1.General Information

This assessment comprises a paper of about 2,000 – 2,500 words (i.e., 7 – 8 pages double- spaced, 12 pts Time New Roman font type). Students are asked to prepare a report setting out a basic analysis of the bond market in two selected countries

Task in Brief:

“You are a bond analyst working for a securities firm. Prepare a report which sets out an analysis of the bond market in two selected countries using the real-world, recent bond data you have collected from reliable sources and the forecasting techniques and concepts covered in the course to replicate realistic predictions for future inflation and interest rates. It is not sufficient to simply present typed or spreadsheet solutions. You are required to demonstrate and explain your assumptions and detailed workings to obtain your solutions, conclusions, arguments, and statements.”

You are reminded that it is an individual assignment and the analysis for the assignment should be done separately.

Materials:

Bond market data and other relevant data from reliable sources, e.g., central banks, Bloomberg, Thomson-Reuter, IMF website, subscribed databases, etc.

Marks:

Assessment 2 constitutes 40% of the total marks for ECON1239. Students are required to complete this assignment, which will contribute towards the final assessment.

Assessment:

The assignment will be marked out of 100. The allocation of marks will be divided among the following areas: (1) General and Presentation, (2) Range and accuracy of calculations and collected data, (3) Economic analysis and interpretation of results and findings, including original contribution

1. Assignment Requirements

Please consult the appendix to this document for an example of how to analyse the bond data within the context of your course. The core elements of this assignment contain eight (8) parts, each carrying an equal weight. Please read carefully the following.

Part 1:

You are required to collect the most recent bond market data, namely, yields to maturity, over the periods for which you have the data. Your data must be from reliable sources, e.g., you should not collect the data from personal blogs. Also, it should not be from too generic sources, i.e., you should not collect data from Wikipedia.

You are required to choose the US and
TWO
other country of your own choosing.

Part 1A:

Collect the yields to maturity and other relevant data, if any, for the maturities of 1, 2, 5, 10, 20, and 30 years. Present your data clearly and neatly in a properly formatted table.

Part 1B:

Consult the appendix to this assignment to gain a basic understanding of the approximate method for predicting future interest rates. Use the approximate method to calculate the discount rate (“DR”) that the bond market appears to consider appropriate over the following periods (see the Appendix):

- For 1-year

- Averaged over 1 – 2 years

- Averaged over 3 – 5 years

- Averaged over 6 – 10 years

- Averaged over 11 – 20 years

- Averaged over 21 – 30 years

Show all of your detailed workings for at least one country, i.e., either for the USA or for the country of your own choosing, or both. Present your calculations clearly and neatly.

Part 2:

Use the reliable internet sources to collect the predicted rates of inflation for all the periods for which you have forecasted the discount rates. Use your calculated discount rates and these inflation rates to predict the real rates of interests for those periods based on the following formula:

Real Rate of Interest = 1 + Nominal Rate − 1

1 + Inflation Rate

For future periods in which there are no predicted inflation rates, you can assume either that the last predicted inflation rate will stay constant for such periods or that the last real rate of interest as calculated will stay constant.
BUT you are required to JUSTIFY your assumptions.

Show all your detailed workings, for at least one country, in this part of your assignment. You can present these workings in an appendix if necessary.

Part 3:

Use your results to compare the predicted rates between the USA and your two selected country. Make sure that you use your own economic analysis of your results or findings. For example, stating that one rate is higher than the other without any further comment on the reasons for it does not constitute economic analysis. In addition, if you use any other expert opinions from such sources as financial newspapers or statements by some central bank, make sure to quote the source properly.

Part 4:

Use your forecasting results in previous parts to make comments on the USA and the rates on TIPS (Treasury Inflation-Protected Securities).

Part 5:

Comment on how the YTMs of Treasury bonds have changed since April 30th 2019 as below. How does the market appear to have changed its predictions?

Part 6:

Use the relevant theories of the term structure of interest rates to discuss how they affect your interpretation/results/findings.

