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Introduction to Foreign Exchange Markets and Risks

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International Financial Management

by Geert Bekaert; Robert J. Hodrick

Publisher: Prentice Hall

Copyright Year: 2009

Publishing Date: 2008/04/09

eText ISBN-10: 0-13-241268-3

eText ISBN-13: 978-0-13-241268-1

Print ISBN-10: 0-13-116360-4

Print ISBN-13: 978-0-13-116360-7

Course: Financial Markets and Institutions

Pages: 840

eTextbook $96.20

(180 day subscription)

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Table of Contents | Description

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ABOUT THIS TITLE - TABLE OF CONTENTS

The Prentice Hall Series in Finance, ii

About the Authors, xxvii

Part I. Introduction to Foreign Exchange Markets and Risks, 1

Chapter 1. Globalization and the Multinational Corporation, 1

1.1. Introduction, 1

1.2. Globalization and the Growth of International Trade and Capital Flows, 2

The Growth of International Trade, 2

The Globalization of Financial Markets, 5

1.3. Multinational Corporations, 8

How Multinational Corporations Enter Foreign Markets, 10

The Goals of an MNC, 10

Corporate Governance Around the World, 12

Multinational Corporations and Foreign Direct Investment, 15

1.4. Other Important International Players, 18

International Banks, 18

International Institutions, 19

Governments, 22

Institutional and Individual Investors, 22

1.5. Globalization and the Multinational Firm: Benefactor or Menace?, 23

A Rocky Road to Free Trade, 23

Do International Capital Flows Cause Havoc?, 24

The Anti-globalist Movement and MNCs, 26

Some Final Thoughts on Globalization, 28

1.6. Overview of the Book, 29

Part I: Introduction to Foreign Exchange Markets and Risks, 29

Part II: International Parity Conditions and Exchange Rate Determination, 29

Part III: International Capital Markets, 30

Part IV: International Corporate Finance, 30

Part V: Managing Ongoing Operations, 30

Part VI: Foreign Currency Derivatives, 30

A Final Introduction, 31

1.7. Summary, 32

Bibliography, 34

Chapter 2. The Foreign Exchange Market, 36

2.1. The Organization of the Foreign Exchange Market, 36

Size of the Market, 38

Types of Contracts Traded, 39

Foreign Exchange Dealers, 39

Foreign Exchange Brokers, 39

Computerized Trading Systems, 40

Other Participants in the Forex Market, 40

The Competitive Marketplace, 40

2.2. Currency Quotes and Prices, 41

Exchange Rates, 42

Exchange Rate Quotes, 42

Vehicle Currencies and Currency Cross-Rates, 46

Triangular Arbitrage, 46

2.3. Inside the Interbank Market I: Bid-Ask Spreads and Bank Profits, 51

Bid-Ask Spreads, 51

The Magnitude of Bid-Ask Spreads, 53

Bid-Ask Spreads All Day Around the World, 54

2.4. Inside the Interbank Market II: Communications and Fund Transfers, 56

Communication Systems, 56

Cross-Currency Settlement (or Herstatt) Risk, 57

2.5. Describing Changes in Exchange Rates, 59

Rates of Appreciation and Depreciation, 62

Continuously Compounded Rates of Appreciation (Advanced), 63

2.6. Summary, 64

Bibliography, 65

Appendix: Logarithms, 66

Chapter 3. Forward Markets and Transaction Exchange Risk, 67

3.1. Transaction Exchange Risk, 68

3.2. Describing Uncertain Future Exchange Rates, 69

Assessing Exchange Rate Uncertainty Using Historical Data, 69

The Probability Distribution of Future Exchange Rates, 72

3.3. Hedging Transaction Exchange Risk, 74

Forward Contracts and Hedging, 74

The Costs and Benefits of a Forward Hedge, 77

Examples of Using Forward Contracts to Hedge Transaction Risk, 78

3.4. The Forward Foreign Exchange Market, 81

Market Organization, 81

Forward Contract Maturities and Value Dates, 82

Forward Market Bid-Ask Spreads, 83

Net Settlement, 86

The Foreign Exchange Swap Market, 87

3.5. Forward Premiums and Discounts, 90

Sizes of Forward Premiums or Discounts, 91

Forward Premiums and Swap Points, 91

3.6. Changes in Exchange Rate Volatility (Advanced), 92

Volatility Clustering, 93

Other Volatility Models, 95

3.7. Summary, 95

Bibliography, 96

Appendix: A Statistics Refresher, 97

Chapter 4. The Balance of Payments, 102

4.1. The Balance of Payments: Concepts and Terminology, 102

Major Accounts of the Balance of Payments, 102

A Double-Entry Accounting System, 104

Current Account Transactions, 104

Capital Account Transactions, 107

Official Reserves Account Transactions, 108

4.2. Surpluses and Deficits in the Balance of Payments Accounts, 109

An Important Balance of Payments Identity, 109

The U.S. Current Account, 109

The U.S. Capital and Financial Accounts, 111

BOP Deficits and Surpluses and the Official Settlements Account, 115

