Fin Markets
Minicase 4
Yield Curve Hypotheses and the Effects of Economic Events
CONCEPTS IN THIS CASE term structure of interest rates default risk risk premium yield curve expectations hypotheses segmented markets theory preferred habitat theory liquidity premium theory
Your employer (a bank) has decided to offer five-year loans to its small business customers. You have been presented the task of determining what the appropriate minimum interest rate should be for the most creditworthy customer. The decision to select a particular fixed rate for the loans depends on our forecast of the interest rates and our internal efficiency in managing the loan. This requires compensation for the costs of making the loan plus profit. You are to use the most recent five-year Canada bond as the basis for determining the minimum interest rate on the small business fixed-rate loans.
Your supervisor indicates that the bank needs to charge two percentage points more than the expected interest rate on Canada bonds for these loans. In addition, the bank has estimated the term premium to be 0.9%. Given this information, and the fact that you know you will need to defend your recommendation, you start to analyze current interest rates as follows:
1. Access local or Internet articles that describe theories about the form of a yield curve.
2. Obtain current information on the Canadian Yield Curve.
3. Plot the current Canadian Yield Curve and interpret its shape using
a. The Expectations Hypothesis
b. The Segmented Markets Theory
c. The Preferred Habitat & Liquidity Preference Theories.
d. Which theory (a, b, or c) do you think best describes the curve?
4. Given the information in responses 1, 2, 3 above, use the expectations hypothesis to calculate and predict interest rates as follows:
e. If the one-year interest rate is expected to be the same as the yield curve over the next three years, what interest rate is expected on a two-year bond one year
Yield Curve Hypotheses and the Effects of Economic Events
CONCEPTS IN THIS CASE term structure of interest rates default risk risk premium yield curve expectations hypotheses segmented markets theory preferred habitat theory liquidity premium theory
Your employer (a bank) has decided to offer five-year loans to its small business customers. You have been presented the task of determining what the appropriate minimum interest rate should be for the most creditworthy customer. The decision to select a particular fixed rate for the loans depends on our forecast of the interest rates and our internal efficiency in managing the loan. This requires compensation for the costs of making the loan plus profit. You are to use the most recent five-year Canada bond as the basis for determining the minimum interest rate on the small business fixed-rate loans.
Your supervisor indicates that the bank needs to charge two percentage points more than the expected interest rate on Canada bonds for these loans. In addition, the bank has estimated the term premium to be 0.9%. Given this information, and the fact that you know you will need to defend your recommendation, you start to analyze current interest rates as follows:
1. Access local or Internet articles that describe theories about the form of a yield curve.
2. Obtain current information on the Canadian Yield Curve.
3. Plot the current Canadian Yield Curve and interpret its shape using
a. The Expectations Hypothesis
b. The Segmented Markets Theory
c. The Preferred Habitat & Liquidity Preference Theories.
d. Which theory (a, b, or c) do you think best describes the curve?
4. Given the information in responses 1, 2, 3 above, use the expectations hypothesis to calculate and predict interest rates as follows:
e. If the one-year interest rate is expected to be the same as the yield curve over the next three years, what interest rate is expected on a two-year bond one year