RSM 230: Decoding Financial Markets: Analysis and Solutions - 2019

This document provides a detailed solution to an assignment for RSM 230: Financial Markets, covering key concepts such as overnight rates, prime rates, AAA-rated sovereign bonds, conventional mortgages, and R-1 ratings for commercial paper. It analyzes Canadian money market and bond rate...Read More

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.

Question 3- US Interest Rates
a. Please retrieve US data for the dates indicated (or the closest preceding date) from FactSet
and use it to complete the table below.
June 29, 2007 December 30, 2008
US Fed Funds Rate
(REFFFUNDEFF-FDS) 5.31 0.05
US Treasury Bill Rate - 1 month
(TRYUS1M-FDS please use charting tab as
explained in class)
4.2386 0.0253
1 month LIBOR rate
(LIBORUSD1M-FDS) 5.32 0.43625
US Commercial Paper Rate – 1 months
(USCP30D-TU1, please use charting tab) 5.29 0.40
Spread US Commercial Paper rate -1
month over US Treasury Bill rate -1 month
5.32-
4.2386=1.0514
0.43625-
0.0253=0.41095
Long Term (30 year) US Treasury Bond
Yield (TRYUS30Y-FDS) 5.1249 2.5572
Spread US Long Term AA Corporate
bond yield over Long Term US Treasury
bond yield (FCBAASUS15Y-FDS)
1.121-5.1249=
-4.0039
3.043 - 2.5572 =
0.4858
Spread US Long Term BBB Corporate
bond yield over 10 year US Treasury bond
yield (FCBBBBSUS10Y-FDS)
1.526-5.0265=
-3.5005
5.825-2.0579 =
3.7671
b. Explain briefly (4-5 sentences) the cause of any general trends or changes you observed in the
interest rates in 2007 versus 2008. In your answer, please address the time period and why the
Federal Reserve would undertake these changes
Solution
In 2007 there was an economic crisis and this explains the reason as to why the federal service
had to increase the rates for the government bond. They needed more money at their disposal.
This is as compared to 2008 where the economy was already stabilizing hence the policy rates on
the long-term maturity bond of the government was lowered. This was to help the uptake f the
short-term corporate bonds to steer the economy even more.

c. Briefly explain what the 3 interest rate differences or “spreads” that you calculated in part a)
represent
Solution
A credit spread can be described as the difference in return of the two bonds that share the same
maturity but different quality. Generally widening credit spreads signal the low ability to service
the obligation.
In reference to the US Commercial paper rate-1 month as compared to the US Treasury bill rate
1- month, the spread shows that in 2008 the ability to pay of the two bonds by the US
government was higher than in 2007. This can be attributed to the fact that during the 2007 crisis
there was some uncertainty.
In regards to spread between the US long-term AA Corporate bond if the long-term US Treasury
bond yield, bonds were more likely to meet their obligations to pay at maturity in 2007 than in
2008. It can be partially attributed to the fact that one of them had a good rating.
In regards to the US long-term BBB corporate bond over the 10 year US Treasury bond the
spread in 2008 was wider as compared to 2007. The rating of the bond and the fact that the
investors would predict better economic future can be accredited to a narrower spread.
Question 5 – Canadian Bond Quotations (15 marks)
a.) What is CANDEAL? What does it do? Explain briefly
Solution
It is a major leading institutional electronic marketplace for Canadian money market securities
which include bonds and derivatives. It provides a marketplace for institutional investors that
enable the buying and selling of the Canadian government bonds and money market instruments.
It was founded in June 2001 and is co-owned by Canada’s top 6 banks and the TMX group.
b.) Find bond quotes for the following two corporate bonds and the Government of Canada bond
listed here and complete the table below.
Issuer Maturity
Date
Bid
Price
Ask
Price
Bid
Yield
Ask
Yield
Moody’s
Bond
Rating
S&P
Bond
Rating
Hydro One HYDONE
4.39
26/09/2041 109.95
4
110.359 3.734 3.70
9
Baa1 A-

ROGERS
Communication
Inc. (RCI)
RCICN
6.68
04/11/2039 129.92
4
130.408 4.454 4.42
4
Baa1 BBB
Canada
5.00
Maturing in
2037
01/06/2037 142.87
7
142.978 2.155 2.14
9
Aaa AAA
c.) Explain what the Bid yield and Ask yield represent. If an investor wishes to buy Hydro One
bonds, what price will they pay?
Solution
Bid yield is the yield to maturity for the current bid price of the bond
Ask yield is the rate of return or the yield that the investor would receive if they bought the bond
at the price asked.
If an investor wishes to buy Hydro One bond they will pay the ask price = 110.359
d.) Why do the three issuers above (Hydro One, Rogers Communication, and Canada) have
different credit ratings? Think about the differences in default risks of Hydro One vs. Rogers
Communication Vs. Government of Canada. How is this difference reflected in the yields and
credit spreads for these bonds?
Solution
The three issuers have different credit ratings because they have different financial strengths that
is their ability to pay the bonds interest and principal in time.
The three issuers also have different default risks which can be seen in their yields and credit
spreads. The government of Canada bond has a low default risk meaning it has a stronger
financial strength compared to the two corporate bonds and this can be depicted by the lower bid
and ask yields i.e. 2.155 and 2.149 respectively. The government bond has lower yields because
the risks faced are minimal while the yields for corporate bonds are higher and so are their
default risks.
Question 6 – Securitization (10 marks)
a) What is the name of the SIV (Special Investment Vehicle)? What function does the SIV
provide?
SIV is as special investment, can be defined as a portfolio of investments that accrue profit
on the difference in price or spreads between the structured financial products and short term
debts. The difference in price helps in accruing interest in that one may borrow in an
wholesome market that is say at 2% and invest in a structured product that is yielding at 5%
hence benefiting from the extra 3 %.

