# SOLUTION: ECON 3307 Saint Marys University Money and Banking Economics Discussion

Money and Banking Assignment
Assignment 2 – Monday class
ECONOMICS 3307: MONEY AND BANKING
Winter 2021
Assigned: Feb 22, 2021
Due: March 05, 2021
Instructions:

Late assignment will not be accepted.
Get to the point. Be clear and concise.
Question 1:
Term Structure of Interest Rates: Go to http://www.yieldcurve.com on the left hand side click on
Yield Curves.
This web site allows you to plot the yield curves for UK Gilts and US Treasuries for different
periods.
a) List the three facts about the term structure of interest rates
b) Select a period and print a plot of an upward yield curve. Make comments using the
theories you studied about the term structure of interest rates.
c) Select another period and print a plot of an inverted yield curve and make comments
using the theories you studied about the term structure of interest rates.
d) Compare, generally, between the UK Gilt and the US treasury yield curves in 2. And
3 citing the power of prediction of the theories of term structure of interest rates in
predicting the 2008/2009 financial crisis.
~1~
Money and Banking Assignment
Question 2:
The Office of the Superintendent of Financial Institutions (OSFI) is an independent agency of the
Government of Canada, established in 1987 to contribute to the safety and soundness of the
Canadian financial system. OSFI supervises and regulates federally registered banks and insurers,
trust and loan companies, as well as private pension plans subject to federal oversight.
Go to OSFI website (https://www.osfi-bsif.gc.ca/Eng/Pages/default.aspx) – under Financial
Institutions – select Financial Data – select Bank. Populate the most recent consolidated balance
sheet of the bank of your choice, and attach a printout.
a)
b)
c)
d)
What is the total amount of loans held by the bank? Use “total currency”
What is this number as a percentage of total bank assets?
Calculate the Equity Multiplier.
Would you buy the share of this bank as an investment? Explain
Question 3:
Bank AAA has \$15 million of fixed-rate assets, \$30 million of rate-sensitive assets,
\$25 million of fixed-rate liabilities, \$20 million of rate-sensitive liabilities, 5 million of demand
deposit, 10 million of securities, and 0.6 million of reserves. Assume that the required reserve is
10%.
a) Reflect the above information in a T account. How much is the Net worth?
b) Calculate the required reserve and the excess reserve if any,
c) Conduct a gap analysis for the bank, and show what will happen to bank income if
interest rates rise by 5%?
d) What would happen if the interest rates fall by 5%?
e) What actions should the bank manager take if interest rates are expected to fall?
~2~
Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Chapter 6
THE RISK AND TERM STRUCTURE
OF INTEREST RATES
Learning Objectives
1. Identify and explain the three factors affecting the risk structure of
interest rates
2. List and explain the three theories of why interest rates vary across
different maturities
6-2
Risk Structure of Interest Rates
• Bond yields differ (sometimes substantially) across bonds of similar
maturity
• Key factors:
– Risk of default
– Liquidity
– Tax considerations
6-3
Long-Term Bond Yields, 1978-2012
6-4
Risk Structure of Interest Rates (cont’d)
• Default Risk: probability that the issuer of the bond is unable or unwilling
to make interest payments or pay off the face value
– Government of Canada bonds are considered default-free (government can raise
taxes or print money to repay)
• Risk Premium: the spread between the interest rates on bonds with
default risk and the interest rates on (same maturity) Canada bonds
• Credit-rating agencies assess and grade risk
6-5
Response to an Increase in Default Risk on Corporate Bonds
6-6
Bond Ratings by DBRS, Moody’s, Standard and Poor’s, and Fitch
6-7
Junk Bonds and Fallen Angels
• Junk bonds – high yielding, high default risk
bonds (rated below BB)
• Fallen angels – investment-grade securities
whose rating have fallen to junk levels
6-8
Risk Structure of Interest Rates (cont’d)
• Liquidity:
– the ease with which an asset can be converted into cash
• cost of selling a bond
• number of buyers/sellers in a bond market
• Income tax considerations:
– interest payments on municipal bonds are exempt from federal income taxes
6-9
Multiple Choice
Three factors explain the risk structure of interest
rates:
(a) liquidity, default risk, and the income tax treatment
of a security
(b) maturity, default risk, and the income tax treatment
of a security.
