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PRICING MONEY: A Beginner’s Guide to Money, Bonds, Futures and Swaps is an introduction to the fixed-income markets. It explains the purpose and design of the most important financial instruments, including deposits, bonds, futures and swaps, and how these instruments are used by the various players in the financial system. The book is for new recruits and potential new recruits in financial markets (consider reading it before rather than after the interview), as well as accountants, lawyers, and those wishing to understand finance. The style is engaging, accessible and non-mathematical, and hence comprehensible by those with no prior financial knowledge.
Pricing Money can be purchased from Amazon.co.uk, Amazon.com, Buy.com, Amazon.fr, Amazon.de, Amazon.co.jp, B&N (same day delivery in Manhattan), as well as other bookshops: cite ISBN 0-471-48700-7.
Below is the text of Chapter 1, made available at jdawiseman.com with the permission of the publisher, Wiley; the usual disclaimer applies. Also available on the web is the Table of Contents.
Let us say the publisher of this book owes me, the author, royalties of £100. The publisher sends me a cheque (a check in the US) for £100. But a cheque is not money; a cheque merely instructs a bank to pay. The publisher banks with NatWest, a large UK high-street (commercial) bank, and it is on this bank that the cheque is drawn. I pay the cheque into my account at HSBC. My publisher’s account at NatWest is lowered by £100, and my account at HSBC is increased by £100. But how does NatWest pay HSBC?
Both NatWest and HSBC have accounts at the Bank of England (BoE). HSBC is owed £100 by NatWest, and requests payment; in response NatWest sends a payment instruction to the BoE. This instruction causes NatWest’s account at the BoE to be lowered by £100, and that of HSBC to be increased by £100. One bank has paid the other; the whole transaction is now complete.
This money on account at the central bank is real money; the other versions are merely promises to pay real money. For most purposes we talk loosely of cash or money, but when the distinction is important we refer to central-bank money. True money, more properly called final money, can take one of only two forms: physical cash, which is rarely used in wholesale financial markets, and central-bank money. Money on account with a commercial bank is not final money; it is merely a promise to pay.
Although the above example described a small payment, the mechanics described are actually more typical of a large payment. Small payments tend to be batched together and netted, so that if HSBC and NatWest each owe the other, only the difference is transmitted. High-street banks, always keen to reduce their costs, care greatly about the detailed mechanics of small payments, but as this book is about the wholesale financial markets, we leave these details unstated.
Exactly the same principle applies in currencies other than British pounds, but in some there are minor complications. The US central bank, the Federal Reserve System (the Fed), is divided into a number of regional reserve banks; money at any of these regional reserve banks is final money. In general, most banks use an account at the Federal Reserve Bank of New York to settle US dollar activity in the wholesale financial markets. The European Central Bank (ECB) is part of the European System of Central Banks, which includes the Bundesbank (Germany’s national central bank), the Banque de France, the Banca d’Italia, and others. Money at any one of the eurozone’s National Central Banks (NCBs) is final money. But these are merely details.
In summary the legal definition of money is money on account at the central bank. Any other form of money is really just a promise to pay central-bank money.
To avoid the difficulties of multiple but linked central banks, we return to the example in sterling (a synonym for British pounds), but now assume that the payment was for £100 million. NatWest has reduced its client’s account by £100 million, and instructed the BoE to pay the same sum from its account to that of HSBC, and when the confirmation arrives, HSBC increases its client’s account by the same amount.
That done, NatWest has £100 million less than it did in its account at the BoE, and HSBC has the same amount more. NatWest now needs to find £100 million, and HSBC has £100 million that is surplus to its immediate requirements. A natural course of action would be for HSBC to lend NatWest the money at an interest rate agreed between the two.
CHF DEPOSITS O/N 2.60- 3.10 T/N 2.83- 3.08 S/N 2.83- 3.08 1/W 2.88- 3.13 2/W 2.88- 3.13 1/M 3.27- 3.42 2/M 3.28- 3.43 3/M 3.30- 3.45 6/M 3.38- 3.53 9/M 3.42- 3.57 12/ 3.50- 3.65
Thus the key purpose of an interbank deposit market, a money market, is to offset the payment system. When customers pay money into their accounts, the bank will want a return on that money. To get that return it will lend the money to other customers or to other banks. And hence, in every currency of relevance to financial markets, banks lend money to each other.
