Valuation of bonds on international markets: International arbitrage pricing theory

Current markets are characterized by low inflation and low interest rates. Bonds are issued with low yield, and their price must be affected by factors other than interest rates and inflation. Investors receive the normal return on their investment, then investments across countries bring additional return in the form of exchange rate risk. This risk affects the price of bonds as well.

The aim of this paper is to define the factors influencing the price of bonds, which are expected to include interest rates, inflation and exchange rates. I apply international arbitrage pricing theory to government bonds. The international arbitrage pricing theory uses a multi-linear regression model, used separately for emerging and developing markets. I use data from government bonds to test the theory between 2000 and 2014. My data sources include the internal databases of the company Thomson Reuters for bond prices, and the International Money Fund. The interest rate is represented by the policy rate. Inflation is defined as the producer price index. The exchange rate is determined as the value of national currency per special drawing rights (SDR). The monthly data is processed using panel analysis. My analysis includes 62 countries. My results confirm the relationship between the movements of the price of bonds and the movements of exchange rates.

I assume that the price of bonds will be affected by the foreign exchange risk more in times of low interest rates and low inflation. Currency depreciation in countries of bond issuance has a negative impact on the price of these bonds. The relationship is closer in countries with low interest rate or low inflation. Foreign exchange risk affects the price of bonds more in emerging markets.