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As an analyst for ANZ, part of your job is to understand the yield curve of Commonwealth Government Securities. The latest yields on CGS are listed below. You have been asked to provide an explanation for the current yield curve using the three theories, pure expectations theory, liquidity premium theory and segmented markets theory. Obviously to fully explain the theories you will need to include in your brief any assumptions of the theories and any calculations regarding forward rates that aid in the explanation of the curve under a particular theory.

1 year yield 4.50%

2 year yield 4.75%

3 year yield 5.25%

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Patrina Schowalter
Patrina SchowalterLv2
28 Sep 2019

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Maria Juarez is a professional tennis player, and your firm manages her money. She has asked you to give her information about what determines the level of various interest rate. Your boss has prepared some questions for you to consider.

a) What are the four most fundamental factors that affect the cost of money, or the general level of interest rate, in the economy?

b) What is the real risk-free rate of interst (r*)and the nominal risk-free rate (r RF)? How are these two rates measured?

c) Define the term inflation premium(IP), default risk premium (DRP), liquidity premium (LP),and the maturity risk premium(MRP). Which of premium is included in determining the interst rate on (1)Short term U.S Treasury securities, (2)Long term U.S Treasury securities, (3)short term corporate securities, (4) long term coporate securities? Explain how the premiums would vary over time and among the different securities listed.

d) What is the term structure of interest rate? What is the yield curve?

e)Suppose most investors expect the inflation rate to be 5% next year, 6% the following year, and 8% thereafter. The real risk free rate is 3%. The maturity risk primium is zero for bonds that mature in 1 year or less and 0.1% for 2 years bonds; then the MRP increases by 0.1% per year thereafter for 20 years, after which it is stable. What is the interest on 1-,10-, and 20-year treasury bonds? Draw a yield curve with these data. What factor can explain why this constructed yield curve is upward-sloping?

f) At any give time, how would the yield curve facing a AAA rated company compare with the yield curve for U.S Treasury securities? At any given time, How would the yield curve facing a BB rated company compare with the yield curve for U.S treasury securities? Draw a graph to illustrat your answer.

g) What is the pure expectations theory? What does the pure expectation theory imply about the term structure of interest rate?

Consider the following model of the saving-investment balance. In this model, the following relationship must remain in balance: S + (M-X) = I + (G-T) where,

S is domestic saving by households and businesses

M is U.S. imports of goods and services

X is U.S. exports of goods and services

I is private domestic investment in capital goods

G is total federal, state and local government spending on goods and services, and

T is the net receipt of tax revenues by federal, state and local governments

The presentation: “Lesson 1: The Savings and Investment Balance” in this week’s lesson can help you understand this identity better.

Clearly, as with any high-level model, there are limitations but let’s try to understand how this model functions mechanically.Consider the model of the saving-investment balance only as an algebraic accounting identity (i.e., do not consider any economic repercussions or additional complications (those can come later)), What does the model predict will happen to gross private domestic investment (I) if:

a) Domestic saving by households was to decrease, everything else remaining the same?

b) U.S. net tax receipts were to increase, everything else remaining the same?

c) There was a sudden increase in exports from the U.S., everything else remaining the same?

d) Pre-tax business profits were to increase, everything else remaining the same?

e) Federal grants to state and local governments were to disappear, everything else remaining the same?

2. Examine the note and bond yields presented below for Treasury and Corporate AAA, AA and A-rate bonds. Why do the yields differ across the securities and within securities, across time? Which premiums or market expectations most appropriately explain those differences? In particular, what accounts for the differences in rates across securities types for the same maturities? And speculate on what factor or factors can best explain why the yields rise as maturities lengthen (within particular types of bonds). Finally, do any securities look out of place and, if so, which and why?

Treasuries

2 year 0.33%

5 year 1.39%

10 year 2.64%

20 year 3.42%

Corporate, AAA

2 year 0.40%

5 year 1.77%

10 year 3.52%

20 year 4.93%

(table continues on next page)

Corporate, AA

2 year 0.63%

5 year 1.91%

10 year 3.50%

20 year 4.43%

Corporate, A

2 year 0.84%

5 year 2.15%

10 year 3.67%

20 year 4.75%

3. Suppose that today the one-year Treasury note yields 0.12% (0.0012 in decimal form), the two-year note yields 0.40% (0.0040), the three-year note yields 0.78% (0.0078), the five-year note yields 1.60% (0.0160), the seven-year note yields 2.22% (0.0222) and the ten-year note yields 2.81% (0.0281). Under the pure expectations theory with no maturity risk:

a) What is the expected yield on a one-year note delivered one year from now?

b) What is the expected yield on a one-year note delivered two years from now?

c) What is the expected yield on a three-year note delivered two years from now?

d) What is the expected yield on a two-year note delivered five years from now?

e) What is the expected yield on a five-year note delivered five years from now?

f) What is the expected yield on a seven-year note delivered three years from now?

Note: This concept is discussed in Chapter 3 of the text and in “Lesson 2: More On Yield Curves and Forward Rate Determination” in this week’s online materials.

4. Assume that interest rate parity holds so that future or forward exchange rates adjust to eliminate investor arbitrage profits. If interest rates in Britain are higher than corresponding interest rates in Japan, would you expect an appreciating pound or a depreciating pound in the futures (forward) market relative to the current spot market rate? In terms of the supply and demand for pounds in the spot and forward currency markets, what is implicitly occurring in each as a result of interest rate parity? Is the pound selling forward at a premium or at a discount relative to the yen? (The presentation “Lesson 3: On Exchange Rates” from this week’s materials can help shed light on this subject. The portion on interest rate parity later in the presentation, so stick with it. It’s also discussed in Chapter 16.)

5. The spot market rate for the euro is 1.4059 Canadian dollars per euro. The 3-month futures (forward) rate on the euro is 1.4147 Canadian dollars per euro. The yield on a 3-month Canadian government security is 1.16 percent (0.0116 decimal), annual percentage rate (APR). The yield on a 3-month euro area security is 0.24 percent (0.0024 decimal), annual percentage rate (APR). Show that interest rate parity (IRP) does not hold by solving for the forward rate that ensures IRP. How would you take advantage of the arbitrage opportunity arising from the actual data (i.e., borrow 1,000,000 euros, convert to Canadian dollars, invest in Canada, sell the proceeds forward and then repay your loan or borrow 1,000,000 Canadian dollars, convert to euros, invest in Europe, sell the proceeds forward and then repay your loan)?

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