Financial Market Assessment: Yield Curves, Bonds, and Loanable Funds

This document provides a comprehensive solution to a financial market assessment, addressing key concepts in finance. The assessment begins with an analysis of yield curves for the US and Europe, comparing and contrasting their shapes and implications for economic growth and interest rates. The solution then proceeds to calculate the market price of corporate bonds issued by a European company, considering factors like coupon rates and time to maturity. Furthermore, the document explores the impact of tax cuts on the supply and demand for loanable funds using the loanable funds model and explaining the effect on interest rates. The assessment also includes time value of money calculations, comparing investment options from different banks and determining the optimal choice based on compounding frequency. Finally, the document analyzes three contract options for a professional football player, using present value calculations to determine the most financially beneficial contract. The document provides detailed calculations and explanations for each question, offering a complete and well-structured solution to the assessment.

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Financial Market Assessment 3

Question 1:
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%
1)The description the yield curves of US and Europe
Since bond yield rate is considered as discount rate that is mainly related with interest rate, so
any reduction in interest rate leads to decrease the bond yield as well, with increase of bond
price. Similarly, with increase in rates of interest cause the rise of bond yield which in turn,
create declination of bond’s market value. As per the data mentioned above, it has been
interpreted that from three months, Central Government Bond Yield Rates has been decreased
with 60% negative till 0.05% in 30- year maturity period. However, there is no specific data given
in 1- month. In addition to this, graphically, this data gives a humped yield having bell - shape
curve with a negative slope as data of both short and long term is lesser than medium-term.
Therefore, through this structure it has been analyzed that European economy is developing at
slow rate. This leads to lower inflation with decrease interest rate for the given financial periods.
On contrast with US treasury bond yield, its data represents a gradually increase from lowest to
highest figure i.e. 0.08% in first month to 1.40% till 30-year period of maturity. This data
represents a normal yield therefore, concerning on the current rate of short-term, it has been
expected that future short-term interest rate will be higher. Therefore, on comparing data of
both countries, it has been expected that relatively there will be a stronger economic growth
rate of US than Europe.
The yield curve of Europe:
The yield curve of US:

QUESTION 1 (continued)
1) Calculate the market price of each bond on 24th 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]
2) 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).
Coupon rate (annual) = – 0.72% + 1.86% = 1.14%
INT = 1.14% x € 1000 = € 11.4
k_d= 4.5% = 0.045
Bond price = = € 852.50
Current total value of 50 Bonds = € 852.50 x 50 = € 42,624.84 € 42,625
To determine the supply and demand for loanable funds in Australia, interaction between both factors
i.e. supply and demand loanable funds are determined first to evaluate the interest rates. So, using
loanable funds model, level of interest rate could be partially explained.

Afterwards, loanable funds supply is then determined by calculating saving rates, lending decisions
regarding with surplus economic units (such units include income which is greater than expenditure)
and financial intermediaries’ lending policy. So, considering such factors, if taxes are cut for business
sector by Australian government then savings amount of households will rise up. This leads to raise
supply of loanable funds with decrease in interest rate.
Regarding with demand of loanable funds, it has been determined by analyzing the expenditure plans
about deficit economic units including further requirement of financing such expenditures, by using
borrowed funds. So, demand for finance will be rise for both household and business requirements in
terms of high expenditures for housing etc., if interest rates are lower interest rate with increased supply
of loanable funds. This will enable Australian Government to push back the interest rate back till that
point after which tax cuts will take place.

QUESTION 2
3)
[4 marks]
(4 + 4 + 4 = 12 marks)

