholesale market, and the client or retail
market.
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Individual transactions in the interbank market usually involve large sums that are multiples of a million USD
or the equivalent value in other currencies. By contrast, contracts between a bank and its client are usually for
specific amounts, sometimes down to the last penny.
Foreign Exchange Dealers:

Banks, and a few nonbank foreign exchange dealers, operate in both the interbank and client markets. They
profit from buying foreign exchange at a bid price and reselling it at a slightly higher ask price. Worldwide
competitions among dealers narrows the spread between bid and ask and so contributes to making the foreign
exchange market efficient in the same sense as securities markets.
Dealers in the foreign exchange departments of large international banks often function as market makers. They
stand willing to buy and sell those currencies in which they specialize by maintaining an inventory position in
those currencies.
Participants in Commercial and Investment Transactions:

Importers and exporters, international portfolio investors, multinational firms, tourists, and others use the
foreign exchange market to facilitate execution of commercial or investment transactions. Some of these
participants use the foreign exchange market to hedge foreign exchange risk.
Speculators and Arbitragers:

Speculators and arbitragers seek to profit from trading in the market. They operate in their own interest, without
a need or obligation to serve clients or to ensure a continuous market. Speculators seek all of their profit from
exchange rate changes. Arbitragers try to profit from simultaneous exchange rate differences in different
markets.
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Central Banks and Treasuries:

Central banks and treasuries use the market to acquire or spend their country's foreign exchange reserves as well
as to influence the price at which their own currency is traded. In many instances they do best when they
willingly take a loss on their foreign exchange transactions. As willing loss takers, central banks and treasuries
differ in motive and behavior form all other market participants. Foreign Exchange Brokers:
Foreign exchange brokers are agents who facilitate trading between dealers without themselves becoming
principals in the transaction. For this service, they charge a small commission, and maintain access to hundreds
of dealers worldwide via open telephone lines. It is a broker's business to know at any moment exactly which
dealers want to buy or sell any currency. This knowledge enables the broker to find a counterpart for a client
quickly without revealing the identity of either party until after an agreement has been reached.
Transactions in the Interbank Market

Transactions in the foreign exchange market can be executed on a spot, forward, or swap basis.
Spot Transactions:
A spot transaction requires almost immediate delivery of foreign exchange. In the interbank market, a spot
transaction involves the purchase of foreign exchange with delivery and payment between banks to take place,
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normally, on the second following business day. The date of settlement is referred to as the "value date." Spot
transactions are the most important single type of transaction (43 % of all transactions).
Outright Forward Transactions:

A forward transaction requires delivery at a future value date of a specified amount of one currency for a
specified amount of another currency. The exchange rate to prevail at the value date is established at the time of
the agreement, but payment and delivery are not required until maturity. Forward exchange rates are normally
quoted for value dates of one, two, three, six, and twelve months. Actual contracts can be arranged for other
lengths. Outright forward transactions only account for about 9 % of all foreign exchange transactions.
Swap Transactions:
A swap transaction involves the simultaneous purchase and sale of a given amount of foreign exchange for two
different value dates. The most common type of swap is a spot against forward, where the dealer buys a
currency in the spot market and simultaneously sells the same amount back to the same back in the forward
market. Since this agreement is executed as a single transaction, the dealer incurs no unexpected foreign
exchange risk. Swap transactions account for about 48 % of all foreign exchange transactions.
Euro Currency
Eurocurrency is currency deposited by national governments or corporations in banks outside their home
market. This applies to any currency and to banks in any country. For example, South Korean won deposited at
a
bank
in
Also
South
Africa,
known
is
as
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considered
Eurocurrency.
"euromoney."
Eurocurrency is deposits in banks that are located outside the borders of the country that issue the currency the
deposit is denominated in. For example, a deposit denominated in Japanese Yen held in a Brazilian bank is a
Eurocurrency deposit. Likewise a deposit denominated in US dollars held in a Singapore bank is a
Eurocurrency deposit, or more specifically or more clearly a Eurodollar deposit.
Eurocurrency does not have to involve either the euro currency or the euro zone.
Today the Eurocurrency and Eurobond markets are active because they avoid domestic interest rate regulations,
reserve requirements and other barriers to the free flow of capital.
A Euro bank is a financial institution anywhere in the world which accepts deposits or makes loans in any
foreign currency
In simple words, Euro currency is any currency (such as Eurodollar, Eurosterling, and Euroyen) which is
deposited or traded in a country other than the country of its origin.
Euro Currency Market