Part 7:

In the light of your findings, comment on the excerpt below from The Economist:

Buttonwood

4-10 March 2017.

“If there is one aspect of the current era sure to obsess the financial historians of tomorrow, it is the unprecedented low level of interest rates. Never before have deposit rates or bond yields been so depressed in nominal terms, with some governments even able to borrow at negative rates. It is taking a long time for investors to adjust their assumptions accordingly. Real interest rates (i.e., allowing for inflation) are also low. As measured by inflation-linked bonds, they are around minus 1 % in big rich economies.”

Part 8:

Discuss how you see the implications of your findings for the stock market.

Appendix

Example 1
: The Expectations Hypothesis

According to the
expectations hypothesis, a bond’s yield to maturity (YTM), which represents investors’ required rate of return on the bond, is directly related to expectations of inflation and prevailing interest rates. Thus, consider the following:

1. A Treasury bond with a face value of $100 and a coupon payment of 7.1% has one year to maturity. Thus, 1 year from now, the bond is scheduled to make a payment of $100 together with a final coupon payment of $100 * 0.071 = $7.1. If the bond is currently priced at

$102.00, the YTM for the bond is

$102.00 = $107.1

1 + YTM

So, YTM = 0.05, or 5.0%. Therefore, we determine 5.0% as the prevailing 1-year interest rate on Treasury bonds. Since Treasury bonds can be considered effectively free from default risk, they provide a useful benchmark for interest rates. For instance, if inflation is running at, say, 2.4% per annum, we might deduce that bondholders require a risk-free
real
rate of interest per annum of approximately 2.6% per annum (≈ 0.05 – 0.024), or more precisely,

Real rate of interest = 1 + nominal interest rate − 1

1 + inflation rate

= 1.05

1.024

− 1 = 1.0254 − 1 = 0.0254 = 2.54%

2. Now suppose that at the same time, a 2-year Treasury bond with a face value of $100 is scheduled to make a coupon payment of 7.1% both 1 year and 2 years from now, and that it is currently priced at $102.99. To determine bond investors’ required rate of return on this bond in Year 2, that is,
YTM
2, we solve the following equation:

$102.99 = $7.1

+ $107.1 ,

1 + YTM₁
(1 + YTM₁)(1 + YTM₂)

where
YTM
1
is the YTM in Year 1 (determined for one-year Treasury bonds as above = 5.0%) and
YTM
2
is the YTM in Year 2. Hence,

$102.99 = $7.1

+ $107.1 ,

1 + 0.05

(1 + 0.05)(1 + YTM₂)

which yields
YTM
2
(in Year 2) = 0.06 (6.0%).

Therefore, it appears that the market anticipates an annual interest rate of 6.0% for Treasury bonds in Year 2, and accordingly, if we believe that bond investors will continue to require a
real
rate of interest on Treasury bonds of 2.54% over 2 years, the bond allows us to predict the investors’ anticipated inflation rate, denoted as
inflation rate
2, for Year 2, as follows:

Real rate of interest₂

= 1 + nominal interest rate₂
− 1 1 + inflation rate₂

0.0254 = 1.06 − 1

1 + inflation rate₂

So,
inflation rate2 (the anticipated inflation rate in Year 2) is

1+0.0254

1 = 0.0337 = 3.37%

Example 2: Forecasting Future Rates

Suppose that a Treasury bond with a face value of $100 and a coupon rate of 5.2% has 1 year to maturity (i.e., a “1-year
bond”). Thus, one year from now, the bond is scheduled to make a payment of $100 together with a final coupon payment of $100 * 0.052 = $5.2. If the bond is currently priced at $100.19, the yield to maturity for the bond over the coming 1-year period (YTM
1) is

$109.19 = $105.2

1 + YTM₁

which yields
YTM
1
= $105.2 − 1 = 0.050, or 5.0%. This is the discount rate,

DR


1
, that the

$100.19

market considers appropriate over the coming 1-year period.