Balance of Payment Statistics Around the World, 116

4.3. The Dynamics of the BOP, 118

The Trade Account and the Investment Income Account, 118

Countries as Net Creditors or Net Debtors, 119

Data on International Investment Positions, 119

4.4. Savings, Investment, Income, and the BOP, 122

Linking the Current Account to National Income, 122

National Savings, Investment, and the Current Account, 123

Current Accounts and Government Deficits, 123

What Causes Current Account Deficits and Surpluses?, 124

Assessing the Openness of International Capital Markets, 128

4.5. Summary, 129

Bibliography, 132

Appendix: A Primer on National Income and Product Accounts, 133

Chapter 5. Exchange Rate Systems, 136

5.1. Alternative Exchange Rate Arrangements and Currency Risk, 136

Exchange Rate Systems Around the World, 136

Currency Risks in Alternative Exchange Rate Systems, 140

Trends in Currency Systems, 144

5.2. Central Banks, 144

The Central Bank’s Balance Sheet, 144

Foreign Exchange Interventions, 149

How Do Central Banks Peg a Currency?, 150

5.3. Flexible Exchange Rate Systems, 151

The Effects of Central Bank Interventions, 152

Empirical Evidence on the Effectiveness of Interventions, 154

5.4. Fixed Exchange Rate Systems, 155

The International Monetary System Before 1971: A Brief History, 155

Pegged Exchange Rate Systems in Developing Countries, 157

Why Not Simply Float?, 160

Currency Boards, 161

Dollarization, 163

5.5. Limited-Flexibility Systems: Target Zones and Crawling Pegs, 163

Target Zones, 163

Crawling Pegs, 166

5.6. How to See an Emu Fly: The Road to Monetary Integration in Europe, 168

The European Monetary System (EMS), 168

On ECUs, Euros, and Franken, 169

Was the EMS Successful?, 171

The Maastricht Treaty and the Euro, 172

Pros and Cons of a Monetary Union (Advanced), 173

5.7. Summary, 174

Bibliography, 176

Part II. International Parity Conditions and Exchange Rate Determination, 178

Chapter 6. Interest Rate Parity, 178

6.1. The Theory of Covered Interest Rate Parity, 178

The Intuition Behind Interest Rate Parity, 180

Deriving Interest Rate Parity, 183

Covered Interest Arbitrage, 185

6.2. Covered Interest Rate Parity in Practice, 188

The External Currency Market, 188

Covered Interest Arbitrage with Transaction Costs (Advanced), 190

6.3. Problems Related to Testing Interest Rate Parity, 196

Default Risks, 196

Exchange Controls, 197

Political Risk, 198

6.4. Hedging Transaction Risk in the Money Market, 201

Hedging a Foreign Currency Liability, 201

Hedging a Foreign Currency Receivable, 202

6.5. The Term Structure of Forward Premiums and Discounts, 203

The Term Structure of Interest Rates, 203

Long-Term Forward Rates and Premiums, 207

6.6. Summary, 209

Bibliography, 212

Chapter 7. Speculation and Risk in the Foreign Exchange Market, 213

7.1. Speculating in the Foreign Exchange Market, 213

Uncovered Foreign Money Market Investments, 213

Speculating with Forward Contracts, 215

Currency Speculation and Profits and Losses, 217

7.2. Uncovered Interest Rate Parity and the Unbiasedness Hypothesis, 223

Exchange Rate Forecasts and Market Efficiency, 223

Uncovered Interest Rate Parity, 224

The Unbiasedness Hypothesis, 225

7.3. Risk Premiums in the Foreign Exchange Market, 227

What Determines Risk Premiums?, 228

Formal Derivation of CAPM Risk Premiums (Advanced), 230

7.4. Uncovered Interest Rate Parity and the Unbiasedness Hypothesis in Practice, 231

International Portfolio Management, 231

Exchange Rate Forecasting, 231

Exchange Rate Determination, 232

The Cost of Hedging, 232

7.5. Empirical Evidence on the Unbiasedness Hypothesis, 234

The Quest for a Test, 234

A Test Using the Sample Means, 236

Regression Tests of the Unbiasedness of Forward Rates, 238

7.6. Alternative Interpretations of the Test Results, 240

Risk Premiums, 241

Do Survey Data Reveal Irrational Expectations?, 242

Peso Problems, 243

7.7. Summary, 248

Bibliography, 251

Appendix 7.1: The Portfolio Diversification Argument and the CAPM, 252

Appendix 7.2: A Regression Refresher, 255

Chapter 8. Purchasing Power Parity and Real Exchange Rates, 259

8.1. Price Levels and Price Indexes, 260

The General Idea of Purchasing Power, 260

Calculating the Price Level, 260

Calculating a Price Index, 260

8.2. The Purchasing Power of a Currency, 262

Internal Purchasing Power, 262

External Purchasing Power, 263

8.3. Absolute Purchasing Power Parity, 263

The Theory of Absolute Purchasing Power Parity, 263

Goods Market Arbitrage, 264

8.4. The Law of One Price, 265

The Perfect Market Ideal, 265

Why Violations of the Law of One Price Occur, 265

How Wide Is the Border?, 268