The market in which borrowing and lending in Eurocurrency takes place is called the Euro currency market. It
has two sides to it, that is, the receipt of deposits and the loaning of the deposits.
The prefix Euro is now outdated because such deposits and loans in different currencies are regularly traded
outside Europe, especially in Singapore and Honking. Thus, Euro markets are also referred to as Offshore
market if such deposits have more widespread geographical base.
The most important Eurocurrency is the Eurodollar. It is followed by the Euro mark, Euro franc (Swiss), Euro
sterling and Euro yen. Initially, only the dollar was used in this fashion, and the market was therefore called the
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Eurodollar market. Subsequently, the other leading currencies such as the German mark, the Japanese yen, the
British pound sterling, and the French and Swiss franc, also began to be used in this way. Thus the market is
now called the Euro currency market. The main reason for the rapid growth of Euro currency markets is that
they provide better deposit and loan rates than offered by domestic banks located in the country that issues the
currency.
The Eurodollar is a U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks.
By locating outside of the United States, Eurodollars escape regulation by the Federal Reserve Board.
Euro-Dollar
By Euro-dollar is meant all U.S. dollar deposits in banks outside the United States, including the foreign
branches of U.S. banks. A Euro-dollar is, however, not a special type of dollar. It bears the same exchange rate
as an ordinary U.S. dollar has in terms of other currencies.
Euro-dollar transactions are conducted by banks not resident in the United States. For instance, when an
American citizen deposits (lends) his funds with a U.S. Bank in London, which may again be used to make
advances to a business enterprise in the U.S., then such transactions are referred to as Euro-dollar transactions.
All Euro-dollar transactions are, however, unsecured credit.
Euro-dollars have come into existence on account of the Regulation issued by the Board of Governors of the
U.S. Federal Reserve System, which does not permit the banks to pay interest to the depositors above a certain
limit.
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As such, banks outside the United States tend to expand their dollar business by offering higher deposit rates
and charging lower lending rates, as compared to the banks inside the U.S. Increase or decrease in the potential
for Euro-dollar holdings, however, depends, directly upon U.S. deficits and surplus, respectively.
Euro-Dollar Market
Euro-dollar market is the creation of the international bankers. It is simply a short-term money market
facilitating banks borrowings and lendings of U.S. dollars. The Euro-dollar market is principally located in
Europe and basically deals in U.S. dollars.
But, in a wider sense, Euro-dollar market is confined to the external lending and borrowing of the worlds most
important convertible currencies like dollar, pound, sterling, Swiss franc, French franc, Deutsche mark and the
Netherlands guilder.
In short, the term Euro-dollar is used as a common term to include the external markets in all the major
convertible currencies.
Euro-dollar operations are unique in character, since the transactions in each currency are made outside the
country where that currency originates.
The Euro-dollar market attracts funds by offering high rates of interest, greater flexibility of maturities and a
wider range of investment qualities.
Though Euro-dollar market is wholly unofficial in character, it has become an indispensable part of the
international monetary system. It is one of the largest markets for short-term funds.
The Euro-dollar market has the following characteristics:

1. It has emerged as a truly international short-term money market.
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2. It is unofficial but profound.

3. It is free.
4. It is competitive.
5. It is a more flexible capital market.
Original customers of the Euro-dollar market were the business firms in Europe and the Far East which found
Euro-dollars a cheaper way of financing their imports from the United States, since the lending rates of dollars
in the Euro-dollar market were relatively less.
The Euro-dollar market has two facts:

(i) It is a market which accepts dollar deposits from the non-banking public and gives credit in dollars to the
needy non-banking public.
(ii) It is an inter-bank market in which the commercial banks can adjust their foreign currency position through
inter-bank lending and borrowing.
The existence of Euro-dollar market in a country, however, depends on the freedom given to the commercial
banks to hold, borrow and lend foreign currencies especially dollars and to exchange them at fixed
official exchange rate.
Benefits of the Euro-Dollar Market

Following benefits seem to have accrued to the countries involved in the Euro-dollar market:
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1. It has provided a truly international short-term capital market, owing to a high degree of mobility of the Eurodollars.
2. Euro-dollars are useful for the financing of foreign trade.
3. It has enabled the financial institutions to have greater flexibility in adjusting their cash and liquidity
positions.
4. It has enabled importers and exporters to borrow dollars for financing trade, at cheaper rates than otherwise
obtainable.
5. It has helped in reducing the profit margins between deposit rates and lending rates.
6. It has enhanced the quantum of funds available for arbitrage.
7. It has enabled monetary authorities with inadequate reserves to increase their reserves by borrowing Eurodollar deposits.
8. It has enlarged the facilities available for short-term investment.
9. It has caused the levels of national interest rates more akin to international influences.
Effects of Euro Dollar Market on International Financial System

1. The position of dollar has been strengthened temporarily, since its operations of borrowing of dollars have
become more profitable rather than its holdings.
2. It facilitates the financing of balance of payments surpluses and deficits. Especially, countries having deficit
balance of payments tend to borrow funds from the Euro-dollar market, thereby lightening the pressure on their
foreign exchange reserves.
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3. It has promoted international monetary cooperation.

4. Over the last decade, the growth of Euro-dollar has helped in easing of the world liquidity problem.
Shortcomings of the Euro-Dollar Market

The major drawbacks of the Euro-dollar market may be mentioned as under:
1. It may lead banks and business firms to overtrade.
2. It may weaken discipline within the banking communities.
3. It involves a grave danger of sudden large- scale withdrawal of credits to a country.
4. It has rendered official monetary policies less effective for the countries involved.
In fact, the Euro-dollar market has created two major problems for an individual country dealing in it. Firstly,
there is the danger of over-extension of the dollar credit by domestic banks of the country; consequently, high
demand pressure on the official foreign exchange may take place.
Secondly, the Euro-dollar market appears as another channel for the short-term international capital movement
for the country, so that the countrys volume of outflow or inflow capital may increase which may again
endanger the foreign exchange reserves and the effectiveness of domestic economic policies.
It has destabilisation effect. It increases the pressure on exchange rate and official foreign exchange reserves.
This may require additional liquidity. If such additional reserves are not provided, it may endanger existence of
the present gold exchange standard.
Above all, the Euro-dollar market has caused the growth of semi-independent international interest rates, on
which there can be no effective control by a single country or an institution.
Page 22
The growth of the Eurocurrency markets

