Analysis of Interest Rates and Credit Risk in Financial Markets

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Business Conditions Analysis

The interest rate is a price. What, then, is the primary function of the interest rate in
financial markets?
In the economy, the interest rate has many functions as it helps in taking the financial decisions
which are involved in trading between the current and the future consumption. The main
function of the interest rate is that it influences the cost of the borrowings and it is considered as
the important component of the total return of investment (Grilli, et. al., 2015). The interest rate
is the price that we pay in order to have liquid holdings. It is the instrument in the economy
which helps in achieving the monetary policy objectives as it is the key variable between the
current and the future consumption.
What is credit risk? Why is the credit risk on US government securities considered to be
zero?
It is the risks from the borrower in the debt which may arise due to failure in making the
payment. It is the risk or the loss due to the failure of the repayment of the borrower’s money. It
is the risk of the lender which will not receive the money of its own capital and the interest
amount. The credit risk on US government securities considered to be zero as the default of the
payment is simply unthinkable. The government securities of the US have the financial interest
and carries a tiny bit of risk in Treasury securities. The credit risk is considered as zero as they
are a competently safe investment in the financial world (Grilli, et. al., 2015).
If the US federal government borrowed money using bonds that were denominated in
Euros would the default risk on these securities likely be considered zero?
Yes, the default risk on the securities will be considered zero when they are denominated in
Euros when the financial deal is made it is the problems can be raised as the payment of the
principal amount and the rate is interesting is due. It is possible that the money which you lent
them is not paid back by the borrower and the probability of not paying the money is the default
risk.

Please state the ex-ante Fisher Equation for interest rates. In this equation, some of the
components are ‘known values” and some are “unknown”. Which are known or unknown,
and why would this distinction matter?
It is the concept of the economy in which the relationship between the real interest rate and the
nominal rate are determined under the effects of inflation. In the equation, ex-ante reflect after
the fact in which the historical return is used to forecast the loss incurred on any given day in the
investment. Ex-ante is the sum of the expected rate of inflation plus the desired real rate of
return, assuming that the default risk is zero (King, and Low, 2014).
i = r + ∏e
In which the “I” is the interest rate, “r” is the real rate and the” ∏e” is the premium for the
expected inflation.
What is the equation for the ex-post value of the real rate of interest? Which, if any, of the
components of this equation, are unknown?
The equation of the ex-post value is r = i - ∏. The real interest rate can be computed by
evaluating the actual rate of inflation. The ex-post is the market rate which is evaluated by
minus the actual inflation. The real rate of interest and the market rate can be ascertained after
the money is paid back. The components of this equation which are unknown are the expected
returns on the accuracy of the risk assessment. If this component is unknown than the true cost
capital cannot be presented.
Using the notions of ex-ante and ex-post interest rates, explain how a bank could be
expecting a huge return on its lending and end up with very small real returns. Could such
banks actually lose money in real terms? Explain.
The banks end up with the small real returns as in the ex-ante the rate of the interest rate is
derived from the investment by firms which is expected while in the ex-post the rate of interest
indicates the true cost of borrowings and lending after the adjustment of the inflation. The banks
expect the huge return in the long return but due to the inflation, they end up with the small real
rerun (Clements, 2014). Bank will lose the money in real term if the inflation is higher as the
value of the lender money doesn’t keep up with the rate of inflation.

If an analyst was considering the effects of interest rates on the future direction of the
economy, would she focus on the short rates as controlled by the central bank or long rates
as controlled by the market? Why?
The analyst will be a focus on both for the future direction of the economy but he will be focused
more on the short rates which are controlled by the central bank so that the financial stability
within the country can be maintained (Kidwell, et. al., 2016). The rates of the fiscal policy will
also be considered. The central bank increases the rate of interest when the rate of inflation
increases. It should be considered as the cost of the borrowings will increase and the disposable
income will reduce and the consumer spending growth will be limited.

References:
 Clements, M. P. (2014). Forecast uncertainty—ex-ante and ex post: US inflation and
output growth. Journal of Business & Economic Statistics, 32(2), 206-216.
 Grilli, R., Tedeschi, G., & Gallegati, M. (2015). Markets connectivity and financial
contagion. Journal of Economic Interaction and Coordination, 10(2), 287-304.
 Kidwell, D. S., Blackwell, D. W., Sias, R. W., & Whidbee, D. A. (2016). Financial
institutions, markets, and money. John Wiley & Sons.
 King, M., & Low, D. (2014). Measuring the''world''real interest rate (No. w19887).
National Bureau of Economic Research.