,Corporate Finance Ross Westerfield Jaffe,Sixth Edition,Chapter Outline,32.1 Terminology32.2 Foreign Exchange Markets and Exchange Rates32.3 The Law of One Price and Purchasing Power Parity32.4 Interest Rates and Exchange Rates: Interest Rate Parity32.5 International Capital Budgeting32.6 International Financial Decisions32.7 Reporting Foreign Operations32.8 Summary and Conclusions,32.1 Terminology,American Depository Receipt (ADR): a security issued in the U.S. to represent shares of a foreign stock.Cross rate: the exchange rate between two foreign currencies, e.g. the exchange rate between and .Euro (): the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands.Eurobonds: bonds denominated in a particular currency and issued simultaneously in the bond markets of several countries.,32.1 Terminology,Eurocurrency: money deposited in a financial center outside the home country. Eurodollars are dollar deposits held outside the U.S.; Euroyen are yen denominated deposits held outside Japan.Foreign bonds: bonds issued in another nations capital market by a foreign borrower. Gilts: British and Irish government securities.LIBOR: the London Interbank Offer Rate is the rate most international banks charge on another for loans of Eurodollars overnight in the London market.,32.2 Foreign Exchange Markets and Exchange Rates,Without a doubt the foreign exchange market is the worlds largest financial market.In this market one countrys currency is traded for anothers.Most of the trading takes place in a few currencies.,FOREX Market Participants,The FOREX market is a two-tiered market:Interbank Market (Wholesale)About 700 banks worldwide stand ready to make a market in Foreign exchange.Nonbank dealers account for about 20% of the market.There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists.Client Market (Retail)Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.,Correspondent Banking Relationships,Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market.International commercial banks communicate with one another with:SWIFT: The Society for Worldwide Interbank Financial Telecommunications.CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.,Spot Rate Quotations,The spot market is the market for immediate delivery. (Settlement is due within two days.)Direct quotationthe U.S. dollar equivalente.g. “a Japanese Yen is worth about a penny”Indirect Quotationthe price of a U.S. dollar in the foreign currencye.g. “you get 100 yen to the dollar”,Spot FX trading,In the interbank market, the standard size trade is about U.S. $10 million.A bank trading room is a noisy, active place.The stakes are high.The “long term” is about 10 minutes.,Cross Rates,Suppose that SDM(0) = .50 i.e. $1 = 2 DM in the spot marketand that S(0) = 100 i.e. $1 = 100What must the DM/ cross rate be?,Triangular Arbitrage,$,Suppose we observe these banks posting these exchange rates.,First calculate the implied cross rates to see if an arbitrage exists.,Triangular Arbitrage,$,The implied S(/) cross rate is S(/) = 80,Credit Agricole has posted a quote of S(/)=85 so there is an arbitrage opportunity.,So, how can we make money?,Triangular Arbitrage,$,As easy as 1 2 3:,1. Sell our $ for , 2. Sell our for , 3. Sell those for $.,Triangular Arbitrage,Sell $100,000 for at S(0) = 1.50receive 150,000,Sell our 150,000 for at S/(0) = 85 receive 12,750,000,Sell 12,750,000 for $ at S(0) = 120,receive $106,250,profit per round trip = $ 106,250- $100,000 = $6,250,The Forward Market,A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today.If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.,Forward Rate Quotations,The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today.Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts.Longer-term swaps are available.,Forward Rate Quotations,Suppose you observe that for Japanese yen, the spot rate is 115.75 = $1.00While the 180-day forward rate is 112.80 = $1.00Whats up with that?The forex market clearly thinks that the yen is going to be worth more in six months (the yen is expected to appreciate) because one dollar will buy fewer yen.,Long and Short Forward Positions,If you have agreed to sell anything (spot or forward), you are “short”.If you have agreed to buy anything (forward or spot), you are “long”.If you have agreed to sell forex forward, you are short.If you have agreed to buy forex forward, you are long.,