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Fixed Income Securities
Funding of Dealer Positions
Money Markets
Part 4B
Funding of Dealer Positions
Government security dealers supply a large
volume of securities to the market
They depend heavily on the money market for
borrowed funds
Most dealers invest very little of their own equity
Ratios of security portfolios held to owners capital
of even 40:1 are common.
The bulk of their operating capital is borrowed
from banks and other financial institutions.

Dealer Positions
Sources of Dealer Funds
Most heavily used
sources of dealer funds
Demand loans from
Repurchase agreements
with banks / lenders
Dealer Positions
Demand Loans
Every major bank posts rates at which it is
willing to make short-term loans to dealers.
Generally two rates are quoted
One for new loans
A lower rate for the renewal of existing loans
A demand loan may be called at any time.
Such loans are virtually riskless because they
are usually collateralized by U.S. government
Dealer Positions
Repurchase agreements
Dealer Lender Sells securities
Makes commitment to buy the securities
back at a later date
Repurchase agreements are an increasingly
popular alternative to demand loans.
They represent a temporary extension of
credit collateralized by marketable securities
Repurchase Agreements
Types of Repos
Term Repos Some repos called Term Repos
are for a fixed length of time.

Continuing Contracts Continuing Contracts
carry no explicit maturity date but may be
terminated at short notice by either party
Repurchase Agreements
Custodial Account
Securities for the collateral are supposed to be
placed in a custodial account at a bank.
When loan is repaid the dealers liability is
canceled and the securities are returned
There is evidence that this safety feature is not
scrupulously followed.
If a dealer goes out of business, lender may have
difficulty in recovering the securities
Dealer firms have collapsed and many S&Ls lost
money from inadequately collateralized loans.
Fed authorities have imposed strict reporting
guidelines on dealers

Repurchase Agreements
Types of Repos
Term Repos Contracts for terms longer
than overnight e.g. contracts for periods
ranging from 1 - 3 months or even longer
Dollar repos They permit the borrower
to repurchase securities that are similar to
but not necessarily the same as the
securities originally sold
FLEX repos They permit lenders to
withdraw a part of the loan whenever cash
is needed.

Repurchase Agreements
Value of Collateral
The interest rate of repos is closely linked to
other money market rates.
Usually the collateral is valued at the current
market price plus accrued interest less a small
discount called a Haircut to reduce the
lenders exposure to market risk.
The longer the term of the repo, and the riskier
and less liquid the security that is pledged, the
larger will be the Haircut.

Repurchase Agreements
Value of Collateral
Repos are periodically market to market.
If the price of the collateral has declined the
borrower may need to pledge additional
Repurchase Agreements
Example of Repo - 1
A party has made an overnight loan of $100
MM to a dealer at 7.2%
Thus the interest payable the next day is:

100,000,000 x 0.072 x 1
___ = $20,000
Repurchase Agreements
Illustration - 2
A dealer wishes to borrow by pledging
securities worth $5MM
Market price is 100-05
Accrued interest is $2.50
Dirty price is $5,132,812.50
Repo interest rate is 4.80%
Tenor is 45days
Amount payable at maturity is $5,163,609.375
Repurchase Agreements
Illustration - 2 (Cont)
During these 45 days there will be fluctuations
in the value of the collateral.
These must be regularly monitored to ensure
adequate collateralization.
Most repos are collateralized by government
Sometimes other money market instruments like
commercial paper and BAs may be used.

Repurchase Agreements
Credit Risk
In practice both borrower and lender are
subject to credit risk
There is no strategy which will reduce the
risk for both the parties.
Increasing protection for one means enhanced
risk for the other.
Repurchase Agreements
Credit Risk
Interest rates rise Interest rates decline
If interest rates rise
sharply, the value of the
collateral will decline and
the lender will be
If interest rates decline,
the value of the collateral
will rise.
In this case, if the
borrower were to go
bankrupt, the lender will
be left with assets which
may be worth less than the
loan amount.
If the lender goes
bankrupt, the borrower will
be left with an amount that
is less than the market
value of the securities.