(c) maturity, liquidity, and the income tax treatment of
a security.
(d) maturity, default risk, and the liquidity of a
security.
(e) maturity, default risk, and inflation.
6-10
Multiple Choice
If the probability of a bond default
increases because corporations begin to
suffer large losses, then the default risk on
corporate bonds will _____ and the
expected return on these bonds will _____.
(a) decrease; increase.
(b) decrease; decrease.
(c) increase; increase.
(d) increase; decrease
6-11
Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax characteristics may have
different interest rates because the time remaining to maturity is different
• Yield Curve: a plot of the yield on bonds with differing terms to maturity
but the same risk, liquidity and tax considerations
– Upward-sloping: long-term rates are above short-term rates
– Flat: short- and long-term rates are the same
– Inverted: long-term rates are below short-term rates
6-12
Interest Rates on Government of Canada Bonds with Different
Maturities
6-13
Facts that the Theory of the Term Structure of Interest Rates Must
Explain
1. Interest rates on bonds of different maturities move together over time
2. When short-term interest rates are low, yield curves are more likely to
have an upward slope; when short-term rates are high, yield curves are
more likely to slope downward and be inverted
3. Yield curves almost always slope upward
6-14
Three Theories to Explain the Three Facts
We will explore three theories:
1. Expectations theory
– explains the first two facts but not the third
2. Segmented markets theory
– explains fact three but not the first two
– combines the two theories to explain all three facts
6-15
Expectations Theory
• The interest rate on a long-term bond will equal an average of the shortterm interest rates that people expect to occur over the life of the longterm bond
• Buyers of bonds do not prefer bonds of one maturity over another; they
will not hold any quantity of a bond if its expected return is less than that
of another bond with a different maturity
• Bond holders consider bonds with different maturities to be perfect
substitutes
6-16
Expectations Theory: Example
• Let the current rate on one-year bond be 6%
• You expect the interest rate on a one-year bond to be 8% next year
• Then the expected return for buying two one-year bonds averages (6% +
8%)/2 = 7%
• The interest rate on a two-year bond must be 7% for you to be willing to
purchase it
6-17
Expectations Theory (cont’d)
• For an investment of \$1
it = today’s interest rate on a one-period bond
iet+1 = interest rate on a one-period bond expected for next period
i2t = today’s interest rate on the two-period bond
6-18
Expectations Theory (cont’d)
• Expected return over the two periods from investing \$1 in the two-period
bond and holding it for two periods
(1 + i2t )(1 + i2t ) − 1
= 1 + 2i2t + (i2t ) 2 − 1
= 2i2t + (i2t )
2
Since (i 2t ) 2 is very small the expected return
for holding the two – period for two perids is 2i 2t
6-19
Expectations Theory (cont’d)
If two one-period bonds are bought with the \$1 investment
(1 + it )(1 + ite+1 ) − 1
1 + it + ite+1 + it (ite+1 ) − 1
it + ite+1 + it (ite+1 )
it (ite+1 ) is extremely small
Simplifying we get
it + ite+1
6-20
Expectations Theory (cont’d)
Both bonds will be held only if the expected returns are equal
2i2t = it + ite+1
it + ite+1
i2 t =
2
The two-period rate must equal the average of the two one-period
rates. For bonds with longer maturities:
i nt =
it + i
e
t +1
+i
e
t +2
+ … + i
e
t + ( n −1)
n
The n-period interest rate equals the average of the one-period
interest rates expected to occur over the n-period life of the
bond
6-21
Expectations Theory (cont’d)
• Explains why the term structure of interest rates changes at different
times
• Explains why interest rates on bonds with different maturities move
together over time (fact 1)
• Explains why yield curves tend to slope up when short-term rates are low
and slope down when short-term rates are high (fact 2)
• Cannot explain why yield curves usually slope upward (fact 3)
6-22
Multiple Choice
• According to the expectations theory of the term structure
• (a) the interest rate on long-term bonds will equal an average
of short-term interest rates that people
expect to occur over the life of the long-term bonds.
• (b) interest rates on bonds of different maturities move
together over time.
• (c) buyers of bonds prefer short-term to long-term bonds.
• (d) all of the above.
• (e) only (a) and (b) of the above
6-23
Multiple Choice
• According to the expectations theory of the term
structure
• (a) when the yield curve is steeply upward sloping,
short-term interest rates are expected to rise in the
future.