8.5. Describing Deviations from PPP, 269

Overvaluations and Undervaluations of Currencies, 269

Predictions Based on Overvaluations and Undervaluations, 270

8.6. The MacPPP Standard, 271

The Big Mac as a Price Index, 271

Comparing Prices Across Countries, 271

Some Predictions of Currency Appreciations, 273

8.7. Exchange Rates and Absolute PPPs Using CPI Data, 274

Interpreting the Charts, 274

Dollar–Pound Data, 275

Deutsche Mark–Dollar Data, 276

Yen–Dollar Data, 276

Canadian Dollar–U.S. Dollar Data, 277

French Franc–Deutsche Mark Data, 278

Italian Lira–Deutsche Mark Data, 278

Mexican Peso–Dollar Data, 279

8.8. Explaining the Failure of Absolute PPP, 280

Changes in Relative Prices, 280

Non-Traded Goods, 281

PPP Deviations and the Balance of Payments, 282

8.9. Comparing Incomes Across Countries, 282

Comparing Incomes in New York and Tokyo, 282

Comparing GDPs Using PPP Exchange Rates, 284

8.10. Relative Purchasing Power Parity, 285

A General Expression for Relative PPP, 286

Relative PPP with Continuously Compounded Rates of Change (Advanced), 287

8.11. The Real Exchange Rate, 288

The Definition of the Real Exchange Rate, 288

Real Appreciations and Real Depreciations, 289

Trade-Weighted Real Exchange Rates, 291

8.12. Summary, 292

Bibliography, 294

Chapter 9. Measuring and Managing Real Exchange Risk, 296

9.1. How Real Exchange Rates Affect Real Profitability, 296

The Real Profitability of an Exporting Firm, 297

9.2. Real Exchange Risk and the Profitability of Domestic and Foreign Firms, 298

The Real Exchange Rate Risk of a Net Exporter, 299

The Real Exchange Risk of a Net Importer, 300

The Real Exchange Risk of an Import Competitor, 302

Measuring Real Exchange Risk Exposure, 302

9.3. Sharing the Real Exchange Risk: An Example, 305

Safe Air’s Situation, 305

Metallwerke A.G.’s Proposal, 305

The Consultant’s Task, 306

Basic Data and Analysis, 307

Analyzing Contracts When Inflation and Real Exchange Rates Are Changing, 309

Designing a Contract That Shares the Real Exchange Risk, 312

Would the Redesigned Contract Be Adopted?, 314

9.4. Pricing-to-Market Strategies, 315

Some Examples of Pricing-to-Market Strategies, 315

Pricing-to-Market by a Monopolist, 316

A Monopolistic Net Importer, 319

Empirical Evidence on Pricing-to-Market, 321

9.5. Evaluating the Performance of a Foreign Subsidiary, 322

Three Types of Subsidiaries, 322

Initial Operating Profitability, 323

Actual Versus Forecasted Operating Results, 323

Comparing the Optimal Response with No Response by Managers, 325

Who Deserves a Bonus?, 326

Assessing the Long-Run Viability of a Subsidiary, 327

9.6. Strategies for Managing Real Exchange Risk, 328

Transitory Versus Permanent Changes in Real Exchange Rates, 328

Production Management, 329

Marketing Management, 330

9.7. Summary, 332

Bibliography, 333

Chapter 10. Exchange Rate Determination and Forecasting, 335

10.1. Parity Conditions and Exchange Rate Forecasts, 335

The Fisher Hypothesis, 336

The International Parity Conditions, 339

Real Interest Rates and the Parity Conditions, 340

10.2. Currency Forecasting Techniques, 342

Fundamental Exchange Rate Forecasting, 342

Exchange Rate Forecasting with Technical Analysis, 343

Evaluating Forecasts, 343

10.3. Fundamental Exchange Rate Forecasting, 346

The Asset Market Approach to Exchange Rate Determination, 346

Sticky Prices and Overshooting, 348

The Real Exchange Rate and the Real Interest Rate Differential, 350

The Real Exchange Rate and the Current Account, 353

The Capital Account and Real Exchange Rates, 354

Equilibrium, 354

Variables That Affect the Real Exchange Rate–Current Account Equilibrium, 355

Forecasting Performance of Fundamental Exchange Rate Models, 356

10.4. Technical Analysis, 357

“Pure” Technical Analysis: Chartism, 357

Filter Rules, 359

Regression Analysis, 362

Evaluating Forecasting Services, 364

10.5. Predicting Devaluations, 366

What Causes a Currency Crisis?, 367

Empirical Evidence on the Predictability of Currency Crises, 368

10.6. Summary, 373

Bibliography, 375

Part III. International Capital Markets, 378

Chapter 11. International Debt Financing, 378

11.1. The Global Sources of Funds for International Firms, 378

The Financing Mix Around the World, 379

11.2. The Characteristics of Debt Instruments, 380

Currency of Denomination, 380

The Nature of Interest Rate Payments: Fixed-Rate Versus Floating-Rate Debt, 383

The International Character of Debt, 385

11.3. A Tour of the World’s Bond Markets, 386

Size and Structure of the World Bond Market, 386

The International Bond Market, 388

The Types of Debt Instruments in the International Bond Market and Their Prevalence, 391

