In most countries, local corporations must often borrow short-term funds to support their operations. Country governments may also need to borrow short-term funds in order to finance their budget deficits. A money market facilitates the process by which surplus units (individuals or institutions with available short-term funds) can transfer funds to deficit units (institutions or individuals in need of funds). Financial institutions such as commercial banks accept short-term deposits and redirect the funds toward def- icit units. In addition, corporations and governments may issue short-term securities that are purchased by local investors.
The growth in international business has led to the corporations and governments of a given country needing short-term funds denominated in a currency other than their own, home currency. First, they may need to borrow funds to pay for imports denomi- nated in a foreign currency. Second, even if funds are needed to support local operations, they may consider borrowing in a nonlocal currency featuring lower interest rates. This strategy is especially appropriate for firms expecting future receivables denominated in that currency. Third, they may consider borrowing in a currency that will depreciate against their home currency, since this would enable repayment of the loan, over time, at a more favorable exchange rate. In this case, the actual cost of borrowing would be less than the interest rate quoted for that currency.
At the same time, some corporations and institutional investors have incentives to invest in a foreign currency. First, the interest rate receivable from investing in their home currency might be lower than what could be earned on short-term investments denominated in a different currency. Second, they may consider investing in a currency that will appreciate against their home currency because then, at the end of the invest- ment period, they could convert that currency into their home currency at a more favor- able exchange rate. In this case, the actual return on their investment would be greater than the interest rate quoted for the foreign currency.
The preferences of corporations and governments to borrow in foreign currencies and of investors to make short-term investments in foreign currencies resulted in the creation
of the international money market. The intermediaries serving this market are willing both to accept deposits and provide loans in various currencies. These intermediaries typically serve also as dealers in the foreign exchange market.
3-2a Origins and Development
The international money market includes large banks in countries around the world.
Two other important components of this market are the European money market and the Asian money market.
European Money Market As MNCs expanded their operations in the 1970s, international financial intermediation emerged to accommodate their needs. Because the U.S. dollar was widely used even by foreign countries as a medium for international trade, there was a consistent demand for dollars in Europe and elsewhere. To conduct international trade with European countries, corporations in the United States deposited U.S. dollars in European banks. The banks accepted the deposits because they could then lend the dollars to corporate customers based in Europe. These dollar deposits in banks in Europe (and on other continents) are known asEurodollars(not to be confused with theeuro,which is the currency of many European countries today).
The growing importance of the Organization of the Petroleum Exporting Countries (OPEC) also contributed to the growth in Eurodollar deposits. Because OPEC generally requires payment for oil in dollars, the OPEC countries began to deposit a portion of their oil revenues in European banks. These dollar-denominated deposits are sometimes referred to aspetrodollars. Oil revenues deposited in banks have sometimes been lent to oil-importing countries that are short of cash. As these countries purchase more oil, funds are again transferred to the oil-exporting countries, which in turn creates new deposits. This recycling process has been an important source of funds for some countries.
Multinational corporations also use other widely traded currencies (such as the British pound) in their European transactions, and these other currencies are deposited for the short term in European banks by some MNCs and then borrowed for short-term periods by other MNCs. Banks serve as the European money market’s financial intermediaries by accepting short-term deposits and providing short-term loans in various currencies.
These European banks also lend to each other in an interbank market whenever some banks have a surplus of funds (from deposits) relative to their volume of loans while other banks need more funds to accommodate loan requests from MNCs and/or govern- ment agencies.
The London Interbank Offer Rate (LIBOR)is the rate most often charged for very short-term loans (such as for one day) between banks. The LIBOR varies among curren- cies because both the market supply of and market demand for funds vary among cur- rencies. As the supply and demand for funds changes, so does the LIBOR.. The term LIBOR is commonly used even though many international interbank transactions do not pass through London. Since the euro is now the currency of many European coun- tries, it is the main currency for interbank transactions in most of Europe. Hence the
term“euro-bor”is widely used to reflect the interbank offer rate on euros.
