Chapter 3. The international financial marketplace key chapter concepts

1. Companies engaged in international financial trans­actions face such problems as political and exchange rate risk in addition to those risks encountered in domestic transactions.

2. The exchange rate is the rate at which a currency can be converted into another currency.

a. The spot rate is the present exchange rate for immediate delivery.

b. The forward rate is the present exchange rate for deliveries of currencies in the future.

3. The theory of interest rate parity states that the per­centage differential between the spot and the forward rate for a currency is equal to the approximate differ­ence in interest rates in the two countries over the same time horizon.

4. The theory of relative purchasing power parity states that in comparison to a period when exchange rates between two countries are in equilibrium, changes in differential rates of inflation between the countries will be offset by equal, but opposite changes in the; future spot currency rate.

5. The forward rate is often considered to be an unbi­ased estimator of the future spot currency rate.

6. The Fisher effect states that nominal interest rates are approximately equal to the sum of the real interest rate and the expected inflation rate.

7. The international Fisher effect theory states that differ­ences in interest rates between two countries should be offset by equal, but opposite changes in the future spot rate.

8. Three important categories of foreign exchange risk are (1) transaction exposure, (2) economic exposure, and (3) translation exposure.

9. A hedge is an offsetting transaction designed to reduce or avoid risk. Forward and futures exchange hedges and money market hedges are used to reduce transaction exposure. Financing with debt denomi­nated in the same currency as foreign assets is a means of hedging against translation and economic exposure.

10. The Eurocurrency market is an important alternative to domestic sources of financing for multinational firms. L1BOR, the London interbank offer rate, is the basic interest rate against which Eurocurrency loans are priced.

Glossary of new terms

Covered Interest Arbitrage A risk-free transaction in which short-term funds are moved between two currencies to take advantage of interest rate differentials. Exchange rate risk is eliminated through the use of Forward contracts.

Direct Quote The home currency price of one unit of a foreign currency.

Economic Exposure The extent to which changes in real exchange rates lead to a change in the value of a firm's operating cash flows and hence its value Also known as operating exposure.

Eurobond An international bond issued outside the country in whose currency the bonds are denominated.

Eurocurrency A currency that is deposited in a bank out side of the country of origin.

Eurodollars U.S. dollars deposited in banks outside of the U.S.

European Currency Unit (ECU) A composite 'currency' consisting of fixed amounts of currencies of the European countries that are part of the Exchange Rate Mechanism.

Exchange Rate The rate at which a currency can be con­verted into another currency.

Fisher Effect A theory stating that nominal interest rates in any country are equal to the real rate of interest plus a premium to compensate for expected inflation.

Foreign Bond An international bond denominated in the currency of the country in which it is issued. The issuer however, is from another country.

Forward Rate The rate of exchange between two curren­cies being bought and sold for delivery at a future date.

Futures Contract A contract calling for the delivery of a standardized quantity and quality of some item, such as a foreign currency, crude oil or government securities at a future point in time at a price set at the present time.

Hedge A transaction in which a position is taken in another market, such as the forward or futures market, to offset the risk associated with a position in the current cash (spot) market.

Indirect Quote The foreign currency price of one unit of the home currency.

Interest Rate Parity The theory that the percentage dif­ferential between the spot and the forward rate for a currency quoted in terms of another currency is equal to the approximate difference in interest rates in the two countries over the same time horizon.

International Bond A bond issued outside the country of the borrower.

International Fisher Effect The theory that the spot exchange rate between two currencies should change by an amount approximately equal to the difference in interest rates in the two countries.

London Interbank Offer Rate (LIBOR) The interest rate at which banks in the Eurocurrency market lend to each other.

Multinational Corporation A firm with direct investments in more than one country.

Nominal Interest Rate A market rate of interest stated in current, not real terms. Nominal interest rates reflect expected inflation rates.

Relative Purchasing Power Parity The theory that the spot exchange rate between two currencies should change by an amount approximately equal to the difference in expected inflation rates in the two coun­tries.

Spot Rate The rate of exchange between two currencies being bought and sold for immediate delivery.

Transaction Exposure The potential for a change in the value of a foreign-currency denominated transaction due to a change in the exchange rate after the transaction is entered into but before it is settled

Translation (Accounting) Exposure The change in owners' (accounting) equity because of a change in exchange rates that affects the “converted” value of foreign assets and liabilities.