Pricing Money: A Beginner’s Guide to Money, Bonds, Futures and Swaps

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.

Chapter 1 (second half), The Money Markets

Two money markets

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.

The euro

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.

Writing money

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.

Settlement details

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.

Summary

• 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.