QUESTION 2
(TIME VALUE OF MONEY)
1) You have just received a bonus of $15,750 and are looking to deposit the money in a bank
for 5 years. You have investigated the annual deposit rate of several Australian banks and
collected the following information:
Bank Annual rate Compounding frequency
Commonwealth Bank of Australia 0.85% Monthly
Westpac Banking Corporation 0.89% Quarterly
Australia and New Zealand Banking Group 0.77% Daily
National Australia Bank 0.82% Annually
i. To determine which bank you should deposit your money in, calculate how much money
you will earn at the end of 5 years at each bank. (round your answer to 2 decimal
places).
[4.5 marks]
ii. You understand that the more frequently interest is earned in each year, the more you
will have at the end of your investment horizon. Is this always true? Discuss this
statement considering your answer from the previous part.
Bank
Annual
rate Compounding frequency Future value ($)
Commonwealth Bank of Australia 0.85% 12 16433.56
Westpac Banking Corporation 0.89% 4 16465.89
Australia and New Zealand Banking Group 0.77% 365 16368.19
National Australia Bank 0.82% 1 16406.43
Amount of money to be deposited ($) 15,750
- Commonwealth Bank of Australia
FV = PV x (1 + r) n = 15,750 x (1 + (0.85%/12))60 = $16,433.56
- Westpac Banking Corporation
FV = PV x (1+r) n = 15,750 x (1+(0.89%/4))20 = $16,465.89
- Australia and New Zealand Banking Group
FV = PV x (1+r) n = 15,750 x (1 + (0.77%/365))1825 = $16,368.19
- National Australia Bank
FV = PV x (1+r) n = 15,750 x (1 + 0.82%)5 = $16,406.43

As per the given calculation, it has been interpreted that Westpac Banking
Corporation is considering as better choice for depositing the money as it might
offer highest return value in future by $16465.89 till the end of five years.
ii.
Bank
Interest earned ($)
(= FV – Deposit)
Commonwealth Bank of Australia 683.56
Westpac Banking Corporation 715.89
Australia and New Zealand Banking
Group 618.19
National Australia Bank 656.43
Since given deposited money amount is calculated with same rate of interest
annually, so, more compounding frequency results in increasing the earned amount after
the end of investment period. However, it will be true only when annual interest rate
remains unchanged regarding with any options. From mentioned options, as Westpac
Banking offer better options of depositing rates on quarterly period i.e. $715.89, so this
will aid in attracting customers more easily, relatively than other banks.
iii.
[1.5 marks]
2) A professional footy player and his agent are evaluating three contract options to play in
the Australian Football League (AFL). Each option offers a signing bonus and a series of
payments over the life of the contract. The player uses 7.25% rate of return (compounded
annually) to evaluate the options.
Year Cash flow Richmond
Football Club
Hawthorn
Football Club
Collingwood
Football Club
0 signing bonus $3,500,000 $3,500,000 $3,500,000
1 Annual Salary $700,000 $850,000 $775,000
2 Annual Salary $750,000 $800,000 $775,000
3 Annual Salary $800,000 $750,000 $775,000
4 Annual Salary $850,000 $700,000 $775,000
(i) Using the information provided above, which contract should be chosen? (Show your
calculations).
Year Cash flow Richmond Football
Club
Hawthorn Football
Club
Collingwood Football
Club

0 signing
bonus
$3,500,000 $3,500,000 $3,500,000
1 Annual
Salary
$700,000 $850,000 $775,000
2 Annual
Salary
$750,000 $800,000 $775,000
3 Annual
Salary
$800,000 $750,000 $775,000
4 Annual
Salary
$850,000 $700,000 $775,000
(i)
Richmond Football Club:
Discounted rate: 7.25% (compounded annually)
Year 1: PV1 = FV1(1+r)-n = 700,000 x (1+7.25%)-1 = $652,680.65
Year 2: PV2 = FV2(1+r)-n = 750,000 x (1+7.25%)-2 = $652,028.62
Year 3: PV3 = FV3(1+r)-n = 800,000 x (1+7.25%)-3 = $648,482.24
Year 4: PV4 = FV4(1+r)-n = 850,000 x (1+7.25%)-4 = $642,435.78
Total of PV = Signing Bonus + PV1 + PV2 + PV3 + PV4
= 3,500,000 + 652,680.65 + 652,028.62 + 648,482.24 + 642,435.78
= $6,095,627.29
Hawthorn Football Club
Discounted rate: 7.25% (compounded annually)
Year 1: PV1 = FV1(1+r)-n = 850,000 x (1+7.25%)-1 = $792,540.79
Year 2: PV2 = FV2(1+r)-n = 800,000 x (1+7.25%)-2 = $695,497.2
Year 3: PV3 = FV3(1+r)-n = 750,000 x (1+7.25%)-3 = $607,952.1
Year 4: PV4 = FV4(1+r)-n = 700,000 x (1+7.25%)-4 = $529,064.76
Total of PV = Signing Bonus + PV1 + PV2 + PV3 + PV4
= 3,500,000 + 792,540.79 + 695,497.2 + 607,952.1 + 529,064.76
= $6,125,054.85

