Comprehensive Report: International Bond and Currency Market Dynamics

This report provides a comprehensive analysis of the international bond and currency markets. Section A delves into bond valuation, calculating prices, durations (both regular and modified), and yield to maturity under various scenarios. It includes detailed calculations for specific bonds, considering changes in interest rates. Section B focuses on the concept of Purchasing Power Parity (PPP), explaining its theory and examining recent empirical literature. The report explores the relationship between exchange rates, inflation, and arbitrage opportunities. The analysis covers spot and forward exchange rates, and the impact of inflation and interest rates on currency values. The report also investigates the application of the international Fisher Parity theorem. The report concludes by discussing the significance of PPP in international finance and its use in comparing the prices of goods and services across different countries.

INTERNATIONAL BOND
AND CURRENCY MARKET

Table of Contents
SECTION A.....................................................................................................................................3
A1.....................................................................................................................................................3
a...................................................................................................................................................3
b...................................................................................................................................................3
c ..................................................................................................................................................3
d...................................................................................................................................................4
A2.....................................................................................................................................................5
a...................................................................................................................................................5
b. .................................................................................................................................................5
A3.....................................................................................................................................................7
a...................................................................................................................................................7
b...................................................................................................................................................7
c...................................................................................................................................................7
d...................................................................................................................................................8
e ..................................................................................................................................................8
f...................................................................................................................................................8
SECTION B.....................................................................................................................................9
Question B2.................................................................................................................................9
a. Purchasing power parity..........................................................................................................9
b. Recent empirical literature relating the Purchasing Power Parity..........................................9
REFERENCES..............................................................................................................................11

SECTION A
A1
a
Price of Bond
Bond A
40
Pvaf(8%,2)+100
Pvaif(8%,2)
4*3.312 +
100*0.735
86.748
Bond B
45
Pvaf(8%,5)+100
Pvaif(8%,5)
4.5*6.710 +
100*.463
76.495
b
New price of bond for
increase in 100 basis
points
Bond A
4.5*3.312+100*
0.735
88.404
Bond B
5*6.710 +
100*.463
79.85

c
Year CF Pv@8% DCF
W = DCF
*years
1 4 0.926 3.70 3.70
2 4 0.857 3.43 6.86
3 4 0.794 3.18 9.53
4 104 0.735 76.44 305.77
86.75 325.86
Duration of
bond
325.86 /
86.75
3.76
Modified
duration 3.76 / (1.08)
3.48
Year CF Pv@8% DCF
W = DCF
*years
1 4.5 0.926 4.17 4.17
2 4.5 0.857 3.86 7.72
3 4.5 0.794 3.57 10.72
4 4.5 0.735 3.31 13.23
5 4.5 0.681 3.06 15.31
6 4.5 0.630 2.84 17.01
7 4.5 0.583 2.63 18.38
8 4.5 0.540 2.43 19.45
9 4.5 0.500 2.25 20.26
10 104.5 0.463 48.40 484.04
76.51 610.28

Duration of
bond
610.28 /
76.51
7.98
Modified
duration 7.98 / (1.08)
7.39
d.
Price of bonds on
Modified duration on
100 basis points
Bond A
Price 86.748
Modified duration 3.48
New Price 83.73
Bond B
Price 76.495
Modified duration 7.98
New Price 70.39
A2
a.
Bond X

PV 1 – 7 8.2442
40*8.2442
Cash Flows 329.768
Par value 1000
Total Cash flows 1329.768
Bond Y
PV 1 – 4 5.7466
45*5.7466
Cash Flows 258.597
Par value 1000
Total Cash flows 1258.597
Bond Z
PV 1 – 10
Cash Flows 0
Par value 1000
Total Cash flows 1000
b.
Bond X
Year
YTM @
4%
YTM
@ 7%
YTM
@ 9% CF Pv CF Pv CF Pv
1 0.9615 0.9259 0.9569 40 38.46 40 37.0 40 38.28
2 0.9246 0.8573 0.9157 40 36.98 40 34.3 40 36.63
3 0.8890 0.7938 0.8763 40 35.56 40 31.8 40 35.05
4 0.8548 0.7350 0.8386 40 34.19 40 29.4 40 33.54
5 0.8219 0.6806 0.8025 40 32.88 40 27.2 40 32.10
6 0.7903 0.6302 0.7679 40 31.61 40 25.2 40 30.72

