Money And Banking Assignment 1 - Economics

Money And Banking Assignmentassignment 1economics Money And Bankings

Money and Banking Assignment Assignment 1 ECONOMICS : MONEY AND BANKING Summer 2016 · Answer all questions · Late assignment will not be accepted. · Get to the point. Be clear and concise. · You may submit the assignment in a group of up to four students. Make sure you indicate clearly the names and IDs on the cover page of the assignment.

1. Coupon Bond Rate Go to under “market†select bonds. Choose 4 different bonds with the following characteristics: · One Federal government bond trading at a premium with more than ten years to maturity · One corporate bond trading at a discount with less than ten years to maturity · One corporate bond trading at a premium more than ten years to maturity · One Provincial government bond trading at a premium with less than ten years to maturity · For each bond, calculate the current yield. · Compare the current yield to the yield to maturity. For which bonds is current yield closer in value to the yield to maturity? Explain

2. Term Structure of Interest Rates : Go to this web site allows you to plot the yield curves for UK Gilts and US Treasuries for different periods. List the three facts about the term structure of interest rates. Select a period and print a plot of an upward yield curve. Make comments using the theories you studied about the term structure of interest rates. Select another period and print a plot of an inverted yield curve and make comments using the theories you studied about the term structure of interest rates. Compare, generally, between the UK Gilt and the US Treasury yield curves in 2 and 3 citing the power of prediction of the theories of the term structure of interest rates in predicting the 2008/2009 financial crisis.

Paper For Above instruction

The assignment addresses fundamental concepts in money and banking, focusing on bond valuation and the term structure of interest rates. These topics are crucial for understanding financial markets and their influence on economic stability and growth. The first part involves practical calculations of bond yields, which provides insight into how investors assess bond attractiveness and risk over different maturities. The second part explores the yield curve, a vital indicator used to predict economic activity and potential crises, emphasizing theoretical frameworks that interpret the shape of the yield curve.

Bond Yields and Market Characteristics

Understanding bonds requires analyzing their current yield and yield to maturity (YTM). The current yield is calculated by dividing the annual coupon payment by the current market price of the bond. YTM considers the total returns expected if the bond is held until maturity, incorporating the present value of future cash flows, including the face value. Bonds trading at a premium have prices above face value, often due to declining interest rates or strong credit perceptions, while those trading at a discount are priced below face value, typically reflecting higher risk or rising interest rates.

In this context, a federal government bond trading at a premium with more than ten years to maturity is likely to have a current yield that closely approximates its YTM due to its high credit quality and stable cash flows. Conversely, corporate bonds at a discount with less than ten years to maturity tend to exhibit a greater disparity between current yield and YTM, given the higher credit risk and shorter time horizon. The comparison reveals that for bonds with high creditworthiness and longer maturities, the current yield is a good estimator of the YTM, while for bonds with higher risk or shorter maturity, the YTM provides a more comprehensive measure of expected return.

Theories and Facts about the Term Structure of Interest Rates

The term structure of interest rates, represented through yield curves, encapsulates expectations about future interest rates, inflation, and economic activity. Three fundamental facts about the term structure include: (1) upward sloping yield curves, indicating expectations of rising interest rates and economic growth; (2) inverted yield curves, often preceding recessions; and (3) the existence of flat curves during transitional economic phases.

Plotting a yield curve during an upward-sloping period typically aligns with the expectations hypothesis or the liquidity preference theory, suggesting investors demand higher yields for longer-term securities due to risks and the preference for liquidity. During such periods, expectations of economic expansion and rising rates dominate. Conversely, inverted yield curves, characterized by short-term yields exceeding long-term yields, often signal market expectations of declining interest rates and an impending economic slowdown or recession. Such inversion is considered a reliable predictor of economic downturns, as evidenced by the 2008/2009 financial crisis, where inverted yield curves preceded the downturn.

Comparison of UK Gilt and US Treasury Yield Curves

In analyzing the UK Gilt and US Treasury yield curves, differences are often observed due to monetary policy, economic outlook, and market expectations. During periods of economic optimism, both yield curves tend to slope upward, reflecting confidence and expectations of growth. Conversely, in downturns, yield curves may invert, reflecting market anticipation of lower rates and economic contraction.

Historical analyses demonstrate that inverted yield curves in both markets have been potent predictors of the 2008/2009 crisis, validating the predictive power of the expectations hypothesis. The US yield curve, in particular, has been regarded as a reliable leading indicator, although UK curves exhibit similar predictive patterns. The consistency of inverted curves before recessions signifies their importance in economic forecasting.

Implications for Financial Markets and Policy

The analysis of the yield curves provides essential signals for investors, policymakers, and economists. Recognizing the patterns and their underlying theories enables anticipation of economic shifts, informing investment strategies and macroeconomic policies. The effectiveness of the expectations hypothesis and liquidity preference theory in explaining real-world phenomena underscores their relevance for understanding market dynamics and preparing for potential downturns.

Conclusion

The evaluation of bond yields and the term structure of interest rates offers profound insights into economic expectations and financial market health. The practical calculations of current yields and YTM, alongside the interpretation of yield curves, demonstrate how market perceptions of risk, growth, and inflation influence interest rates across different maturities. Moreover, the historical predictive capacity of inverted yield curves emphasizes their value as economic indicators, reinforcing the importance of these concepts in macroeconomic analysis and financial decision-making.

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