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RSM 230: Financial Markets Principles And Constraints

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Question:

Financial markets bring borrowers & investors together to create wealth
 
Most of the wealth is held by individual households who lend or invest money through the financial system
Aside from creating wealth, financial markets solve important problems:
Search costs, double coincidence of wants, liquidity, contracting costs, default
Asymmetric Information, Adverse Selection and Moral Hazard
Market Intermediaries can act as an agents or principals
Understand the basic functions of different Financial intermediaries and how they help to solve problems & inefficiencies
Mutual funds, Banks, Pension Funds, Insurance Companies, Brokers, Exchanges.
 
 

Answer:

Question 1 – Definitions

  1. Overnight rate

It’s a rate where main participants in money markets lend and borrow money overnight (for a day) among them. It is also the interest rate that Canada’s commercial banks lend and borrow funds for a day among each other. It is sometimes used by the Bank of Canada to influence the monetary policy for Canada. (Scheithauer, 2011) 

  1. Prime rate (In Canada)

It is also known as prime lending rate. It is an annual rate of interest which main financial institutions and major banks in Canada focus their lending rates on, for a variety of loans and lines of credit. It is usually influenced by policy rates of interest which the Bank of Canada has set. According to (Li, 2009) , prime rate changes with the changes brought about by money market conditions

  1. AAA-rated sovereign bond

AAA can be defined as the highest possible rating that is allocated to a particular issuer’s bond by the specific credit rating agency. They are perceived to have a small risk of default; hence they yield the smallest returns in relation to other bonds with the same maturity date. The rating agencies such as Fitch, Moody’s and Standard and Poor do access the likeliness of a borrower to pay his debts and this helps debt traders in the secondary market. Therefore AAA rated sovereign bond is one which has the highest likeliness to pay.

  1. Conventional Mortgage

It is a loan for not more than 80% of the purchase price for the property (appraised value of the property). To get the conventional mortgage, the down payment should at least be 20% of the purchase price.

  1. R-1 (low) Rating for Commercial Paper

This can be defined as a rate issued by the rating agencies to the short term debts. For example in US and Canada, the three most relevant agencies are Fitch, Moody’s and Standard & Poor. R-1 (low) represents as a good credit quality rating, with R-1 high & R-1 mid being the only superior rating above it. There are a total of 5 categories namely: Superior, good, adequate, speculative, and highly speculative.

Question 2 – Canadian Money Market and Bond Rates

  1. Fill out the table with appropriate Canadian interest rate for each of these dates.

Securities

December 30, 2016

December 31, 2018

Target for the Overnight Rate (V39079)

0.50

1.75

1-month T-bill (V39063)

0.43

1.63

1-month Banker’s Acceptance Rate (V39068)

0.89

2.25

I-month Prime Corporate Paper Rate (V39072)

0.84

2.22

Prime Rate (V80691311)

2.70

3.95

Bank Rate (V39078)

0.75

2.00

5 year conventional mortgage rate (V80691335)

4.64

5.34

5 year Guaranteed Investment Certificate

Rate (V80691341)

1.45

2.20

5 year Gov’t of Canada Bond Yield (V39053)

1.11

1.88

Gov’t of Canada  Long-term

Benchmark Bond Yield (V39056)

2.31

2.18


Briefly explain what may have caused the change in yields on money market securities between December 2016 and December 2018. Please cite which money market securities you are referencing. What do you conclude is the major influence for money market interest rates?

Solution

The changes in yields or yield curves are mainly attributed to the changes in interest rates in both the short term and long term maturity bonds. The government of Canada in the period prior to December 2018 has been increasing the policy rates on the short term bonds meant that the long term bonds had a less yield than the short term. Hence the yield curve seemed to be inverted.

  1. Calculate and report the change in Gov’t of Canada long term bond yields that occurred between December 2016 and December 2018

Solution

There was change in long-term bond yield from 2.31 in December 2016 to 2.18 in December 2018 and a change in 1-month T-bill from 0.43 in December 2016 to 1.63 in December 2018. The long-term bond yield changed by -0.13 which depicts a decline in the interest rates.

  1. How did the change in bond yields differ from the change that occurred in 1 month T bill rates?

Solution

There was an increase of 0.77in the interest rates from December 2016 and December 2018 in the 5-year Government of Canada bond yield and a decline of 0.13 in the interest rates from December 2016 to December 2018 for the government of Canada long-term benchmark bond yield. However, the 1-month T-bill rates went up from 0.43 in December 2016 to 1.63 in December 2018, an increase of 1.20. The 1-month T-bill increase was higher than that of the 5-year bond and the long-term benchmark bond.

  1. What impact did these changes have on the slope of the Government of Canada Yield curve?

Solution

The yield curves explain the relationship between the maturity date of a certain bond and the interest rates showing the differences in what they will yield. The increase in the yield percentage of the short term 1-month T-bill means more investors opted to invest in it than in the long term bonds. This caused the yield curve to look inverted in the months leading to December 2018

  • Briefly explain why, in your opinion, the slope of the yield curve changed

Solution

The slope of the yield curve seemed to take the downward slope looking simply because more investors chose to take the short term bonds with higher interest rates than the long term bonds with lower interest rates and hence lower returns.

