The Global Financial Environment:

Markets, Institutions, Interest

Rates, and Exchange Rates

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

Types of Financial Transactions

Direct transfer
Indirect transfer
Through an investment banking
house
Through a financial intermediary

The Stock Market

Organized Exchanges versus Overthe-Counter Market
NYSE versus Nasdaq system
Differences are narrowing

International Financial Markets

Eurodollar markets
Dollars held outside the U.S.
Mostly Europe, but also elsewhere

International bonds
Foreign bonds: Sold by foreign borrower,
but denominated in the currency of the
country of issue.
Eurobonds: Sold in country other than the
one in whose currency it is denominated.

International stocks
ADRs: Certificates representing ownership
of foreign stock held in trust.
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What Various Types of Risks Arise

When Investing Overseas?
Country risk: Arises from investing or
doing business in a particular country. It
depends on the countrys economic,
political, and social environment.
Exchange rate risk: If investment is
denominated in a currency other than the
dollar, the investments value will depend
on what happens to exchange rate.
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The Cost of Money

What do we call the price, or cost,
of debt capital?
What do we call the price, or cost,
of equity capital?

Fundamental Factors Affecting the

Cost of Money
Production opportunities
Time preferences for consumption
Risk
Expected inflation

Real versus Nominal Rates

k*

= Real risk-free rate.

T-bond rate if no inflation;
1% to 4%.

= Any nominal rate.

kRF

= Rate on Treasury securities.

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The Determinants of Market Interest

Rates
k = k* + IP + DRP + LP + MRP
Where:
k

= Required rate of return on a debt security.

k*

= Real risk-free rate.

IP

= Inflation premium.

DRP
LP
MRP

= Default risk premium.

= Liquidity premium.
= Maturity risk premium.
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Premiums Added to k* for Different

Types of Debt
ST Treasury:
LT Treasury:
ST corporate:
LT corporate:

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The Term Structure of Interest Rates

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

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Hypothetical Treasury Yield Curve

Interest
Rate (%)
15

Maturity risk premium

10

Inflation premium

1 yr
10 yr
20 yr

8.0%
11.4%
12.65%

5
Real risk-free rate

Years to Maturity

0
1

10

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What Determines the Shape of the

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

The Pure Expectations Theory (PEH)

Shape of the yield curve depends on the investors
expectations about future interest rates.
If interest rates are expected to increase, L-T rates
will be higher than S-T rates and vice versa. Thus,
the yield curve can slope up or down.
PEH assumes that MRP = 0.
Long-term rates are an average of current and
future short-term rates.
If PEH is correct, you can use the yield curve to
back out expected future interest rates.

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Observed Treasury Rates

Maturity
Yield
1 year
6.0%
2 years
6.2%
3 years
6.4%
4 years
6.5%
If PEH holds,
what does the
market expect
5 years
6.5%

will be the interest rate on one-year

securities, one year from now? Three-year
securities, two years from now?

Conclusions About PEH

Some argue that the PEH isnt correct,
because securities of different maturities
have different risk.
General view (supported by most
evidence) is that lenders prefer S-T
securities, and view L-T securities as
riskier.
Thus, investors demand a MRP to get
them to hold L-T securities (i.e., MRP > 0).
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Other Factors That Influence

Interest Rate Levels
Federal Reserve Policy
Federal Budget Deficit or Surplus
International Factors
Level of Business Activity

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Trading in Foreign Currencies

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

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Trading in Foreign Currencies

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

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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,
kh = periodic interest rate in the home country.
kf = periodic interest rate in the foreign country.
f1 = one-year forward rate
e0 = current spot rate
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Interest Rate Parity (IRP)

Interest rate parity shows why a
particular currency might be at a
forward premium or discount.
If domestic interest rates are higher than
foreign interest rates, the foreign currency
is selling at a forward premium.
Discounts prevail if domestic interest rates
are lower than foreign interest rates.
Arbitrage forces interest rates back to
parity.
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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.
Ph = Pf(Spot rate)
or
Spot rate = Ph/Pf
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Inflation, Interest Rates, and

Exchange Rates

Lower inflation leads to lower

interest rates, so borrowing in lowinterest countries may appear
attractive to multinational firms.
However, currencies in low-inflation
countries tend to appreciate
against those in high-inflation rate
countries, so the true interest cost
increases over the life of the loan.
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