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ECON 100 Tutorial 23

ECON 100 Tutorial 23. Rob Pryce www.robpryce.co.uk/teaching. Question 1. What are ‘exchange risk’ and ‘default risk’ and what is their respective relevance for state borrowing within the European Union?. Exchange Risk: Risk that the currency that the bond is in will devalue

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ECON 100 Tutorial 23

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  1. ECON 100Tutorial 23 Rob Pryce www.robpryce.co.uk/teaching

  2. Question 1 What are ‘exchange risk’ and ‘default risk’ and what is their respective relevance for state borrowing within the European Union? Exchange Risk: Risk that the currency that the bond is in will devalue Default Risk: Risk that the debt cannot be covered.

  3. Question 2a New bonds (with a redemption value of €1000) pay a coupon of 5per cent over 40 years. Use a discount rate of 0.03 to obtain the current value of the bond. V = 50 [1 – (1.03)-40]/0.03 + 1000/(1.03)40 V = 1155.74 + 306.56 = 1462.30 Discounted value of coupon payments Discounted value of redemption payment

  4. Question 2b New bonds (with a redemption value of €1000) pay a coupon of 5 per cent over 40 years. Use a discount rate of 0.05to obtain the current value of the bond. V = 50 [1 – (1.05)-40]/0.05 + 1000/(1.05)40 V = 857.95+ 142.05 = 1000

  5. Question 2c New bonds (with a redemption value of €1000) pay a coupon of 5 per cent over 40 years. If the coupon value were doubled, would the bond price double? NO! Because we don’t double the redemption value

  6. Question 2d • With interest rates anticipated to rise, how does this affect the bond price? The bond price would fall. Bond prices and interest rates are negatively related. This page explains the relationship well.

  7. Question 3a • New Greek bonds (say, with a redemption value of €1000) pay a coupon of • 2 per cent annually for 3 years (02/2012 - 02/2015) • 3 per cent for the following 5 years (02/2015 - 02/2020 • 4.3 per cent until final maturity in 2042 (02/2020 - 02/2042) Use a discount rate of 0.05 to obtain the 2012 value of a newly issued bond maturing in 2042

  8. Question 3a • New Greek bonds (say, with a redemption value of €1000) pay a coupon of • 2 per cent annually for 3 years (02/2012 - 02/2015) • 3 per cent for the following 5 years (02/2015 - 02/2020 • 4.3 per cent until final maturity in 2042 (02/2020 - 02/2042) Use a discount rate of 0.05 to obtain the 2012 value of a newly issued bond maturing in 2042

  9. Question 3b • New Greek bonds (say, with a redemption value of €1000) pay a coupon of • 2 per cent annually for 3 years (02/2012 - 02/2015) • 3 per cent for the following 5 years (02/2015 - 02/2020 • 4.3 per cent until final maturity in 2042 (02/2020 - 02/2042) Use a discount rate of 0.03653to re-evaluate V. What is the significance of this rate? V = €1000 which means that the bond trades at the “par value”. A bond selling at par has a coupon rate such that the bond is worth an amount equivalent to its original issue value or its value upon redemption at maturity.

  10. Question 3c This question was very much trial-and-error. The answer is 7.763%

  11. Question 3d What interpretation might be given to an auction price of €500or less? This means that the yield on bonds is around 7% or higher. If the government wanted to issue new bonds, they would have to offer competitive yields on the bonds. Many analysts think that yields over 7% are unsustainable and that there may be a risk of default.

  12. Question 4

  13. Question 4 What was the Exchange Rate Mechanism (ERM)? The UK government thought that they could have the same low inflation as Germany if it had a similar currency The £ was “pegged” to the German D-Mark. (the exchange rate was only allowed to be within a band) This means that UK had to match interest rates with the Germans. (if they didn’t, then people could convert £ into DM and buy German bonds)

  14. Question 4 What was Black Wednesday? In the UK, the government wanted lower interest rates to boost the economy Germany wanted higher interest rates because of inflationary concerns – remember the Taylor rule The UK didn’t want to increase interest rates because of housing trouble. Investors wanted to sell £ to buy German bonds, which meant the value of the £ fell. The UK government intervened by selling gold reserves to buy the £, and tried to find a compromise with Germany about what the common interest rate could be. However, it became clear that no common interest rate existed.

  15. Question 4 What was Black Wednesday? Currency speculators began shorting £ The UK government couldn’t keep the value of the £ within the ERM band and had to drop out. The £ fell in value.

  16. Question 4 ‘Today the pound was devalued, we withdrew from the Exchange Rate Mechanism, the pound fell, interest rates were raised first of all by 2 per cent then by another 3 per cent and they took the 3 per cent off and the speculators have made about £10 billion at the expense of the British tax payers.’(Tony Benn, 2002)Examine the view that the profit made by currency speculators on ‘Black’ Wednesday, Sept 16, 1992 was ‘at the expense of the British tax payers.’

  17. Any Questions? Email: r.pryce@lancaster.ac.uk Web: www.robpryce.co.uk/teaching OfficeHour: Wednesday, 9:45 – 10:45 Charles Carter C Floor or by appointment (email me)

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