The Eurocurrency markets could not develop prior to 1958 since it was only in that year that the major
currencies were made convertible following the Second World War. Even then, they became convertible only
for non-residents.
Restrictions on the resident convertibility of the currency continued in the UK until 1979 and in most of the
other major industrial countries into the 1980s or 1990s. Following the introduction of non-resident
convertibility, major US and European banks began to open branches outside their country of origin. This was
particularly true of US banks because restrictions on branch banking within the US allowed banks to operate
only in their home states. Thus the ambitious banks from the major US financial centres sought expansion
outside the USA.
The opening of bank branches abroad meant that foreign currency earned through ordinary trading transactions
could be placed anywhere where there was a demand for such funds, allowing depositors to seek out banks with
the highest yields. The growth of the market can then be explained by a variety of demand and supply factors
and the interaction between them. The principal causes of the growth in the supply of funds to the market were:
(a) Regular US balance of payments deficits, which produced large dollar holdings by European companies;
(b) US central bank regulations that
(i) established upper limits on the interest rates that could be paid on deposits in US banks and that made it easy
for eurobanks to offer more attractive rates; and
(ii) forbade the payment of any interest on deposits placed for less than thirty days, whereas eurobanks were
able to offer interest even on overnight deposits;
Page 23
(c) The existence of exchange controls that limited the activities of domestic banks but from which eurobanks
were relatively free;
(d) The concern of eastern European countries that their dollar deposits in the USA might be blocked by the US
government for political reasons connected with the then flourishing Cold War;
(e) From 1973 on, the large volume of oil receipts that the OPEC countries wished to deposit on favourable
terms, again preferably outside the USA for political reasons connected with US support for Israel;
(f) The dramatic growth of flight capital to Swiss and other banks, encouraged by the development of financial
centres such as Luxembourg and Liechtenstein in which regulation ensured the protection of the anonymity of
lenders;
(g) The use by central banks of the market in order to increase returns on their holdings of international
reserves. Thus, the supply of funds to the market increased as a result of a mixture of commercial, economic
and political factors. The market would not have grown in the way that it did, however, if there had not also
been a large demand for eurodollars by borrowers. Reasons for this included:
(a) US government discouragement from 1963 onwards of borrowing by foreign companies directly from the
US market through the imposition of a tax (the interest equalization tax) that increased the cost of borrowing in
the USA for borrowers in most of the industrial nations;
(b) The fact that the eurobanks were free of the reserve requirements imposed on domestic banks, allowing
them to maintain a lower spread between borrowing and lending rates (paying higher rates to depositors and
charging lower rates to borrowers);
(c) The invoicing of a growing proportion of world trade in US dollars, increasing the advantage to firms of
holding their working balances for financial and commercial use in dollars in order to avoid exchange rate risk;
Page 24
(d) US government limitations on the amount of capital that US transnational corporations could shift out of the
USA to invest abroad, forcing them to borrow outside the USA and providing the market with a major group of
very credit-worthy borrowers. The eurocurrency market is largely an inter-bank or wholesale market with a
chain of interbank transactions normally occurring en route to an end-user of funds. It deals only in large
amounts, usually of $1 million or more, and loaned are made on an unsecured basis. The size of the sums
involved means that the fixed costs of transactions are spread over large quantities of funds, increasing still
further the attractiveness of the terms the market has been able to offer to both borrowers and lenders.
Efficiency was increased and costs lowered further by rapid improvements in communications and computer
technology.
The nature of the market We have noted that eurocurrencies other than eurodollars exist. Nonetheless, the
market has been dominated by eurodollar deposits. These are typically time deposits for short periods. However,
terms have tended to lengthen over the years, with an increasing amount of intermediate credit. The existence of
differential yields in various financial centres caused arbitrage and interbank activity to become very important
within the market. From the point of view of the domestic economy, the eurocurrency market is a parallel
money market serving as a source of funds for the short-term financing of foreign trade, for banks to make
window-dressing liquidity adjustments at certain times of year and, occasionally, as a major source of finance
for some borrowers (for example, for local authorities and hire purchase companies in the UK). The market is
outside the control of any single country and is largely unregulated. It would, of course, be possible for
individual countries to seek to regulate more thoroughly offshore banks operating from their territories.
However, countries in which the market is important fear that such action would cause the market to move
elsewhere, resulting in a significant loss of invisible earnings to the country in question. Just as most deposits
were for very short to short periods, loans initially tended to be for short periods. However, the needs of
borrowers for loans of longer time periods (eurocredits) was met by the development of rollover loans with a
floating interest rate. In these cases, the borrower typically receives a six-month credit with a guarantee that it
Page 25
will be renewed (rolled over) every six months for the life of the loan, which may be for ten years or longer.
Each rollover is accompanied by adjustment of the interest rate payable to keep it in line with the market
interest rates banks are having to pay on their deposits. Such adjustments are made according to a formula such
as (LIBOR + spread). Box 2 deals with international influences on domestic interest rates. The spread is specific
to each loan to cover the administrative costs of the bank and its gross profit including lending risk (sovereign
risk + default risk). The estimate of the default risk will depend largely on the borrower's credit rating issued by
the international credit-rating agencies, principal among which are the US firms Moody and Standard and Poor.
Because eurocredits tend to be for very large amounts, they are often made by syndication, with a lead bank
acting to co-ordinate a loan from many banks (running sometimes, particularly in the case of sovereign lending,
into the hundreds).
Issues relating to Eurocurrency markets

