Research Title:
Economics/Finance
(1) An explanation of the factors that 'may' cause eurocurrency
interest rates to differ from 'equivalent' domestic money
market rates (numerical explanation helpful).
(2) Also, the relationship between different eurocurrency
interest rates and the relevant spot and forward market exchange
rates. The consequences of a disturbance to the relationship
in (2) caused by an unexpected change in a country's base
rate (considering the equilibrium adjustment process in terms
of the market responses of both international lenders and
borrowers).
Two important factors differentiates the Eurocurrency
market form the domestic financial market. 
" The transaction cost and the information costs are
smaller in the Euromarkets than the national financial markets.
There are several reasons for this. But the most important
one is the huge volume of transactions that take place in
the Euromarkets. There are also a huge number of institutional
investors. Transaction costs associated with this kind of
volumes not only become insignificant in relative terms, but
also diminish in absolute terms because of the economies of
scale .the financial innovations associated with these low
transaction costs have made a huge qualitative appeal for
the Eurocurrency market
" The second major difference between the domestic and
the Eurocurrency market leis in the governments regulations
.The Euromarkets are commonly be exempt from regulations such
as reserve requirements and the interest rate ceilings.
The factors that create interest rate differential between
the domestic and Eurocurrency markets
" Interest Rate ceiling on the domestic deposits:
The differential domestic interest rates create within the
Eurocurrency markets can create a differential interest rate
set-ups within the Eurocurrency zone.
" Reserve requirements on domestic deposits: the differential
requirement in the domestic deposits i.e. the cash reserve
ratios, capital adequacy ratios can create a differential
interest rate set ups within the Eurocurrency zone.
" Insurance premium on domestic deposits: the differential
in the insurance premium in the domestic deposits can create
an interest rate differential between the domestic and Eurocurrency
markets.
" Marginal reserve requirements on accepting deposits
from abroad: the differences in the guidelines among different
countries within the Eurocurrency zone create interest rate
differential between the domestic and Eurocurrency markets
" Intervention of the central bank exclusively in the
domestic market as opposed to the Euromarkets (like Banque
de France)
" Capital Controls: Restrictions on residents to lending
to the Euromarkets differential in the transaction cost including
the communication and brokerage fee: this offers a vital source
in the interest rate differential between the domestic and
Eurocurrency markets .The difference in the transaction cost
change the real interest rate in domestic countries and the
fixed rate of interest that is
" Difference in the Forward exchange rates and the exchange
rate expectations: the difference in the forward exchange
rates and the expected rates create an interest rate differential
between the domestic interest rate and the Eurocurrency interest
rates. The effect in these interest rates may lead to the
arbitrage opportunities in the markets. But the subsequent
changes in the forward exchange rates and the expected changes
in the forward exchange rates nullify all the arbitrage opportunities
that may have arrived because of the change.
The relationship between Eurocurrency interest rates and
the relevant spot and forward market exchange rates.
Discussion of the forward exchange market traditionally takes
place under the assumption that it is the forward rate rather
than the interest rate that adjusts to maintain parity In
the event of a change in the foreign interest rate; interest
rate parity is restored by the change in the changes in the
forward premium. Allowing the new interest rate differential
to be maintained at least in the short run. Only in a situation
of full long run equilibrium, where the interest rate differential
has to reflect the inflation differential between the two
countries, is the adjustment of the domestic interest rate
considered. In the long run it is difficult to continue to
support an interest rate differential however we should not
assume that forward premium will definitely adjust in the
short run t balance the changes in the interest rate as that
will preclude short run interdependence .The expectations
effect can lead to the lowering down of the Eurocurrency market
as well .For example in 1979 when the abolition of exchange
controls and realization of the arbitrage became more efficient,
the subsequent changes in the interest rate in the US has
made lowering of the UK interest rate.
