This article has been prepared mainly by R. B. Johnston of the Bank's Overseas Department.
This article discusses some systematic relationships which have been observed between domestic and eurocurrency interest rates. It describes a model to explain these relationships, based on the extra costs which banks incur from holding reserve requirements against domestic deposits. Statistical tests have been used to compare the marginal cost of three-month money (after allowing for the extra cost of reserve requirements) in the euro-dollar and domestic US markets, and in the euro-deutschemark and domestic West German markets. These tests confirm that, in the absence of disruptions to the free flow of capital, the differences in these costs are virtually zero and that domestic banks effectively arbitrage between the euro and domestic money markets. The article concludes that the eurocurrency market is not independent of domestic money markets and that its role as a channel for short-term capital flows appears to be very closely linked to the activities of domestic banks.
Some aspects of the determination of euro-currency interest rates