There has been a considerable debate over the years concerning the extent to which the development of the
eurocurrency market has been a good or a bad thing. The principal argument for the defence is that it has
narrowed the spread between lending and borrowing rates of interest and has provided important hedging
facilities for transnational corporations.
It has thus greatly increased the international mobility of short-term capital and has been a major force for
integrating international capital markets. Supporters also argue that it has played a particularly important role in
the re-cycling of funds from countries with balance of payments surpluses to those in deficit, most notably in
the re-cycling of the surplus of the oil-rich OPEC countries following the large oil price rises of 1973 and 1979.
The case for the prosecution comprises three issues: the contribution of the markets to increased world inflation;
their impact on the ability of national governments to control their own economies; and the threat to stability of
Page 26
the international monetary and credit system. These days, the debate over these issues relates to the whole
system of international finance, not just to the eurocurrency market. The growth of the offshore markets in the
1960s and 1970s and the consequent ability of financiers to avoid the regulations imposed by national monetary
authorities was one of the major factors in the decisions by national monetary authorities in the 1980s to remove
restrictions on convertibility.
This allowed capital to move much more freely from country to country without the necessary intervention of
offshore banking. The inflation argument rests on the view that the eurocurrency market has acted to increase
the stock of international money. The usual form of this argument is through a multiplier model derived from
the domestic bank credit multiplier model for domestic economies and can easily be seen from a consideration
of Box 1.
This view is developed in Box 3 and is contrasted with the alternative portfolio approach. The argument that the
eurocurrency market has reduced the power of governments to control their own economies rests on the
proposition that the rapid movement of capital from one country to another removes the ability of single
countries to determine their own interest rates. Any attempt by governments to control the flow of capital in or
out through capital controls can be avoided with increased ease because of the ability of banks and firms to
move bank deposits around. In the case of developing countries in particular, the eurocurrency market
facilitated capital flight and put great pressure on many governments, forcing them to operate much more
stringent economic policies than would otherwise have been needed. There has also been an argument over the
impact of eurocurrency markets on domestic interest rates.
The standard view in relation to eurodollars has been that the eurodollar market is only a segment of the much
larger market for dollar-denominated deposits and loans and, therefore, eurodollar rates are limited by US rates,
rather than the other way around. According to this view, eurodollar deposits must normally pay an interest rate
at least as high as that in the USA and, thus, that the supply of deposits to eurobanks becomes infinitely elastic
Page 27
at the US deposit rate. Equally, because borrowers consider a loan from a US bank to be as good as, if not better
than, a loan from a eurobank, foreign institutions must offer rates no higher than those charged by US banks.
That is, the demand for Eurodollar loans becomes infinitely elastic at the US loan rate. Indeed, before
corporations became better informed about the euromarkets, eurodollar loan rates had to be noticeably below
US prime-rate loans. Another reason for the decline in differential was that domestic loan practice began to
incorporate the euromarket principles of roll-over, and cost-plus pricing and both markets were influenced by
the fact that the best borrowers had the alternative of borrowing directly by issuing short-term commercial
paper. A differential remained in borrowing rates between the eurodollar and domestic US markets well after it
had disappeared in lending rates.
This is considered in Appendix A. Despite these views on the lack of impact of the eurodollar market on US
interest rates, it has frequently been argued that the eurocurrency market is large relative to most domestic
European markets and consequently is capable of exerting a considerable impact on domestic short-term interest
rates in Europe. The instability argument has two facets. Firstly, the free movement of large amounts of capital
has increased the ability of speculators to mount attacks on currencies within fixed exchange rate systems, such
as the attacks launched against sterling and the lira in September 1992.
It has also increased the volatility of exchange rates of currencies not within fixed exchange rate systems.
Secondly, the fact that the market is largely unregulated and does not have a formal lender of last resort, as in
the case of domestic banking systems, is argued to increase greatly the possibility of bank failure. Further, any
failure of a single bank is likely to have considerable implications for other banks because of the high number
of interbank transactions in the market. In the early years of the international debt crisis of the developing
countries after 1982, there were widespread fears of the failure of several major international banks leading to
the collapse of a large part of the international banking system. Similar fears were expressed following the
Page 28
problems in the newly emerging markets in 1998 (dealt with in Box 4) and the subsequent near-collapse of the
US hedge fund, Long-Term Capital Management. , in September 1998.
On the other hand, it is sometimes argued that banks know that the governments of the industrial countries
cannot afford to let the international banking system collapse and will thus always act to rescue the major banks.
This view goes on to suggest that this increases the feeling of security of banks and encourages them to make
risky loans with high profit potential. Thus, one side of the debate over the causes of the international debt crisis
points to irresponsible behaviour by the banks as a principal factor.

Everything exists for something, likewise the Euro-currency market. Euro-currency market is a market in banks
deposits and loans in currencys that are not the domestic currency of the bank. Euro-banks have some
competitive advantages compared with the domestic banks for the reasons that they do not have the official
regulation and reserve requirements. Furthermore with the economies of scale, the Euro-banks are able to offer
a lower loan interest rate and a higher deposit interest rate against the domestic banks. Thus through the deposits
transaction the Euro-currency market can add the total volume of the world credit. This is known as the function
of credit creation of the Euro-currency market. Moreover, the existence of the Euro-currency market adds the
opportunity for arbitraging and may help banks protect themselves from the forward exchange market.
The Bank for International Settlements (hereafter BIS) 20 years ago defined a Euro-dollar as: a dollar that has
been acquired by a bank outside the United States and used directly or after conversion into another currency
for lending to a non-bank customer, perhaps after one or more redeposits from one bank to another. Basically,
Euro-currency market is a market in interest-bearing bank deposits dominated in currencies other than the
domestic currency of the bank involved2. It is a banking market which involves borrowing and lending
conducted outside the legal jurisdiction of the authorities of the currency that is used. It has two sides to it: the
receipt of the deposits and the loaning out of these deposits. For instance, the Euro-dollar deposits are dollar
Page 29
deposits held in London and Paris; Euro-yen loans are yen loans lent to Germany or Switzerland from British
banks. By far the most important Euro-currency is the Euro-dollar, which currently accounts for approximately
65-70 per cent of all Euro-currency activities, followed by the Euro-mark, Euro-franks (swiss), Euro-sterling
and Euro-yen. The use of the prefix Euro is somewhat misleading because dollar deposits held by banks in
Hong Kong or Tokyo are equally outside the legal jurisdiction of the US authorities and also constitute Eurodollar deposits. This more widespread geographical base means that Euro currency markets are often referred to
offshore markets.
The initial boost of the Euro-currency market trace back to the summer of 1957 with the sterling crisis: the
Bank of England reimposed restriction of sterling financing of the non UK trade. Because UK banks can not use
sterling for external purpose, they resorted to using dollars for their external operations. And the deficit on the
US balance of payments emerged in the late 1950s resulted in increased foreign holdings of dollars. By mid1958, a European market in dollar deposits and loans had become established. 3 There are other causal factors
that induce the development of the Euro-currency market, such as monetary policy and capital control in the
US; the breakdown of the Bretton Woods and the floating of the Exchange rates; recycling and the international
debt crisis and the interbank market and the financial innovation.
The competitive advantages of the Euro-currency market

