In reading 14, section 4.4.2 the book has below two paragraphs
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To me both looks contradictory or at least I am not able to understand. As per first paragraph if a country has weaker currency say INRUSD where exchange rate is say 65 INR per 1 USD the bond yield in India would be higher. I guess it make sense because if bond yield is not higher in India vs US then why a US investor would convert its USD into INR and invest in INR bonds. Question #1 -> Is this logic correct?
Now second paragraph says if the currency is severly undervalued then bond yield will be lower. So that means if say instead of being 65 INR to 1 USD, if we severly undervalue INR and make it 85 INR to 1 USD then are we saying the bond yield in India would be less than US. Question #2 -> Have I understood is correctly? Question #3 -> What is the differnece between a weaker currency and that same currency is severly undervalued. In both case the currency is weak. So isn’t there should be one relationship between bond yield and weakness?
Can anyone who has understood this concept enlightened me please?
value of the currency is what it is in the market. You do not do anything to control it. Based on parameters in the market - GDP, etc. the currency today shows a value of X but it should actually be Y - (a much higher value)
1st one is a statement of actually what is … (Polish Currency is actually weaker than the EURO – as a result of which the Polish Bonds have a positive spread with regards to other EURO bonds).
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2nd one is a question of perception … your currency is weaker today - but is expected to become stronger.
Question #2 might be “if the currency is severely undervalued then bond yield will be lower than what it will be when the currency is valued correctly.” If the INR is undervalued, investors will rush to purchase INR and Indian bonds. It will lead to a rise in bond price and a lower bond yield.
For Question #3, a weaker currency is less competitive when compared to a stronger currency. The former is not as attractive to an investor as the latter. An undervalued currency is attractive to investors.
The only difference between two cases, is the prospect of the currency. If INR is viewed to stay at the same level of 65:1 (or worse), then yield in India has to be higher to entice investors to invest in India, but if the perception that INR is going to get much stronger in future, the interest rates in India do not have to higher as investors will still invest in INR and gain on future exchange rate movement
Hello, can anyone offer some clarification on this please…the curriculum says “As demonstrated by the Greek exit crisis, however, the situation changes sharply when the market perceives an imminent threat of devaluation (or withdrawal from the common currency). Spreads then widen throughout the curve, but especially at the shortest maturities, and the curve will almost certainly invert. Why? Because in the event of a devaluation, yields in the devaluing currency will decline sharply (as the premium-risk currency collapses), generating much larger capital gains on longer-term bonds and thereby mitigating more of the currency loss.”
How the the curve (the bond’s yield curve I guess) invert with yields in the devaluing currency declining more at the short end than at the longer end? Am I getting it correctly?