11.4. International Banking, 395

Banks as MNCs, 396

Types of International Banking Offices, 398

Small Belgian Bank Carves Out a Niche, 400

International Banking Regulation, 401

11.5. International Bank Loans, 403

Eurocredits, 403

The Euronote Market, 407

The Major Debt Arrangers, 408

11.6. Comparing the Costs of Debt, 409

The All-in-Cost Principle, 409

Minimizing the Cost of Debt Internationally, 411

11.7. Summary, 419

Bibliography, 421

Chapter 12. International Equity Financing, 423

12.1. A Tour of International Stock Markets, 423

The Size of Stock Markets, 423

The Organization and Operation of Stock Markets, 426

Turnover and Transaction Costs, 430

Emerging Stock Markets, 432

12.2. International Cross-Listing and Depositary Receipts, 438

American Depositary Receipts, 440

Global Depositary Receipts, 442

12.3. The Advantages and Disadvantages of Cross-Listing, 445

Why Firms Choose to Cross-list, 445

Why Firms Decide Against Cross-listing, 449

12.4. Strategic Alliances, 452

12.5. Summary, 453

Bibliography, 455

Chapter 13. International Capital Market Equilibrium, 457

13.1. Risk and Return of International Investments, 457

The Two Risks of Investing Abroad, 458

The Volatility of International Investments, 459

Expected Returns, 461

Sharpe Ratios, 462

13.2. The Benefits of International Diversification, 462

Risk Reduction Through International Diversification, 462

The Effect of International Diversification on Sharpe Ratios, 466

13.3. Optimal Portfolio Allocations, 469

Preferences, 469

The Case of One Risky Asset, 470

The Mean Standard Deviation Frontier, 473

13.4. The Capital Asset Pricing Model, 475

Assumptions and Origins, 475

A Derivation of the CAPM (Advanced), 476

Interpreting the CAPM, 477

Domestic Versus World CAPMs, 479

13.5. The CAPM in Practice, 481

A Recipe for the Cost of Equity Capital, 482

The Benchmark Problem, 482

Beta Estimation, 484

The Risk Premium on the Market, 485

13.6. Integrated Versus Segmented Markets, 487

Investing in Emerging Markets, 487

The Cost of Capital in Integrated and Segmented Markets, 489

Segmentation and Integration over Time, 491

Home Bias and Its Implications, 493

13.7. Alternative Cost-of-Capital Models, 496

The Usefulness of the CAPM, 496

The Arbitrage Pricing Theory, 497

The Fama-French Factor Model, 498

13.8. Summary, 500

Bibliography, 503

Chapter 14. Political and Country Risk, 507

14.1. Political Risk Versus Country Risk, 507

Country Risk, 507

Political Risk Factors, 509

The Debt Crisis, 511

14.2. Incorporating Political Risk in Capital Budgeting, 516

Adjusting Expected Cash Flows for Political Risk, 517

Adjusting the Discount Rate Instead of Cash Flows, 520

14.3. Country and Political Risk Analysis, 522

Country Risk Ratings, 522

The PRS Group’s ICRG Rating System, 525

Country Credit Spreads, 529

Computing Political Risk Probabilities, 541

14.4. Managing Political Risk, 542

Structuring an Investment, 542

Project Finance, 547

14.5. Summary, 550

Bibliography, 552

Part IV. International Corporate Finance, 555

Chapter 15. International Capital Budgeting, 555

15.1. An Overview of Adjusted Net Present Value, 555

Step 1: Discount the Cash Flows of the All-Equity Firm, 556

Step 2: Add the Value of the Financial Side Effects, 556

Step 3: Value the Growth Options, 557

15.2. Deriving the NPV of Free Cash Flow, 557

Incremental Profits, 558

Earnings Before Interest and Taxes (EBIT), 559

Net Operating Profit Less Adjusted Taxes (NOPLAT), 559