As the alternative mechanisms of the domestic markets for credit creation and capital movement, Eurocurrency markets must have some competitive advantages. The main reason of the continuing success of Eurobanking despite the relaxation of regulation on US banks is that they are able to offer higher deposit rate and
lower loan rates than US banks, i.e. the interest rate spread is lower for Euro-banks than US banks (shown in the
Figure 1)4.
Page 30
SL
Rate of
Interest
SL
SD
SD
D
DL
O
Volume Ooffofsit
SL: the loan supply of the domestic market;
SL: the loan supply of the Euro-currency market
SD: the deposits supply of the domestic market
SD: the deposits supply of the Euro-currency market
DL: the demand of deposits in the domestic market
AB: interest margin in the domestic market
CD: interest margin in the Euro-currency market
Figure 1
The lower Euro-banks interest margin can be accounted for the following factors:
First, Euro-banks, unlike the US banks have no official regulation. They are not official imposed reserve
requirement on banks foreign currency liabilities. Thus Euro-banks do not need to hold reserve assets. This
means they have a less-constrained asset structure. For example, up until 1990 the Federal Reserve imposed a 3
per cent reserve requirement on US banks so that for every $100 taken in only $97 could be lent out; on an
interest rate of 10 per cent this amounted to a need to charge 10.31 per cent to cover the cost of the reserves.
Second, the economies of scale derived in international business, the more competitive structure of the Eurocurrency market. For the size of the Euro-bank deposits and loans is much greater than that of the domestic
banks, the cost involved with per unit dollar deposit and loan transaction is much lower than that of the
domestic banks.
Page 31
Third, the Euro-banks have a low entry standard which makes the Euro banking business very competitive.
Compared with the Euro-banks, due to the official regulation and reserve requirement imposed from the central
bank, the domestic banks have more to do to cover the high operation cost and transaction cost.
Fourth, unlike the domestic banks which need to pay the deposit insurance to make sure their savings are safe
and thus eliminate the bank panics, the Euro-banks have not to do so.
Finally, in the domestic banking business, the domestic banks may have low quantity customers just like the
ordinary savings and deposits from the residents. But since Euro-currency market is a wholesale market, the
Euro-banks only based on the high quantity customers which means that they can charge a lower risk premium
than the domestic banks do.