Repurchase Agreements
The lender can ask for margin.
i.e. he can lend less than the market value of
the assets.
This will increase the risk for the borrower
The borrower can ask for reverse margin.
i.e. he can ask the lender to lend more than
the market value of the securities.
This will increase the risk for the lender
Repurchase Agreements
Margins (Cont)
In practice it is the lenders who receive
This is because they are parting with cash
which is the more liquid of the two assets.
Thus the market value of the collateral will
exceed the loan amount.
The excess is called a Haircut
Repurchase Agreements
Margins (Cont)
A pension fund is prepared to offer bonds
with a face value of $25MM
Enters into a 3day repo
The collateral is a T-bond with a coupon of 6%
and a price of $95
AI is $2
Haircut is 1.25%
Repo rate is 7.50%
Loan amount = 25,000,000x97/100x0.9875
= $23,946,875
Amount repayable at maturity is:
23,946,875x(1+0.075x3/360) =
Loan amount = 25,000,000x97/101.25 =
Motivation for Repos
A dealer acquires a bond from a client and is
unable to sell it by EOD.
Since trading is over he needs to arrange for
funds since the client has to be paid on the
following day
Consequently he needs to borrow funds.
This is the typical sequence that leads to a Repo
The sequence of steps may be stated as follows
Motivation (Cont)
Dealer buys a bond which remains unsold by
the end of the trading day
Using the bond as collateral he borrows funds
from a lender and pays the original seller on
Assuming the bond is sold on T+1 he will
receive the funds on T+2
On T+2 he will retrieve the bond given as
collateral and transfer it to the buyer
Reverse Repo
Such transactions offer a convenient route for
lenders to park excess funds for short periods.
From the perspective of the lender such an
arrangement is called a reverse repurchase
agreement or a reverse repo.
Thus every repo must be matched by a reverse
A dealer looking to borrow funds will do a repo.
A dealer looking to place funds will do a reverse
Repurchase Agreements
Motivation for Reverse Repos
A dealer sells to satisfy a customer but is unable to
purchase it by EOD
In this case he has money and needs access to a bond
So he borrows the bond by giving the money as collateral
The bond is handed over to the buyer on T+1
Assume he is able to buy the bond on T+1
On T+2 he will return the bond to the lender of cash and
retrieve the cash with interest
The cash will be handed over to the party from whom he has
bought on T+1
If the bond desired is in short supply -`being on special
the repo rate may be considerably lower than the general
collateral rate
General collateral rate Most government
securities can be bought at a rate called the
general collateral rate.
Thus most securities are close substitutes for each
Special repo rates Sometimes a security
may be in high demand and the lender may
charge a lower rate.
Such rates are called special repo rates.
Repurchase Agreements
Repos (Cont)
To promote a smoothly functioning market
the Federal Reserve frequently participates
in repos with primary dealers.
It may buy securities on a short-term basis and
then sell them back
It may sell securities with an agreement to buy
Repurchase Agreements
Repos (Cont)
By selling securities to dealers the FED
temporarily absorbs dealer funds and reduces
the ability of the dealers banks to make loans.
Thus while dealers use repos to increase their
earnings from trading, the FED uses them to
steady the money market.
Repurchase Agreements
Sale and Buyback
In a standard repo aka Classic Repo the sale and
repurchase price are identical
So the interest is separately computed and paid
All coupons on the underlying collateral during
the life of the repo will be handed over to the
borrower as and when they are received by the
Technically the borrower though not the legal owner
is the beneficial owner
Sale and Buyback (Cont)
Here too the securities are sold with an
agreement for forward repurchase
So there is transfer of ownership
But a repo is a single transaction whereas a sale
and buyback is a combination of two distinct cash
market trades
There are no margins in this case
No need for additional collateral if the securities
decline in value
So there is greater credit risk for the lender
Sale and buyback (Cont)
In a classic repo coupons are immediately passed
on to the borrower
Here the coupon is factored into the repurchase price
Classic repos often allow substitutions
Sale and buyback transactions do not have such
Repos are covered by industry standard contracts
Sale and buyback contracts do not have standard
Negotiable CDs
What is a CD?
It is an interest bearing receipt for funds left with a depository
institution for short periods of time.
The minimum maturity as per U.S. law is 7 days.
There is no maximum limit.
Most CDs are issued at par and pay interest explicitly.
They are not discount instruments.
Payment is made in Fed Funds on the day of maturity.
There also exist discount CDs that are similar to T-bills in structure
Nego CDs
True Money Market CDs
True money market CDs are negotiable
instruments that can be resold before
The round lot for trading is $1,000,000
They may be registered on the books of the
issuing banks or else may be issued in bearer
CDs issued in bearer form are more convenient for
Nego CDs
Non-negotiable Time Deposits vs. Negotiable CDs
Time Deposits CDs
An investor will deposit a
sum of money with a bank
for a stated period of time
The depositor will be
issued a bearer security
Investor is paid interest at
a specified rate
Investor is entitled to claim
deposit with interest at the
end of the period
It cannot be easily
terminated until it matures
It can be liquidated at any
time at the prevailing
marker rate
Nego CDs
Consider a CD with a face value of V.
The funds owed on maturity is given by:

