Slide 1Key Concepts and SkillsChapter Outline20.1 TerminologyTerminology20.2 Foreign Exchange Markets and Exchange RatesFOREX Market ParticipantsExchange RatesExampleCross RatesTriangular ArbitrageTriangular ArbitrageTriangular ArbitrageTriangular ArbitrageTypes of TransactionsAbsolute Purchasing Power ParityRelative Purchasing Power ParityExample20.4 Interest Rate ParityInterest Rate ParityInterest Rate ParityIRP and Covered Interest ArbitrageIRP and Covered Interest ArbitrageIRP and Covered Interest ArbitrageIRP and Covered Interest ArbitrageReasons for Deviations from IRPInternational Fisher Effect20.5 International Capital BudgetingHome Currency ApproachForeign Currency Approach20.6 Exchange Rate RiskShort-Run ExposureLong-Run ExposureTranslation ExposureManaging Exchange Rate Risk20.7 Political RiskQuick Quiz20-1I N T E R N AT I O N A L C O R P O R AT E F I N A N C EChapter 20Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.20-2KEY CONCEPTS AND SKILLS•Interpret exchange rate quotes and describe their meaning•Differentiate between spot and forward rates•Specify the distinction between purchasing power parity and interest rate parity, and the implications for changes in exchange rates•Articulate the basics of international capital budgeting•Describe the impact of political risk on international business investing20-3CHAPTER OUTLINE20.1 Terminology20.2 Foreign Exchange Markets and Exchange Rates20.3 Purchasing Power Parity20.4 Interest Rate Parity, Unbiased Forward Rates, and the International Fisher Effect20.5 International Capital Budgeting20.6 Exchange Rate Risk20.7 Political Risk20-420.1 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 Member States on 1 January 1999. •Eurobonds: bonds denominated in a particular currency (usually the issuer’s home currency) and issued simultaneously in the bond markets of several countries20-5TERMINOLOGY•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 nation’s capital market by a foreign borrower •Gilts: British and Irish government securities•LIBOR: the London Interbank Offered Rate is the rate most international banks charge one another for loans of Eurodollars overnight in the London market20-620.2 FOREIGN EXCHANGE MARKETS AND EXCHANGE RATES•Without a doubt, the foreign exchange market is the world’s largest financial market.•In this market, one country’s currency is traded for another’s.•Most of the trading takes place in a few currencies:•U.S. dollar ($)•British pound sterling (£)•Japanese yen (¥)•Euro (€)20-7FOREX 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.20-8EXCHANGE RATES•The price of one country’s currency in terms of another.•Most currency is quoted in terms of dollars.•Consider the following quote:•Euro 1.29167 .77419•The first number (1.29167 ) is how many U.S. dollars it takes to buy 1 Euro•The second number (.77419) is how many Euros it takes to buy $1•The two numbers are reciprocals of each other (1/1.29167 = .77419)20-9EXAMPLE•Suppose you have $10,000. Based on the rates in Figure 20.1, how many Swiss Francs can you buy?•Exchange rate = 1.0821 Francs per dollar•Buy 10,000(1.0821) = 10,821 Francs•Suppose you are visiting Bombay and you want to buy a souvenir that costs 1,000 Indian Rupees. How much does it cost in U.S. dollars?•Exchange rate = 54.965 rupees per dollar•Cost = 1,000 / 54.965 = $18.1920-10CROSS RATES•Suppose that S $/£ (0) = 1.5• i.e., $1.50 = £1.00 in the spot market•and that S¥/$(0) = 100• i.e., $1 = ¥100•What must the ¥/£ cross rate be?,£$$¥£¥ since  150 )0(£1¥150£1$1.50$1¥100£¥£/¥S20-11TRIANGULAR ARBITRAGE$£¥Credit Lyonnais S$/£(0) = 1.50Credit AgricoleS¥/£(0) = 185BarclaysS¥/$(0) = 120Suppose we observe these banks posting these exchange rates.First calculate the implied cross rates to see if an arbitrage exists.20-12TRIANGULAR ARBITRAGE$£¥Credit Lyonnais S$/£(0) = 1.50Credit AgricoleS¥/£(0) = 185BarclaysS¥/$(0) = 120The implied S¥/£ cross rate is S¥/£(0) = 180Credit Agricole has posted a quote of S(¥/£)=185, so there is an arbitrage opportunity.So, how can we make money?$1.50£1×¥120$1=¥180 £120-13TRIANGULAR ARBITRAGE$£¥Credit Lyonnais S$/£(0) = 1.50Credit AgricoleS¥/£(0) = 185BarclaysS¥/$(0) = 120As easy as 1 – 2 – 3:1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $.20-14TRIANGULAR ARBITRAGESell $150,000 for £ at S$/£(0) = 1.50receive £100,000 Sell our £ 100,000 for ¥ at S¥/£(0) = 185 receive ¥18,500,000Sell ¥ 18,500,000 for $ at S¥/$(0) = 120receive $154,167profit per round trip = $ 154,167 – $150,000 = $4,16720-15TYPES OF TRANSACTIONS•Spot trade – exchange currency immediately•Spot rate – the exchange rate for an immediate trade•Forward trade – agree today to exchange currency at some future date and some specified price (also called a forward contract)•Forward rate – the exchange rate specified in the forward contract•If the forward rate is higher than the spot rate, the foreign currency is selling at a premium (when quoted as $ equivalents).•If the forward rate is lower than the spot rate, the foreign currency is selling at a discount.20-16ABSOLUTE PURCHASING POWER PARITY•Price of an item is the same regardless of the currency used to purchase it.•Requirements for absolute PPP to hold:•Transaction costs are zero•No barriers to trade (no taxes, tariffs, etc.)•No difference in the commodity between locations•For