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• W344673093 abstract "I. INTRODUCTION The difference between the offshore Eurocurrency deposit rate and domestic onshore deposit rate for the same currency is frequently positive. Eurobanks, however, are not required to provide deposit insurance or hold reserves against deposits. Consequently, it is frequently argued, they operate at a relative cost advantage to domestic banks, and can thus offer a higher deposit rate to the depositor. Risk differences are less frequently cited as the reason for the difference between offshore and onshore deposit rates. Sovereign risk is always present in offshore deposits and a difference in bank credit quality between offshore and onshore banks may also exist. Firstly, given common risks and costs, the law of one price suggests that all offshore trading centers will offer identical deposit rates for the same Eurocurrency. When this is the case, their risk premia will obviously be identical. Secondly, if one ignores offshore deposit risk and assumes an equal cost advantage in acquiring offshore deposits, the difference between Eurocurrency rates for two different currencies traded within a single Eurocurrency trading center must logically be explainable by the Fisher effect, i.e., a difference in expected inflation rates between the two home countries whose currencies denominate the offshore deposits. In fact, the pricing convention in the interest rate and currency swap markets ignores intra-market risk differences between Eurocurrencies. For example, the floating leg of a fixed-for-floating yen interest rate swap is usually set at the benchmark 6-month Euroyen rate, whereas the corresponding floating leg of a fixed-for-floating yen currency swap is usually set at the benchmark 6-month Eurodollar rate regardless of the denomination of the underlying currency. The fixed leg of both the yen interest rate swap and the yen currency swap are identically priced for identical maturities. Combining the two results in a yen-floating-for-dollar-floating currency (basis) swaps. Implicitly, this pricing convention only recognizes the difference between expected inflation rates contained in the benchmark Euroyen rate of the interest rate swap and the benchmark Eurodollar rate of the currency swap; any risk differences imbedded in these two rates have been implicitly ignored by identically pricing the fixed legs. An empirical study to determine if the current currency swap market convention of treating intra-market pairs of equal-maturity Eurocurrency time deposits as being equivalent-risk assets would be a contribution to the literature. In the present study, we argue that the difference between Eurodeposit and domestic deposit rates is based on differences in the risk premia embedded in the respective rates rather than cost advantages. In Section II, we provide a primer on the Eurocurrency market to formally establish the relevant questions. In Section III, we develop a model that defines the excess Eurocurrency market risk premium as comprised of both sovereign and credit risk components. We also develop testable hypotheses for explaining differences in risk within and across Eurocurrency trading centers. In Section IV, we empirically test our hypotheses using daily data for several Eurocurrencies. Section V offers a summary and conclusion. II. A PRIMER ON THE EUROCURRENCY MARKET To make loans and investment in securities, commercial banks need first to obtain deposits as a source of funds. A principal source of funds for domestic banks in major banking centers worldwide are negotiable certificates of deposits (CDs). In the U.S., dollar denominated CDs presently account for 19 (27) percent of total resident bank liabilities (deposits). While there is no limit on maximum maturity, CDs typically have maturities less than one year. By comparison, sterling CDs presently account for 6 (7) percent of resident bank liabilities (deposits) in the U.K. In Japan, yen CDs amount to 4 (6) percent of resident bank liabilities (deposits). …" @default.
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• W344673093 date "2009-06-22" @default.
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• W344673093 title "Eurocurrency Risk Premia" @default.
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