Question

ABC issues 100,000,000 EUR denominated bonds with 5% coupon interest and 5 years to maturity. The face value of the bond is EUR 1,000, and ABC bonds are sold in the market for EUR 980. The transaction costs are 1.5% of the nominal value of the bond. At the time of the issue, the spot rate is $1.1520 per EUR (or EUR/USD1.1520), EUR risk-free rate is 4%, and the EURO is expected to appreciate by 1% per year.

a. What is the Yield to Maturity in EUR terms?

b. What is the All in Cost in EUR terms?

c. What percentage of the EUR AIC can be attributed to transaction costs?

d. What is the credit spread in EUR terms?

e. Given the expected appreciation of the EUR, what is the USD all-in cost of the EUR denominated bond issue?

f. Suppose market misprices ABC’s credit risk by 20 basis points in the USD segment as compared to credit risk in EUR. In other words, if the EUR credit risk is 2%, we expect the credit risk in a dollar-denominated issue to be 2.20%. Suppose the annualized transaction cost in percentages is the same as the EUR transaction cost. What should be your best estimate of all-in cost in a dollar-denominated bond issue?

(HINT: Use International Fisher Effect to convert EUR denominated interest rates into USD)

Answer 1

(a)

(b)

(c)   

(d) EUR is expected to increase by 1% every year that is next year EUR will be

= 1.1520 + (4% of 1.1520) + (1% of 1.1520)

=1.1520 +0.04608 + 0.01152

= 1.2096

therefore , Credit Spread = 1.2096 - 1.1520

=0.0576 EUR