Now suppose that a Treasury bond with a face value of $100 and a coupon rate of 7.1% has 2 years to maturity (i.e., a “2-year
bond”). Thus, one year from now, the bond is scheduled to make a payment of $100 * 0.071 = $7.1, and 2 years from now, it will make a payment of

$100 together with a final coupon payment of $7.1. If the bond is currently priced at $102.99, we can find the yield to maturity for the 2-year bond (YTM
2) by solving the following equation:

$102.99 = $7.1

1 + YTM₂

+ $107.1

(1 + YTM₂)(1 + YTM₂)

Therefore,
YTM
2
= 5.48%.

The question we now ask is:

What is the discount rate, DR


2


, that the market appears



to consider appropriate for the 2nd year?

Note that it is
not
5.48%, because this is the discount rate
averaged
over the 2 years (and recall that the appropriate discount rate is 5.0% for the 1st year). In fact, to solve for the discount rate that the market is imposing in the 2nd year,
DR
2, we need to solve:

$102.99 = $7.1

1 + YTM₁

+ $107.1

(1 + YTM₁)(1 + DR₂)

where
YTM
1
is the YTM in Year 1 (determined for 1-year Treasury bonds as above = 5.0%) and
DR
2
is the appropriate discount rate for Year 2. Therefore,

$102.99 = $7.1

1 + 0.05

+ $107.1

(1 + 0.05)(1 + DR₂)

which yields
DR
2
(in Year 2) = 0.060 (6.0%).

Suppose now that a Treasury bond with a face value of $100 and a coupon rate of 5.0% has 5 years to maturity. Thus, one year from now, the bond is scheduled to make a payment of

$100 * 0.05 = $5.0, and thereafter, until 5 years from now, make a payment of $100 together with a final coupon payment of $5.0. If the bond is currently priced at $91.80, we can solve for the yield to maturity for a 5-year bond (YTM
5) using the following equation:

$91.80 = $5.0

1 + YTM₅

+ $5.0

(1 + YTM₅)2

+ $5.0

(1 + YTM₅)3

+ $5.0

(1 + YTM₅)4

+ $105.0 (1 + YTM₅)5

which yields
YTM
5
= 7.0%.

We now ask:

What is the discount rate, DR


3/5,



that the market appears to consider



appropriate for years 3 to 5

?
To answer this question, we solve the following equation:

$91.80 =
^$5.0

1+DR1

+ $5.0

(1+DR1)(1+DR2)

+ $5.0

(1+DR1)(1+DR2)(1+DR3/5)1

$105.0 (1+DR1)(1+DR2)(1+DR3/5)3

+ $5.0 +

(1+DR1)(1+DR2)(1+DR3/5)2

where
DR
1
= 5.0% and
DR
2
= 6.0%, so that:

$91.80 = $5.0

1.05

+ $5.0 (1.05)(1.06)

+ $5.0

(1.05)(1.06)(1 + DR_3
/
5)1

+ $5.0

(1.05)(1.06)(1 + DR_3
/
5)2

+ $105.0

(1.05)(1.06)(1 + DR_3
/
5)3

which yields
DR
3/5
= 8.16% .

Nominal rates, inflation, and real rates

As Treasury bonds are regarded as effectively free from default risk, they provide a useful benchmark for interest rates. For example, if we predict that inflation will be running at, say, 6.0% per annum over the next 3, 4, and 5 years ahead, we can deduce that bondholders require a risk-free

real

rate of interest of approximately
DR
3/5
as calculated above

minus

the inflation rate = 8.16% - 6.0% = 2.16% per annum. More precisely, we would deduce that bond investors anticipate a risk-free real rate of interest per annum for 3, 4 and 5 years forward as

Real rate of interest = 1 + nominal interest rate − 1

1 + inflation rate

= 1.0816

1.06

− 1 = 1.02 – 1 = 0.020, or 2.0%.

Alternatively, if we considered that investors will have a required real rate of return on Treasury bonds equal to, say, 2.5%, we would deduce the market’s prediction for inflation in years 3 –

5 as
^1.0816
– 1 = 5.5%.