Gross Cash Flow, 560

Free Cash Flow, 560

Discounting Free Cash Flows, 560

15.3. Financial Side Effects, 562

The Costs of Issuing Securities, 562

Tax Shields for Certain Securities, 562

The Proper Discount Rate, 563

Costs of Financial Distress, 564

The Equilibrium Amount of Debt, 564

Subsidized Financing, 565

15.4. Growth Options, 566

Problems with the Discounted Cash Flow Approach, 567

15.5. Parent Versus Subsidiary Cash Flows, 568

A Three-Step Approach to Determining the Value of a Foreign Subsidiary, 569

15.6. The Case of International Wood Products, 569

IWPI-Spain’s Free Cash Flows, 570

The Parent Company’s Perspective, 576

Valuing the Financial Side Effects, 580

The Full ANPV of IWPI-Spain, 582

The Cannibalization of Export Sales, 583

15.7. Summary, 584

Bibliography, 587

Appendix: Deriving the Value of a Perpetuity, 587

Chapter 16. Additional Topics in International Capital Budgeting, 589

16.1. Alternative Approaches to Capital Budgeting, 590

The ANPV Approach, 590

Two Valuation Alternatives to ANPV, 590

The WACC Approach to Capital Budgeting, 590

The Flow-to-Equity Method of Capital Budgeting, 596

The Pros and Cons of Alternative Capital Budgeting Methods, 597

16.2. Forecasting Cash Flows of Foreign Projects, 598

The Choice of Currency, 598

Reconciling the Two Methods for Discounting Foreign Cash Flows, 598

16.3. Case Study: CMTC’s Australian Project, 600

The Australian Investment Proposal, 600

Gathering the Economic Data, 601

Discounted Cash Flows, 603

Case Solution, 603

The Expected Real Appreciation of the U.S. Dollar, 610

16.4. Terminal Value When ROI Equals r_WACC, 611

Terminal Value with Perpetual Growth, 611

Equilibrium Rate of Return on Investment, 611

16.5. Tax Shields on Foreign Currency Borrowing, 614

The Tax Implications of Borrowing in a Foreign Currency, 614

Foreign Currency Borrowing by Banana Computers, 615

16.6. Conflicts Between Bondholders and Stockholders, 619

The Incentive to Take Risks, 619

The Underinvestment Problem, 620

Other Managerial Problems Caused by Financial Distress, 622

16.7. International Differences in Accounting Standards, 622

16.8. Summary, 623

Bibliography, 624

Chapter 17. Risk Management and the Foreign Currency Hedging Decision, 625

17.1. To Hedge or Not To Hedge, 625

Hedging in an Entrepreneurial Venture, 626

Hedging in a Modern Corporation, 626

The Hedging-Is-Irrelevant Logic of Modigliani and Miller, 627

17.2. Arguments Against Hedging, 628

Hedging Is Costly, 628

Hedging Equity Risk Is Difficult, if Not Impossible, 629

Hedging Can Create Bad Incentives, 634

17.3. Arguments for Hedging, 634

Hedging Can Reduce the Firm’s Expected Taxes, 634

Hedging Can Lower the Costs of Financial Distress, 639

Hedging Can Improve the Firm’s Future Investment Decisions, 640

Hedging Can Change the Assessment of a Firm’s Managers, 640

17.4. Merck’s Hedging Rationale, 642

Developing Natural Operating Hedges, 643

Merck’s Five-Step Procedure, 643

17.5. Hedging Trends, 645

Information from Surveys, 645

Empirical Analysis of Why Firms Hedge, 646

To Hedge or Not to Hedge: Understanding Your Competitors, 646

17.6. Summary, 647

Bibliography, 649

Part V. Managing Ongoing Operations, 650

Chapter 18. Financing International Trade, 650

18.1. The Fundamental Problem with International Trade, 650

18.2. International Trade Documents, 652

Bills of Lading, 653

Commercial Invoices, 654

Packing Lists, 654

Consular Invoice, 655

