BAFI3258 Managerial Finance Research Report
Assessment Task 2 – Research Report (Individual Assignment)
1. General Information
Assessment Task 2 comprises a paper of about 2,000 – 2,500 words (or 8-10 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. The due date for this assessment task is specified on the Canvas course site.
Task in Brief:
“You are a bond analyst working for a fund. 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 hence, the analysis for the assignment should be done separately.
Bond market data and other relevant data from reliable sources:
- Central banks (e.g., Federal Reserve, RBA), Government (e.g., US Treasury Department), Bloomberg, International Monetary Fund, WorldBank, OECD, etc.
- Mainstream financial websites, e.g., MarketWatch, Yahoo Finance
- Subscribed databases available via RMIT Library
Assessment 2 constitutes 40% of the total marks for BAFI3258. Students are required to complete this assignment.
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.
A Rubric Marking: Marking Guide lists specific points under each of these three categories is provided on Canvas for the assessment of your assignment. This should be used as a guidance in the preparation of your assignment.
2,000 – 2,500 words, typed 12 pts, Times New Roman font type, A4-sized pages.
Submission & Due date: Midnight 14 May 2023
Submit your Assessment Task 2 to “Assignments” via Canvas
2. Assignment Requirements
Please consult the Appendix (see the below) 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 through the following instruction carefully.
IMPORTANT: You are required to choose TWO countries: the USA and ONE other country from below list (in alphabetic order)
- Republic of Korea
- United Kingdom
You are required to collect the most recent bond market data, namely, yield to maturity (YTM), 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).
Collect the YTMs 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.
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”) (future interest rates) that the bond markets appear 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 your detailed workings for at least one country, i.e., either for the US or for the country of your own choosing, or both (to be included in the Appendix of your submission). Present your calculated DRs clearly and neatly in a properly formatted table.
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 DRs and these inflation rates to predict the REAL rates of interests for those periods based on the following formula:
For the 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 or that the predicted inflation rates are calculated based on historical rates. You are required to JUSTIFY your assumptions.
Show all your detailed workings in an Appendix.
Use your results to compare the predicted future interest rates (DRs) between the USA and your selected country. Make sure that you use your own economic analysis of your results and/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. If you use any other expert opinions from such sources as financial newspapers or statements by some central banks, make sure to quote the source properly.
Use your forecasting results in previous parts to make comments on the US market and the rates on TIPS (Treasury Inflation-Protected Securities).
Comment on how the YTMs of Treasury bonds have changed since July 1st, 2021, e.g. how does the bond market appear to have changed its predictions? You will need to collect and present the YTMs of the Treasury bonds that you have selected and fill out the table below. Please present the data for current bond rates, as well as the bond rates on July 1st, 2021
|T||US||(The other country)|
Use the relevant theories of the term structure of interest rates to discuss how they affect your interpretation/results/findings.
In the light of your findings, discuss the following comments from Dr Jeromy Powell, Chair of Federal Reserve Bank in relation to the Federal Reserve Bank’s monetary policy (i.e., please discuss the implications of Fed’s decision on inflation expectation, Treasuries’ real rate of return and the Treasury yield curve):
8 March 2023.
“We are seeing the effects of our policy actions on demand in the most interest-sensitive sectors of the economy. It will take time, however, for the full effects of monetary restraint to be realized, especially on inflation. In light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, the Committee slowed the pace of interest rate increases over its past two meetings. We will continue to make our decisions meeting by meeting, taking into account the totality of incoming data and their implications for the outlook for economic activity and inflation.”
Discuss how you see the implications of your findings for the equity markets (specifically, the implications on equity valuation and the sector rotations for equity performance).
APPENDIX – APPROXIMATE METHOD.
Example 1: Expected Interest Rates & Inflation Rates.
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:
- Expected Interest Rate: 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
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,
- Expected Inflation Rate: 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, YTM12, we solve the following equation:
where YTM1 is the YTM in Year 1 (determined for one-year Treasury bonds as above = 5.0%)
and YTM1,2 is the 1-year YTM as of Year 2. Hence,
which yields YTM1,2 (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 rate2, for Year 2, as follows:
So, inflation rate2 (the anticipated inflation rate in Year 2) is
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 (YTM1) is
which yields YTM1=, or 5.0%. This is the discount rate, DR1, that the market considers appropriateover 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 (YTM2) by solving the following equation:
Therefore, YTM2 = 5.48%.
Note: You can solve for YTMs using the IRR function in Excel. Alternatively, you can set up your Excel spreadsheet for the valuation of the bond as the fundamental equation above and gradually adjust the input YTM2 until you get the valuation to equal $102.99; this can be done easily using the Excel “Goal Seek” or “Excel Solver”.
The question we now ask is: What is the discount rate, DR2, that the market appears to consider appropriatefor 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, DR2, we need to solve:
where YTM1 is the YTM in Year 1 (determined for 1-year Treasury bonds as above = 5.0%) and DR2 is the appropriate discount rate for Year 2 (YTM12). Therefore,
which yields DR2 (in Year 2) = 0.060 (6.0%).
|Approximate approach Instead of using the above equation to determine the DR2 value in Year 2, we can approximate DR2 by applying the following simple relation: (1+ DR1)(1+ DR2) = (1+YTM2)2 (YTM2 is the YTM for a 2-year bond), for which we have DR1= 0.05 and YTM2 = 0.0548, so that: (1.05)(1+ DR2) = (1.0548)2 which yields the approximate value of DR2 = (1.0548)2 / (1.05) – 1 = 0.0596 (5.96%), as compared with DR2 = 0.060 (6.0%) as computed previously. Thus, the approximation appears sufficient.|
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 (YTM5) using the following equation:
which yields YTM5 = 7.0%.
We now ask: What is the discount rate, DR3/5, that the market appears to consider appropriate for years 3 to 5? To answer this question, we solve the following equation:
where DR1 = 5.0% and DR2 = 6.0%, so that:
which yields DR3/5 = 8.16%.
|Approximate approach Note that rather than use the above method to determine the DR3/5 value for Year 3 through Year 5, we can approximate it by using the following relation: (1+ DR1) (1+ DR2) (1+ DR3/5)3 = (1+YTM5)5 for which we have DR1= 0.05, DR2 = 0.06 and YTM5 = 0.07, so that: (1.05) (1.06) (1+ DR3/5)3 = (1.07)5 yielding DR3/5 = , which compares with DR3/5 = 0.0816 (8.16%) calculated earlier.|
Part 2: 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 DR3/5 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
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.