Session 1 - Overview of the Financial Markets

TEXTBOOK/SLIDES:
1.1 Finance Defined
- Finance is the study of how and under what terms savings (money) are allocated between
lenders and borrowers
- Excess money you can invest (lenders) or need money for some reason
(borrowers)
- Finance is different from economics because finance is not just about how
resources are allocated, it examines the terms and through what channels
allocations are made
- Finance requires a basic understanding of:
- Economics (principles)
- Accounting (information)
- Law (legality and constraints)
- Markets and players (institutional structure)
- Basically the transfer of funds that form a piece of paper that is a financial contract called
financial securities
- Lead to fraud so corporate law and facilitation of funds required

1.2 Real Versus Financial Assets

- Wealth
- Assets - Liabilities = Net Worth
- Financial assets like claims/securities
- Liabilities are claims on you
- Net worth is basically equity - what you own or your capital
- Equity securities (shares/stocks) are traded securities in a company’s
capital
- Canada’s balance sheet aggregates individuals (households), businesses, and government
- Total wealth in Canada (aka net worth or equity) is about $6.6 trillion = $6,852
assets - $236 billion liabilities
- Per capita: $6.6 billion / 33 million = 200,000 per person
- Some are more wealthy than others obviously
- One person’s asset is another’s liability
- Each Canadian worth about $200,000
- Real assets are tangible things that compose personal and business assets
- Personal assets are the value of houses, the land the house is on, major
appliances in the house (TV, washing machines, etc.) and cars → last two are
consumer durables because they last many years
 - Business assets include office buildings, factories, mines, and more (non-
residential); the machinery and equipment, the land they are on, stock or
inventories
- Management in charge of business finance are responsible for deciding to
build factories, increasing inventory holdings, and making strategic asset
acquisition decisions (ex: buying another firm → mergers and acq) → increase
through economic growth, more consumer goods, balance between human
cap and nat/physical assets
- All asset acquisitions or capital expenditure (capex) decisions
- Consumer items plus real investments to produce goods
- ONLY focuses on things that we can measure
- Should be both human capital (skills and education of people) and natural
capital (land, forests, etc)
- Intangible assets are not physical things (trademarks, patents, research &
developments, processes); grossly underestimated in national accounts
- Standard classification
- Household sector - interests of the consumer; personal finance: predominantly
lends
- Business sector - intermediate producer - real investment; business finance:
predominantly borrows
- Government sector - public goods (ex: provincial - health and education; federal
- defence and trade); government finance: predominantly borrows
- Foreign sector - international finance: mix of lending and borrowing
- Financial assets are contractual claims that one individual or institution has on another
- Includes stocks, bonds, short-term paper, insurance contracts, promised payments
from government/pensions and corporations
- Need to disaggregate the data → National Balance Sheet Accounts of StatCan
- Collect financial data on the major agents in the financial system and track
borrowing and lending between agents
- Individuals as a group tend to other major agents in the system,
creating financial assets → it is offset by another person’s assets
- If you add up value of real assets of all three domestic sectors, it results in total market
value of real assets $6,851 billion
- If you add up total net financial assets of the three sectors, it is a value of -$236 billion,
which is the net financial assets owed by Canadians to non-residents
- Value of the net assets owned by Canadian residents are the sum of these two: $6,615
billion
- Financial liabilities are the opposite of financial assets (i.e. loans for individuals are
liabilities for them whereas they are assets for banks)
- INDIVIDUALS OWN MOST OF THE WEALTH
- Stocks and shares in companies show the value of the company but they are often
owned by individuals
- Net foreign investment in Canada was 0.236 trillion
- Household sector is main source of savings
Household Finance

- Major real assets are houses for individuals

- Financing
- Consumer credit: charge cards
- Loans (mainly bank loans)
- Mortgages: loans secured by real property (houses)
- Investment
- Deposits at “deposit taking institutions” (ex: banks)
- Debt: loans to institutions (bonds)
- Pension and insurance claims
- Shares
- Foreign portfolio investments

1.3 The Financial System

- The household sector is the primary provider of funds to business and government
- The basic financial flow is “intermediated” through the financial system, which
comprises of:
 - Financial intermediaries are entities that invest funds on behalf of others and
change the nature of the transactions
- Market intermediaries are entities that facilitate the working of markets and help
provide direct intermediation but do not change the nature of the transaction; also
called brokers

- Channels of intermediation
- Intermediation is the transfer of funds from lenders to borrowers
- Ex: individuals borrowing from friends, family, etc. (directly) and another is
from financial institutions like RBC (indirectly) who is a financial intermediary
that borrows from
individuals who
loan their savings
 - Market intermediaries are typically called brokers

Session 2: Fuhnancial Markets

READINGS:
SLIDES
Table of Contents
- Defining the money market as it relates to fixed income securities
- Pricing and yield convention of money market securities
- Understanding differences in yield between money market securities
- Key money market instruments that are traded in the market
- T-Bills
- BAs
- CP
- Securitizations
- Asset backed CP

The Money Market

- Deals with debt securities with a maturity <1 year
- Marketable and liquid, have high moneyness
- Demand comes from big institutions and corporations who have excess cash or
are reluctant to invest in long term. They look for very short term, safe
investments.
- Supply comes from major financial institutions who see it as a low cost source of
funds.
- BoC overnight rate is the key interest rate as it affects all short term rates.
- Almost all securities are discount notes.
History of Cdn Money Market
- Before 1934 DNE
- Call loans went to NY or London.
- Demand loans that the banks make where they can get repaid instantly (next day)
to meet cash needs
- Sep 20, 1931 - Great Britain went off the gold standard and the pound sterling was no
longer convertible into gold. Other countries followed and soon most currencies were
“floating” (set by market forces, rather than fixed)
- Canada had no way of intervening in the FX market to affect the value of the C$
- 1934 Macmillan Report recommended
- Central bank
- Cdn money market
- T-bill auctions
Discount Notes
- Promissory note
- “Promise to pay”
- Bearer note: whoever has the note can present it to the bank for payment
- Clean: no conditions just an unconditional promise
- Usual terms 30,60,90 day for corporates
- Very large sums of money $millions
- Flexible terms
- Sold for less (discount) than face value
- Wholesale market dominated by large sophisticated institutions trading large sums of
money.
- GECC’s notes are guaranteed by its US parent General Electric
- Like a parent co-signing a student loan.
Pricing and yield convention
- T-Bills, Commercial Papers, Bankers Acceptances are all discount notes.
- Investors buy them at a discount and the money market instrument matures at par, face ,
maturity value.
- No interest payments made over the life of the money market instruments
- For securities that trade on a discount basis:
- Interest income earned = Face Value - Purchase Price
Example
- Market quoting of the security is to quote as a % of face value.
- 30 day promissory note is quoted at 99.50. You pay $995 (Price=P) for the security,
which is worth $1000 (Par/face value=F) at maturity.
- Its discount is 0.50%, which is the % discount from the face value, so 100-99.50 =
0.50%.
- Yield (K) or interest rate?
- K = (F-P)/P = (100-99.50)/99.50 = 0.005025 = 0.5025%
- This is 0.5025% for 30 days.
- Interest rates are usually expressed on an annual basis,
- US: 360 days or a 30/360 day count basis.
- Canada: 365 days or an actual/actual (normally 365) day count basis.
- Canada:
- K=0.005025 * 365/30 = 6.1139%
- US (discount yield)
- K=0.005025 * 360/30 = 6.0302%
- To go to Canadian from US multiply by 365/360
- Bank of Canada data shows US rates on a Canadian yield basis
- This is called the money market yield convention; bonds are quoted differently
- A basis point (beep) is 1/100 of a percentage point.
Calculate the price of a Canada T-Bill given
rBEY = (F-P)/P * 365/n)
- P = market price which will mature at $1000, n= number of days to maturity (90 days)
r=5%
- P = F/(1+r(n/365)) = 1000/(1+0.05(90/365)) = $987.82
- If R ↑ , then P ↓ , if R ↓ , P ↑