When one bank lends another money, it will be at an agreed interest rate, and for repayment on an agreed maturity. Typical maturities for interbank money range from 1 day for overnight money to 6 months, and even out to 1 year, though with much less active trading in the longer maturities. The money market is so important that many banks maintain screens showing the latestprices at which they are willing to borrow and lend. The figure shows a copy of prices for Swiss-franc deposits, as published by Credit Suisse First Boston (CSFB), a large Swiss investment bank, late in the morning of 30 November 2000. At this time CSFB was willing to accept 3-month Swiss-franc deposits at a rate of 3.30%, and to lend Swiss francs to other high-quality banks for the same period at a rate of 3.45%. CSFB was making a market in these deposits, bidding for 3-month funds at 3.30%, and offering 3-month funds at 3.45%. The intention of such market-making is to borrow some at 3.30%, lend some at 3.45%, and keep the 0.15% difference, the bid-offer spread, as profit.
Let us say that Goldman Sachs, an American investment bank, needs to borrow Swiss francs for 6 months. One course of action would be for Goldman Sachs to borrow them for 6 months from CSFB at the screen price of 3.53%.
But there are alternatives. For example, Goldman Sachs could borrow the money for only 3 months (at the rate of 3.45%), and after 3 months reborrow the money. Why do this? To have the same cost as a 6-month loan, the reborrowing would have to be at 3.58%. This should make intuitive sense; 3.53%, the 6-month rate, is close to the average of 3.45% and 3.58%, the rates for the first and second 3-month periods.
So, if Goldman Sachs thinks that in 3 months’ time the cost of 3-month money will be less than 3.58%, then it would be cheaper overall for Goldman Sachs to borrow now for 3 months at 3.45%, and then in 3 months to reborrow at the rate then prevailing. Of course, if Goldman Sachs thinks that in 3 months’ time the cost of borrowing Swiss francs for 3 months is likely to be higher than 3.58%, it should borrow for the entire 6-month period now.
So the breakeven cost of 3-month money in 3 months’ time is 3.58%. This is said to be the forward price. The current price, also known as the spot price, of 3-month money is 3.45%; the 3-month forward price of 3-month money is 0.13% over spot. Market prices are implying that Swiss short-term interest rates are rising.
Goldman Sachs has more choices. If it believes that rates are unlikely to rise, then it might be cheapest to borrow for 1 day, and reborrow the money each subsequent day. Or if it thinks that rates are about to rise to very high levels, perhaps the best course would be to borrow money for 1 year (at 3.65%), and in 6 months’ time to lend these Swiss francs at the then-prevailing rate, hopefully much higher. No matter which view it takes, by choosing to borrow money at one maturity rather than another, Goldman Sachs is implicitly expressing an opinion on the future path of short-term rates. That opinion is measured, and can only be measured, against the current forward prices.
Exactly the same reasoning applies to an industrial corporation that needs to borrow Swiss francs for 6 months. It cannot avoid some form of implicit speculation; by choosing to borrow at one maturity rather than another, it is taking a view on the future path of interest rates, and that view should be measured against the market’s forward prices.
Let us return to our example, in which HSBC has lent NatWest £100 million, for let us say 3 months. After 3 months, NatWest returns the £100 million with interest. But what would happen if NatWest were to become bankrupt? Of course, the insolvency of a major high-street British bank is very unlikely; but it is not impossible. In this unlikely event, HSBC would lose its £100 million.
This insolvency risk, also known as credit risk or default risk, is very important. Banks deal not only with each other, and not only with top-quality financial institutions from countries with honest and competent financial supervision, but also with riskier entities (people, companies, or even governments). With some of these entities the risk of insolvency is significant.