The official LIBOR was historically measured as the average of the rates reported by banks at a particular time. The prices and performance of most of these banks’positions in loans and derivative securities are affected by LIBOR. Many types of financial transac- tions have a floating value or interest rate that is tied to a market interest rate, and LIBOR (or some offset from LIBOR) is typically specified as the market interest rate for those transactions. In 2012, country governments detected that some banks were falsely
reporting the interest rate they offered in the interbank market in order to manipulate LIBOR and thereby boost the values of their investments that were tied to LIBOR. This scandal prompted financial markets to devise ways of establishing the market interest rate that do not rely on the rates reported by participating banks.
Asian Money Market Like the European money market, theAsian money market originated as a market involving mostly dollar-denominated deposits; in fact, it was origi- nally known as the Asian dollar market. This market emerged to accommodate the needs of businesses that were using the U.S. dollar (and some other foreign currencies) as a medium of exchange for international trade. These businesses could not rely on banks in Europe because of the distance and different time zones. Today, the Asian money market is cen- tered in Hong Kong and Singapore, where large banks accept deposits and make loans in various foreign currencies. The major sources of deposits in this market are MNCs with excess cash and government agencies. Manufacturers are major borrowers in this market.
Banks within the Asian money market usually lend to each other when some banks have excess funds and other banks need more funds. The Asian money market is inte- grated with the European money market in that banks in Asia lend to and borrow from banks in Europe.
3-2b Money Market Interest Rates among Currencies
The money market interest rates in any particular country depend on the demand for short-term funds by borrowers relative to the supply of short-term funds provided by savers. In general, a country that experiences both a high demand for and a small supply of short-term funds will have relatively high money market interest rates. Conversely, a country with both a low demand and a large supply of short-term funds will have rela- tively low money market interest rates. Money market rates tend to be higher in devel- oping countries because they experience higher rates of growth and so more funds are needed (relative to the available supply) to finance that growth.
Quoted money market interest rates for various currencies are displayed in Exhibit 3.4.
Notice how the money market rates vary substantially among some currencies. This variance is due to differences in the interaction between the country’s total supply of short-term funds available (bank deposits) and that country’s total demand for short- term funds by borrowers.
Normally, the money market interest rate paid by corporations that borrow short- term funds in a given country is slightly higher than the rate paid by that country’s national government. The rate paid by the government is considered to be a risk-free rate by investors who believe there is no risk of the government defaulting on the funds it borrows. Corporations pay a higher rate because investors who supply the funds require it to reflect the risk of corporate default on the borrowed funds.
Global Integration of Money Market Interest Rates Money market interest rates among countries tend to be highly correlated over time because conditions that affect the supply and demand for short-term funds tend to change in a similar manner among countries. When economic conditions weaken in many countries, the corporate need for liquidity declines and so corporations reduce the amount of short-term funds they wish to borrow. Then the aggregate demand for short-term funds and also money market interest rates will decline in many countries. Conversely, when economic condi- tions strengthen in many countries, there is an increase in corporate expansion and so corporations need additional liquidity to support their expansion. Under these condi- tions, the aggregate demand for funds (and also money market interest rates) will rise in many countries.
Risk of International Money Market Securities When MNCs and govern- ment agencies issue debt securities with a short-term maturity (one year or less) in the international money market, these instruments are referred to as international money market securities. Normally these securities are perceived to be very safe, especially when they are rated high by rating agencies. And because the typical maturity of these securities is one year or less, investors are less concerned about the issuer’s financial condition dete- riorating by the time of maturity than if the securities had a longer-term maturity. How- ever, some international money market securities have defaulted, so investors in this market need to consider the possible credit (default) risk of the securities that are issued.
International money market securities are also exposed to exchange rate risk when the currency denominating the securities differs from the investor’s home currency. Specifi- cally, the return on investment in the international money market security will be reduced when currency denominating the money market security weakens against the home currency. This means that, even for securities without credit risk, investors can lose money because of exchange rate risk.