ECOS2004, Money and Banking
Tutorial 4
Answer guide
1. Consider the following three hypothetical shapes of the yield curve for government
securities:
a. The yield curve is inverted
b. The yield curve is horizontal
c. The yield curve is U-shaped (downward sloping for the first few years and then
upward sloping thereafter)
How could theory explain the position of each curve? Can you suggest a reason why it is unusual,
historically, to observe a U-shaped yield curve?
Case (a). Recall that the yield curve normally slopes upward, assuming there is a term premium, but
also incorporates expectations of future short-term interest rates. An inverted yield curve could be
explained if the current level of short-term rates exceeds its expected future average by more than
enough to offset the term premium. This might occur if there is some reason for thinking the short-
term policy rate is unusually high; for example if the central bank is responding to temporarily high
inflation or strong business cycle conditions, so the policy rate is currently high but expected to fall in
the future.
Case (b). There are two possible explanations for a horizontal yield curve. One possibility is that there
may be no term premium (hence the expectations theory of the term structure is correct) and the
current short-term rate is equal to its expected future average. This would generate a horizontal yield
curve. An alternative explanation is that there is a term premium, so the yield curve would normally
slope upwards, but the current short-term rate exceeds its expected future average by just enough to
offset the term premium.
Case (c). This would require expectations that the short-term interest rate will fall for a period of time
and then increase over a subsequent future period. It is historically unusual to observe this because
market participants would find it difficult to form well-based expectations a long way into the future.
Typically they will make a judgment about whether the short-term rate is high or low relative to some
normal level, and will expect it to gradually return to normal over a period of time. They don’t have
enough information to form well-based expectations about changes in the direction of movement in
interest rates a long way into the future.
2. Suppose you are an asset manager holding a mix of 10-year bonds and short-term money
market investments. Now you receive a piece of economic news that leads you to expect
future short term interest rates on average to be lower than you previously expected.
Suppose also that 10-year bond yields do not immediately react to this information. In that
situation, how should you adjust your portfolio to optimise your expected returns? Explain
the reason for your answer.
You are starting from a position where you are happy with the mix of investments that you have. If
your revised expectations are correct, the lower than expected future path of short term rates will
eventually become apparent to all market participants, and so 10-year bond yields will fall at some
future point. This means the price of 10-year bonds will rise at that point. If you are confident in this
expectation, you should increase your holdings of 10-year bonds now so that you can make a capital
gain when the price rises in future.
Another (equivalent) way of thinking about it is that one part of your portfolio is currently being
invested in a succession of short-term money market instruments, the other part is invested in 10-
year bonds. The expected yield on the short-term part of the portfolio has fallen, so if 10-year bond
yields are unchanged, the bonds have become relatively more attractive.
3. How does the expectations theory of the term structure explain key aspects of the
behaviour of yield curves? What is the feature that cannot be accounted for by the
expectations theory? Explain why this is the case, and how an alternative theory can
account for this feature.
The expectations theory explains the following key facts:
• Interest rates on bonds of different maturities move up and down together over time – they
are correlated, but not perfectly. The expectations theory can explain this because short term
rates tend to move slowly over time, so when the current short-term rate changes it influences
expected future short-term rates. Example: suppose the policy rate in Australian were
unexpectedly increased to 1 per cent. Most market participants would expect it to stay at least
at that level and probably to rise further from that level over the next 2-3 years. So yields on
bonds of those maturities would rise to reflect that expectation.
• When short-term rates are low, the yield curve is usually upward sloping, and when short-
term rates are high the yield curve is usually inverted. This can be explained by the fact that if
the short-term rate moves to an extreme position (either high or low) it tends to move back
towards its average over time. So when the short-term rate is low it is expected to rise, giving
an upward sloping yield curve. When it is high it is expected to fall, giving an inverted yield
curve.
• This feature also explains why short term rates tend to have a larger range of variation over
medium to long periods of time than long term rates. Mathematically, if we think of long term
rates as averages of short term rates, we can say that averages are less variable than the thing
they are averaging.
• The expectations theory cannot explain why yield curves slope upwards on average. Why?
Because the short-term rate cannot be permanently below its own average. To explain an
upward sloping yield curve there needs to be some investor preference for shorter maturities.
In other words, given a choice between two bonds with equal expected returns, investors
prefer the one with the shorter time to maturity. This in turn means that longer term bonds
have to have higher expected returns than shorter term bonds in order for investors to hold
them. This is what is incorporated in the preferred habitat theory.
