Understanding Financial Markets: Key Definitions and Canadian Interest Rates

RSM 230: FINANCIAL MARKETS
WINTER 2019

Question 1 – Definitions
a) 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)
b) 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
c) 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.
d) 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.
e) 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
a. 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
b. 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.
c. 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.
i. 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.
ii. 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
iii. 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.
d. 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.