Image used to convey the idea of currency conv...

Foreign exchange market operates where currencies are bought and sold, where as in Euro currency market currencies are deposited and borrowed.

The reason Foreign market operates on exchange rate and Euro currency market operates on interests rates.

1) The Euro currency market originated out of the need of investors to hide identity to circumvent regulatory control.

2) The growth of their market was triggered by

  • Regulatory requirement of the federal reserve which imposed ceilings on bank deposits interest rates in the US
  • Regulation of the federal reserve act which enforced reserve requirements on bank deposits in the US
  • Interest equalization tax was introduced in 1963 in US
  • The voluntary retirement programme introduced in the US in 1965

3) Transactions in this market essentials creates assets and liabilities in non-resident countries

4) Although the utilization of the currency takes outside the country of origin the fund continue to remain in the country of issue.

5) Free entry and exit from this market makes it highly competitive with very fine rates available to deposits and borrowers.

6) All transactions in this market are unsecured, uninsured and unregulated.

7) The market deals only in freely convertible currency having universal acceptance such as USD/GBP/EUR/JPY/CHP/CAD

8) Due to unsecured nature of the market deposits are accepted only for maturities ranging from 1 day to 1 year.

9) 85% of the deposits have 6 months maturity.

10) Loans given in this market are also unsecured . The basis for loans is the credit ratings of the borrowers and viability of the project being financed/

11) While the deposit base predominately has maturity of 6 months , borrowers required finance for medium to long-term ranging from 5-10 years , this created asset liability mismatch which resulted in both liquidity risk and interest rates risk for the lender. To overcome this problem all loans are rolled over in 6 months basis they get renewed with resetting of interest rates.

12) Since the interest rates are variable a common reference rate has been evolved the profitability of the bank is kept constant through the life time of loan by specifying a “makeup” over the reference rate. that was LIBOR +2%