Collingwood Football Club
Discounted rate: 7.25% (compounded annually)
Year 1: PV1 = FV1(1+r)-n = 775,000 x (1+7.25%)-1 = $722,610.72
Year 2: PV2 = FV2(1+r)-n = 775,000 x (1+7.25%)-2 = $673,762.91
Year 3: PV3 = FV3(1+r)-n = 775,000 x (1+7.25%)-3 = $628,217.17
Year 4: PV4 = FV4(1+r)-n = 775,000 x (1+7.25%)-4 = $585,750.27
Total of PV = Signing Bonus + PV1 + PV2 + PV3 + PV4
= 3,500,000 + 722,610.72 + 673,762.91 + 628,217.17 + 585,750.27
= $6,110,341.07
Conclusion: From the given calculations, it has been concluded that Hawthorn Football Club will
prove better option that other, to make contract because over the life of the contract, its present
value i.e. $6,125,054.85 will be higher than others.
(ii) The given quote i.e. “a dollar today is worth more than a dollar tomorrow” mainly
indicates the value of money which changes as per time rise up. As per this stated
theorem, the time value of money of current period is considered as more worthy than in
future, just because fluctuations in interest and inflation rates. It there will remain a
positive interest rate throughout the year, then only in that condition spending power of
dollars will be increases. But in case of rising in inflation rates over time, then in turn,
this will rise price of entire goods or services, that results in decreasing the dollar’s
spending power. Therefore, in such case, it is depicted by this quote that taking risk to
investing a dollar, people will expect more gain than just getting the dollar back. With
each unit of risk, expectations for higher return will slightly be more. The financial
organizations who offer appealing rates of interest rates to investors through loanable
funds, and the stock market which is able to beat out inflation over time, then investing
the amount in such an era will be worth the money invested more far in future than other
options.
(ii)
[4 marks]
(iii) Explain the phrase “a dollar today is worth more than a dollar tomorrow”
[2 marks]
(6 + 6 = 12 marks)
QUESTION 3
(DERIVATIVE SECURITIES)
1) Melbourne Capital Ltd considers selling European call options on ANZ Bank Ltd for $1.50 per
option. The current market price is $17.70 on 28th September 2020, the exercise price is $20, and
the maturity of each call option is 6 months.
(i) Under what circumstances does the investor make a profit?

Investors are considered as those individuals who prefer buy all options, just to
earn a profit. In this regard, if spot price is relatively greater than exercise price
with difference slight higher as compared to call premium. Therefore, as per
given question, the investors will earn profit only when spot rate reaches to $
21.50 and.
[2 marks]
(ii) Under what circumstances will the option be exercised? [2 marks]
The option as per given criteria, could be exercised only when market price
relatively greater than $20.
(iii) How many call options should the investor sell to raise a total capital of $1,260,000?
[2 marks]
Since investor sells call options of Europe call at $1.50 each, so, in such case,
for increasing the total capital of $1,260,000, they have to sell in given ratio
$1,260,000 : $1.50= 840,000 (call options)
2) Company A agrees to enter into an FRA agreement with Company B in which Company A
borrows $ 40,000,000 in 6-month time for a period of 9 months, and Company B invests $
40,000,000 in 6-month time for a period of 9 months. The 6-month interest rate is 0.77% per
annum and the 9-month interest rate is 0.89% per annum.
(i). What is the interest rate that both companies agreed upon?
Both Company A and Company B will be agreed if interest on trade date is 0.89% per annum
for the period of 9 months [1
mark]
(ii). Suppose that at the expiry date of the FRA, the 6-month interest rate is 0.81% per
annum and the 9-month interest rate is 0.96% per annum, calculate the compensatory
payment and which party receives it?
Interest differential = (Settlement rate – Contract rate) x amount
= (0.96% - 0.89%) x 9/12 x 40,000,000
= 21000
Settlement amount = 21000/ (1 + (0.96% x 9/12)
= 20,849.88
Since Settlement rate > Contract rate, borrower receives the payment
[2 marks]
(iii). Suppose that at the expiry date of the FRA, the 6-month interest rate is 0.79% per
annum and the 9-month interest rate is 0.86% per annum, calculate the compensatory
payment and which party receives it?
Interest differential = (0.86% - 0.89%) x x 40,000,000
= -9000
Therefore, settlement amount = -9000/ (1 + (0.86% x 9/12))
= -8942.32
Since settlement rate < contract rate, investor receives the payment.
[2 marks]

