The Global Financial Environment:
Markets, Institutions, Interest
Rates, and Exchange Rates
Corporate Finance
Dr. A. DeMaskey
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Learning Objectives
Questions to be answered:
What are the major types of financial markets?
How is capital transferred between savers and
borrowers?
What are the major types of international financial
markets?
How are market interest rates and exchange rates
determined?
What is the term structure of interest rates?
What determines the shape of the yield curve?
What other factors influence interest rate levels?
How does the level of interest rates affect business
decisions?
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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
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Types of Financial Transactions
Direct transfer
Indirect transfer
Through an investment banking house
Through a financial intermediary
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The Stock Market
Organized Exchanges versus Over-theCounter Market
NYSE versus Nasdaq system
Differences are narrowing
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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 country’s economic, political, and
social environment.
Exchange rate risk: If investment is
denominated in a currency other than the
dollar, the investment’s 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?
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Fundamental Factors Affecting the
Cost of Money
Production opportunities
Time preferences for consumption
Risk
Expected inflation
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Real versus Nominal Rates
k*
= Real risk-free rate.
T-bond rate if no inflation;
1% to 4%.
k
= 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
=
Default risk premium.
LP
=
Liquidity premium.
MRP
=
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 (%)
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Maturity risk premium
10
Inflation premium
1 yr
10 yr
20 yr
8.0%
11.4%
12.65%
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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
1 year
2 years
3 years
4 years
5 years
Yield
6.0%
6.2%
6.4%
6.5%
6.5%
If PEH holds, what does the market expect
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 isn’t correct,
because securities of different maturities have
different risk.
General view (supported by most evidence) is
that lenders prefer S-T securities, and view LT 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: U.S. dollar price of one unit of
foreign currency.
Indirect 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  kh 

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.
or
Ph = Pf(Spot rate)
Spot rate = Ph/Pf
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Inflation, Interest Rates, and
Exchange Rates
Lower inflation leads to lower interest
rates, so borrowing in low-interest
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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