  1. Using your definition of a conventional mortgage (in Question 1, d) as well as your findings in part a) above and other research, what do you believe causes mortgage rates to change?

Solution

Changes of mortgage rates over time are caused by the interference of supply of money and demand in the market economy.  Fluctuation in any of these factors, interferes with the rates of interest prospective homeowners are charged by the lenders. In addition, the changes in economic developments influence and help in understanding how mortgage rates are determined.

Question 3- US Interest Rates

  1. Please retrieve US data for the dates indicated (or the closest preceding date) from FactSetand use it to complete the table below.           

 

June 29, 2007

December 30, 2008

US Fed Funds Rate

(REFFFUNDEFF-FDS)

5.31

0.05

US Treasury Bill Rate - 1 month (TRYUS1M-FDS please use charting tab as explained in class)

4.2386

0.0253

1 month LIBOR rate  

(LIBORUSD1M-FDS)

5.32

0.43625

US Commercial Paper Rate – 1 months (USCP30D-TU1, please use charting tab)

5.29

0.40

Spread US Commercial Paper rate -1 month over US Treasury Bill rate -1 month

5.32-4.2386=1.0514

0.43625-0.0253=0.41095

Long Term (30 year) US Treasury Bond Yield (TRYUS30Y-FDS)

5.1249

2.5572

Spread US Long Term AA Corporate bond yield over Long Term US Treasury bond yield (FCBAASUS15Y-FDS)

1.121-5.1249=       -4.0039

3.043 - 2.5572 = 0.4858

Spread US Long Term BBB Corporate bond yield over 10 year US Treasury bond yield (FCBBBBSUS10Y-FDS)

1.526-5.0265=      -3.5005

5.825-2.0579 = 3.7671

Explain briefly (4-5 sentences) the cause of any general trends or changes you observed in the interest rates in 2007 versus 2008.  In your answer, please address the time period and why the Federal Reserve would undertake these changes

Solution

In 2007 there was an economic crisis and this explains the reason as to why the federal service had to increase the rates for the government bond. They needed more money at their disposal. This is as compared to 2008 where the economy was already stabilizing hence the policy rates on the long-term maturity bond of the government was lowered. This was to help the uptake f the short-term corporate bonds to steer the economy even more.

  1. Briefly explain what the 3 interest rate differences or “spreads” that you calculated in part a) represent  

Solution

A credit spread can be described as the difference in return of the two bonds that share the same maturity but different quality. Generally widening credit spreads signal the low ability to service the obligation.

 

In reference to the US Commercial paper rate-1 month as compared to the US Treasury bill rate 1- month, the spread shows that in 2008 the ability to pay of the two bonds by the US government was higher than in 2007. This can be attributed to the fact that during the 2007 crisis there was some uncertainty.

 In regards to spread between the US long-term AA Corporate bond if the long-term US Treasury bond yield, bonds were more likely to meet their obligations to pay at maturity in 2007 than in 2008. It can be partially attributed to the fact that one of them had a good rating.

 In regards to the US long-term BBB corporate bond over the 10 year US Treasury bond the spread in 2008 was wider as compared to 2007. The rating of the bond and the fact that the investors would predict better economic future can be accredited to a narrower spread.

Question 5 – Canadian Bond Quotations (15 marks)

a.) What is CANDEAL? What does it do? Explain briefly

Solution

It is a major leading institutional electronic marketplace for Canadian money market securities which include bonds and derivatives. It provides a marketplace for institutional investors that enable the buying and selling of the Canadian government bonds and money market instruments. It was founded in June 2001 and is co-owned by Canada’s top 6 banks and the TMX group.

b.) Find bond quotes for the following two corporate bonds and the Government of Canada bond listed here and complete the table below.

Issuer

 

Maturity Date

Bid

Price

Ask Price

Bid
Yield

Ask
Yield

 

Moody’s

Bond Rating  

S&P Bond Rating

Hydro One

HYDONE 4.39

 

26/09/2041

109.954

110.359

3.734

3.709

Baa1

A-

ROGERS

Communication

Inc. (RCI)

RCICN

6.68

 

04/11/2039

129.924

130.408

4.454

4.424

Baa1

BBB

Canada

5.00

Maturing in 2037

01/06/2037

142.877

142.978

2.155

2.149

Aaa

AAA


c.) Explain what the Bid yield and Ask yield represent. If an investor wishes to buy Hydro One bonds, what price will they pay?

Solution

Bid yield is the yield to maturity for the current bid price of the bond

Ask yield is the rate of return or the yield that the investor would receive if they bought the bond at the price asked.

If an investor wishes to buy Hydro One bond they will pay the ask price = 110.359

d.) Why do the three issuers above (Hydro One, Rogers Communication, and Canada) have different credit ratings?  Think about the differences in default risks of Hydro One vs. Rogers Communication Vs. Government of Canada.  How is this difference reflected in the yields and credit spreads for these bonds?  