Certificate of Analysis, 655

18.3. Methods of Payment, 655

Cash in Advance, 655

Documentary Credits, 656

Documentary Collections, 661

Sales on Open Account, 662

International Financing on the Internet, 663

18.4. Financing Exports, 663

Bank Line of Credit, 663

Banker’s Acceptances, 664

Buyer Credit, 665

Selling Accounts Receivable, 665

Limited-Recourse Financing: Forfaiting, 665

Export Factoring, 666

Government Sources of Export Financing and Credit Insurance, 668

18.5. Countertrade, 670

Transactions Without Money, 671

Countertrade Involving Money or Credit, 672

18.6. Summary, 673

Bibliography, 675

Chapter 19. Managing Net Working Capital, 676

19.1. The Purpose of Net Working Capital, 676

Inventories as Assets, 677

Other Current Assets, 677

Short-Term Liabilities, 677

19.2. International Cash Management, 678

Constraints on International Cash Management, 678

Cash Management with a Centralized Pool, 678

19.3. Cash Transfers from Affiliates to Parents, 685

International Dividend Cash Flows, 685

International Royalty and Management-Fee Cash Flows, 686

Transfer Pricing and Cash Flows, 687

Strategies for Dealing with Blocked Funds, 693

19.4. Managing Accounts Receivable, 695

Currency of Denomination, 695

Leading and Lagging Payments, 698

Credit Terms, 700

19.5. Inventory Management, 700

Optimal Inventory Theory, 700

19.6. Summary, 703

Bibliography, 706

Part VI. Foreign Currency Derivatives, 707

Chapter 20. Foreign Currency Futures and Options, 707

20.1. The Basics of Futures Contracts, 707

Futures Versus Forwards, 707

The Pricing of Futures Contracts, 711

20.2. Hedging Transaction Risk with Futures, 714

Hedging at Nancy Foods, 714

Potential Problems with a Futures Hedge, 716

20.3. Basics of Foreign Currency Option Contracts, 719

Basic Option Terminology, 719

Options Trading, 722

20.4. The Use of Options in Risk Management, 725

A Bidding Situation at Bagwell Construction, 725

Using Options to Hedge Transaction Risk, 726

Hedging with Options as Buying Insurance, 731

Speculating with Options, 735

Options Valuation, 738

20.5. Combinations of Options and Exotic Options, 743

Range Forwards and Cylinder Options, 744

Other Exotic Options, 746

20.6. Summary, 747

Bibliography, 750

Chapter 21. Interest Rate and Foreign Currency Swaps, 751

21.1. Introduction to Swaps, 751

Currency Swaps Versus Interest Rate Swaps, 752

The Size of the Swap Markets, 753

21.2. Interest Rate Swaps, 754

Interest Rate Risk, 755

The Nature of Interest Rate Swap Contracts, 756

The Profitability of Interest Rate Swaps, 757

Dealing with Credit Risks: Requiring Collateral and Marking to Market, 758

21.3. Foreign Currency Swaps, 758

The Mechanics of Modern Currency Swaps, 760

Comparative Borrowing Advantages in Matched Currency Swaps, 762

Swapping Bond Proceeds and Coupon Rates with Quoted Swap Rates, 768

Currency Swaps as a Package of Forward Contracts, 772

The Value of a Currency Swap, 773

The Rationale for Currency Swaps, 774

21.4. Parallel Loans and Back-to-Back Loans, 775

Parallel Loans, 776

Back-to-Back Loans, 778

21.5. Summary, 779

Bibliography, 781

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For undergraduate and graduate students enrolled in an international finance course. Bekaert/Hodrick equips future business leaders with the analytical tools they need to make sound financial decisions in the face of a competitive global environment.

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