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This is known as covered interest arbitrage(CIA). CIA moves the market toward equilibrium because purchasing a currency on the spot market and selling in the forward market will narrow the gap between forward premium/discount and interest rate differentials. Assume that an investor (Roel) has $1,000,000. The morning conditions indicate to Roel that a CIA transaction that exchanges 1 million dollars for Japanese yen, invested in a six-month euroyen account and sold forward back to dollars, will yield a profit of $4,638 ($1,044,638 - $1,040,000) over and above that available from a Eurodollar investment. The condition change rapidly so Roel has to execute the following steps quickly: 1.Convert $1,000,000 at the spot rate of Yen106.00/$ to Yen106,000,000 (see ‘Start’) 2.Invest the proceeds, Yen106,000,000, in a euroyen account for six months, earning 4.00% per annum, or 2% per 180 days. Which results in Yen108,120,000 3.Sell the future yen proceeds forward for dollars at the 180-day forward rate of Yen103.50/$. This action ‘locks in’ gross dollar revenues of $1,044,638 (see ‘End’) 4.Compare the profit of the Eurodollar rate (8.00%) and the profit of the euroyen rate: $1,044,638 - $1,040,00 = $4,638. Verspreiden niet toegestaan | Gedownload door Sybe klaas Kappe ([email protected])lOMoARcPSD|105219
Some forecasters believe that forward exchange rates are unbiased predictorsof future spot exchange rates. Intuitively this means that the distribution of possible actual spot rates in the future is centered on the forward rate. Unbiased prediction simply means that the forward rate will, on average, overestimate and underestimate the actual future spot rate in equal frequency and degree. Chapter 10 – International Capital Structure & Cost of Capital (Week 5)Cost of Capital The cost of capital is the minimum rate of return an investment project must generate in order to pay its financing costs. For a levered firm, the financing costs can be represented by the weighted average cost of capital: Where, K = Weighted average cost of capital λ= Debt to total market value ratio Kl = Cost of equity capital for a levered firm t = Marginal corporate income tax rate i = Pretax cost of debt Verspreiden niet toegestaan | Gedownload door Sybe klaas Kappe ([email protected])lOMoARcPSD|105219
Cost of Capital in Segmented vs. Integrated Markets The cost of equity capital (Ke) of a firm is the expected return on the firm’s stock that investors require. This return is frequently estimated using the Capital Asset Pricing Market (CAPM). If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio. Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital. Does the Cost of Capital differ among Countries?