Question

la) Under the terms of a currency swap, a company has agreed to receive a fixed interest rate of 10% per annum on an American dollar loan with a notional principal of $5 million. In exchange, the company will pay a fixed interest rate of 8% per annum on a Dutch Euro Loan with a notional principal of €2.5 million. Net interest payments are exchanged every six months. The swap has a remaining life of thirteen months. The current interest rates are 7% per annum in America and 6% per annum in Holland. Assume both rates are with continuous compounding for all maturities (Assuming a flat terms structure). The current exchange rate is €1 = $2. Calculate the current value of the currency swap for the company in American dollars. 10 Marks b) If investors perceive greater interest rate risk, what will happen to equilibrium interest rate in the bond market? Explain using the bond demand and supply framework. 2 Marks c) How will a decrease in the federal government's budget deficit affect the equilibrium interest rate in the bond market? Explain using the bond demand and supply framework. 2 Marks d) What is the expected return on a bond if the return is 9% two-thirds of the time and 3% one- third of the time? What is the standard deviation of the returns on this bond? Would you prefer this bond or one with an identical expected return and a standard deviation of 4.5? Why? 4 Marks

Answer 1

Answers to b) and c)

b) If investors perceive greater interest rate risk, what will happen to equilibrium interest rate in the bond market? Explain using the bond demand and supply framework.

Ans: When the economy booms, the demand for bonds increases, the general income and wealth of public rises and the supply of bonds also increases as the investment opportunities become more attractive. The supply and demand curves shift to the right henceforth. But the demand curve shifts less than the supply curve for the equilibrium interest rates to rise. So if we apply the same logic, when the there is a recession, the opposite happens. Hence the interest rates tends to magnify the fluctuations in an economic cycle.

The interest rate while explaining using bond demand and supply is that bond prices are inversely related to interest rates.When interest rates go up, prices of fixed rate bonds fall.

When market interest rates rise, prices of fixed rate bonds fall. This phenomenon is known as interest rate risk.

When the interest rate on a bond is above the equilibrium interest rate, there is excess fall in the bond market and the interest rate will fall.

Bond market players monitor economic indicators that may sign future changes in the of the economy performance , which signal changes in the risk-free interest rate and in the required return from investing in the bonds. If there are unexpected unfavourable conditions like interest rate risk, indicates a weaker economy which increased the expectations of lower interest rates and places bond prices under pressure.

c) How will a decrease in the federal government's budget deficit affect the equilibrium interest rate in the bond market? Explain using the bond demand and supply framework.

An decrease in the federal government's budget deficit, can reduce the yields offered on bonds and increase in budget deficit can increase the yields offered on bonds.

During late 1990’s the US government had a budget surplus, which then resulted in a lower risk-free interest rate.

An important way in which the Federal Reserve decreases the money supply is by selling bonds to the public.

When the Fed sells bonds to the public, it increases the supply of bonds, thus shifting the supply curve to the right. The result is that the intersection of the supply and demand curve occurs at a lower price and a higher equilibrium interest rate, and the interest rate rises. With the liquidity preference, the decrease in the money supply shifts the money supply curve to the left, and the equilibrium interest rate rises. The logic here is same for bond supply and demand analysis with the logic of money demand and supply during the boom period in the economy.