Treasury Management

Analysis of the Yield Curve

Hand-out Questions 1

1. If a pure discount three-year bond sells for $782 and a pure discount four-year
bond sells for $733, what is the expected 12-month interest rate in three years
time? Both have a face value of $1000.

Year 3 rate= r3
Year 4 rate=r4

3(1+r3) *782=$1000
3(1+r3) = 1.2788

4(1+r4) = 1000
4(1+r4) = 1.3643

-1= -1 =0.0668 = 6.68% (the expected 12-month interest rate in three years time)

2. Year 4 rate: r4
3. 3(1+r3) * 782 = $1000
4. 3(1+r3) = 1.2788
5. 4(1+r4) * 733 = 1000
6. 4(1+r4) = 1.3643
7. The expected 12-month
interest rate in three years
time:
8. – 1 = – 1 = 0.0668 =
6.68%
9. Year 3 rate: r3
10. Year 4 rate: r4
11. 3(1+r3) * 782 = $1000
12. 3(1+r3) = 1.2788
13. 4(1+r4) * 733 = 1000
14. 4(1+r4) = 1.3643
15. The expected 12-month
interest rate in three years
time:
16. – 1 = – 1 = 0.0668 =
6.68%
Year 3 rate: r3
Year 4 rate: r4
3(1+r3) * 782 = $1000
3(1+r3) = 1.2788
4(1+r4) * 733 = 1000
4(1+r4) = 1.3643
The expected 12-month
interest rate in three years
time:
– 1 = – 1 = 0.0668 = 6.68%
Year 3 rate: r3
Year 4 rate: r4
3(1+r3) * 782 = $1000
3(1+r3) = 1.2788
4(1+r4) * 733 = 1000
4(1+r4) = 1.3643
The expected 12-month
interest rate in three years
time:
– 1 = – 1 = 0.0668 = 6.68%
Year 3 rate: r3
Year 4 rate: r4
3(1+r3) * 782 = $1000
3(1+r3) = 1.2788
4(1+r4) * 733 = 1000
4(1+r4) = 1.3643
The expected 12-month
interest rate in three years
time:
– 1 = – 1 = 0.0668 = 6.68%
Year 3 rate: r3
Year 4 rate: r4
3(1+r3) * 782 = $1000
3(1+r3) = 1.2788
4(1+r4) * 733 = 1000
4(1+r4) = 1.3643
The expected 12-month
interest rate in three years
time:
– 1 = – 1 = 0.0668 = 6.68%
2. If 12-month interest rates are expected to be 6% in three years time, describe how
investors could take advantage of the pricing in question 1. What impact would this
have on interest rates?
Debt at the end of the 3 years = 782*3(1+r3) = 782*1.2788= $1000

Debt at the end of the 4 years= 782*4(1+r4) = 782*1.3643= $1066.85

As the interest rate is expected to be 6% in three years, $1000 bond will borrowed at 6% and
debt will be repaid.

Debt at the end of 4 years is $1000*1.06= $1060

Profit= 1066.85-1060= $6.85

3. Twelve-month interest rates for the next four years are expected to be 5%, 6%, 6.8%
and 7.4% respectively. Calculate the yield to maturity on:
i) a pure discount four-year bond, and
ii) a four-year 8% annual coupon bond. Find the PV of this particular bond.
Explain why there is a difference.
U se calc. P/Y, CIY=1
FV=1000 (AS NO VLAUE SO 1000)
PV= 1061.34
N=4
PMT= 1000*8%=80
I/Y=6.22093%
4. An investor purchases the following debt instruments with a $1,000 face value, for
$826.44 and $1,000 respectively.
i) a pure discount two-year bond, and
ii) a two-year 10% annual coupon bond
Calculate the return after two years if immediately after purchase interest rates
a) fall by 1% p.a.
b) remain constant, and
c) increase by 1`% p.a. on all maturities.
(Assume that the yield curve is flat). – NO EFFECT ON PURE DISCOUN BOND. oT
WILL HAVE AN EFFECT ON COUPON BOND( DICOUNTED RATE)
 If the discount rate is same, return is same.
If constant then more. If less then less.

Finance plays a role in cost of funds as borrowing an dlending will be associated with the
some form of cost.

Term yield refers to the income that an investment generates which is separate from the
principal amount. It also takes in play whether you make a capital gain or a capital loss. Total
return an investment is to make, include interest receipts gain and loss.

Graph y will be yield and x will be the time to maturity.

What a yield will be at a particular point of time.- denoted by the graph
The upward sloping curve, normal or psotive yield curve

The downward yield curve, inverse or negative

Inverted U, known as round curve.

Chapter 13- read expectancy theory which is important to cover.

This theory says that shape of the yield curve is the current short term and future rates.

If you have a choice of placing an investment of short term againt the long term

Short period low interest. Long period high interest.

If you plan investment on long term or short term and if you rolled the short term over and
over ewqual to long term the amount of yielf you earn is same.

2 years security 10 % return. 6 months %

If you place the money on 6 months and roll it over for another 6 months and again for other 6
months for two years will be the same return if you keep the same money for 24 months.

You can have a much more access you funds when you palce it in 6months rather for 24
monthsmmonths.

When inflation hits, yield instead of going up goes down. Why is the shape is because what
the govn does( monetary and fiscal policy) Depends upon the interest rates, change in rates.
Monetary policy accommodates the shape of the yield. Min wage levels will go up. More
money in the circulation against the RBA so they will increase the rate further.
Central bank itself, RBA. It is an independent body. They can do whatever they want to
change.

Access to information. It will affect the shape of the yield.