• (b) when the yield curve is downward sloping, shortterm interest rates are expected to decline in the
future.
• (c) yield curves should be as equally likely to slope
downward as slope upward.
• (d) all of the above
• (e) only (a) and (b) of the above.
6-24
Multiple Choice
• Over the next three years, the expected path of 1-year
interest rates is 4, 1, and 1 percent. The
• expectations theory of the term structure predicts that
the current interest rate on 3-year bond is
• (a) 1 percent.
• (b) 2 percent
• (c) 3 percent.
• (d) 4 percent.
• (e) 5 percent.
6-25
Segmented Markets Theory
• Bonds of different maturities are not substitutes at all
• The interest rate for each bond with a different maturity is determined by
the demand for and supply of that bond
• Investors have preferences for bonds of one maturity over another
• If investors generally prefer bonds with shorter maturities that have less
interest-rate risk, then this explains why yield curves usually slope upward
(fact 3)
6-26
Multiple Choice
• According to the segmented markets theory of the term structure
• (a) the interest rate for each maturity bond is determined by
supply and demand for that maturity bond.
• (b) bonds of one maturity are not substitutes for bonds of other
maturities, therefore, interest rates on bonds of different
maturities do not move together over time.
• (c) investors’ strong preferences for short-term relative to longterm bonds explains why yieldc urves typically slope upward.
• (d) all of the above
• (e) none of the above.
6-27
• The interest rate on a long-term bond will equal an average of short-term
interest rates expected to occur over the life of the long-term bond plus a
liquidity premium that responds to supply and demand conditions for that
bond
• Bonds of different maturities are partial (not perfect) substitutes
6-28
i nt =
it + ite+1 + ite+ 2 + … + ite+ ( n −1)
n
+ l nt
• where lnt is the liquidity premium for the n-period bond
at time t
• lnt is always positive and increases with the term to
maturity
6-29
Preferred Habitat Theory
• Closely related to the liquidity premium theory
• Investors have a preference for bonds of one maturity over another
• They will be willing to buy bonds of different maturities only if they earn a
somewhat higher expected return
• Investors are likely to prefer short-term bonds over longer-term bonds
6-30
The Relationship Between the Liquidity Premium (Preferred
Habitat) and Expectations Theory
6-31
Liquidity Premium and Preferred Habitat Theories (cont’d)
• Interest rates on different bonds move together
– Explained by first term in the equation
• Yield curves slope upward when short-term rates are low and downward
when short-term rates are high
– Explained by the liquidity premium term in the first case and by a low expected
average in the second case
• Yield curves typically slope upward
– Explained by a larger liquidity premium as the term to maturity lengthens
6-32
Yield Curves and the Market’s Expectations of Future Short-Term
Interest Rates
6-33
Yield Curves for Government of Canada Bonds
6-34
Multiple Choice
According to the liquidity premium theory of the term
structure
(a) the interest rate on long-term bonds will equal an average
of short-term interest rates that people expect to occur over
the life of the long-term bonds plus a term premium.
(b) buyers of bonds may prefer bonds of one maturity over
another, yet interest rates on bonds of different maturities
move together over time.
(c) even with a positive term premium, if future short-term
interest rates are expected to fall significantly, then the yield
curve will be downward sloping.
(d) all of the above
(e) only (a) and (b) of the above.
6-35
Multiple Choice
If 1-year interest rates for the next five years are
expected to be 4, 2, 5, 4, and 5 percent, and the 5year term premium is 1 percent, then the 5-year
bond rate will be
(a) 1 percent.
(b) 2 percent.
(c) 3 percent.
(d) 4 percent.
(e) 5 percent
6-36
Multiple Choice
If the yield curve has a mild upward slope, the
liquidity premium theory (assuming a mild
preference for shorter-term bonds) indicates that the
market is predicting
(a) a rise in short-term interest rates in the near future
and a decline further out in the future.
(b) constant short-term interest rates in the near future
and further out in the future
(c) a decline in short-term interest rates in the near future
and a rise further out in the future.
(d) a decline in short-term interest rates in the near future
and an even steeper decline further out in the future.