V + T
____ x V x c

original term to maturity
c interest rate
Nego CDs
A firm purchases a $100,000 CD
Duration = 6 months
Interest rate @ 7.5%
It would receive:
100,000 x {1 + (0.075 x 180/360)} = $103,750

Nego CDs
Yield on CDs
The yield on CDs is normally higher than the T-
bill rate due to
Greater default risk
A thinner resale market
Tax exemptions granted to T-bills by state and
local governments.
Nego CDs
Yields (Cont)
Quoted yields are on a simple interest basis
Let N be # of days from issue to maturity
Tm be # of days from settlement to maturity
c is the coupon rate
y is the quoted yield
V is the face value
P is the dirty price
Yields (Cont)
Original term to maturity is 180 days
Face value is 1,000,000
Coupon rate is 4.80%
Current term to maturity is 144 days
Quoted price is 1,000,000
Maturity value = $1,024,000
Example (Cont)
Yields (Cont)
If we are given the yield we can compute the
The expression for the price is given by
Yields (Cont)
Original term to maturity = 180 days
Face value = 1,000,000
Coupon = 5.20%
Term to maturity = 108 days
Quoted yield = 5.60%
What is the dirty price?
Price (Cont)
Price (Cont)
Price can be decomposed into clean price plus
accrued interest
AI = Vxcx(N-Tm)/360
In our example
AI = 1,000,000x.052x(180-108)/360 = $10,400
Clean Price = 1,009,048 10,400 = 998,648
Global CDs - Euro
Eurodollar CDs are negotiable dollar time
deposits issued by foreign branches of U.S.
banks and foreign owned banks.
They carry higher rates than comparable
domestic CDs due to greater perceived risk.
They can carry maturities in excess of one year
and rates are adjusted every 3 to 6 months to
match changes in the LIBOR.
Nego CDs
Yields on CDs
These are a function of demand and supply.
CDs are not riskless because the issuing bank
could fail.
For the issuing bank, the effective cost of the CD is
greater than the quoted rate of interest because
of reserve requirements and insurance premia.
Nego CDs
A bank is quoting 8% p.a. on a 3 month
Reserves @ 5% and are non-interest
Effectively $8 interest is being offered on
$95 of usable funds
Effective rate =
= 8.42%
Nego CDs
The insurance premium is 8 b.p.
Effective cost is
8.42 + 0.08 = 8.50%
Nego CDs
Term CDs
They have an original term to maturity in
excess of 1 year
Usually pay coupons semi-annually
Price is the PV of all cash flows to be received
as of the settlement date, with discounting at
the quoted yield
In principle it is analogous to bond valuation
but there are certain differences
Term CDs (Cont)
The interest in a coupon period is cxVxNi/360
and not cxV/2
Where Ni is the # of days in the ith coupon
Therefore the coupon will vary from period to
The second difference is that the kth cash flow
is discounted based on the actual number of
days in the coupon period

A CD with a coupon rate of 4.8% was issued
on 1 July 2009
It matures on 30 June 2011
On 1 September 2009 the quoted yield is 5%
We have to first calculate the number of days
in each coupon period
And the number of days from the date of
settlement to the first coupon
Example (Cont)
Start with the cash flow at maturity
Discount it back to the penultimate coupon
Add the coupon at the penultimate coupon
date to the PV obtained at the previous step
Discount the sum back to the previous coupon
Repeat the procedure till you reach the
settlement date
Valuation (Cont)
Valuation (Cont)
Valuation (Cont)
Valuation (Cont)
Valuation (Cont)
This is the dirty price of the CD as on 1
September 2009
The AI = 1,000,000x.048x62/360 =8266.67
The clean price is 1,004,629.27 8266.67 =