- Suppose price increases to $1000

- R=1000-1000/1000 = 0.00%
- Some interest rates in US and Europe have been negative at times since October 2008.

Money Market Securities by type of issuer

Treasury Bills Fed. or Prov. Government - Safest type of short-term debt instrument
issued by the govt
- Most liquid securities in the money
market

Bankers’ Banks/Trust Companies - Short term promissory note issued by a

Acceptances (BAs) corporation, bearing the unconditional
guarantee (acceptance) of a major
Chartered Bank.
- BAs offer yields greater to T-Bills

Commercial Paper Corporations - Short term, unsecured debt issued by the

largest corporations

Asset backed Special Purpose Vehicle - CP backed by an income-producing asset

commercial paper (SPV) class (i.e. Credit cards) and issued out of
(ABCP) - created a trust or conduit.
through
securitisation
Treasury Bills
- Short term notes issued from the treasury of the govt.
- Federal govt t-bills
- Provincial government t- bills
- Main issues are 91, 183, 273, and 374 day maturities (divisible by 7), but maturities are
issued to ensure liquidity in these benchmarks.
- Auctioned on Tuesdays through sealed bids from registered securities distributors or
dealers.
- Bills are issued to successful bidders two days after the auction (Thursdays)
- T-Bills are issued by the Department of Finance and the auction is managed by
the Bank of Canada
- Acts as the federal government’s fiscal agent
- Provincial debt auctioned by provincial authorities such as Ontario
Financing Authority in Ontario.
- Primary Fed. T-Bill dealers
- Bank of Montreal, CIBC, Desjardins, HSBC, Laurentian Bank Securities,
Merrill Lynch, National Bank Financial, RBC, Scotia Capital, TD bank
- Treasury Bill Auction
- Bids submitted by authorized dealers
- Anyone with a BoC bid identification number (BIN) can submit bids through an
authorized dealer.
- Each dealer has a bidding limit to prevent market manipulation
- Primary dealers are limited to 25% for themselves and 25% for customers
with BIN to a max of 40% in total.
- Other dealers have a 10% limit
- BoC submits a bid for its own purchases
 - Non-competitive bids are accepted in full or pro-rated up to dealer and customer
limits at an average yield price.
- Competitive bids in terms of rising yields where each dealer can submit up to 7
bids for a minimum of $100,000 in multiples of $1,000.
- Dealers who bid the highest price (lowest yield) “win” T-bills at the
auction.
- Example:
- $10 billion auction of 91 day T-Bills
- $7 billion non-competitive bids and
- $1 billion at 99.30 or yield 2.8275%
- $1 billion at 99.32 or yield 2.7461%
- $1 billion at 99.34 or yield 2.6648%
- $1 billion at 99.36 or yield 2.5836%
- Bank would accept all the bids up to 99.32 (not 99.30)
- Non-competitive would buy at average of 99.34
- Bank of Canada usually puts in a reserve bid to set floor price
- Note bids are per $1000, but we always quote in 100s!

Canadian Depository for Securities (CDS)

- Since Nov. 1995 all T-bills have been issued in global certificate form for the full
amount registered in the name of CDS. All payments then go through CDS.
- T-Bill purchases and sales are made through a dealer with access to debt clearing service
offered by CDS. Prior to 1995 T-bills were issued in bearer form similar to the GECC
note.
- Transfers are made as book entries on CDS computer system
- No more physical notes!
- The Govt also periodically issues cash management bills (CMBs)
- CMBs are T-Bills with maturities of less than 3 months
- CMB auctions can take place on any business day, typically next-day delivery.

Commercial Paper
- Short term unsecured promissory notes issued by a company rather than govt. (example
GECC)
- Usually issued 5-45 days (average 30-35 days)
- Rolled over
- Must finance current transactions (inventories, accounts payable)
- Problem: corporations can default, that is, not meet their financial obligations
- However, investors are not really “investing”, simply “parking” cash for a short
period of time
- Investors in CP are unwilling to accept any risk:
 - Time horizon is very short
- Amounts invested are very large
- Yields are very low relative to default free T-bill yields.
- Since CP is supposed to have low default risk any fear of default causes a “flight
to quality” as investors refuse to roll over CP and there is a liquidity crisis for
the firm.
- Securities legislation protects investors and makes sure
- All info is known about an issuer
- Prices are not manipulated (by broker or market participants)
- Criminals cannot sell securities
- People in the business are well trained
- Information Memorandum is required for the issuance of CP which outlines
guarantees, denomination, bank lines, and rating
- Traditionally CP could not be sold to uninformed retail investors, the min investment was
at least $50,000-97,000, depending on province.
- In 2005 this limit was removed and instead CP could be sold to anyone as long as it had
the highest credit rating
- The Dominion Bond Rating Service (DBRS) is the major Cdn rating agency for money
market securities.
Default Risk
- Suppose default-free yield on a one year note is 10%. You decide to invest in CP with a
20% chance of default. If it defaults, you get nothing. What is the breakeven interest
rate (K)?
- Probability 80% you get (1+k)
- Probability 20% you get nothing
- Your expected return on the CP must be at least 10%
- 0.80*(1+K) + 0.20*0 = 1.10% so K=37.5%
- There would be a 27.5% credit spread: difference between the yield on security with
default risk and the default-free govt security with the same term to maturity
- Actual credit spread on 90-day CP September 5,2014 was 0.24%
Canadian Money Market Yields
- T-Bill yields are close to the overnight rate
- CP paper yields are higher - Why?
- What makes these rates go up and down
Dominion Bond Rating Service (DBRS)
- Independent Cdn-owned rating agency
- Acquired in 2015 by the Carlyle Group and Warburg Pincus
- Rates money market instruments and long term bonds
- Estimates the probability of default and what is likely to be received in default; gives
each security issue (not company) a credit rating
- As part of its rating on money market instruments it requires a backup line of credit from
a major bank
- Line of credit just means that in an emergency the CP issuer could borrow from
the bank to pay off the CP
- Line of credit is necessary to assure CP holders that they will get repaid when
there is a “flight to quality”
- R-1 and R-2 are regarded as investment grade
- Many large institutional investors cannot buy below R-2
- Higher demand for these securities.