7 0.7599 0.5835 0.7348 40 30.40 40 23.3 40 29.39
8 0.7307 0.5403 0.7032 40 29.23 40 21.6 40 28.13
9 0.7026 0.5002 0.6729 40 28.10 40 20.0 40 26.92
10 0.6756 0.4632 0.6439 40 27.02 40 18.5 40 25.76
11 0.6496 0.4289 0.6162 40 25.98 40 17.2 40 24.65
12 0.6246 0.3971 0.5897 40 24.98 40 15.9 40 23.59
13 0.6006 0.3677 0.5643 40 24.02 40 14.7 40 22.57
14 0.5775 0.3405 0.5400 1040 600.57 1040 354.1 1040 561.57
Price
1000.0
0 670.23 948.89
Coupon
Payments
YTM @
8%
YTM
@ 10%
YTM
@ 9% CF Pv CF Pv CF Pv
1 0.9615 0.9524 0.9569 40 38.46 40 38.1 40 38.28
2 0.9246 0.9070 0.9157 40 36.98 40 36.3 40 36.63
3 0.8890 0.8638 0.8763 40 35.56 40 34.6 40 35.05
4 0.8548 0.8227 0.8386 40 34.19 40 32.9 40 33.54
5 0.8219 0.7835 0.8025 40 32.88 40 31.3 40 32.10
6 0.7903 0.7462 0.7679 40 31.61 40 29.8 40 30.72
7 0.7599 0.7107 0.7348 40 30.40 40 28.4 40 29.39
8 0.7307 0.6768 0.7032 40 29.23 40 27.1 40 28.13
9 0.7026 0.6446 0.6729 40 28.10 40 25.8 40 26.92
10 0.6756 0.6139 0.6439 40 27.02 40 24.6 40 25.76
11 0.6496 0.5847 0.6162 40 25.98 40 23.4 40 24.65
12 0.6246 0.5568 0.5897 40 24.98 40 22.3 40 23.59
13 0.6006 0.5303 0.5643 40 24.02 40 21.2 40 22.57
14 0.5775 0.5051 0.5400 1040 600.57 1040 525.3 1040 561.57
Price 1000.0 901.01 948.89

0
Yield 9.00%
Bond Y
Coupon
Payments
YTM @
8%
YTM
@ 10%
YTM
@ 7% CF Pv CF Pv CF Pv
1 0.9615 0.9524 0.9662 45 43.27 45 42.9 45 43.48
2 0.9246 0.9070 0.9335 45 41.61 45 40.8 45 42.01
3 0.8890 0.8638 0.9019 45 40.00 45 38.9 45 40.59
4 0.8548 0.8227 0.8714 45 38.47 45 37.0 45 39.21
5 0.8219 0.7835 0.8420 45 36.99 45 35.3 45 37.89
6 0.7903 0.7462 0.8135 45 35.56 45 33.6 45 36.61
7 0.7599 0.7107 0.7860 45 34.20 45 32.0 45 35.37
8 0.7307 0.6768 0.7594 1000 730.69 1000 676.8 1000 759.41
Price 1000.7 937.23 1034.5
Yield 10.00%
Bond Z
Zero Coupon
Bond
Yield to
maturity
(1000/456
.39)^((1/1
0*2)-1)
Yield to
maturity 4.00%

