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The Global Financial Environment

:
Markets, Institutions, Interest
Rates, and Exchange Rates

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Types of Financial Markets
Physical Asset versus Financial
Asset Market
Money Market versus Capital
Market
Primary versus Secondary Market
Open versus Negotiated Market
Spot versus Futures Market
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Recent Trends in Financial Markets Globalization Derivatives Stock Ownership Patterns 3 .

Types of Financial Transactions Direct transfer Indirect transfer Through an investment banking house Through a financial intermediary 4 .

The Stock Market Organized Exchanges versus Overthe-Counter Market NYSE versus Nasdaq system Differences are narrowing 5 .

but also elsewhere International bonds Foreign bonds: Sold by foreign borrower. but denominated in the currency of the country of issue. Mostly Europe.S. International stocks ADRs: Certificates representing ownership of foreign stock held in trust.International Financial Markets Eurodollar markets Dollars held outside the U. Eurobonds: Sold in country other than the one in whose currency it is denominated. 6 .

What Various Types of Risks Arise When Investing Overseas? Country risk: Arises from investing or doing business in a particular country. Exchange rate risk: If investment is denominated in a currency other than the dollar. and social environment. It depends on the country’s economic. 7 . political. the investment’s value will depend on what happens to exchange rate.

of equity capital? 8 . of debt capital? What do we call the price. or cost. or cost.The Cost of Money What do we call the price.

Fundamental Factors Affecting the Cost of Money Production opportunities Time preferences for consumption Risk Expected inflation 9 .

k = Any nominal rate. 1% to 4%.Real versus Nominal Rates k* = Real risk-free rate. 10 . T-bond rate if no inflation. kRF = Rate on Treasury securities.

DRP LP MRP = Default risk premium.The Determinants of Market Interest Rates k = k* + IP + DRP + LP + MRP Where: k = Required rate of return on a debt security. IP = Inflation premium. 11 . = Maturity risk premium. = Liquidity premium. k* = Real risk-free rate.

Premiums Added to k* for Different Types of Debt ST Treasury: LT Treasury: ST corporate: LT corporate: 12 .

13 . A graph of the term structure is called the yield curve.The Term Structure of Interest Rates Term structure: the relationship between interest rates (or yields) and maturities.

0% 11.65% 5 Real risk-free rate Years to Maturity 0 1 10 20 .4% 12.Hypothetical Treasury Yield Curve Interest Rate (%) 15 Maturity risk premium 10 Inflation premium 1 yr 10 yr 20 yr 8.

Perceptions about the relative riskiness of securities with different maturities.What Determines the Shape of the Yield Curve? Expectations about future inflation. .

the yield curve can slope up or down.The Pure Expectations Theory (PEH) Shape of the yield curve depends on the investors’ expectations about future interest rates. Long-term rates are an average of current and future short-term rates. If interest rates are expected to increase. If PEH is correct. L-T rates will be higher than S-T rates and vice versa. 16 . you can use the yield curve to “back out” expected future interest rates. PEH assumes that MRP = 0. Thus.

what does the market expect 5 years 6.2% 3 years 6.Observed Treasury Rates Maturity Yield 1 year 6. two years from now? .0% 2 years 6.4% 4 years 6.5% will be the interest rate on one-year securities.5% If PEH holds. one year from now? Three-year securities.

investors demand a MRP to get them to hold L-T securities (i.Conclusions About PEH Some argue that the PEH isn’t correct. because securities of different maturities have different risk. General view (supported by most evidence) is that lenders prefer S-T securities. MRP > 0).. Thus. and view L-T securities as riskier.e. 18 .

Other Factors That Influence Interest Rate Levels Federal Reserve Policy Federal Budget Deficit or Surplus International Factors Level of Business Activity 19 .

S. dollar. Indirect quotation: quotation Foreign currency price per one unit of U. 20 . Spot Exchange Rate Quotations Direct quotation: quotation U.Trading in Foreign Currencies A spot rate is the rate applied to buy currency for immediate delivery.S. Note that an indirect quotation is the reciprocal of a direct quotation. dollar price of one unit of foreign currency.

that is.S. In practice. on the basis of U.Trading in Foreign Currencies A cross rate is the exchange rate between any two currencies not involving U.S. dollar exchange rates. 21 . currency arbitrage opportunities exist. cross rates are usually calculated from direct or indirect rates. dollars. When currencies are not related to one another in a consistent manner.

Trading in Foreign Currencies A forward rate is the rate applied to buy currency at some agreed-upon future date. Forward premium: FR > SR Forward discount: FR < SR The primary determinant of the spot/forward rate relationship is relative interest rates. 22 .

Interest Rate Parity (IRP) Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries: f1 1  k h   e0 1  k f  Here. kf = periodic interest rate in the foreign country. f1 = one-year forward rate e0 = current spot rate 23 . kh = periodic interest rate in the home country.

the foreign currency is selling at a forward premium.Interest Rate Parity (IRP) Interest rate parity shows why a particular currency might be at a forward premium or discount. 24 . Discounts prevail if domestic interest rates are lower than foreign interest rates. If domestic interest rates are higher than foreign interest rates. Arbitrage forces interest rates back to parity.

Ph = Pf(Spot rate) or Spot rate = Ph/Pf 25 .Purchasing Power Parity (PPP) Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries.

so the true interest cost increases over the life of the loan. However. Interest Rates. 26 .Inflation. so borrowing in lowinterest countries may appear attractive to multinational firms. currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries. and Exchange Rates Lower inflation leads to lower interest rates.