-
Bank Guaranteed CP: Bankers’ Acceptances
- Sometimes the market is so worried about default that they don’t buy the securities
- Problems of asymmetric info
- Only the highest-rated issuers can issue CP in the Cdn market
- Cdn market is very conservative
- Sub R-1 (low) notes normally have to be guaranteed by a chartered bank even
though they are investment grade
- Bank guaranteed note is called a Bankers Acceptance
- Nothing to do with trade as in the US
- Simply a bank guaranteed CP
- Bank charges a stamping or guarantee fee of 0.50-1.0% for guaranteeing or
accepting the liability on the note, just as GE does for GECC’s CP
- This is fee income for banks

-
- Low rated company may have difficulty issuing CP directly to markets or may be
required to have a bank guarantee
- Pays a fee and substitutes bank’s credit rating for its own
- Company provides bank with a “promise to pay” draft
- Bank provides cash (at discount of the promised future payment)
- Based on this promised payment, bank issues banker’s acceptance which is sold to
investors and traded in secondary markets at discounted price
- At maturity, bank makes promised payment, collects from company
 -
Securitisations
- Commonly called asset backed commercial paper (abcp)
- Securitization is the process of bundling or pooling various asset classes promising to
pay a future stream of payments
- Including residential mortgages, commercial mortgages, lines of credit, credit
card payments, auto loans, auto leases, equipment loans/leases, accounts
receivables
- Transforms loan-type assets into tradable fixed-income assets.
- Put assets into a trust or special investment vehicle (SIV) - assets are collateral
- SIV issues CP to finance the purchase of the securities
- Generally over-collateralized, that is, put 110% worth of securities into a trust
- Often have some form of guarantee or deficiency agreement, so someone else
absorbs some losses if they occur
- Underlying assets are generally low risk loans, where they are pooled to reduce
risk
- Historic statistics on default rates used to judge the level of risk.
 -
US Sub-Prime
- US housing prices rose dramatically 2002-2006 and with them mortgage financing
- Many of mortgages were securitized
- Mortgages were often originated by the mortgage agent and not the bank
- Mortgages were held in a SIV and securities were issued against them
- Securities were sold to sophisticated investors
- Credit ratings on the securities by Standard and Poors and Moodys were
invariably very high, since historic default rates were very low
- Sub prime mortgages
- Low quality investors: NINJA mortgages
- Often with terms that assumed housing prices would continue to rise (e.g.
“balloon payments”)
- As US house prices moderated and then fell in 2007 (year over year down 15% in August
2008) defaults increased and the value of these securities collapsed

Canadian ABCP “freeze” in 2007

- By summer 2007 anything related to US sub-prime mortgages became toxic
- Nobody knew where the losses were or how much the US banks might lose
- Conventree, major Cdn dealer, in an effort to reassure investors indicated about 5% of
Canadian ABCP may be linked to US subprime
- Dealers could not sell underlying assets at “fair” prices
- Investors would not roll over ABCP and could not get their money back
- Dealers called on Cdn banks to honour their backup lines of credit, but they
generally refused citing “major market disruption”
- ABCP froze and took years to sort out
- In contrast, US banks had to honour their guarantees plus they directly held US ABCP.
Is Securitization Bad?
- Can be very helpful as it provides liquidity to banks
- Trouble arose because of the pooling of poorer quality loans which were less understood
(in part of because of re-securitization)
- Goldman Sachs, Spring 2006 issue (GSAMP Trust 2006-S3)
- 8274 California second mortgages, first mortgage generally for 80%
- Second mortgagee cannot foreclose if the payments are made on the first
mortgage
- Average equity 0.71% so 99.29% debt financed
- 58% were no or low documentation mortgages (NINJA mortgages)
- Many had teaser or low initial interest rates to get people to buy
- Notional value $493million
- 93% was rated investment grade
- Spring 2007 18% were in default (expected rate of 1%)
- August 2007 anything sub-prime related became TOXIC (fucking deadbeats)

Investor Protection Only Bank Accounts and Bank Deposits are Insured
- T-Bills are guaranteed by the govt issuer
- Bank accounts and GIC’s are government insured by CDIC up to $100,000
- Accounts containing CP, BA’s and securitizations are Not insured
- If the issuer or guarantor default you lose $$$
- CIPF private insurance coverage of $1mil protects only against fraud
- Any investment advice you receive is not guaranteed

SESSION 3 – The Canadian Economy and the Bank of Canada

Bank of Canada
- Canada’s central bank (a bankers bank)
o Founded in 1934 as a private company, in 1938 it became a Crown Corporation
o 12 directors appointed by the government for three-year term, and they appoint a
governor (Steph Poloz 2013) and senior deputy governor for seven-year terms.
o The Deputy Minister of Finance sits on the committee, but does not vote
o The governing council of the Bank determines policy
- In 1967, ultimate monetary authority was given to the government. However, in the case of
disagreement with the Bank, the Minister of Finance has to issue a public letter of direction, which
has never been done.
- Acts as Government’s fiscal agent managing foreign exchange reserves, financing and cash
management.

Bank of Canada Functions

To promote the economic and financial welfare of Canada, we
 - Conduct monetary policy in a way that fosters confidence in the value of money
- Supply quality bank notes that are readily accepted and secure against counterfeiting
- Promote the safety and efficiency of Canada’s financial system
- Provide efficient and effective funds-management services
- Communicate our objectives openly and effectively and stand accountable for our actions.