b) What are the assets included in this trust and who is the Seller of the assets to this trust?
The assets in this trust car makes of Ford Company, including cars, utility’s and light trucks.
Fords Credit Canada Limited is the seller.
c) Name the investment dealers who were underwriters of these asset backed notes.
The investment dealers included:
Merrill Lynch Canada Inc.
BMO Nesbitt Burns Inc.
CIBC World Markets Inc.
Scotia Capital Inc.
TD Securities Inc. RBC
Dominion Securities Inc.
d) What is collateral? In your own words, explain what is meant by ‘overcollateralization’.
What is the purpose of doing this?
Solution
Collateral can be termed a security issued to a lender for giving a loan to a borrower. The
borrower pledges an asset to the lender such that he has the power to seize it if the borrower
defaults on his obligation.
Over-collateralization is a scenario whereby the issuer of a security or the lender posts more
collateral that is needed so as to secure the risk of defaulting. Thus its purpose is to reduce the
risks of any unexpected defaults by the borrower that in the scenario of loans
e) In your own words, explain two benefits to Ford from undertaking this securitization.
Solution
Reduced funding costs
This is because even if they may have a low rating say BB as a company but their assets
maintain a high quality rating such as AAA or AA and therefore they can borrow at significantly
low rates by using their high quality assets as collateral.
Increased revenue growth
With reduced cost for getting funding it means the profits will be higher than they normally
would be without the reduced value of costs incurred. Profits are equal to the difference between
the marginal benefit and the marginal costs. Borrowing loans at low rates means that the
company will have reduced costs.

Question 7 – Problems
a) The yield on Company XYZ's commercial paper is 3.5%. What will it cost you to buy
$100,000 face value of this Canadian security if it matures in 60 days?
Solution
3.5% = ($ 100 000 – P/ P) * 365/60
0.035 = $100000/P – 1 * 6.0833
0.00575 = $100000/P -1
1.00575 = $100000/P
P = $100000/1.00575
P = $99427.991
$99 427.991 is the face value of the Canadian security if it matures in 60 days.
b) What is the yield on a US Treasury Bill with a 60-day term to maturity, priced at $99.20 per
$100 face value?
Solution
r bey = ($100 – P)/P * 360/n
r = ( $100 – 99.20)/99.20 * 360/60
r = 0.048387 * 100
r = 4.8387%
The yield for the US Treasury Bill is 4.8387%
c) Today is January 31, 2019. A bond has a $1000 par value, a 4% coupon (paid semi-
annually) and matures in exactly 3 years. Its yield to maturity is 4%.
i) What is the price of this bond?
Solution
Bond price = C * (1- 1/(1+i)^n)/i + M * 1/(1+i)^n
i = yield to maturity date
n = total number of coupon payments
e = coupon payments
C = ($1000 * 0.04 * 0.5)
C = 20
P = 20 * (1-1/(1+4%)6) + 1000 * (1/(1+4%)^6)
P = 20 * (0.2097) + 790.31
P = 4.194 + 790.31
P = 794.504
The price of the bond is $794.504

ii) Assume that you decide to purchase this bond on April 10, 2019. How much accrued
interest will you have to pay?
Solution
$794.504 * 70/365
$794.504 * 0.19178
= $152.371
d) You just purchased a 20-year Government of Canada strip (zero coupon) bond at a price of
$750.
i) What is the yield to maturity on this zero coupon bond?
Solution
The yield to maturity rate is 2.153%
ii) At what price do you need to purchase this bond in order to obtain a 7% yield to
maturity?
Solution
Bond value of a zero-coupon bond = F/(1+r)^t
t = time to maturity
F = face value
r = rate of the yield
Thus:
750 = F/(1+2.153%) ^20
750 * (1.02153) ^20 = F
F = 1,148.38
X = 1148.38 / (1 + 7%)^20
X = 1148.38 / 3.86968
X = $ 297
The purchase price for the bond with 7% yield to maturity is $297
REFERENCES
Li, J. Z. (2009, May 26). Recent changes in the prime rate behaviour. Review of quantitive
finance and accounting, pp. 177-192.
Scheithauer, D. N. (2011, November). Monetary policy implementation and overnight rate
persistence. Journal of International Money and Finance, 30(7), 1375-1386.