The solution is called repo. Just as before, the bank lends its client the money. Also, the client lends the bank government bonds (described in Chapter 2) of the same value and over the same period of time. If the bank were lending £100 million cash for 3 months to a client, the client would lend £100 million worth of government bonds for the same period of time. The loan is said to be collateralised, and the government bonds are the collateral.
Under normal circumstances, after 3 months the client returns the £100 million plus interest, and the bank returns the bonds. But if the client should become insolvent and be unable to pay the money, the bank can recover its loss by selling the collateral that it holds.
For the bank that is lending money, the advantage of collateralisation is that it almost eliminates the credit risk. For the borrower of money, the disadvantage is that collateral must be found. The borrower’s disadvantage and the lender’s advantage are reflected in the price; the interest rate on a collateralised loan is below that on a non-collateralised loan. The precise gap varies across currencies, and within a currency it varies across maturities and according to the quality of the collateral and the counterparty, but a typical unsecured-secured differential is 0.1% to 0.5%.
It might help the reader to liken a repo to a residential mortgage. In both cases the cost of borrowing is cheapened by giving collateral to the lender. In one case the collateral is a financial asset, in the other the legal rights to a property. Of course, a mortgage can only be used to borrow money if one has a property, or is going to use the money to buy a property. Likewise, repo can only be used to cheapen the cost of borrowing for those who own suitable collateral, or who are going to use the money to buy that collateral.
In this example the collateral used was a government bond. By turnover and volume outstanding, this is the most common form of repo. But the parties may well agree to use other collateral, and there is a repo market in corporate bonds and other financial assets.
The origin of the term ‘repo’ is a contraction of the word ‘repurchase’. In a repurchase agreement, a borrower of money would sell some financial asset to the lender of money, and at the same time agree to a later repurchase of that asset. The effect was that of a collateralised loan, with the interest rate being a function of the ratio of the sale and repurchase prices. This sale and repurchase is no longer the usual way to trade repo; the modern repo legal agreement more robustly manages a default by either side.
So in summary a repo is just a collateralised deposit. The collateral increases the creditworthiness and hence reduces the interest rate on the deposit.
The news services give the impression that central banks decide interest rates. For example, they might report that the Federal Reserve raised the interest rate from 6% to 6.50%, or that the European Central Bank raised rates by a quarter percent to 4.25%, or that the Bank of England left rates unchanged at 6%.
But we have just seen that banks lend money to each other at rates chosen by the market. There is no seeking of permission from a central bank: if Goldman Sachs is willing to lend 1-month US dollars at 6.2%, and CSFB is willing to borrow, then they trade. So what does the official interest rate mean, and how do central banks implement it?
Recall that many commercial banks have accounts with the central bank. These accounts are subject to rules about overdrafts, each central bank having its own rules. Some central banks prohibit overdrafts; at the end of each day no account may be overdrawn. Other central banks are less strict, specifying that every account must have a positive balance on average, where the averaging is conducted over a period of time known as a reserve period.
Whichever the case, commercial banks need to avoid having an overdraft at the central bank, either on average or every day. So what can an overdrawn bank do? It can borrow money from another bank. But this only works if, between them, the banks have enough. If their balances total an overdrawn state, then borrowing money from each other only passes the overdraft around. Bank-to-bank borrowing can only move rather than extinguish the overdraft. The escape is to borrow money directly from the central bank. And the rate at which the central bank lends money can indeed be chosen by the central bank; this is the rate that makes the headlines.
In their money-market operations, almost all central banks lend money against collateral; they use repo rather than accept the credit risk of unsecured lending. For some the only eligible collateral in this repo operation is the debt of the local government; others accept almost anything. The remaining details of the intervention also vary considerably from central bank to central bank: some intervene every day, others once a week; some lend money overnight, others for weeks at a time.
Some central banks occasionally use a form of auction to choose the rate at which funds are lent to the market. This is known as a floating or variable policy rate, but even when this is used the central bank sometimes determines the outcome in advance by specifying that bids below a certain cutoff will not be accepted. Whatever the detail of the central bank’s money-market operations, the commercial banks are obliged to turn to the central bank to clear their overdrafts. Thus central banks have great control over short-term interest rates.