Major Activities 1: Note Issue & Seigniorage

- Buys government securities by issuing bank notes
o Pays the Royal Canadian Mint $0.12 for a $1 coin, which lasts almost forever (no more
pennies)
o Prints $20 notes at a cost of $0.06, each one lasts on average two years. If the $20 is
invested at 5% then over two years the notes generates $2 in revenue at a cost of 6
cents for $1.94 profit. New polymer notes 2.5X longer.
- Money is anything widely accepted as a means of payment
o Cdn. Currency is “legal tender”, which means it has to be accepted (fiat)
o Prior to 1970 notes said “I promise to pay the bearer $ on demand”
- Government monopoly (counterfeit), prior to 1935 50% of notes in circulation were issued by
chartered banks.

Canadian $20 note: 1935 series

- Princess Elizabeth is on the $20 note (8 years old) à Queen Elizabeth II in 1952

1986 Goodbye paper, hello Loonie and Toonie

- $1 note was not included in the 1986 series; first $1 coin minted 1987
- $2 note withdrawn in 1996
- Both replaces with coins by the Royal Canadian Mint
- The US still has pennies and $1 notes

Bank of Canada announces Canada’s New Polymer Notes

- Replaced paper notes with polymer (starting with $100 in Nov. 2011 and $50 in March 2012
- $20, $10, $5 unveiled and issued by end of 2013

Benefits of new polymer notes

- Incorporate innovative and easy-to-verify security features that will significantly increase their
protection against counterfeiting
- Very durable, lasting 2.5 times longer than paper notes

How this change may affect your business

- You can play a role in helping to remove paper notes from circulation by keeping your polymer
and paper notes of the same denomination separated in your tills
- Bundle polymer and paper notes separately in your bank deposit
- Machines that count cash or accept cash payments (e.g. self-serve kiosks) may need adaptation to
process polymer notes efficiently and some equipment may require replacement. Please contact your
 equipment suppliers to determine if your machines will function properly with Canada’s new polymer
notes.

Graph – counterfeits have decreased over the years

Bitcoins
- Bitcoins are digital money (think Airmiles or credit card points)
o Created by computer “mining”
o Transferred through distributed ledgers (more later on money)
- Phenomenal growth & very important technology, but
o Worries about money laundering
o Loss of control by central banks
o Loss of $1 billion in seignorage by the Government of Canada
- Banned in China and soon in South Korea
- Kristoffer Koch invested 150 kroner ($26.60) in 5,000 bitcoins in 2009 (Guardian Dec 9, 2015)
They would now be worth $US 95 million, but he sold 20% to buy an apartment

Major Activity 2: Payment System

- Payments Canada (successor since 2015 to the Canadian Payments Association)
o Cheques are cleared when banks exchange cheques between each other;
o Cheques are settled when banks pay for what they owe by writing
- Large Value Transfer System (LVTS)
o Wire transfer of large items that occurs throughout the day; ($171 billion a day);
settled at end of the day
o Must use SWIFT, have settlement account at Bank of Canada and collateral as Bank
guarantees payment
- Automated Clearing Settlement System (ACSS)
o Debit, automatic bank payments 11% paper, 89% electronic ($20 billion a day)
cheques declining
o Cleared next day at six regional offices by 11:00 with settlement through LVTS at
12:00

LVTS Volume
- In 2015, $43 trillion passed through LVTS ($171 billion/day)
- In comparison, $6.5 trillion passed through ACSS in 2015

ACCS Volume
- In 2015, $43 trillion passed through LVTS ($171 billion/day)
- In comparison, $6.5 trillion passed through ACSS in 2015
Bank of Canada Role in Payments System
- Payments Canada members maintain settlement balances to settle their obligations (about 12
currently)
o Members borrow from the Bank if they are short of cash to make their payments:
liquidity provision
o Otherwise they earn interest on their deposits
o There are NO reserve requirements in Canada (as there are in the US)
- Bank guarantees settlement and settles Government of Canada payments anre receipts
- Banks acts as Canada’s representative on international issues
- The Bank does not own Payments Canada

Major Activity 3: Monetary Policy

- Money is valuable as:
o Means of exchange: avoids barter and double coincidence of wants
o Unit of measurement: basis of measurement and accounting
o Store of value
- Historically all sorts of things have been used as currency
o Calgary Dollars
o Rare items like cigarettes; limestone, shells (Pacific), boiled eggs (Zimbabwe), tea
bricks (China), chocolate (South America)
- Around 650 BC metallic coins ted to be used, particularly gold since it does not decay
- First paper currency in Sichuan in 1024 (Jiaozi)
- 1935 Cdn. Government monopoly

Rai stone at the Bank of Canada – Currency Museum in Ottawa

- Limestone is rare in the South Pacific and was used as a currency: the larger the better
- Since they are so large, legers (oral history) were used to indicate who owned them
- This is essentially no different to bitcoins

Objectives of Monetary policy

- Ensure low and stable inflation (reduction in the value of money)
- Avoid inflationary “boom and bust” cycles to keep the economy on a stable growth track
- Maintain purchasing power
- Inflation is simply the change in value of what a basket of goods over time, that is, what fiat
(state) currency can actually buy

Benefits of low inflation

- Easier to plan and contract for the future by reducing distortions
- Reduces uncertainty
- Results in lower nominal interest rates and encourages long term investment
- Preserves purchasing power for those on fixed incomes
- Fosters confidence in the financial system and participation (reduces the underground
economy)
 - Avoids inflationary spirals as people increase prices to get ahead of expected inflationary
increases
- Has coincided with better labour relations

Inflation Targeting
- Inflation targeting
- 1980’s Canada recognised there was no longer a stable relationship between monetary aggregates
and inflation
- 1991 the BofC and the Government of Canada agreed to a five-year plan
o Reduce inflation from 6% successively to 2%
o Subsequent five year agreements have renewed an inflation target of 2% in a 1-3%
operating band
o Highly successful & last reviewed 2016
- Focusses on CPI median, trim and common (statistical smoothing)
- Fed now targets 2% as does the Bank of England, the ECB and most central banks

Why 2%?
- Actual inflation is probably lower than the 2% targeted by the Bank
o The CPI is based on a basket of goods and re-priced (Eco will talk about different
indexes)
o Few individuals consume the CPI basket of goods which include housing
o Bank estimates actual inflation is 0.5% less than the CPI
- Some positive inflation rate is useful for wage negotiations even if in real terms nothing happens
(money illusion and “sticky” wages)
- The Bank claims that nominal interest rates cannot fall below 0% so 2% inflation adds a cushion
(turns out this is not true)

Why not higher inflation?