1.025

1.General Information

This assessment comprises a paper of about 2,000 – 2,500 words (i.e., 7 – 8 pages double- spaced, 12 pts Time New Roman font type). Students are asked to prepare a report setting out a basic analysis of the bond market in two selected countries

Task in Brief:

“You are a bond analyst working for a securities firm. Prepare a report which sets out an analysis of the bond market in two selected countries using the real-world, recent bond data you have collected from reliable sources and the forecasting techniques and concepts covered in the course to replicate realistic predictions for future inflation and interest rates. It is not sufficient to simply present typed or spreadsheet solutions. You are required to demonstrate and explain your assumptions and detailed workings to obtain your solutions, conclusions, arguments, and statements.”

You are reminded that it is an individual assignment and the analysis for the assignment should be done separately.

Materials:

Bond market data and other relevant data from reliable sources, e.g., central banks, Bloomberg, Thomson-Reuter, IMF website, subscribed databases, etc.

Marks:

Assessment 2 constitutes 40% of the total marks for ECON1239. Students are required to complete this assignment, which will contribute towards the final assessment.

Assessment:

The assignment will be marked out of 100. The allocation of marks will be divided among the following areas: (1) General and Presentation, (2) Range and accuracy of calculations and collected data, (3) Economic analysis and interpretation of results and findings, including original contribution

1. Assignment Requirements

Please consult the appendix to this document for an example of how to analyse the bond data within the context of your course. The core elements of this assignment contain eight (8) parts, each carrying an equal weight. Please read carefully the following.

Part 1:

You are required to collect the most recent bond market data, namely, yields to maturity, over the periods for which you have the data. Your data must be from reliable sources, e.g., you should not collect the data from personal blogs. Also, it should not be from too generic sources, i.e., you should not collect data from Wikipedia.

You are required to choose the US and
TWO
other country of your own choosing.

Part 1A:

Collect the yields to maturity and other relevant data, if any, for the maturities of 1, 2, 5, 10, 20, and 30 years. Present your data clearly and neatly in a properly formatted table.

Part 1B:

Consult the appendix to this assignment to gain a basic understanding of the approximate method for predicting future interest rates. Use the approximate method to calculate the discount rate (“DR”) that the bond market appears to consider appropriate over the following periods (see the Appendix):

- For 1-year

- Averaged over 1 – 2 years

- Averaged over 3 – 5 years

- Averaged over 6 – 10 years

- Averaged over 11 – 20 years

- Averaged over 21 – 30 years

Show all of your detailed workings for at least one country, i.e., either for the USA or for the country of your own choosing, or both. Present your calculations clearly and neatly.

Part 2:

Use the reliable internet sources to collect the predicted rates of inflation for all the periods for which you have forecasted the discount rates. Use your calculated discount rates and these inflation rates to predict the real rates of interests for those periods based on the following formula:

Real Rate of Interest = 1 + Nominal Rate − 1

1 + Inflation Rate

For future periods in which there are no predicted inflation rates, you can assume either that the last predicted inflation rate will stay constant for such periods or that the last real rate of interest as calculated will stay constant.
BUT you are required to JUSTIFY your assumptions.

Show all your detailed workings, for at least one country, in this part of your assignment. You can present these workings in an appendix if necessary.

Part 3:

Use your results to compare the predicted rates between the USA and your two selected country. Make sure that you use your own economic analysis of your results or findings. For example, stating that one rate is higher than the other without any further comment on the reasons for it does not constitute economic analysis. In addition, if you use any other expert opinions from such sources as financial newspapers or statements by some central bank, make sure to quote the source properly.

Part 4:

Use your forecasting results in previous parts to make comments on the USA and the rates on TIPS (Treasury Inflation-Protected Securities).

Part 5:

Comment on how the YTMs of Treasury bonds have changed since April 30th 2019 as below. How does the market appear to have changed its predictions?

Part 6:

Use the relevant theories of the term structure of interest rates to discuss how they affect your interpretation/results/findings.