Due to the competitive advantages, the Euro-currency market is more efficient than the domestic banking
systems. Thus the significant effects of the Euro-currency market in the modern banking business can be
described in three aspects:
First, the Euro-Currency market has the advantages which guarantee its ability to add to the total volume of
the world credit. This marvelous contribution can be described from the basic operating mechanics of the
market. Assume a company A has a 10 million dollar deposits at a bank in New York and decides to transfer its
dollar deposits to a Euro bank B in London. Thus the balance sheet changes will be shown in the following
table:
Page 32
Liabilities
Net change
Assets
+10m
+10m
+10m
+10m
However the Euro bank B will not hold that deposits in London but in that bank in New York. Therefore at this
point there is no direct effect on the U.S. money supply or volume of the bank deposits since only the ownership
of the deposits has been changed in the transaction. However it has increase the total volume of the world
deposits as the U.S. bank has not lost deposits but the Euro bank has gain a deposit of 10 million dollars which
increase the lending capacity of the Euro bank. Then Euro bank B has to find the customer to lend the deposit
for gaining profit from the differential between the loan-deposit interest rates. Suppose the Euro bank B lends
the deposits on the inter bank market to the Euro bank C. The balance sheet of bank C is just the same as
depicted in the above table and since the bank C will also hold its dollar deposit in the U.S. bank. Thus the total
dollar deposits in the world have no changes but the ownership does. Continuing bank C has to seek to lend the
deposit and by chance a company in France will borrow the deposits and sell it spot for French francs and the
Banque de France will buy the dollar in order to prevent upward appreciation of the Francs. The Banque de
France will hold the dollar deposits in the U.S. banks. If the Banque de France deposits in the euro-currency
market the process will repeated and the multiple creation of the euro market credit will occur.
The key in this case is that the total volume of the world credit increases as the transfer of funds from U.S. to
the euro-dollar market that improve the lending capacity of the euro banks without reducing that of the U.S.
banking system. It also implies increased velocity of the money. Another essential point is that the dollar has
never leave the United States. Moreover in this case, there is a rise in the foreign exchange reserves of the
Banque de France which results the rise in the high-powered money and the money supply in France.
Thus, the euro currency market must have some competitive advantages that enable the euro market to provide
the credit that would not be given by the domestic institutions. Considering this issue, it is suitable to use the
Page 33
analytic framework when discussing the non-bank financial intermediation in two aspects. One is that the Eurocurrency market in the domestic bank deposits in that Euro-market transactions involve changes only in the
ownership but not the total volume of bank deposits. When the transactions happen, though the ownership of the
deposits has changed but the dollar deposits have never leave the U.S. banking system. This is similar to NBFIs
within a country who are lending and borrowing bank deposits. They have borrowed money from the banks but
they also hold the deposits in their banking account, That is to say the money has never leave the banking
system. The other aspect is to say that Euro banks have increased their lending capacity of the credit thus the
total volume of the world credit has increased. This is quite the same as the NBFIs.
Thus the methodology in analyzing the Euro-currency market is that of non-bank financial intermediation.
Basically the same as the NBFIs, if any of the following conditions is fulfilled, the credit generated within the
Euro-currency market adds to the total volume of credit:
(1)The internal efficiency enables Euro currency market to serve a small margin. As analyzed in Figure 1, the
competitive advantages give the Euro banks ability to serve a lower lending interest rate than domestic banks
can. Since the demand of the credit is sensitive to the lower lending interest rates charged by the euro banks
compared with lending rate in national banking systems, the lending capacity of the euro banks is more
powerful than that of the domestic banks.
(2) The competitive advantages of the euro banks forces domestic banks lending interest rates to be lower.
Thus again the case in (1) that the demand of credit will be sensitive to the lower lending interest rates which
undoubtedly will increase the total volume of the world credit.
(3) Resulting from the case discussed before, in general, borrowing from the euro-currency market, with the
funds switch to some other currency, leads a rise the external component of high-powered money through
central bank foreign exchanged market intervention. Thus because of the interventionbuying dollar
deposits/selling the domestic currency, the money supply of the central bank will increase and also the high-
Page 34
powered money. Therefore banks will receive more deposits which will raise the lending capacity of the
domestic banks. And the total volume of the credit in that country will increase.
(4) Identically, if the U.S. residents are facing an excess demand of credit which will drive up the lending
interest rates, they will excess into the euro currency market to borrow the money for the lower lending interest
rates compared with the domestic banks. Also, if the U.S. residents face another situation of the higher
creditworthiness criteria which means they encounter a high requirement for the borrowing, they will borrow in
the euro currency market.
(5) Actually due to the competitive pressure, Euro banks create a demand of credit that otherwise will not
occur. This is the case in early 1970s, the euro banks were inducing developing countries to borrow in the euro
currency markets on a larger scale than they had initially planned.
(6) The volume of the world credit will increase to the extent that capital flows through the euro markets from
countries where the banking system has an excess demand of funds to those having excess supply of the money.
This is to say that without the role euro currency market as the intermediation, the credit effect of increasing the
total volume of the world credit will not exist.
Moreover, Euro-currency market increases the arbitrage opportunity. Normally, arbitrage involves in two
different currencies, for instance, one investor may arbitrage between sterling and dollar. However, the
existence of Euro-currency market changes this situation. The arbitrage between two different currencies is only
one possibility. The reason for that is after the emergence of the Euro-currency market; there may be two dollar
markets in which one is the dollar deposits in Untied States and the market of Euro dollars in London. Thus the
arbitrage can happen between the US dollars and the London dollars. This is to say arbitrage may not always
involve in different currencies, but it may involve in the same currency between two different locations. Also
for example, there are Euro-dollar market, Euro-sterling market, Euro-frank market and Euro-yen market in
London. This add an another arbitrage possibilityarbitrage between different currencies in the same
location.
Page 35
Thirdly, the Euro-currency market is an important mechanism that banks protect themselves by acting as a
market maker in forward exchange market. As a market maker in forwards, banks involve themselves in the
forward exchange risk. However the reason for that is they can protect themselves through the Euro-currency
market operations. For instance, suppose a corporation A wants to sell a Japanese Yen forward to the bank, in
another word, a bank had to purchase a forward of Japanese Yen of three months and promise to give dollars at
a fixed price agreed today, the banks thus immediately face an exchange rate risk in case Japanese Yen are going
to be appreciated in three months. To avoid such risk, the bank then does the following transactions: firstly, it
borrows Japanese Yen in the Euro-yen market at an interest rate of 5%, Then it sell Japanese Yen spot for
dollars. Finally, it invests these dollars to euro-dollar market at, say at a rate of 7%. By making the above
transactions, the bank has a totally balanced and riskless position in forward exchange markets.
Finally, due to their worldwide locations and national origin, the Euro-banks always engaged in a more wide
range of banking business with the counterparties such as the government, financial institutions and private
investors. Without the constraints in the regulation and creditworthiness criteria, the Euro-banks can allocate
their funds more productively and more efficient compared with the domestic banks. This may create a fruitful
profit for the Euro-banks in doing the modern banking business and may involve in some special loans for the
special purpose.
The Eurocurrency market and Inflation