- Difficult to control inflationary expectations
- Biggest note was $1 trillion Zimbabwe after which they reverted to using US $ which Presidence
Mugabe could not control

Monetary Policy
- The Bank changes interest rates to affect aggregate demand and inflationary pressures
- When economy is over stimulated the Bank increases interest rates to slow down the economy
and vice versa
- The Bank looks at a variety of indicators:
o Unemployment rate
o Its own indicator of labour market conditions
o Capacity constraints
o Its Bank loan officer survey to assess the demand for loans and credit conditions
o Unit labour costs

Tools of Monetary Policy

 - Bank of Canada targets the overnight interest rate
- The overnight rate is the rate charged by a bank to settle its transactions with other banks via the
LVTS
o Banks always have minor imbalances and need to borrow or lend to settle up at the
Bank of Canada
o The Bank of Canada has a target for the overnight rate within a +/- 0.25% band so the
target might be 4% in range 3.75% - 4.25%
o The bank then lends money to the chartered banks at the top of the range and pays
interest on deposits at the bottom of the range
- The bank rate is this top of the operating range or 4.25%
- In the US the borrowing rate (discount rate) is 1.0% over the federal Funds rate.

Increase Interest Rates

- If the Bank of Canada wants the overnight rate to increase it may do three things:
o Announce the change: markets usually respond immediately
o Move Government of Canada deposits from the chartered banks to its own account
§ This reduces settlement balances at the Bank of Canada forcing institutions to
borrow pushing up interest rates
§ This is called deposit-redeposit
o Open market operations through purchase and sale agreements known as repos (or
PRAs) or the reverse
- Impact
o Increases overnight rate immediately and usually the prime rate
o Prime rate is the base interest rate that chartered banks charge their “best” customers
and normally 2% higher than the overnight rate (currently 2.2%)

Other Effects
- Increased interest rates
o Monetary policy directly affects short term interest rates
o It affects medium and longer term interest rates with declining importance
o Little impact on long term interest rates
- Increases the foreign exchange (FX) rate
o The price of foreign currency (US$) per Canadian dollar (C$)
o 80% of Canada’s trade is with the US so we benchmark against the US$: say E (US$
per C$) 0.80 cents US or E (C$ per US$) 1.25
o Higher interest rates make Cdn. Investments more attractive, so capital flows in
pushing up the value of the C$ from say $0.80 US to $0.85 US
o FX rates change when the market expects interest rate changes

How Monetary Policy Works

Demand Impact
 - Increased interest rates
o Higher prime rate reduces business investment
o Higher mortgage rates reduces demand for housing
o Higher consumer loan rates reduce consumer credit
- Higher Exchange Rate
o Makes foreign goods and travel cheaper increasing imports
o Makes Cdn. Exports more expensive reducing exports
- Reduction in aggregate demand: more unemployment and lower price pressures
- US recently has played up the wealth effect as well as the income effect as interest rates affect
the value of financial securities and wealth

Transmission
The extent and the timing of the response depend on the expectations of:
- Investors
- Borrowers
- Consumers
- Producers

Both demand and prices are frequently subject to international or domestic shocks
- The oil crisis in the 1970s
- Political uncertainty
- The Asian crisis

The lags are long and subject to uncertainty

People used to work on an 18-month lag, but now?

Major Activity 4: Security and Efficiency of the System

- The Bank controls the money supply and can buy anything simply by printing more B of C bills:
it is the ultimate lender of last resort
- The Bank engages in Purchase and Resale Agreements (PRA) to provide support when needed
o It buys securities at one price say $100 and then sells them back at say $101 charging
the bank rate
o The institution has then exchanged securities for cash at the Bank of Canada, which it
can use to meet its commitments
o Under the Bank of Canada Act, the Bank can only make loans with eligible securities
as collateral
o Since 2015 PRAs are now called repos

Types of Loans
- Standing liquidity facility (SLF)
o Any member of the CPA can borrow to settle transactions at the bank rate: facilitates
liquidity
o Regular borrowing and lending happens all the time
- Emergency lending facility (ELF)
 o Solvent institutions that have suffered severe liquidity problems, ie., unforeseen
drawdown of cash
§ Banks have illiquid assets (loans)
§ Depositors may withdraw funds at any time: Bank Run (more later)
o Federally incorporated banks and trust and loan companies have access to ELF (credit
unions indirectly)
o Close co-operation with Office of Superintendent of Financial Institutions (OSFI)
o Under extreme circumstances the Bank can lend to anyone whose activities endangers
the integrity of the financial system

Bank Lending

Other Central Banks

- Bank of Canada 1934
- Federal Reserve System in the US 1913 (12 member banks – districts)
- Bank of England 1694
- Bank of Japan 1882
- European Central Bank 1999

- Mandates differ
o Fed has target for economic growth as inflation
o ECB cannot buy long-term government debt directly since it would be financing
governments (Greece etc.) Ha!!

US Monetary Stimulus
- Federal Funds rate at 1.00-1.25%
- Operation Twist (Quantitative easing or Bond Buying: money printing)
o $85 billion of monthly bond purchases (Treasuries and mortgage backed securities) to
lower long term (mortgage) interest rates
o Started Sep 2011 finished October 2014 accumulated over $4 trillion in assets
- Tapering
o Gradual easing of exceptional stimulus
§ Purchases cease at “6.5% unemployment”
§ US unemployment rate now 3.9%
- Question is when and how quickly it “unwinds” or sells its massive bond holdings

Other QE
- ECB (March 2016, confirmed July 14,2017)
o Cut its overnight rate to 0.0%
o Lowered bank deposit rate to -0.4%
o Increased buying to 80 billion Euros a month (including Corporate bonds)
o Long term cheap bank loans
- Japanese Central bank (October 2014)
 o Expanded QE to $55 billion a month
- Bank of England (August 2016)
o Restarted 60 billion pound QE following Brexit
o Cheap bank loans
o Lowered policy rate to 0.25%
o Letter from Chancellor of the Exchequer (Aug. 4,2016)
- End in sight for all of them?

Absolute key to understanding financial markets is the state of the economy and current monetary
policy

Key Learning (Things that are important)

- Main Functions of the BofC
- Seignorage
- Payments System
- Monetary Policy
o Benefits of low inflation
o Inflation targeting
- Tools of monetary policy
o Interest rate channel
o Foreign exchange rate channel
o Lags
- Financial market stability
o What the Bank worries about
o Actions of other central banks
o Quantitative easing

Bank of Canada FAQ (Practice Questions)

1. Who is responsible for monetary policy?
o The inflation-control target – one of the two cornerstones of Canada’s monetary policy
– is set jointly by the Bank and federal government. However, the day-to-day
administration of monetary policy is the responsibility of the Bank’s Governing
Council, composed of the Governor, Senior Deputy Governor, and Deputy Governors
o The Bank of Canada Act requires regular consultations between the Governor and the
Minister of Finance on the direction of monetary policy. If a profound disagreement
were to occur between the Bank and the gov’t, the Minister of Finance could issue a
written directive to the Governor specifying a change in policy. This would most
likely result in the Governor’s resignation. However, such a directive has never been
issued.