CDs (Cont)
Coupon Date
Actual Starting
Date Coupon
Ending Date
Actual Ending
No. of Days
15 SEP 2001
17 SEP 2001
17 JAN 2002 17 JAN 2002 =14 + 28 + 15 =
15 SEP 2001
17 SEP 2001
15 MAR 2002 15 MAR 2002 =13+31+30+31
+31+28+15 =
15 MAR 2002 15 MAR 2002 15 SEP 2002 16 SEP 2002
+31+31+16 =
15 SEP 2002
16 SEP 2002
15 MAR 2003
17 MAR 2003 =14+31+30+31
+31+28+17 =
15 MAR 2003 17 MAR 2003 15 SEP 2003 15 SEP 2003 =14+30+31+30
+31+31+15 =
182 63
Prior to the introduction of such instruments
Corporate treasurers were reducing bank deposits
in favor of T-bills, repos and other money market
Negotiable CDs were designed to attract
deposits back to the banking system
Commercial Paper
Commercial Paper
Unsecured promissory notes are known as
commercial paper
Large corporations borrow billions of
dollars in the money market through these
Such paper consists of short-term
unsecured promissory notes issued by well
known companies that are financially
strong and carry high credit ratings
Comm Paper
Funds raised for
The funds raised are normally used for current
transactions such as:
Purchase of raw materials
Payment of accrued taxes
Meeting of wage and salary obligations
Other short-term obligations rather than for
capital account transactions.
Comm Paper
Bridge Financing
These days a substantial number of paper
issues are used to provide `bridge financing
for long-term projects
Issuing firms usually plan to convert their
short-term paper into more permanent
financing when the capital market looks more
Comm Paper
LCs and Bank Guarantees
A letter of credit (LC) is a document issued by
a bank called Issuer or Opener at the
request of a client Applicant in favor of a
stated beneficiary
An LC states that it will effect payment of a
stated sum for specified goods and services
against presentation of a predefined set of
LCs (Cont)
There are two broad categories of LCs
Commercial LCs
Standby LCs
Commercial LCs are used to cover the
movement of goods
Standby LCs are used for other financial
A commercial LC is a direct instrument of
LCs (Cont)
Bank guarantees too are used to provided
reassurance to the beneficiary
But it differs from an LC from the point of view
of the banks position
An LC is a direct undertaking of the bank to
the beneficiary
When a shipment is made under an LC the bank
will not wait for the buyer to default before
making a payment

LCs (Cont)
In the case of a bank guarantee however if the
buyer is unable or unwilling to pay, the bank
as the guarantor will pay the supplier
Thus a guarantee comes into play only when
the buyer fails to pay
It is therefore a Contingent Guarantee
In an LC the principal liability is the banks
It must first pay and then collect
LCs (Cont)
Thus a guarantee is more risky for the supplier
And less risky for the bank
An LC is less risky for the supplier
And more risky for the bank
In both cases however the bank accepts full
liability for the specified amount
Buyers of Commercial Paper
Paper is generally issued in multiples of $1,000
& in denominations designed to meet the
needs of the buyer.
It is traded mainly in the primary market.
Opportunities for resale in secondary market are
Investors are careful to purchase those issues
whose maturity matches their planned holding
Resale has increased in recent years

Comm Paper
Yankee Paper
Yankee paper Foreigners also issue paper in
the U.S. market.
Issuers can often issue Yankee paper at a
cheaper rate than what it would cost them to
borrow outside the U.S.
Foreign issuers generally pay higher rates than
American issuers of comparable credit quality.
This is to compensate American investors for the
difficulty of gathering information on foreign
issuers and the lack of name recognition.

