Fundamentals of Financial Instruments - Sunil K. Parameswaran

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was a legitimate fear that such deposits could be impounded by the US government. Thus, these countries began depositing their dollars with European banks. As trade grew, the European banks soon discovered that there was a ready demand for these dollars by parties based outside the United States. As a consequence, an active Eurodollar market came into existence.

       Due to capital market controls imposed by the US government. In the 1960s, through a legislation called regulation Q, the US government imposed low interest rate ceilings on US banks, and simultaneously imposed significant reserve requirements.

      An interest ceiling meant that banks could not offer depositors more than the rate that had been mandated by the law, even if prudent business practices required them to do so. The implications of bank reserves may be explained as follows. When a unit of currency is deposited with a bank, only a fraction of it can be lent out. The balance has to be kept either in the form of approved securities or as cash. This amount is known as a reserve. The lower the reserve ratio, the more will be the money available with the bank for commercial lending. Consequently, the lower the reserve ratio, the higher will be the rates paid on deposits and the lower will be the lending rates, for the larger the amount of funds available for lending, the smaller will be the net interest margin that banks can afford to operate with.

      As a consequence of these two factors, depositors became reluctant to park their funds with American banks, for these institutions could not offer attractive interest rates. At the same time, borrowers too were disenchanted, for the rates on loans were very high.

       Lack of government regulations on Eurodollar deposits: Eurodeposits are relatively unregulated. For instance, the Federal Reserve, which is the central bank of the United States, does not regulate dollar deposits maintained outside the borders of the United States. Besides, such deposits do not suffer from statutory reserve requirements. Even if there is no statutory reserve requirement, however, banks by themselves usually maintain voluntary reserves as a measure of caution.

       Due to the large flow of Petrodollars into international banks from the Oil Producing Export Countries (OPEC): There was a war in the Middle East in 1973 after which the oil-exporting countries recognized the full worth of their oil reserves as an economic weapon. Rising crude oil prices ensured that these countries were flush with funds, and the Euromarket, due to its lack of reserve requirements, and relatively low cost of operation due to economies of scale, was instrumental in recycling these so-called Petrodollars.

      The international bond market provides borrowers with a source of medium- to long-term funds. Borrowers include multinational corporations, domestic corporations, governments, national, and supranational financial institutions. It gives investors in the debt markets a way to diversify their portfolios over several different currencies. We have already highlighted the wisdom of not putting all one's eggs in one basket. But it is not necessary that all the securities chosen should be from the same country. Transnational diversification enables investors to take the diversification process a step further. The market consists of two broad segments: Eurobonds and Foreign Bonds.

      A bond denominated in the currency of the country in which it is sold, but issued by an entity from a foreign country, is called a foreign bond. For example, if a US company were to sell yen-denominated bonds in Japan, it would be classified as a foreign bond.

      Thus, bonds may be classified into three categories: domestic bonds, foreign bonds, and Eurobonds. If Sony were to issue yen-denominated bonds in Japan, it would be categorized as a domestic bond, for the issuer and the currency of issue are local. But if IBM were to issue yen-denominated bonds in Japan, it would come under the category of a foreign bond. This is because although the currency is local, the issuer is from a foreign country. Finally, if either IBM or Sony were to issue US dollar–denominated bonds in Japan, it would be categorized as a Eurobond issue, because the currency is foreign. In this case, the nationality of the issuer is irrelevant.

      Foreign bonds are known by nicknames. Bonds sold in the United States are called Yankee bonds; those sold in Japan are called Samurai bonds; and those sold in the United Kingdom are called Bulldog bonds.

      The Eurobond market has grown much more rapidly than the foreign bond market. This is due to several reasons.

      Eurobond issues are not subject to the regulations of the country in whose currency they are denominated. Consequently, they can be brought to the market quickly and with less disclosure. This gives the issuer of the bonds greater flexibility to take advantage of favorable market conditions. Consider a bond issue from the issuers' perspective. The greater the regulations, the greater the time lag between planning and implementation; thus there is a greater chance of missing favorable market conditions. Consequently, issuers, and the investment banks that advise them, prefer markets characterized by minimal regulations. On the other hand, domestic securities issues are regulated by the market regulator of the country. In the United States it is the Securities and Exchange Commission (SEC).

      The origin of the Eurobond market was fueled by the imposition of a tax called the Interest Equalization Tax, which was imposed by the US government in 1963 on the interest received by American investors from Yankee bonds. What had happened was that due to the interest rate ceiling in the United States, domestic institutions were unable to pay a high rate of interest to investors. Foreigners sought to take advantage of this situation by issuing Yankee bonds with relatively higher rates of return. The objective of the Interest Equalization Tax was to ensure that American investors did not perceive Yankee bonds to be attractive, despite their higher interest rates. The motivation for this measure was to arrest the perceived flight of capital from the United States. As a consequence, foreigners were forced to relocate their dollar borrowings to outside the United States.

      Because of their unique features, investors are willing to accept a lower yield from Eurobonds than from other securities of comparable risk, but which lack the favorable tax status.

      Eurobonds are not usually registered with any particular regulatory agency but are, however, listed on a stock exchange, typically London or Luxembourg. Listing is done not so much for the purpose of facilitating trading, but to circumvent restrictions imposed on certain institutional investors like pension funds, which are prohibited from purchasing unlisted securities. Most of the trading in Eurobonds takes place OTC.

      Compared to debt markets, equity markets have been relatively slow to globalize. However, the winds of change are blowing across the world and markets are increasingly becoming modernized as well as integrated. The doctrine of LPG – Liberalization, Privatization, and Globalization – is gaining currency across the world. New developments in communications technology, coupled with deregulatory changes, and greater awareness of the benefits of international portfolio diversification on the part of investors, have led to rapid integration of equity markets

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