2. How does the Bank of Canada implement monetary policy?

o The Bank implements monetary policy by influencing short-term interest rates. It does
this by raising and lowering the target for the overnight rate (also known as the key
 policy rate). This is the interest rate at which major financial institutions borrow and
lend one-day (or overnight) funds among themselves.

3. What is the difference b/w monetary and fiscal policy?

o Monetary policy refers to the measures taken by the Bank of Canada to influence the
economy by regulating the amount of money in circulation
o Fiscal policy (budgetary policy refers to the measures taken by the gov’t to increase or
decrease public spending and taxes.

4. Why doesn’t the Bank of Canada just print enough money to pay off all the national debt?
o Because doing so would reduce the value of our money, raise interest rates, and
undermine the growth of the economy – the exact opposite of our goals
o If the Bank were to print money to repay the national debt or to finance government
programs it would be adding greatly to the amount of money in circulation. This
would encourage people to spend and borrow more, and the economy would receive
a temporary boost. But overall demand for g&s would grow faster than the
economy’s ability ot produce, and this would inevitably lead to higher inflation.

5. Does the Bank of Canada set the “prime rate”?

o No. Financial institutions set their own prime rates based on the cost of short-term
funds, and on competitive pressures among them The Bank influences the cost of
short-term funds by setting the target for the overnight rate.

6. What is the Bank Rate?

o The Bank Rate is the rate at which the Bank of Canada lends funds to financial
institutions. It is set at 0.25 percent above the target for the overnight rate, which is
the Bank’s key policy rate (see below.)

7. What is the target for the overnight rate?

o The target for the overnight rate is the average interest rate that the Bank wants to see
in the marketplace for one-day (or “overnight” loans between financial institutions.
Changes in this rate influence other interest rates, such as those for consumer loans
and mortgages.

8. What is the connection b/w the target for the overnight rate and the Bank Rate?
o The Bank has refined the way it conducts monetary policy over the years. In 1994, it
established an operating band for the overnight rate, and in 1996 it changed the way
it sets the Bank Rate.
o The Bank Rate is now set at the top of the operating band. It is always one-quarter of a
percentage point above the target for the overnight rate, which is at the middle of the
band. The Bank Rate is also the rate at which the Bank will lend money overnight to
the financial institutions that take part in Canada’s most important payments system,
the Large Value Transfer System.
 o The bottom of the operating band is the interest rate the Bank pays on deposits that
financial institutions have with us.
o The Bank always changes the target for the overnight rate, the operating band, and the
Bank Rate at the same time, and by the same amount.

9. Why is the target for the overnight rate the preferred monetary policy indicator?
o The target is the appropriate rates to use when comparing the levels of interest rates
with those of other countries. It corresponds directly to the U.S. Federal Reserve’s
“target for the federal funds rate,” the Bank of England’s two-week “repo rate” and
the minimum bid rate for refinancing operations (the repo rate) at the European
Central Bank.

Session 4 (Time Value of Money):

Canadian Retail Interest Rates:

- Canadian retail interest rates are the rates on “small” deposits.
- Interest on a “deposit” varies.
- Time deposits are locked in
- Savings Deposits can be cashed immediately
- Interest rates vary across institutions
- All deposits are guaranteed by the CDIC (Canadian Deposit Insurance Corporation)
- Rate depends on how badly the institution needs money
- Longer Term rates have a “security”
- “Certificates of deposit” convert deposits in to a contract similar to promissory notes.
- These guaranteed investment certificates (GICs) largely fund fixed term mortgages.
Principles:
- Money or cash is a medium of exchange.
- Money has a time value because it can “normally” be invested today and be worth more
tomorrow.
- The opportunity cost is the value to you of investing elsewhere.
- The required rate of return (k) is the investors opportunity cost and is also known as the
discount rate since it normally reduces future values to their present values
- Discount rates differ across time as the Toronto Star’s data shows

Security and Investment Valuation:

- Investments have different payoffs in terms of cash we call “cash flow”
- We need to adjust for this to determine present value
- In general, there are three adjustments:
- Time Value of Money: Risk free money at future dates are worth less than current
dollars. (Inflation?)
- Risk Value of Money: Highly risky future cash flows are worth less than risk free
amounts.
- Tax Value of Money: Certain types of cash flows are preferentially taxed. We only care
about after tax cash flow, ie the amount we keep.

Simple Interest:
- Simple interest is interest received or paid only on the initial investment (principal)
- 𝑉𝑉𝑉𝑉𝑉(𝑉𝑉𝑉𝑉 𝑉) = 𝑉 + (𝑉 × 𝑉 × 𝑉)
- Ex. $1000 after 3 years at 10%
- Value = 1000 + (3 * 1000 * 0.1)
- Value = 1000 + 300
- Value = $1300

Compound Interest:
- Interest is earned on the principal and on the future interest payments.
- 𝑉𝑉 = 𝑉𝑉(1 + 𝑉)n
- Ex. $1000 after 3 years at 10%
- FV = 1000(1+ 0.1)^3
- FV = $1331
- Albert Einstein Quote
- Compound interest generates an exponential function, but since all the interest is reinvested, you
cannot withdraw anything until the end.𝑉𝑉

Present Value:
- Simply reverses compounding
𝑃𝑃
- 𝑃𝑃 =
(1 + 𝑃)𝑃
- We can use PVIF (Present Value Interest Factor) for the present value of a single sum.
 1
- 𝑉𝑉𝑉𝑉 =
(1+𝑉)𝑉
- We often just use P and F for present and future values

The Four Basic Time Value of Money (TVM) Problems:

- How much will I have in the future?
𝑉
- 𝑉 = 𝑉(1 + 𝑉)
- What’s it worth today?
𝑉
- 𝑉 =
(1 + 𝑉)𝑉
- What rate of return is that?
𝑉 𝑉
- 𝑉 = √ − 1
𝑉
- How long do I have to wait?
𝑉𝑉(𝑉/𝑉)
- 𝑉 =
𝑉𝑉(1 + 𝑉)
- Start with PV formula and rearrange to get the others

Choosing Between Investments: NPV:

- NPV is the incremental benefit (value) of an investment
-
Cost Payoff

Investment A $950 $1210

Investment B $950 $1100

- Are either of them worthwhile at k=10%?

-
A B

Present Value $1000 $909

Cost $950 $950

Net Present Value $50 $-41

- A is better because the net present value is better.