A. The bank multiplier approach
Page 36
This can be derived from Box 1. It is clear that the loans of the 1st Sunshine Bank are unaffected by
subsequent eurobank activity. However, on the basis of a single deposit (that of Gascoigne plc), the
eurobank system generates additional lending to Babe Struth Inc. and this in turn leads to extra
expenditure. Where the recipients of Babe Struth's expenditure re-deposit in a eurobank, another round
of expenditure takes place. Thus, it is argued that there is a multiplier in operation and the size of the
multiplier will depend on the extent to which the original eurobank loans are re-deposited in other
eurobanks.
It is usually accepted that most eurobank loans are deposited, rather, in domestic banking systems,
bringing the process to a halt. In other words, the re-deposit rate within eurobanks is held to be small
and hence the multiplier is thought to be quite small - perhaps around 1.25. Even a small multiplier,
however, supports the view that the eurocurrency market has caused a growth in the world money stock
and has thus contributed to inflation.
B. The portfolio approach
Essentially, this is based on the view that eurobanks can only lend if someone wishes to borrow.
Borrowers, in turn, will be influenced by prospects of profits on investments undertaken with borrowed
funds and the rate of interest payable on loans. Eurobanks will not influence the first of these two. Thus,
to the extent that they also do not influence interest rates, any loans made to endusers by eurobanks
would have been made in any case. All that has happened is that borrowers have moved from one source
of funds to another. The eurobanks therefore cannot create credit. As long as there is a stable demand for
and supply of deposits, expansion within the eurobanks will be balanced by contraction elsewhere.
The weakness of this approach as we have suggested is that:
Page 37
(i)
the eurobanks have allowed restrictions elsewhere in the financial system to be avoided,
increasing the effective demand for and supply of deposits; and
(ii)
(ii) by lowering borrowing rates and reducing the spread between borrowing and lending rates,
they have encouraged borrowing.
Euro Bonds
Eurobonds are today a subject of heated debate among euro area policy makers when trying to find a proper exit
to the present Euro sovereign debt crisis, even if it is quite clear that they have more pros than cons. There is
wide agreement on the fact that, in the medium term, Eurobonds are going to be the key element for the success
of the euro area and of the euro. But, in the short term, they may be difficult to implement until those Member
States with the highest credit rating feel comfortable with a new and stricter fiscal framework for the euro area
which avoids moral hazard by any euro area Member State or, even better, a proper design of Eurobonds which
also would avoid moral hazard. The present euro sovereign debt crisis is mainly the result of a poor and badly
designed fiscal governance of the euro area which was criticised, from the very beginning, by a large majority
of academics who saw the potential dangers of having a monetary union without even a light fiscal union or a
large fund to attend to asymmetric shocks, being real or financial. These dangers have lately become apparent
for financial markets, which have lost trust in the future of the euro area and are even showing doubts about the
survival of the euro as it is designed today. This lack of trust may become endemic unless the euro area leaders
come with solutions that can regain their confidence, which is not being the case today and, unfortunately, the
inflexible attitude of a minority of Member States could end up producing even greater mistrust by markets
unless a reasonable solution is agreed at the end of March. Going forward, Eurobonds are going to be essential
to regain confidence from the markets and from the large majority of euro area citizens. Eurobonds already
exist, given that the EFSF bond issues are practically the same except that their guarantee is proportional to the
Member States participation in the capital of the ECB and is not a joint guarantee, a feature proper Eurobonds
Page 38
need to have for being successful. The quickest way to avoid moral hazard is a full fiscal union where high debt
Member States loose fiscal sovereignty, but, at the same time, the best way to reach in the future a fiscal union
is by making more debt partially guaranteed by an increasing number of euro area Member States. This way
would produce the right incentives to get present levels of debt down and a common fiscal policy and not the
other way round.
PROS AND CONS OF EUROBONDS
Benefits
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 selffulfilling 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.
Costs
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
Page 39
an implicit guarantee (when they could only issue too little debt before the existence of the Eurobond) 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. Eurobonds - concepts and implications.
Euro Equity
Newly public companies that want to raise more money tend to issue this type of stock. Euro equity is a term used to
describe an initial public offer occurring simultaneously in two different countries. The company's shares are listed
in various countries rather than where the company is based. This method differs from cross-listing where company
shares are listed in the home market and then listed in a different country. Euro equities are sometimes European
securities
sold
on
several
national
markets.
The Eurobond and euro note markets