QUESTION 3 (continued)
3) A mining company in Australia has entered into a contract to export iron ore into China with
delivery in three months’ time. The contract is denominated in Chinese Yuan, CNY and is valued
at CNY 500 million. The current spot exchange rate is AUD/CNY 5.18. Assume that the expected
spot rate in three months’ time is AUD/CNY 5.13. The three-month futures contract for
Australian dollar and Chinese Yuan is trading at AUD/CNY 5.09. Should the mining company use
the futures market to hedge the exchange rate exposure? Explain why or why not?
With hedging:
AUD received after 3 months = Amount in CNY / The futures contract price today
= 500,000,000 / 5.09 = AUD 98,231,827.11
Without hedging:
AUD received after 3 months = Amount in CNY / The expected spot rate in 3 months
= 500,000,000 / 5.13 = AUD 97,465,886.94
With hedging, the AUD received after three-months is higher. Hence, the mining company should use
futures to hedge the exchange rate exposure
[3 marks]
(6 + 5 + 3 = 14 marks)
QUESTION 4
(Contemporary issues in FMs)
1) In response to the COVID-19 pandemic, Australian government implements numerous
policies to provide economic support to the Australian economy. Briefly discuss the role
played by the Australian government to rescue the economy.
[max 6 marks].
The outbreak of pandemic attack i.e. COVID-19 has put a worst impact on almost all
nations where it has spread rapidly, in terms of socio-economic loss. It has created a
significant challenge to global economy and further improvement on health system as it still
increases at higher rate. However, government has respond aggressively to reduce the
spreading rate of Coronavirus and support public and businesses to deal with its economic
consequences. But still, impact of this pandemic virus worsening the condition of market
more adversely. In context with Australia, its government has made a number of policies
for supporting the public and households, it includes salaries, assistance of companies to
maintain employment by giving funds to run business well, regulatory protection,
increasing accessibility of health system especially for local and ethnic communities etc.
Hereby, financial support includes salary subsidies to apprentices and interns, keeping
people employment by Government JobKeeper payments and more.
2) On April 7th, 2020, Fitch Ratings Inc. downgrades Australia's four biggest banks credit
ratings. How does this affect borrowers, lenders, and financial institutions? What are the
implications of this downgrade to the health of the financial system?
Among the four largest Australian banking groups, T Fitch Ratings on 7 April 2020, has
downgraded The Publisher's Default Ratings (IDR), in order to prevent the dissemination
and reduce the impact of COVID-19 by decreasing its spreading rate. Over this pandemic
period i.e. from last six months, GDP of Australia is projected to reduce more, with
increase in unemployment rate. Therefore, it will affect financiers and borrowers more,
because most of the business seems not to be in desired state to restart their business
after the beginning of restructuring. Along with this, some households might be not in

condition to pay their debt after the repayment holidays that are provided by the banks
during the last six months. In addition, asset measurements also likely to decrease from
current level in upcoming 12 to 18 months. However, to ensure that profit will be squeezed
by lower interest rates, Australian financial institutions also cut their long-term cash ratios
to 0.25%. This drop in official interest rate considers as risk as decrease in rates will
directly impact on net profit margins of banks.
As Fitch Ratings Inc downgrades among four biggest banks of Australia, so, consequences of
this can be measured in terms of economic recession with rising credit ratings. From answer 1,
it has been concluded that COVID- 19 puts a huge negative impact on economy of Australia
which force RBA to reduce interest rate to 0.25%, for boosting the economy growth and
encouraging the investors for borrowing money from financial institutions. Therefore, it raises
the situations in front of borrowers to lend money from banks with the lower interest rate, which
in turn, will increasing the demand for borrowing. Since, credit rating impacts highly on the
ability of borrowers to get a loan, so, getting a good credit rating will allow them to lend money
on less charges of interests. However, it has evaluated that with lower credit rating arises
higher risks on biggest four banks and other financial institutions to get less return on amount
given to borrowers, so this indicates another economic downturn factor. Therefore, for
maximizing profit ration and maintain the value of return, it has seen that lenders may demand
higher interest rates. Financial institutions and banks have to pay more under such conditions
for lenders. Along with this, lower credit rating would also decrease customer loyalty and trusts
of investors with banks that may rise difficulties in front of banks and other financial institutions
to get desire opportunity cost of holding money. Henceforth, downgrading of banks, will in turn
increase pressure for Australia's four biggest banks.