Comm Paper
International Paper - Yen
Yen denominated paper was allowed in
1987 after Japanese companies threatened
to move their short-term borrowing
programs abroad.
In 1988 foreigners were allowed to issue
Samurai paper in Japan.
Comm Paper
International Paper - Euro
The Euro-paper market evolved in the 1980s.
The market sees large volumes because issuers
can tap foreign investors.
Many U.S. firms which have had difficulty
borrowing at home due to low credit quality
have found the Euro market to be less quality
Comm Paper
International Paper Euro (Cont)
Large investors in Euro-paper include:
International banks
Private corporations
Foreign central banks
In contrast U.S. paper is bought mainly by
money market mutual funds.
Euro-paper is priced below the face value and
appreciates in value as maturity approaches.
The quoted interest rate is a discount rate like
in the case of T-bills.
Comm Paper
Example Euro (Cont)
Assume that we wish to acquire Euro-paper
with a face value of $100MM and a time to
maturity of 90 days
If the discount rate is 6%, the price would be
100,000,000 - 100,000,000 x 0.06 x (90/360)
= 98,500,000
Comm Paper
Maturity of US Paper
Maturities of US paper range from 3 days
(weekend paper) to 270 days
US paper is generally not issued with a
maturity exceeding 270 days
Because any security with a maturity in excess
of 270 days must be registered with the SEC
Comm Paper
Ratings and Rating Agencies
Depending on the credit standing of the issuer
paper is rated as:
Desirable or
Firms issuing paper generally seek ratings from
multiple issuers.
It is extremely difficult to market unrated paper.
About 75% of the firms that currently sell paper
are prime rated.
Generally notes bearing ratings from at least two
agencies are preferred by investors.
Comm Paper
Summary of the Rating Systems
Company Higher
A/ Prime
A/ Prime
Moodys P-1 P-2, P-3 NP NP
S&P A-1+,
A-2, A-3 B, C D
Fitch F-1+,F-1 F-2,F-3 F-5 D
Comm Paper
Credit Rating
We will illustrate using S&Ps rating scale.
A-1= strong degree of safety for timely repayment
A-2 = satisfactory degree of safety
A-3 = adequate safety
B,C = risky or speculative
D = default history
A-1; A-2; and A-3 are investment grade
Comm Paper
Credit Rating
Agencies are paid by the issuers of paper.
A good rating makes it easier and cheaper to
However rating agencies always look at the
issue from the perspective of a potential
Their credibility is based on their track record from
the standpoint of accuracy.
Comm Paper
Evaluation Criteria
Rating agencies use the following criteria.
Strong management.
Good position for the company in a well
established industry.
Good earnings record.
Adequate liquidity.
Ability to borrow to meet both anticipated and
unanticipated needs.
Comm Paper
Bills of Exchange
Bills (Cont)
Drawer: He is the party who makes out the bill
A bill is always drawn by the person who will
be paid
Drawee: Is the party who is ordered to pay
A bill is always drawn on the drawee
What is a bill?
It is an undertaking to pay a specified amount
of money at a future date upto 12 months in
the future
It is a form of short-term finance for the
Bills can be sold in the money market at any
time prior to their maturity date
Bills are classified on basis of the entity which
gives the undertaking to pay
Bank bills
Trade bills

Bills (Cont)
Trade bills are drawn by one non-bank
company on another typically demanding
payment for a trade debt
A bank bill is drawn on a commercial bank and
is therefore payable by the bank
Bills (Cont)
A bill of exchange is also known as a Draft
A Draft may be a
Sight Draft
Time Draft

Sight Drafts
In such cases the importer has to pay for
the goods on sight of the draft.
His bank will not release the shipping
document until he pays.
Such transactions are known as
Documents Against Payment transactions.
Time Drafts
These are also known as Usance Drafts.
The bank will release the shipping documents
in such cases as soon as the importer accepts
the draft by signing on it.
The importer need not pay immediately.
In other words the exporter is offering him
credit for a period.
When the importer accepts a draft it becomes
a Trade Acceptance.
Drafts and BAs
In the case of a sight draft the importers bank
will pay on presentation.
In the case of a time draft it will accept it by
signing on it.
A draft that is accepted by a bank is called a
Bankers Acceptance
It is obviously more marketable than a trade
The Market for BAs
In the U.S. there is an active secondary
market for BAs.
They are short term zero coupon assets which
are redeemed at the face value on maturity
BAs with a face value of 5MM USD are
considered to constitute a round lot.
Once a BA is issued the exporter can get it
discounted by the accepting bank.
i.e. he can sell it for its discounted value.
he can sell it to someone else in the secondary