One might expect that a currency’s money market would be based in that currency’s financial capital: US dollars in New York, sterling in London, yen in Tokyo, Swiss francs in Zurich, etc. This was so until the late 1950s, when the Soviet Union, concerned that its dollar deposits in New York might be frozen by the US government, opened a dollar account with a European bank. Then in 1963 the US introduced Regulation Q, which imposed a maximum rate of interest that could be paid on domestic dollar deposits, and in 1965 introduced a lending tax.
The upshot of this regulation was that banks benefited from doing business outside the reach of US law, and London came to dominate this offshore dollar business. Accounts ‘in London’ are subject to the law of England and Wales, so US sanctions, restrictions and taxes cannot apply. In time the banks in London, often branches of US banks, started actively trading deposits in other currencies as well.
Nowadays regulation is lighter, and so money can be moved cheaply to and from London; therefore the price of London money generally tracks very closely that of domestic money. But there have been differences between domestic and London interest rates. These differences have had different causes at different times: tax laws, bank regulations, the possibility that a country might introduce exchange controls, and the differences between the creditworthiness of the banks in London and those in the domestic market.
The London money market is particularly active in dollars, sterling, euros, yen, and Swiss francs, with less liquidity (ease of trading in large size) in Australian, Canadian and New Zealand dollars. Deposits in most other currencies trade only in their domestic market.
The terminology for London money is confusing. When dollar deposits started to trade in London, they were called eurodollars, the ‘euro’ prefix then meaning that the currency was outside its home jurisdiction. And hence euromarks for London-traded Deutschmarks, eurolira for Italian lira in London, euroyen, euroswiss, and so on. The use of the ‘euro’ terminology subsequently became more widespread. Much corporate debt (discussed in more detail later) is issued under the law of England and Wales, even if the currency is that of the US, Germany or Switzerland. Thus tradable debt (bonds) issued in London became known as eurobonds.
Now fast-forward to 1999, the start of Europe’s single currency, called the euro. The words ‘eurodollar’ and ‘euroswiss’ become ambiguous. They still refer to London-delivery dollars and Swiss, but now they can also mean exchange rates between euros and US dollars and between euros and Swiss francs. On rare occasions one even hears the term ‘euroeuro’ for London-delivery euros. So the word ‘euro’ needs to be interpreted with care.
Several European countries, including Germany, the Netherlands, France, Italy and Spain, are members of EMU, Europe’s Economic and Monetary Union. These countries share a common currency called the euro, their former national currencies having been merged together. This irrevocable merger was achieved by legal diktat, and now, in law, each of the former national currencies is a denomination of the euro.
There are 100 cents in the US dollar. US law is clear: if you are owed 100¢, then you are owed $1. This 100-to-1 ‘exchange rate’ is irrevocable; it cannot be changed. Indeed, if you deposit in your bank account 1000¢, and then deposit $10, the bank does not keep a separate tally of how many dollars and how many cents have been deposited, it only knows that the account contains $20.
Under European law, and the law of the countries of the EU, the euro is no different. It too comes in various denominations, including the euro cent (at an exchange rate of 100 to 1), the Deutschmark (at an exchange rate of 1.95583 to 1), the Dutch guilder (2.20371 to 1), the French franc (6.55957 to 1), etc. Legally, the Deutschmark exists as a currency in the same sense that the US cent exists: the Deutschmark is a denomination of a primary currency, the euro, albeit a non-decimal denomination.
Note that US dollars and US cents have different physical manifestations, the former on paper printed green on white, the latter as metal coins. This makes no difference; they are still the same currency. Likewise, the Deutschmark and the French franc have different physical forms, but this too is irrelevant, because they are both denominations of the euro.
