Question

QUESTION 1

(the interest rates)

You are a senior financial analyst and have been asked to analyse recent developments in the Euro era and the U.S markets and advise the top management on the economic conditions in both markets. You have collected data on the euro area yields of the central government bonds and the U.S. treasury bond yields. For this purpose, you have downloaded the following data from the European Central Bank and the U.S Federal Reserve Bank on 24^th September 2020 (Mo = month, Yr = Year):

24/09/2020
Time to Maturity	Euro area Central Government Bond Yield Rates	U.S. Treasury Bond Yield Rates
1 Mo	-	0.08%
3 Mo	-0.60%	0.10%
6 Mo	-0.62%	0.11%
1 Yr	-0.66%	0.12%
2 Yr	-0.71%	0.14%
3 Yr	-0.74%	0.16%
4 Yr	-0.74%	-
5 Yr	-0.72%	0.27%
7 Yr	-0.63%	0.46%
10 Yr	-0.49%	0.67%
20 Yr	-0.17%	1.19%
30 Yr	-0.05%	1.40%

REQUIRED:

1. Considering both yield rates on 24^th September 2020, depict the yield curves charts and describe the implied market outlook in the Euro area and the U.S. market to the top management.

[4 marks].

QUESTION 1 (continued)

2. Calculate the market price of each bond on 24^th September 2020 that issued by North Polar Ltd., a European company specialises in manufacturing semiconductors, using the yield curve data provided in the table above. What is the current total value of minimum application?

Corporate Bonds Fact Sheet
Issuer	North Polar Ltd.
Issuing date	24th September 2020
Bond expiration date	24th September 2025
Face value	€ 1000 per bond.
Minimum application	50 Bonds (€ 50,000)
Interest rate	Floating Interest Rate. The Interest Rate is the sum of the Market Rate plus the Margin.
Coupon rate (annual)	Central Government Bond Yield + 1.86% p.a.
Coupon payment	Annually (coupon payment is paid on 10th July every year)
Market Yield	4.5%

[4 marks]

3. Suppose the Australian government has announced tax cuts for the business sector. Using the loanable funds model, explain how this will impact the supply of and demand for loanable funds and the interest rate in Australia. (Explain your answer using diagrams).

Answer 1

Solution:

Yield Curve Chart for Euro area Central Government Bond Yield Rates:

Case 1: Bonds having maturity dates ranging from 1 month to 7 Years:

Depiction: Inverted Yield curve

X axis represents- Maturity Date

Y axis represents- Yield

This Yield curve chart indicates that the long term yields are falling below the short term yields. In this scenario, investing for long term bonds is not a right investment strategy. The investor should invest for a short term investment horizon as the stability in the market is not guaranted. Here, the market outlook is not optimist for long term investors and is favorable for short term investors.

Case 2 : Bonds having maturity dates for more than 7 Years:

Depiction: Normal Yield Curve

X axis represents- Maturity Date

Y axis represents- Yield

This Yield curve chart indicates that if an investor chooses to invest in the treasury bonds for more than 7 years then the yield on the maturity will be better than the other bonds having maturity periods less than 7 years. The market seems to be stabilized in the long term and If the investor selects the treasury bond with maturity period of 30 years then he would get the best yield among the other mentioned bonds with different maturity dates.

• Yield curve chart for U.S. Treasury Bond Yield Rates:

Depiction: Normal Yield Curve

X axis represents- Maturity Date

Y axis represents- Yield

The yield rates on the U.S Treasury bonds are increasing with the increasing maturity dates, which indicate the optimism in the market. The Investment in U.S treasury bond is risk adjusted and will demand higher compensation for the risk associated with the long term maturity bonds as the yield rates are directly proportional to the maturity dates.

Conclusion: U.S. Treasury Bond Market is stable than that of Euro area Central Government Bond. So, to compensate the risk and to favour the both short term and long term investors, U.S. Treasury Bond Market is a better investment option.