Question

Assume that 10-year zero coupon indian rupee debt is sold by the indian government to domestic investors at a yield apy of 10% per annum. Suppose that world bank, a aaa rated entity world-wide with no default risk, wishes to issue rupee debt of the same maturity on the same date. World bank can sell matching maturity dollar debt at yield of 4% per annum. The rupee trades on the issue date at inr 60 = $1. An investor wishing to buy or sell rupees 10-year forward will pay inr 107.45 = $$, which is equivalent to an annual currency depreciation rate of 6% per annum.

Answer 1

Assume that investors are rational and that taxation is symmetric in the sense that all

investors in debt are subject to a single tax rate that cannot be avoided or evaded (That is, this

question is not about taxes).

1. Assuming perfect markets of the sort in the MM theorems, discuss why World Bank

rupee debt should be priced to yield 10% per annum.

2. Assume that investors abroad are willing to buy World Bank rupee debt at a yield of

8% per annum. Discuss what imperfections can let World Bank issue cheap debt.

3. Politicians argue that “Let World Bank borrow at 8% and on-

lend the money to the Indian government at 8.25%. This lowers the country’s cost of

capital.”