Choosing Between Investments: IRR:

- Solve for rate of return specific for those cash flow, that is called the internal rate of return, or
IRR
 -
A B

Payoff $1210 $1100

Cost $950 $950

Rate of Return 12.85% 7.61%

- You would accept an investment if IRR > k (opportunity cost)

- In this case, 12.85% > 10%, you would invest
- Monetary policy lowers interest rates and hurdle rates to boost investment and spending.

Annuities:
- An annuity is a finite series of equal periodic cash flows
- A perpetuity is an infinite series of equal and periodic cash flows
- An ordinary annuity has cash flows starting at the end of the first period (loans, mortgages)
- An Annuity due has cash flows at the beginning of the period (rent)
𝑉 𝑉 𝑉
- 𝑉 = + ....
1+𝑉 (1 + 𝑉)2 (1 + 𝑉)𝑉

Valuing Annuities:

1 1
𝑉 = 𝑉 [ [1 − ]]
𝑉 (1 + 𝑉)𝑉
𝑉 → ∞ 𝑉(1/𝑉)

Annuities:
- Infinite Annuity
𝑉
- 𝑉𝑉 = [ ]
𝑉
- Finite Annuity
1
𝑉 (1 − )
(1 + 𝑉)𝑉
- 𝑉𝑉𝑉𝑉 =
𝑉
- Subtracts out the value of perpetuity at time t
- Present Value Annuity Factor (PVAF)

Quoted Rates
- What does 12% interest mean if it is compounded semi annually?
- You get 6% after 6 months, and a further 6% at the end of the year.
 - The Effective Annual Rate (EAR) takes in to account the frequency of compounding (m), and
the fact you get some money back earlier to reinvest.
𝑉𝑉 𝑉
- 𝑉𝑉𝑉 = 𝑉 = (1 − ) − 1
𝑉

Growing Perpetuity:
- Assume payments go on forever with inflation (k)
𝑉
- 𝑉 =
𝑉−𝑉
- Inflation protection is very valuable as it increases future cash flows.

Session 5: The Bond Market

Debt Instruments:
- Money Market (Short Term)
- Commercial Paper (CP) / BAs / T Bills
- Loans
- Mainly banks, but also trust and loan companies and insurance companies
- Normally shorter term with a single issuer can be structured like a mortgage or interest
only until maturity (syndicated loan market)
- Basic interest rate is Prime
- Bonds
- Marketable, long term loans
- Traditionally notes 5 year bonds, not anymore
 - Usually issues to many lenders and placed through dealers

Bond Market Participants:

- Issuers (borrowers):
- Government of Canada
- Provinces and municipalities
- Government agencies
- Corporations
- Special Purpose Vehicles
- Non-Residents: “Maple” bond market
- Purchasers (mainly institutional investors):
- Insurance companies
- Pension funds
- Bond mutual investors
- Investment Counselors
- Retail Investors
- Traded in Over The Counter market in large denominations
- Some on TSX, plus TMX group just purchased 40% of Candeal to get deeper in to the bond
business
- If traded, the Trustee (transfer agent) will be responsible for transferring ownership

Bond as a Contract:
- A bond is a legal contract of indebtedness
- The Issuer (aka borrower) owes principal and interest to the purchaser.
- The issuer uses he bond to raise capital and the proceeds are used to help pay for the issuers
business plans.
- Ex, to pay for capital expenditures
- Differs from money market contract in its term to maturity and separate interest payments called
coupons. (aka the cash flows of a bond)
- Recall that money market instruments are sold at a discount of their face value.
- Interest is the cost of “renting” the money as such it is an expense of doing business just like
renting a building or workers time.
- Equity is ownership and payments to equity holders are not tax deductible.
- Canada Revenue Agency (CRA or Revenue Canada) defines a security as debt so that the interest
paid is tax deductible if:
- Interest is compensation for the use or retention of money owed to another
- Interest must be referable to a principal sum
- Interest accrues from day to day.

Bonds:
- Issuers borrow money from investors
- Borrowers are governments or corporations
- Amount borrowed is par or face value of bond
- Characteristics of a bond
 - Two components:
- Principal
- Interest Payments (Coupons)
- Repayment of principal at maturity date
- Interest payments are called coupons, usually fixed for the term of the bond.
- Pay interest semi-annually (north america), or annually (europe)
- Term to maturity > 1 year
- Market price determined by yield to maturity (YTM)

Trustee:
- A trust company acts as a trustee to make sure the terms of the bond are upheld
- Bearer bonds: Coupon is clipped and sent in for payment to the trust company.
- Registered Bonds: Canadian Depository Securities (CDS) holds the global registry and
income can be reported to revenue canada.
- Indenture establish the terms of the bond
- Covenants are clauses within the indenture with restrictions
- Legally a bond is covered under contract law, although there may be some rights under
securities law, so the indenture is critical
- Changing the terms of the indenture usually require ½ or ⅔ majority of the value outstanding.
- The trustee at its discretion or on the request of 25% of the bond holders informs the issuer that
all of the debt is due immediately if the terms are not met. Failure to pay means court action,
bankruptcy.

Bond Indenture:
- Bond issuer: the borrower of funds
- Par, principal or face value: the legal amount owed at maturity usually $1000 but quoted in
$100
- Coupon rate: the annual rate of interest, usually fixed for the life of the bond and paid semi-
annually.
- Nominal Bond is when the coupon is fixed in $ terms
- Inflation Adjusted (real return) bond: pays a coupon as a % of an inflation adjusted
value
- Floating rate: interest floats with a market rte like Prime or yield on BA’s
- Zero Coupon: Long term discount bond, no coupon
- High yield: Non-investment grade or junk bonds with a high yield
- Coupon payment: Dollar value of each coupon
- Coupon payment date: Date at which the interest is paid
- Maturity date: date on which the par value is repaid
- Perpetuals (consols): Bond with no maturity date
- Yield or Yield to Maturity (YTM): The discount rate used to value the bond if held to maturity

Other Indenture Terms: Optionality:

- Optionality: someone has the right to change some terms of the loan.
- Callable bond- borrower can repay before the maturity date by paying a premium
 - Extendable or Retractable Bond: the investor can extend or shorten the maturity date
- Putable bond: the investor can sell it back to the issuer for par value if something
happens to the company
- Convertible bond: a corporate bond than an investor may exchange for shares of the
issuing corporation
- Exchangeable bond: bond that the investor can exchange for something else

Other Indenture Terms: Protective Covenants:

- Positive covenants require the issuer to do something:
- Use proceeds from sales of assets for specified purposes & sell assets only with
permission of bondholders
- Redeem or call the bonds prior to maturity if something bad happens (doomsday call)
- Maintain specified coverage ratios, leverage, working capital
- Maintain assets pledged in good condition
- Provide audited financial information
- Negative Covenants prevent the issuer from doing something bad:
- Paying dividends beyond specified amounts or when specified coverage, liquidity, or
leverage ratios are violated.
- Issuing debt with a prior claim and only a limited amount of new debt with an equal
claim to assets (debt ranking pari passu)

The Yield Curve:

- By auctioning ‘benchmark’ bonds, the Government of Canada is building the yield curve
- The yield curve is made up of the yields for T-Bills and bonds with different terms to
maturity.
- This is the minimum rate of interest that investors will accept for any term to maturity
- With a credit rating of AAA, this is considered to be the risk-free rate
- A key function of the yield curve (aka the government curve) is to serve as a benchmark
for pricing all other bonds or debt that is issued.

