Question

QUESTION 2: 4 POINTS Suppose initially, the interest rate on U.S. Treasury bonds is equal to that on bonds issued by Greek government. In 2010 and 2011, the government of Greece risked defaulting on its bonds due to a severe budget crisis. (1) Using bond market graphs, graphically show the effects on U.S. Treasury bonds and comparable-maturity Greek bonds. (2 points) Greek government bonds U.S. Treasury bonds (2) What is the impact on prices and interest rates of Greek bonds relative to U.S. Treasury bonds? (2 points)

Answer 1

(1)

In following graphs, D0 and S0 are initial demand and supply curve for bonds, intersecting at point A with initial price P0 and quantity Q0.

(a) US Treasury bond market

Risk of default for Greek bonds increases the demand for US treasury bonds which are substitutes for Greek bonds, shifting Treasury bond demand curve to right, increasing their price and quantity. Bond price and interest rate are negatively related, so higher US treasury bond price will decrease interest rate of these bonds.

In following graph, as demand increases, D0 shifts right to D1, intersecting S0 at point B with higher price P1 and higher quantity Q1.

90 91 9

(b) Market for Greek bond

A risk of default decreases the demand for Greek bonds, shifting its demand curve to left, decreasing both their price and quantity. Bond price and interest rate are negatively related, so lower bond price will increase interest rate of Greek bonds.

In following graph, as demand decreases, D0 shifts left to D1, intersecting S0 at point B with lower price P1 and lower quantity Q1.

3 9.

(2)

Since price of Greek bonds will decrease and price of US treasury bonds will increase, spread between Greek bond and Treasury bond price will decrease.

Since interest rate on Greek bonds will increase and interest rate of US treasury bonds will decrease, spread between Greek bond and Treasury bond interest rate will increase.