Part 7:

In the light of your findings, comment on the excerpt below from The Economist:

Buttonwood

4-10 March 2017.

“If there is one aspect of the current era sure to obsess the financial historians of tomorrow, it is the unprecedented low level of interest rates. Never before have deposit rates or bond yields been so depressed in nominal terms, with some governments even able to borrow at negative rates. It is taking a long time for investors to adjust their assumptions accordingly. Real interest rates (i.e., allowing for inflation) are also low. As measured by inflation-linked bonds, they are around minus 1 % in big rich economies.”

Part 8:

Discuss how you see the implications of your findings for the stock market.

Appendix

Example 1
: The Expectations Hypothesis

According to the
expectations hypothesis, a bond’s yield to maturity (YTM), which represents investors’ required rate of return on the bond, is directly related to expectations of inflation and prevailing interest rates. Thus, consider the following:

1. A Treasury bond with a face value of $100 and a coupon payment of 7.1% has one year to maturity. Thus, 1 year from now, the bond is scheduled to make a payment of $100 together with a final coupon payment of $100 * 0.071 = $7.1. If the bond is currently priced at

$102.00, the YTM for the bond is

$102.00 = $107.1

1 + YTM

So, YTM = 0.05, or 5.0%. Therefore, we determine 5.0% as the prevailing 1-year interest rate on Treasury bonds. Since Treasury bonds can be considered effectively free from default risk, they provide a useful benchmark for interest rates. For instance, if inflation is running at, say, 2.4% per annum, we might deduce that bondholders require a risk-free
real
rate of interest per annum of approximately 2.6% per annum (≈ 0.05 – 0.024), or more precisely,

Real rate of interest = 1 + nominal interest rate − 1

1 + inflation rate

= 1.05

1.024

− 1 = 1.0254 − 1 = 0.0254 = 2.54%

2. Now suppose that at the same time, a 2-year Treasury bond with a face value of $100 is scheduled to make a coupon payment of 7.1% both 1 year and 2 years from now, and that it is currently priced at $102.99. To determine bond investors’ required rate of return on this bond in Year 2, that is,
YTM
2, we solve the following equation:

$102.99 = $7.1

+ $107.1 ,

1 + YTM₁
(1 + YTM₁)(1 + YTM₂)

where
YTM
1
is the YTM in Year 1 (determined for one-year Treasury bonds as above = 5.0%) and
YTM
2
is the YTM in Year 2. Hence,

$102.99 = $7.1

+ $107.1 ,

1 + 0.05

(1 + 0.05)(1 + YTM₂)

which yields
YTM
2
(in Year 2) = 0.06 (6.0%).

Therefore, it appears that the market anticipates an annual interest rate of 6.0% for Treasury bonds in Year 2, and accordingly, if we believe that bond investors will continue to require a
real
rate of interest on Treasury bonds of 2.54% over 2 years, the bond allows us to predict the investors’ anticipated inflation rate, denoted as
inflation rate
2, for Year 2, as follows:

Real rate of interest₂

= 1 + nominal interest rate₂
− 1 1 + inflation rate₂

0.0254 = 1.06 − 1

1 + inflation rate₂

So,
inflation rate2 (the anticipated inflation rate in Year 2) is

1+0.0254

1 = 0.0337 = 3.37%

Example 2: Forecasting Future Rates

Suppose that a Treasury bond with a face value of $100 and a coupon rate of 5.2% has 1 year to maturity (i.e., a “1-year
bond”). Thus, one year from now, the bond is scheduled to make a payment of $100 together with a final coupon payment of $100 * 0.052 = $5.2. If the bond is currently priced at $100.19, the yield to maturity for the bond over the coming 1-year period (YTM
1) is

$109.19 = $105.2

1 + YTM₁

which yields
YTM
1
= $105.2 − 1 = 0.050, or 5.0%. This is the discount rate,

DR


1
, that the

$100.19

market considers appropriate over the coming 1-year period.