e.
The results obtained in part b and d are accurate as they have been derived by considering
the increase in 100 basis points. The increase is reflected in price of the bonds. They are more
closer to actual prices as they are also computed using the increase in interest rates and actual
prices are also computed using by discounting the cash flows at present rate. It makes the
approximations closer to actual price.
A3
a
Current exchange rate
RM/£ 1199/269
4.46
b.
Actual 5.33
PPP price 4.46
Overpriced
Arbitrage profits
Sell at UK 533
Buy at RM 446
Arbitrage profits 87
Cash Flows
c. Bid Ask
Spot exchange 5.33 5.36
Inflation in Malaysia 3.00% 3.00%
Expected rate 5.490 5.521

d.
International Fisher
Parity holds
Interest Rate UK 2.50%
Inflation rate 2.00%
Real interest rate 2.45%
Nominal interest rate
Real + expected
interest rate
3.65%
Expected interest rate 1.20%
e
Expected spot exchange
rate
Spot exchange rate RM/£ 5.33 5.37
Interest Rate 2.50% 2.50%
Spot rate 5.46 5.50
f
Forward rate 5.5 5.55
Arbitrage profits
CIB

Purchase £ @ 5.37 1000000
5370000
At 2.5%
1025000
Sell at 5.50
1025000*5.5
5637500.00
Arbitrage profits 267500
SECTION B
Question B2
a. Purchasing power parity
The purchasing power parity is a theory which relates with the exchange rates among the
two different types of currencies which are in equilibrium at the time when the purchasing power
is same in all the two countries (Jabeen, 2018). In simple words it means that the exchange rates
among the two countries must be equal in the ratio of the price of the two countries product. This
is majorly because of the reason that when the country trades with one another then this involves
the two different exchange rates and because of this there is difference in the prices of the same
product in the two different countries. For instance, if a particular product is sold at 750
Canadian Dollar in Vancouver then it should be costing 500 US Dollar in the Seattle. The major
reason for this is that when the exchange rate among the Canada and US is 1.50 that is CAD/
USD. Further if this price of the product will be Vancouver is only 700 CAD then the consumer
of Seattle will prefer to purchase the product from the other country. This process is being
defined as the arbitrage which is carried out on a larger scale.

b. Recent empirical literature relating the Purchasing Power Parity
As discussed above, the PPP is the rate of the currency conversion which equalizes with
the purchasing power of the other currencies by way of eliminating the difference among the
price level among those countries. The purchasing power parity is a price relative which assist
the country in finding the ratio of the price of the national currency of the same type of good but
in the different countries. But on the other side there may be difference in the PPP inflation and
the exchange rates of the two different countries as their level of poverty, and other tariffs may
be different in both the countries which are being compared. The major law underlying this PPP
is that if in case there is not any cost of transaction or the barriers to trade for any particular good
then the price of that particular good must be same within every country whether domestic or
international (Gilboa and Mitchell, 2020). But the only major difference among the rates of the
two countries the exchange rates are different.
Further with the evaluation of the literature it was clear that it is assumed that the
exchange rate between the two different currencies is actually seen as per the foreign exchange
market. The major reason for this is that when the two countries have the similar product then the
difference in the exchange rates causes the difference in the prices of the product and services of
the company in the different countries (George and Rhodes, 2019). Further with the evaluation it
was seen that the PPP is assumed to have and hold it either in long run which holds for a much
stronger positon in the long run as compared to the short run. On the further evaluation it was
found that the PPP exchange rates are very useful for the country but it is very difficult for the
country as they have to find out the prices of the different types of the product as compared to
other countries. Further it was evaluated that major use of PPP is to make the spatial volume of
the comparison of the GDP and the comparison of the prices of the various types of price level.
In addition to this the another major recommended use of the PPP is used to group the
countries on the basis of the volume index of the GDP or the national income of the country.
This is also used to analyse the changes which are done over time within the relative GDP and
the per capita income of the country and the relative prices. In addition to this the PPP theory of
exchange rate is used when the official exchange rate of the country is artificially manipulated by
the government of the country. Thus, because of this if the country is having the stronger
government control within the economy then this will enforce the official exchange rates for the
country and the currency will have some greater fluctuations. In against of this the if the