Yeah, it is kind of odd that this comes up just now... I had a similar experience with a relative a few days ago, over her use of the term "darkies". She actually meant no disrespect. It was a term she learned from her father from England, years ago. Whether or not he was racist, I have no idea. I let it slide because I knew she meant no disrespect.

As for your situation, it's much more complex. I would be inclined to matter-of-factly tell them that I am uncomfortable with such views, wished that they would refrain from talking in this manner in my presence, and offer to leave their conversation if my views bothered them. Teach tolerance with tolerance.

Of course, if they give you a rough time, you can choose other friends. I've always said that I can get along with anyone or I can get along without them.