Now suppose that a Treasury bond with a face value of $100 and a coupon rate of 7.1% has 2 years to maturity (i.e., a “2-year
bond”). Thus, one year from now, the bond is scheduled to make a payment of $100 * 0.071 = $7.1, and 2 years from now, it will make a payment of

$100 together with a final coupon payment of $7.1. If the bond is currently priced at $102.99, we can find the yield to maturity for the 2-year bond (YTM
2) by solving the following equation:

$102.99 = $7.1

1 + YTM₂

+ $107.1

(1 + YTM₂)(1 + YTM₂)

Therefore,
YTM
2
= 5.48%.

The question we now ask is:

What is the discount rate, DR


2


, that the market appears



to consider appropriate for the 2nd year?

Note that it is
not
5.48%, because this is the discount rate
averaged
over the 2 years (and recall that the appropriate discount rate is 5.0% for the 1st year). In fact, to solve for the discount rate that the market is imposing in the 2nd year,
DR
2, we need to solve:

$102.99 = $7.1

1 + YTM₁

+ $107.1

(1 + YTM₁)(1 + DR₂)

where
YTM
1
is the YTM in Year 1 (determined for 1-year Treasury bonds as above = 5.0%) and
DR
2
is the appropriate discount rate for Year 2. Therefore,

$102.99 = $7.1

1 + 0.05

+ $107.1

(1 + 0.05)(1 + DR₂)

which yields
DR
2
(in Year 2) = 0.060 (6.0%).

Suppose now that a Treasury bond with a face value of $100 and a coupon rate of 5.0% has 5 years to maturity. Thus, one year from now, the bond is scheduled to make a payment of

$100 * 0.05 = $5.0, and thereafter, until 5 years from now, make a payment of $100 together with a final coupon payment of $5.0. If the bond is currently priced at $91.80, we can solve for the yield to maturity for a 5-year bond (YTM
5) using the following equation:

$91.80 = $5.0

1 + YTM₅

+ $5.0

(1 + YTM₅)2

+ $5.0

(1 + YTM₅)3

+ $5.0

(1 + YTM₅)4

+ $105.0 (1 + YTM₅)5

which yields
YTM
5
= 7.0%.

We now ask:

What is the discount rate, DR


3/5,



that the market appears to consider



appropriate for years 3 to 5

?
To answer this question, we solve the following equation:

$91.80 =
^$5.0

1+DR1

+ $5.0

(1+DR1)(1+DR2)

+ $5.0

(1+DR1)(1+DR2)(1+DR3/5)1

$105.0 (1+DR1)(1+DR2)(1+DR3/5)3

+ $5.0 +

(1+DR1)(1+DR2)(1+DR3/5)2

where
DR
1
= 5.0% and
DR
2
= 6.0%, so that:

$91.80 = $5.0

1.05

+ $5.0 (1.05)(1.06)

+ $5.0

(1.05)(1.06)(1 + DR_3
/
5)1

+ $5.0

(1.05)(1.06)(1 + DR_3
/
5)2

+ $105.0

(1.05)(1.06)(1 + DR_3
/
5)3

which yields
DR
3/5
= 8.16% .

Nominal rates, inflation, and real rates

As Treasury bonds are regarded as effectively free from default risk, they provide a useful benchmark for interest rates. For example, if we predict that inflation will be running at, say, 6.0% per annum over the next 3, 4, and 5 years ahead, we can deduce that bondholders require a risk-free

real

rate of interest of approximately
DR
3/5
as calculated above

minus

the inflation rate = 8.16% - 6.0% = 2.16% per annum. More precisely, we would deduce that bond investors anticipate a risk-free real rate of interest per annum for 3, 4 and 5 years forward as

Real rate of interest = 1 + nominal interest rate − 1

1 + inflation rate

= 1.0816

1.06

− 1 = 1.02 – 1 = 0.020, or 2.0%.

Alternatively, if we considered that investors will have a required real rate of return on Treasury bonds equal to, say, 2.5%, we would deduce the market’s prediction for inflation in years 3 –

5 as
^1.0816
– 1 = 5.5%.

1.025