Banks quote the same interest rate for deposits in dollars and deposits in cents, because they are the same currency. Likewise, it must be the same interest rate for deposits in euros, Deutschmarks, Dutch guilders, French francs and the former national currencies of the other EMU members, because they are all the same currency. And because these are all the same currency, wholesale financial markets quote prices in euro, not in the former national currencies.
|GBP||UK pound (sterling)|
|NZD||New Zealand dollar|
|MXN||Mexican (new) peso|
|PLN||Polish (new) zloty|
|ZAR||South African rand|
|RUB||Russian, new rouble|
The following are former
national currencies that
have been absorbed into
|NLG||Dutch guilder, florin|
Codes beginning with
‘X’ have special meanings
|XEU||ECU, now the euro|
Having discussed the ambiguities in the word ‘euro’, it is worth mentioning other possible sources of ambiguity in the writing of money. One might think that ‘$100m’ means one hundred million dollars. But the ‘m’ is ambiguous. In English ‘m’ means a million, in French it is the abbreviation for ‘mille’, meaning a thousand (though the abbreviation is more usually written in uppercase). A French speaker would write one hundred million as 100MM, and could well read 100m as one hundred thousand. And the dollars are ambiguous; they could be from any one of a number of countries, including the US, Canada, Australia, New Zealand and Singapore.
To avoid ambiguity in currency names, international standard ISO 4217 specifies official currency abbreviations. Each of these abbreviations has 3 letters: in most cases the first two letters identify the country, the third the currency. Codes for the most important currencies are shown in the table overleaf. Henceforth it will be assumed that readers are comfortable with the first seven in this list: USD, EUR, JPY, GBP, CHF, CAD and AUD, and at least approximately with their current values.
Money amounts should be written unambiguously: USD 100 million and USD 100,000,000 are both clear. Unless the context is clear and not legally binding, readers are advised to avoid use of the suffix ‘m’.
The word ‘billion’ used to be ambiguous. In American English a billion is a thousand million; in old British English it used to mean a million million and it still does in some other languages. But in English the Americans have won: a billion is always a thousand million, and a trillion is always a million million. Because the words ‘million’ and ‘billion’ sound so similar, in spoken English the word ‘yard’ (a contraction of ‘milliard’) is often used as a synonym for a thousand million.
Care should also be taken when writing and reading dates. In America ‘03/10/08’ is March 10, 2008; in most of the rest of the world it is 03 October 2008.
There is a detail about money markets that will prove important later. In most currencies the money market is said to be ‘T+2’. This means that settlement, when delivery of funds takes place, occurs 2 business days after the trade date (the ‘T’ in ‘T+2’). The settlement date is also known as the value date.
So if on Monday 13 August 2007 J. P. Morgan agrees to lend USD to CSFB for 3 months, J. P. Morgan would pay this money to CSFB two days after trading, on 15 August, and it would be returned with interest 3 months after that, on 15 November 2007. Most currencies’ money markets are T+2, including USD, EUR, JPY and CHF. The main exception to T+2 is sterling, which is T+0, also known as same-day settlement. In sterling, standard practice is to settle a trade on the same day that it is agreed. However, counterparties can always agree to a non-standard settlement, but in the absence of such agreement, GBP is T+0 and almost all others are T+2.
There is a standard definition of the seemingly simple phrase ‘3 months’. For example, when is 3 months after 30 November 2009? It can’t be 30 February 2010, because there isn’t such a day. And it can’t even be 28 February 2010, because that is a Sunday. As it is, the official definition from the International Swap Dealers Association (ISDA) says that 3 months after Monday 30 November 2009 is Friday 26 February 2010, but the point is that there is a precise definition.
Payments in the real economy cause banks’ balances with the central bank to rise and fall. A bank with a shortfall will want to borrow it from a bank with an excess, and hence there is an interbank deposit market (a money market).
This market exists, with maturities from 1 day to 1 year, in every currency, and in the major currencies it exists both domestically and in London.
A market participant, by choosing to borrow or lend money at any particular maturity, is implicitly speculating against the forward rates implied by the spot rates.
Banks also lend money against collateral; the secured nature of this lending reduces the credit risk, and hence it reduces the interest rate.
Central banks have great control over short-term interest rates.
The euro is a legal construct that makes the former national currency units irrelevant to wholesale financial markets.
Of Pricing Money, only chapter 1 and the Table of Contents are published on the web. To read the rest, please do purchase a copy, which can be done at the bookshops above.
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