Canadian and US bonds make semi-annual interest payments, each equal to half the annual coupon rate
and reflects the clean price without the accrued interest.

Government Bond Pricing:

- Priced in $100, even though par is $1000
- Quoted prices exclude accrued interest
- Accrued interest for GoC bonds is calculated as follows:
- 𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉 = 𝑉𝑉𝑉𝑉𝑉𝑉 /
𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉 𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉𝑉
2( )
𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉 𝑉𝑉𝑉𝑉 𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉 𝑉𝑉𝑉𝑉𝑉𝑉
- Ex. 183 days between interest settlement dates; 100 days since the last payment, on an
8% bond is:
- ($80/2)* 100/183 or $21.86. This is paid in addition to the quoted price
- In Europe bonds are priced including accrued interest, a quote that is referred to as a dirty price.
 - Assuming exactly 6 months until the first interest payment date, a bond is priced by the PV
formula.

Cash Flow Pattern of a Bond:

- The Purchase Price or Market price of a bond is the PV of the cash inflows (coupons and
principal) discounted at the bond's yield-to-maturity.
- The frequency of the coupon payment will depend on market convention.

Calculating the YTM of a bond:

Example, a 2 year bond with a 9.125% coupon selling at $105.18
- Face value f $1000 will be received as principal repayment at maturity
- Semi-annual cash flows are (0.09125 * 1000) / 2= $45.63
- Market price is 105.18% the face value of the bond
- You pay (1.05018)(1000) = $1051.80 today to buy this bond
- Yield to maturity: y is the discount rate that satisfies
45.63 45.63 45.63 45.63
- + (1 + 𝑉)2 + (1 + 𝑉)3 + (1 + 𝑉)4 = 1051.80
(1 + 𝑉)
- In our example, y = 3.165%
- Therefore, YTM = y*2 = 6.33%
- Bond equivalent yield

Interest Rates and bond prices have an inverse relationship

Coupons vs Yield to Maturity (YTM)

- Essentially, a bond “locks in” a particular rate of interest for a period of time.
- Locked-in interest rate is called a coupon which is part of the bond trust indenture and is fixed
over the lifetime of the bond.
- Coupon Rate = Government Benchmark Bond Yield + Credit Spread
- Credit spread is the extra yield required to compensate the investor for the risk of a
particular borrower.
- Since coupon is predetermined based on market conditions at the time of issuance, the bond
price will change as market conditions change over the bonds lifetime.
- Yield to Maturity (YTM) of a bond captures the current market movements and changes daily
with the price of a bond
- Market Movements include:
- Changes in overnight rate (yield ↑ ⇒ price ↓ )
- Changes in demand (demand ↑ ⇒ price ↑ ; yield ↓ )
- Changes in inflation (inflation ↑ ⇒yield ↑ ; price ↓ )
- Changes in riskiness (credit spread ↑ ⇒risk ↑ ; price ↓ )

How much do bond prices fall when interest rates rise?

Bond prices are based on the structure of the cash flows. The price of a bond is the PV of the cash flows
discounted at the current YTM. When interest rates rise, the amount the price falls depends on the coupon
rate and the term to maturity.
- For two bonds with the same term to maturity:
- Higher coupons → less sensitive to change in interest rates (cash flows occur earlier and
can be reinvested)
- Lower coupons → more sensitive to change in interest rates
- For two bonds with the same coupon rate:
- Shorter term-to-maturity → less sensitive to change in interest rates (cash flows occur
earlier and can be reinvested)
- Longer term-to-maturity → more sensitive to change in interest rates

NOTE: Bond prices are INVERSELY related to YTM and POSITIVELY related to the COUPON
RATE.

Trading Bonds and Settlement:

- Two key dates:
- Trade date: when a trade is executed
- Settlement date: when payment is made
- Settlement amount: the total cost, consisting of trade price + accrued interest, to the settlement
date
- Settlement risk: exists because one counterparty may fail to deliver on the terms of a contract
- Settlement dates:
- Treasury Bills: same day as trade
- Government bonds: Trade date + 2 days
- Corporate bonds: trade date + 2 days
- Bank for International Settlements (BIS): recommended shorter periods to reduce risk
- Change to T+2 for bonds implemented in sept 2017

Holding Period or Actual Returns:

- Yield measures the return if the bond is held to maturity
- If the bond is sold beforehand, there is the possibility of a capital gain or loss if interest rates
change.
- Suppose a bond with 10 years to maturity (8% coupon) is held for 6 months and interest rates
decrease from 4.38% to 4% so the price increases from $950 to $1000
- Calculate capital gains and income yield
- The Holding Period Return is the sum of the two.

Fisher Effect: RF = Real Rate + Expected Inflation

Determining Bond Ratings:

- Companies pay to have their bonds rated
- Reduces uncertainty regarding credit risk
 - Limited public market for unrated issues
- Rating agency analysis
- Initial site visit and historical review
- Provisional report sent to company for comment
- Finalize report and rating
- Issuer rating: for general use
- Issue raring: for particular use
- Basic principles
- Stable rating philosophy: see through temporary economic events
- Hierarchy: What is the ranking of the claim on the firm's income and assets?
- Notching of different issues depending on priority

Factors Affecting Bond Credit Ratings:

- Core profitability
- Asset quality
- Strategy and management strength
- Business strength
- Misc issues

Empirical Evidence Regarding Debt Rating as a Predictor of Default:

- The quality of ratings can be assessed by their correlation with future default (predictive power)
- Default rates increase as the DRBS rating goes down - the rating is a good indicator of credit
risk
- Default rates are very low for investment grade bonds
- There is an exponential increase in default risk as credit quality deteriorates
- DRBS modifies ratings over time as the financial condition of the issuer changes

Corporate Credit Spreads

- The credit spread (interest rate differential) between government bonds increases {decreases}
when the economy slows down {speeds up}
- This is because:
- The probability of default increases: is the business generating sufficient cash to pay
bond holders?
- The recovery rate decreases: are prices depressed? (as they usually are in recessions)