6-37
Mishkin/Serletis
The Economics
of Money, Banking,
and Financial Markets
Chapter 10
ECONOMIC ANALYSIS OF FINANCIAL
REGULATION
Learning Objectives
1. Identify the reasons for and the forms of a government safety net in
financial markets
2. List and summarize the types of financial regulation and how each
reduces asymmetric information problems
10-2
Bank Panics and the Need for Deposit Insurance
• Bank failure: when a bank is unable to meet its obligations, so must go
• Asymmetric information may lead to a bank panic
– Before deposit insurance, depositors would have to wait until the bank was
liquidated
– Unable to asset quality of bank assets, depositors would withdrawal money even
from good banks
– This is described as a bank run
• Methods to handle a failed bank
– Payoff Method
– Purchase and assumption method
10-3
Bank Panics and the Need for Deposit Insurance (CDIC)
• Bank failure: when a bank is unable to meet its obligations, so must go
• Asymmetric information may lead to a bank panic
– Before deposit insurance, depositors would have to wait until the bank was
liquidated
– Unable to asset quality of bank assets, depositors would withdrawal money even
from good banks
– This is described as a bank run
• Methods to handle a failed bank
– Payoff Method
– Purchase and assumption method
10-4
Other Forms of the Government Safety Net
• The central bank can provide support to troubled
institutions by acting as a lender of last resort
• The government can provide direct financial support to
troubled institutions
– The Canada Mortgage and Housing Corporation did this
– The U.S. Treasury (and others) did this as well
• Governments can also take over (nationalize) troubled
institutions and guarantee all creditors’ loans will be
paid in full
10-5
Moral Hazard and Adverse Selection Issues
A government safety net can be a mixed blessing
• Moral Hazard
– Depositors do not impose discipline of marketplace
– Financial institutions have an incentive to take on greater risk
– Risk-lovers find banking attractive
– Depositors have little reason to monitor financial institutions
10-6
“Too Big to Fail” Quandary
• Regulators are reluctant to close down large financial institutions and
impose loses on their creditors because doing so might precipitate a
financial crisis
– Support is therefore given to institutions, even if they are not entitled to it but
merely because they are “too big”
• Increases moral hazard problems at big banks
– Once large depositors and creditors know that a bank is too big to fail, they have no
incentive to monitor the bank
10-7
Financial Consolidation and the Government Safety Net
• Larger and more complex financial organizations challenge regulation
• Leads to increased “too big to fail” problem
• Extends safety net to new activities, increasing incentives for risk taking in
these areas
– Securities underwriting, insurance, real estate activities
10-8
Types of Financial Regulation
1.
2.
3.
4.
5.
6.
7.
8.
Restrictions on asset holdings
Capital requirements
Prompt corrective action
Chartering and examination
Assessment of risk management
Disclosure requirements
Consumer protection
Restrictions on competition
10-9
Restrictions on Asset Holdings
• Attempts to restrict financial institutions from too much risk taking
• Hard for depositors and creditors to monitor banks, so regulations restrict
certain types of asset holds
– Prohibit holdings of common stock
• Promote diversification of assets
– Reduces risk by limiting the amount of load in particular categories or to individual
borrowers
10-10
Capital Requirements
• There are two forms:
1. Leverage ratio, capital divided by the bank’s total assets
• A “well capitalized” bank has a leverage ratio above 5%;
• Lower leverage ratios, especially below 3%, trigger increased regulatory restrictions
2. Risk-based capital requirements
• The Basel Accord, requires banks hold as capital at least 8% of their risk-weighted assets
• Other issues

Off-balance-sheet activities
Regulatory arbitrage
10-11
Financial Supervision: Chartering and Examination
• Two main forms of financial supervision
1. Chartering
– Screen proposals for new institutions, then assign charters
– After receiving a charter, banks required to file periodic call reports that reveal its
assets and liabilities
2. On-Site Examination
– Examiners give banks a CAMELS rating: Capital adequacy, Asset quality,
Management, Earnings, Liquidity, Sensitivity to market risk
10-12
Assessment of Risk Management
• Greater emphasis on evaluating soundness of management processes for
controlling risk
• Risk rating based on
1.
2.
3.
4.
Quality of oversight provided
Adequacy of policies and limits for all risky activities
Quality of the risk measurement and monitoring systems
• Interest-rate risk limits
– Internal policies and procedures
– Internal …
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