The consequences of a disturbance to the Eurocurrency interest
rate and the spot and forward exchange rates caused by an
unexpected change in a country's base rate:
In the Theoretical world when the interest rate change in
a domestic currency leads to a disturbance in the interest
rate parity relation by some exogenous shock, one or more
of the following adjustments can take place
" A change in the domestic interest rate
" A change in the foreign interest rate
" Change in the foreign exchange rate
" A change in the spot exchange rate
If we assume a situation where a differential opens or widens
in favour of the UK Assets, then we can see that the investors'
portfolios are in disequilibrium. Investors will try to conduct
change in their portfolios in response to this differential
The spot rate of the domestic currency appreciates as the
investors move into the GBP (Great Britain Pound) assets;
the forward exchange rates depreciates as they sell the GBP
forward to cover the investments in GBP .The UK interest rate
falls a s the funds are invested in UK and the foreign interest
rate may rise as the funds move out of the foreign centre
.the extent of the rise in the foreign interest rate deepens
on the depth of the foreign centre .If the foreign investments
have come from USA , then the change is expected to be quite
small as the huge depth in the money market of the USA .
If we assume that the interest rates and the spot exchange
rates are exogenous and given, then we could say that if a
differential opens up or widens because of an exogenous shock
in the country's' base rate, the forward exchange rate will
adjust itself to eliminate the differential and hence the
arbitrage opportunities that may have arisen because of this
differential. The change in the forward rates will adjust
itself swiftly to nullify all these arbitrage opportunities.
By allowing the interest rate differential to exist and by
neutralising all the arbitrage opportunities the adjustments
of the forward exchange rates allows a measure of independence
for monetary policy. The changes in the interest rates and
the shocks in the equilibrium thus do not affect the monetary
policies to a huge extent.
In case of fixed spot exchange rates and fixed forward exchange
rates in the Eurocurrency markets, the interest rate will
adjust to meet the change in the domestic interest rate occurred
in response to the shock to attain the equilibrium.
In case of fixed spot exchange rate and floating forward
exchange rate in the Eurocurrency market for example in UK,
and there is a differential opens up in the market because
of the shock, then the arbitrage opportunities will allow
the investors to invest in GBP and it will put pressure on
GBP to appreciate .The authorities have to intervene to sell
spot GBP to maintain the spot exchange rate and to prevent
appreciation, the free forward market will appreciate according
to the differential and there could be another gap opening
up in the spot and the forward rates forcing the authorities
to adjust the spot rate.
Thirdly in case of free spot exchange rate and free forward
exchange rate, the difference in the interest rates can be
maintained in the short run as the spot exchange rates and
the forwards exchange rates will adjusts themselves to maintain
the differential without any arbitrage opportunities to counter
the shocks.
The present scenario in Eurocurrency & the Domestic
interest rates & Conclusion .
Looking at the interest rates in this table, we can see the
way the interest rates are integrated in the Eurocurrency
market vis a vis the domestic market .If we look at the shocks
in the global markets due to the recent events there has been
the adjustments in the forward and the spot exchange rates
to neutralise any arbitrage opportunities that the shocks
may have introduced. Looking at the 3-month money market,
we can say the differentials in the interest rates are quite
stable and that indicates the non-existence of the arbitrage
opportunities in the market .The reason for the non-arbitrage
opportunities can only be the adjustments in the changes in
the exchange rates in the Eurocurrency market. Looking at
the ten year govt bonds interest rates, we can see the changes
in all the countries and the regions have followed the same
declining trend .the reasons could be the economic downturns
across the regions but they also indicate the way the interest
rates adjust themselves no nullify any arbitrage opportunities
in the Eurocurrency and the domestic markets that may have
arisen due to the changes in the interest rates in the domestic
markets. In case the differential is preserved, we can definitely
say that the differential in the interest rates in taken care
of by the changes in the spot exchange rates and the forward
exchange rates.
- BIBLIOGRAPHY
- The Eurocurrency Markets , Domestic Financial Policy
& International Instability : Heather D Gibson 1989
: Macmillan.
- The Eurocurrency Market Handbook .2nd Edition :Dr Eugene
Sarver 1990 : New York Institute of Finance
- The Eurocurrency Markets and their Implications :John
Hewson & Eisuke Sakakibara : 1975 Lexington Books
- The Economist journal : May Edition .
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