Credit Risk for BAs
The credit risk involved in holding a BA is
It represents an obligation on the part of the
accepting bank.
It is also a contingent obligation on the part of
the exporter.
i.e. if the bank fails to pay, the holder has recourse
to the exporter who is the drawer of the draft
Buying and Selling Bills - Illustration
A co. has drawn a bill on HSBC for $5,000,000
Maturity 150 days
The bank accepted it and sold it to Barclays at
a discount @ 5.25%
30 days hence Barclays sold the bill to ABN
Amro at a discount @ 4.75%
Illustration (Cont)
Purchase price:
5,000,000 [1 (5.25/100) * (150/360)]
= $4,890,625
Sale price:
5,000,000 [1 (4.75/100) * (120/360)]
= $4,920,833.33

Illustration (Cont)
$4,920,833.33 - $ 4,890,625 = $ 30,208.33
ROI on a 360-day year basis
(30,208.33/4,890,625) * (360/30)
= 7.41%
Money Market Yield for a Bond
There is a difference in the way price/yield is
calculated on a term CD and on a bond.
This can make comparisons difficult
One way to facilitate a comparison is to
calculate the money market yield for a bond
CD price calculations use exact day-counts
whereas bond assume regular time intervals
between coupons
The discounting for a CD from the nearest
coupon date to the settlement date is using
simple interest
Bond markets use compound interest to discount
The day count conventions for CDs and bonds
are usually not the same
Money Market Yield
Consider the T-bond with a face value of
Paying a coupon of 8% per annum semi-
The coupon dates are 15 July and 15 January.
The maturity date is 15 January 2033.
Today is 15 September 2013.

Illustration (Cont)
K = 122/184 = .6630
N = 39
If we use a dirty price of $843.5906
The money market yield is 9.8649%
Valuing a ZCB with a non-integer time
to maturity
If the ZCB has an integer number of periods till
We divide the discount rate by 2
Multiply the number of years to maturity by 2
To be consistent with bond valuation based on
semi-annual coupons
How do we deal with zero-coupon bonds
which have a non-integer time to maturity?
Consider a zero-coupon bond with a face
value of $10,000
The maturity date is 15 September 2018
We are on 15 December 2013
The quasi-coupon dates on a semi-annual
basis are
15 September and 15 March
Illustration (Cont)
Let us assume an Actual/Actual day-count
Between 15 September and 15 March there are
181 days
Between 15 December and 15 March there are 90
Thus the first period is 90/181 = 0.4972
Illustration (Cont)
If the YTM is 10% per annum the price is
9.4972 =
Obviously the clean price is equal to the dirty
Eurocurrency Deposits
The Eurocurrency Market
What is a Eurocurrency?
A freely traded currency deposited in a bank outside its
country of origin.
The term Euro simply means outside the country of origin
Dollars traded outside the U.S. are Eurodollars.
Yen traded outside Japan are Euroyen.
Euros traded outside Europe are Euroeuros
The rupee is not a freely convertible currency
E.g. If a bank in Dubai were to accept rupee deposits they would constitute
Eurocurrency Markets
These deposits need not be with European banks.
Although originally most banks which accepted such
deposits were located in Europe.
E.g. Banks in Tokyo, Singapore and Hong Kong also accept
dollar deposits.
These are often called Asian Dollar markets.
Why Eurocurrency Markets?
Why should a bank outside the U.S accept deposits
denominated in U.S.D.?
1. After World War II, the U.S. dollar became the preferred
currency for global trade. Everyone wished to hold dollar
2. During the cold war, Warsaw Pact countries were reluctant
to hold dollar balances with American banks. There was a
fear that such deposits could be impounded by the U.S.
government. But they needed such balances to finance
3. European banks began to realize that such funds could be
profitably lent out, and consequently began to accept such