Solution

The three issuers have different credit ratings because they have different financial strengths that is their ability to pay the bonds interest and principal in time.

The three issuers also have different default risks which can be seen in their yields and credit spreads. The government of Canada bond has a low default risk meaning it has a stronger financial strength compared to the two corporate bonds and this can be depicted by the lower bid and ask yields i.e. 2.155 and 2.149 respectively. The government bond has lower yields because the risks faced are minimal while the yields for corporate bonds are higher and so are their default risks.

Question 6 – Securitization

  1. What is the name of the SIV (Special Investment Vehicle)? What function does the SIV provide?

SIV is as special investment, can be defined as a portfolio of investments that accrue profit on the difference in price or spreads between the structured financial products and short term debts. The difference in price helps in accruing interest in that one may borrow in an wholesome market that is say at 2% and invest in a structured product that is yielding at 5% hence benefiting from the extra 3 %.

 

  1. What are the assets included in this trust and who is the Seller of the assets to this trust?

The assets in this trust car makes of Ford Company, including cars, utility’s and light trucks. Fords Credit Canada Limited is the seller

Name the investment dealers who were underwriters of these asset backed notes.

  1. The investment dealers included:

Merrill Lynch Canada Inc.

BMO Nesbitt Burns Inc.  

CIBC World Markets Inc.

Scotia Capital Inc.

TD Securities Inc. RBC

Dominion Securities Inc.

  1. d)    What is collateral?  In your own words, explain what is meant by ‘overcollateralization’.  What is the purpose of doing this?

Solution

Collateral can be termed a security issued to a lender for giving a loan to a borrower. The borrower pledges an asset to the lender such that he has the power to seize it if the borrower defaults on his obligation.

Over-collateralization is a scenario whereby the issuer of a security or the lender posts more collateral that is needed so as to secure the risk of defaulting. Thus its purpose is to reduce the risks of any unexpected defaults by the borrower that in the scenario of loans

  1. e) In your own words, explain twobenefits to Ford from undertaking this securitization.                      

     Solution

Reduced funding costs

This is because even if they may have a low rating say BB as a company but their assets maintain a high quality rating such as AAA or AA and therefore they can borrow at significantly low rates by using their high quality assets as collateral.

Increased revenue growth

With reduced cost for getting funding it means the profits will be higher than they normally would be without the reduced value of costs incurred. Profits are equal to the difference between the marginal benefit and the marginal costs. Borrowing loans at low rates means that the company will have reduced costs.

Question 7 – Problems

  1. The yield on Company XYZ's commercial paper is 3.5%. What will it cost you to buy $100,000 face value of this Canadian security if it matures in 60 days?

Solution

3.5% = ($ 100 000 – P/ P) * 365/60

0.035 = $100000/P – 1 * 6.0833

0.00575 = $100000/P -1

1.00575 = $100000/P

P = $100000/1.00575

P = $99427.991

$99 427.991 is the face value of the Canadian security if it matures in 60 days.

  1. What is the yield on a US Treasury Bill with a 60-day term to maturity, priced at $99.20 per $100 face value?

Solution

r bey = ($100 – P)/P * 360/n

r = ( $100 – 99.20)/99.20 * 360/60

r = 0.048387 * 100

r = 4.8387%

The yield for the US Treasury Bill is 4.8387%

  1. Today is January 31, 2019.  A bond has a $1000 par value, a 4% coupon (paid semi-annually) and matures in exactly3 years. Its yield to maturity is 4%.
  1. What is the price of this bond?

Solution

Bond price = C * (1- 1/(1+i)^n)/i + M * 1/(1+i)^n

i = yield to maturity date

n = total number of coupon payments

e = coupon payments

C = ($1000 * 0.04 * 0.5)

C = 20

P = 20 * (1-1/(1+4%)6) + 1000 * (1/(1+4%)^6)

P = 20 * (0.2097) + 790.31

P = 4.194 + 790.31

P = 794.504

The price of the bond is $794.504

  1. Assume that you decide to purchase this bond on April 10, 2019.  How much accrued interest will you have to pay?

Solution

$794.504 * 70/365

$794.504 * 0.19178

= $152.371

  1. You just purchased a 20-year Government of Canada strip (zero coupon) bond at a price of $750.  
  2. What is the yield to maturity on this zero coupon bond?   

Solution

The yield to maturity rate is 2.153%

  1. At what price do you need to purchase this bond in order to obtain a 7% yield to maturity?

Solution

Bond value of a zero-coupon bond = F/(1+r)^t

t = time to maturity

F = face value

r = rate of the yield

Thus:

750 = F/(1+2.153%) ^20

750 * (1.02153) ^20 = F

F = 1,148.38

X = 1148.38 / (1 + 7%)^20

X = 1148.38 / 3.86968

X = $ 297

The purchase price for the bond with 7% yield to maturity is $297

 

References

Li, J. Z. (2009, May 26). Recent changes in the prime rate behaviour. Review of quantitive finance and accounting, pp. 177-192.

Scheithauer, D. N. (2011, November). Monetary policy implementation and overnight rate persistence. Journal of International Money and Finance, 30(7), 1375-1386.

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