Question

Suppose the interest on Russian government bonds is 7.8%, and the current exchange rate is 27.1 rubles per dollar. If the forward exchange rate is 27.6 rubles per dollar, and the current U.S. risk-free interest rate is 4.1%, what is the implied credit spread for Russian government bonds? The implied credit spread for Russian government bonds is %. (Round to two decimal places.)

Answer 1

Solution :

As per the Interest rate Parity model

Exchange rate differential = Interest rate differential

Thus we have

( Forward Rate / Spot Rate ) = [ ( 1 + Risk free Rate in Russia ) / ( 1 + Risk free Rate in U.S. ) ]

As per the Information given in the question we have

Spot rate as 1 $ = 27.1 Rubles

Thus we have Spot rate as R / $ = 27.1 Rubles

Forward rate as 1 $ = 27.6 Rubles

Thus we have Forward rate as R / $ = 27.6 Rubles

U.S. Risk free rate = 4.1 %   = 0.041

Russian Risk free rate = To find

Let the Russian risk free rate be “ x “

Applying the above information in the equation we have

( 27.6 / 27.1 ) = ( 1 + x ) / ( 1 + 0.041)

( 27.6 / 27.1 ) = ( 1 + x ) / 1.041

1.018450 = ( 1 + x ) / 1.041

1.018450 * 1.041 = ( 1 + x )

1.060207 = 1 + x

1 + x = 1.060207

x = 1.060207 – 1

x = 0.060207

x = 6.0207 %

Thus the Russian risk free interest rate = 6.0207 %

The formula for calculating the implied credit spread for Russian government bonds is

= Interest on Russian Government bonds – Russian risk free rate

As per the information available we have

Interest on Russian Government bonds = 7.8 %   ;   Russian risk free rate = 6.0207 %

Applying the above information in the formula we have

Implied credit spread for Russian government bonds = 7.5 % - 6.0207 % = 1.4793 %

= 1.48 % ( when rounded off to two decimal places )

Thus the Implied credit spread for Russian government bonds = 1.48 %