Eurocurrency Markets (Cont)
One of the significant reasons for the
explosive growth of Eurocurrency markets was
the existence of interest rate ceilings and high
reserve requirements in the U.S.
Interest Rate Ceiling
An interest rate ceiling is easy to comprehend.
It precluded banks from paying interest at more than the
stipulated maximum rate
Consequently their ability to attract deposits diminished.
What is a reserve and how does it work?
When a bank accepts a deposit of Rs 100 in India, it
cannot lend out the entire amount.
A fraction of the deposit has to be maintained in the
form of approved government securities and as cash
with the RBI.
This amount is known as a reserve.
The objective is to bolster the safety of the deposit
Should we set reserves at a high level?
Obviously the higher the reserve percentage, the
greater is the safety for the depositors
On the flip side, the higher the reserves, the lower is
the income for the bank
Government securities do not pay market rates of interest
It would be more profitable for the bank to lend the money
locked up as a reserve to a borrower
Should we set reserves at a high level?
The issue is more serious when reserves have to be
kept in the form of cash.
Cash reserves yield either nil returns or very low returns
Example - Reserves
Due to high reserve requirements American banks
could not offer attractive rates on deposits.
Matters were made worse by imposing a ceiling on the
deposit rate
At the same time they could not attract borrowers, because
the lending rates were high.
Consequently European banks began attracting both
lenders as well as borrowers leading to the growth of
the Eurodollar market

Lack of Regulations
Eurocurrency deposits are outside the purview of the
country to which the currency belongs
E.g. The U.S. Federal Reserve cannot regulate Eurodollars
There are no statutory reserve requirements
Even though there are no statutory requirements, banks do
keep voluntary reserves as a measure of caution

There was a war in the Middle East in 1973, after
which Arab countries began to use oil prices as an
economic weapon
Rising crude prices lead to large dollar balances with Arab
Petrodollars (Cont)
Why Eurobanks could attract this money?
1. There were no reserve requirements
2. The transactions costs were low due to economies
of scale.
3. Thus Eurobanks could offer high interest rates to
4. At the same time could lend the funds at relatively
low rates to borrowers

A french exporter ships champagne to a
New York importer accompanied by a bill
for $10,000
The importing firm pays for the champagne
by issuing a cheque denominated in dollars
and deposits it in a US bank First
American bank where the French firm has
a checking account
Eurocurrency Deposits
Illustration (Cont)
Assets Liabilities
Deposit in US Bank = $10,000
After the check clears the results are:
French Exporters Account
Assets Liabilities
First American Banks Account
Deposit owed to French Exporter
= $10,000
Eurocurrency Deposits
Illustration (Cont)
This is not a Eurodollar deposit since
deposit occurs in the US
The French Exporter is offered an attractive
rate of return on its dollar deposit by its
own local Paris bank
It moves its dollar deposit there
Paris bank wants to loan these dollars to other
customers in the US
Eurocurrency Deposits
Illustration (Cont)
Assets Liabilities
Deposit in US Bank = - $10,000
The 4 transactions will be:
French Exporters Account
Assets Liabilities
First American Banks Account
Deposit owed to French Exporter
= - $10,000
Eurocurrency Deposits
Deposit in Paris Bank = + $10,000
Reserves transferred to
Correspondent Bank = - $10,000
Illustration (Cont)
Assets Liabilities
Reserves transferred from
First American Bank =
US Correspondent Banks Account
Assets Liabilities
Paris Banks Account
Deposit owed to French Exporter
= $10,000
Eurocurrency Deposits
Deposit owed to Paris Bank =
Deposit with US Correspondent
Bank = $10,000
Illustration (Cont)
Assume the Paris bank makes a loan of
$10,000 to a small oil company in Manchester.
The British company needs US dollars to pay
for shipment of petroleum drilling equipment
from Texas
Illustration (Cont)
Assets Liabilities
Loan to British company = +
Paris Banks Account
Assets Liabilities
British Oil Companys Account
Loan from Paris Bank = $10,000
Eurocurrency Deposits
Deposit in Correspondent
Bank = - $10,000
Deposit with US Correspondent
Bank = $10,000
Illustration (Cont)
Assets Liabilities
Deposit owed to French
exporter = $10,000
Paris Banks Account
Eurocurrency Deposits
Amount owed by British Oil
Company = + $10,000
Eurocurrency Deposits (Cont)
The creation of an ED deposit does not lead to
a situation where the money leaves the US
It is the ownership of the money that is
transferred across the border
Most deposits are short term
Range from call money to one year deposits
Calls deposits are like demand deposits placed
with US banks
Eurocurrency (Cont)
Euro CDs are also available
These are often a low cost alternative to a
domestic CD
No reserve requirement
No need for FDIC cover
There is also a market for eurocurrency bank
This is the equivalent of the Fed Funds market