CASE STUDY based ASSIGNMENT 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 any country's bond as the basis for determining the minimum interest rate on the small business fixed-rate loans. the bank needs to charge two percentage points more than the expected interest rate on selected country's bonds for these loans. In addition, the bank has estimated the term premium to be 1.5%. 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 selected country's Yield Curve. 3. Plot the current 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: a. 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 from now? b. What interest rate is expected on a three-year bond one year from now? C. What relationship do you find between interest rates and maturity? d. If investors attach term premiums of 2.5%, 1.75% and 2.85% to the one- two-and three-year bonds: i. What would be the interest rate on a two-year security? ii. What would be the interest rate on a three-year security? iii. What is the forward rate for one-year Canada bonds one year from now? iv. What is the adjusted forward rate for one-year Canada bonds one year out? 5. After describing the current yield curve and forecasting interest rates using both the expectations and preferred habitat and liquidity premium methods above, a. What is your recommended minimum interest rate for the five-year fixed rate loans? b. How would this rate be adjusted for customers that have some credit risk? CASE STUDY based ASSIGNMENT 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 any country's bond as the basis for determining the minimum interest rate on the small business fixed-rate loans. the bank needs to charge two percentage points more than the expected interest rate on selected country's bonds for these loans. In addition, the bank has estimated the term premium to be 1.5%. 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 selected country's Yield Curve. 3. Plot the current 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: a. 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 from now? b. What interest rate is expected on a three-year bond one year from now? C. What relationship do you find between interest rates and maturity? d. If investors attach term premiums of 2.5%, 1.75% and 2.85% to the one- two-and three-year bonds: i. What would be the interest rate on a two-year security? ii. What would be the interest rate on a three-year security? iii. What is the forward rate for one-year Canada bonds one year from now? iv. What is the adjusted forward rate for one-year Canada bonds one year out? 5. After describing the current yield curve and forecasting interest rates using both the expectations and preferred habitat and liquidity premium methods above, a. What is your recommended minimum interest rate for the five-year fixed rate loans? b. How would this rate be adjusted for customers that have some credit risk