- •Chapter 3: The international financial marketplace key chapter concepts
- •Glossary of new terms
- •Financial challenge
- •Introduction
- •The global economy and multinational enterprises
- •Table 3—1
- •Table 3—1
- •Foreign currency markets and exchange rates
- •Direct and Indirect Quotes
- •Table 3 — 2 Spot Foreign Exchange Rates
- •Spot Rates
- •Forward Rates
- •Table 3 — 3. Forward Foreign Exchange Rates
- •Foreign Currency Futures
- •Table 3-4. Futures Contract Quotations
- •Foreign Currency Options
- •The Eurocurrency Market
- •Factors that affect exchange rates
- •Covered Interest Arbitrage and Interest Rate Parity
- •Purchasing Power Parity
- •Expectations Theory and Forward Exchange Rates
- •The International Fisher Effect
- •An Integrative Look at International Parity Relationships
- •Figure 3—1. International Parity Conditions: An Integrative Look
- •Forecasting future exchange rates
- •Using Forward Rates
- •Using Interest Rates
- •Foreign exchange risk
- •Transaction Exposure
- •Table 3-5. Example of Transaction Exchange Rate Risk
- •Economic Exposure
- •Translation Exposure
- •Table 3 – 6. Effect of a Decrease in the Exchange Rate on American Products' Balance Sheet
- •International finance and the practice of financial management
- •Ethical issues: payment of bribes abroad
- •Summary
- •Questions and topics for discussion
- •Self test problems
- •Problems
- •Solutions to self test problems
Summary
Firms engaged in international financial transactions face risks and problems not faced in domestic transactions, including difficulties encountered in doing business in different currencies and problems associated with different government regulations, tax laws, business practices, and political environments.
A Eurocurrency is a currency deposited in a bank located outside of the country of origin. The Eurocurrency market is an important alternative to domestic sources of financing for multinational firms. The interest rate charged for Eurocurrency loans is tied to LIBOR, the London interbank offer rate.
The exchange rate is the rate at which one currency can be converted into another. The spot rate is the rate of exchange for currencies being bought and sold for immediate delivery today. The forward rate is the rate of exchange between currencies to be delivered at a future point in time—usually 30, 90, and 180 days from today. The futures rate also is a rate of exchange between currencies to be delivered at a future point in time. In contrast to forward contracts, futures contracts are standardized with respect to size and delivery date and are traded on organized exchanges, such as the International Monetary Market. Foreign currency options give the option holder the right to buy or sell a foreign currency at a fixed price over some time horizon.
The theory of interest rate parity states 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.
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 two countries will be offset by equal, but opposite changes in the future spot currency rate.
The forward rate is often taken as an unbiased estimator of the future spot currency rate.
The nominal rate of interest is approximately-equal to the sum of the real rate of interest and the expected inflation rate. This relationship is known as the Fisher effect.
The international Fisher effect theory states that differences in interest rates between two countries will be offset by equal, but opposite changes in the future spot rate.
Forecasts of future spot exchange rates can be derived from forward rates, if available, or from observed interest rates between two countries in conjunction with the international Fisher effect theory.
Firms that compete in a global economy face three categories of foreign exchange risk:
1. Transaction or short-term exposure
2. Economic (operating) or long-term exposure
3. Translation (accounting) exposure
Many risk-reducing strategies are available to firms facing these risks, including the use of various hedges, such as a forward hedge and a money market hedge.