A Eurobond is a debt security handled internationally by syndicates, groups of bankers and/or brokers who
underwrite and distribute new issues of securities or large blocks of outstanding issues. It is typically in bearer
(non-registered) form and is issued outside the country of the currency in which it is denominated. Borrowers
and lenders are spread around the world, while the intermediaries are spread around Europe, with the majority
of business being done from London. The market was founded in the early 1960s and has provided a
Page 40
competitive source of funding for borrowers who can tap discreet but important sources of finance. Japanese
banks, pension funds and insurance companies have become important lenders in recent years and there are still
plenty of wealthy individuals who prefer the anonymity offered by bearer securities. The eurobond market is the
world's second-largest securities market after the US bond market in terms of trading volume and the third
largest after the US and Japanese bond markets in terms of debt outstanding. Conventional eurobonds consist of
straights and convertibles. Straights are normal bonds that carry unquestioned rights to the repayment of
principal on a specified future date, and to fixed interest payments on stated dates. They do not carry rights to
any additional interest, principal or conversion privilege. Convertibles are bonds that can be converted from one
form into another. In euromarket usage, the conversion is into ordinary shares at a specified future date and at a
pre-determined price, set when the bond is issued (usually at a premium to the current share price). Interest rates
are usually lower on convertibles because lenders are attracted by the possibility of being able to buy shares at a
favourable price. In recent years, many other forms of security have developed. These have included floating
rate eurobonds and dual currency bonds. Floating rate eurobonds are popular with investors seeking the
protection of capital. Interest rates are re-fixed every three or six months, removing the threat to capital value
posed by very volatile interest rates. Thus, most floating rate eurobonds are bought by banks anxious to lock
into assets with a yield greater than, but calculated in the same way as, the cost of their funds in the money
markets: as in the case of rollover eurocurrency loans, floating rate eurobonds generally have their coupons set
in terms of a percentage margin over LIBOR. Issues of floating rate eurobonds (floaters) grew greatly during
the 1980s, largely due to the increased need for banks to buy assets with low credit risk as other lending,
notably sovereign lending to developing countries, became more risky. At the same time, many borrowers found
floaters a much cheaper form of borrowing than syndicated credit and have used them to repay their loans early.
This has added to the banks' demand for them by taking other loans off their books. The average life of issues
increased from 9.7 years in 1978 to over 12 years by 1984, partly as the result of the issue of perpetual with no
final maturity. Many variations on floating rate Eurobonds have developed including flip-flop options, which
allow the investor to switch from undated perpetual into a four-year floater paying a lower rate of interest, while
Page 41
maintaining the right to switch back again into the perpetual issue. Dual currency bonds are usually issued in a
currency other than US dollars (most commonly Swiss francs), with the coupon denominated in that currency,
but the bond repayable in dollars. The coupon interest rate is usually greater than it would otherwise be because
the lender assumes a forex risk. For example, consider a one-year Australian dollar bond with an option to repay
in US dollars. Assume a current exchange rate of $A1 = $US0.7, an exercise price of 72 cents and a coupon rate
of 8 per cent against the 5 per cent available on an ordinary one-year bond. If, at the end of the year, the
Australian dollar has appreciated, the borrower will repay in US dollars; if it has depreciated, repayment will be
in Australian dollars. Reverse dual currency bonds have also been issued with the bond payable and the coupon
rate denominated in US dollars but repayable in other currencies. Sometimes borrowers are given the option of
repaying
in
any
one
of
number
of
currencies.
Conclusion
The foreign exchange market, also known as the forex, FX, or currency market, involves the trading of one
currency for another. The most important Eurocurrency is the Eurodollar. It is followed by the Euro mark, Euro
Page 42
franc (Swiss), Euro sterling and Euro yen. Initially, only the dollar was used in this fashion, and the market was
therefore called the Eurodollar market. Subsequently, the other leading currencies such as the German mark, the
Japanese yen, the British pound sterling, and the French and Swiss franc, also began to be used in this way.
Thus the market is now called the Euro currency market. The main reason for the rapid growth of Euro currency
markets is that they provide better deposit and loan rates than offered by domestic banks located in the country
that issues the currency. Due to the competitive advantages, the Euro-currency market is more efficient than the
domestic banking systems. Considering this issue, it is suitable to use the analytic framework when discussing
the non-bank financial intermediation in two aspects. One is that the Euro-currency market in the domestic bank
deposits in that Euro-market transactions involve changes only in the ownership but not the total volume of
bank deposits. Eurobonds are today a subject of heated debate among euro area policy makers when trying to
find a proper exit to the present Euro sovereign debt crisis, even if it is quite clear that they have more pros than
cons. There is wide agreement on the fact that, in the medium term, Eurobonds are going to be the key element
for the success of the euro area and of the euro.
Also Euro currency market has economic significance. The Euro-currency market is an important mechanism
that banks protect themselves by acting as a market maker in forward exchange market. As a market maker in
forwards, banks involve themselves in the forward exchange risk. However the reason for that is they can
protect themselves through the Euro-currency market operations. Without the constraints in the regulation and
creditworthiness criteria, the Euro-banks can allocate their funds more productively and more efficient
compared with the domestic banks. This may create a fruitful profit for the Euro-banks in doing the modern
banking business and may involve in some special loans for the special purpose.
References
1. Economics of Global Trade and Finance Mcom part 1 semester 1 and 2,Manan Prakashan publications.
Page 43
2. Clarke, William, the City in the World Economy, London, Institute of Economic Affairs, 1965.
3. Friedman, Milton, "The Euro-Dollar Market: Some First Principles," Morgan Guaranty, Survey (October
1969), pp. 4-14. Gurley, J. G., and E. S. Shaw, Money in a Theory of Finance, Washington, The Brookings
Institution, 1960.
4. Aliber, Robert Z., "The Interest Rate Parity Theorem: A Reinterpretation," Journal of Political Economy, 81
(November/December 1973), pp. 1451- 1459.
Page 44

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Geographical Extent of the Foreign Exchange Market

Functions of foreign exchange market

Euro currency, euro currency market

Euro dollar, euro dollar market

Characteristics of euro dollar market

Benefits of euro dollar market

Effects of Euro Dollar Market on International Financial System

Shortcomings of the Euro-Dollar Market

The growth of the Eurocurrency markets

Issues relating to Eurocurrency markets

The competitive advantages of the Euro-currency market

Pros and Cons of Euro Bonds

Mcom SEM 2 (Economics)

Geographical Extent of the Foreign Exchange Market

The Size of the Market

The participants in the foreign exchange market comprise;

Mcom SEM 2 (Economics)

Functions of the Foreign Exchange Market

Transfer of Purchasing Power:

Minimizing Foreign Exchange Risk:

Foreign Exchange Dealers:

Participants in Commercial and Investment Transactions:

Speculators and Arbitragers:

Mcom SEM 2 (Economics)

Central Banks and Treasuries:

Transactions in the Interbank Market

Outright Forward Transactions:

Mcom SEM 2 (Economics)

Euro Currency Market

Mcom SEM 2 (Economics)

The Euro-dollar market has the following characteristics:

2. It is unofficial but profound.

The Euro-dollar market has two facts:

Benefits of the Euro-Dollar Market

Mcom SEM 2 (Economics)

Effects of Euro Dollar Market on International Financial System

3. It has promoted international monetary cooperation.

Shortcomings of the Euro-Dollar Market

The growth of the Eurocurrency markets

Mcom SEM 2 (Economics)

Mcom SEM 2 (Economics)

Mcom SEM 2 (Economics)

Issues relating to Eurocurrency markets

Mcom SEM 2 (Economics)

Mcom SEM 2 (Economics)

The economic significance of the Euro-currency market

The competitive advantages of the Euro-currency market

Mcom SEM 2 (Economics)

The economic significance of the Euro-currency market

Mcom SEM 2 (Economics)

Mcom SEM 2 (Economics)

The Eurocurrency market and Inflation

Mcom SEM 2 (Economics)

Mcom SEM 2 (Economics)

The Eurobond and euro note markets

Mcom SEM 2 (Economics)

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