4. Suppose the expected yields on 1-year government bonds over the next 10 years are given
by the sequence [1.2, 1.4, 1.8, 2.4, 2.7, 3.3, 3.8, 4.6, 5.1, 5.3] per cent. Suppose also that the
liquidity premium for a bond with maturity of n years is given by:
𝑳𝑷𝒏 = 𝟎. 𝟏(𝒏 − 𝟏)
Calculate (to two decimal places) the yield on a 5-year and a 10-year bond.
5-year bond: The yield will be (average of the first five figures) + 0.1*4 = 1.9 + 0.4 = 2.3 per cent
10-year bond: (Average of the 10 figures) + 0.1*9 = 3.16 + 0.9 = 4.06 per cent
If the preferred habitat theory is correct, what would happen to the slope of the yield curve if the
government decided to issue more of its bonds with 10-year maturities and less with shorter
maturities?
The slope of the yield curve would steepen. Increased supply of 10-year bonds means their price falls
(yield rises). Equivalently, we can say that the relative yield on 10-year bonds has to rise to induce
investors to hold the extra amount that is being supplied.
5. From the RBA web site, look up the value for each of the following as at 30 January 2023:
• Yields on 3-year, 5-year and 10-year Australian government bonds
• Yields on NSW Treasury corporation bonds of the same maturities
What can we learn about interest rate expectations from these comparisons?
What other factors could be affecting the differences between these bond yields?
These figures can be found in the Statistics section of the RBA web site
[Link] . Note that NSW Treasury Corporation bonds are bonds
issued by the NSW government (Treasury Corporation is the government agency that manages this).
Australian government (%) T-Corp (%)
3 year 3.18 3.60
5 year 3.28 3.74
10 year 3.53 4.28
The cash rate as of 30 Jan. 23 is 3.1 per cent. So the amount of upward slope in the risk free yield curve
(10 year Australian government bonds minus the cash rate) is (3.53 – 3.1) per cent, or just over 0.5
per cent.
The following chart shows how this measure of the slope of the yield curve has moved over time (this
was shown in lectures, and can be found in the RBA Chart Pack):
Most of the time over the past 20 years, this figure has been between 0 and 2 per cent, so the ‘normal’
upward slope is about 1 per cent, which is what you would get if the cash rate were not expected to
either rise or fall over the future period. To get a larger than normal upward slope, the cash rate must
be expected to rise in future (which makes sense, given it is so low currently), and to get less than the
normal upward slope, the cash rate must be expected to fall in the future.
The table above shows that yields for NSW T-Corp bonds at these maturities are higher than for
Australian government bonds (by between 42 and 75 basis points). This indicates that in a choice
between Australian and NSW government bonds of equal yield and maturity, investors would prefer
Australian government bonds. NSW government bonds need to have a higher yield than the Australian
government bond of the same maturity to induce investors to hold them. This might be either because
the state government bonds are less liquid or they are perceived to have a higher default risk (or some
combination of the two).
We can also observe that the amount of upward slope in the NSW T-Corp yield curve between 3 and
10 years is larger than for Australian government bonds. So the investor preference for Australian
government bonds is stronger for longer maturities.
Questions 6 – 10 make use of the following assumptions concerning two hypothetical banks. Each
bank has five items on the balance sheet: capital, deposits, reserves, loans and securities.
Bank A
Total assets = $500m
Ratio of capital to assets = 5 per cent
Ratio of reserves to assets = 3 per cent
Ratio of liquid assets to total assets = 12 per cent
Bank B:
Total assets = $400m
Ratio of capital to assets = 8 per cent
Ratio of reserves to assets = 4 per cent
Ratio of liquid assets to total assets = 5 per cent
6. Construct balance sheets for Bank A and Bank B.
Note: Liquid assets = Reserves + Securities
Bank A
Assets Liabilities
Reserves 15 Deposits 475
Securities 45 Capital 25
Loans 440
Total 500 Total 500
Bank B
Assets Liabilities
Reserves 16 Deposits 368
Securities 4 Capital 32
Loans 380
Total 400 Total 400
7. Show the effect on both banks if there is a transfer of customer deposits of $10m from Bank
B to Bank A.
Deposits and Reserves increase by $10m in the receiving bank and fall by $10m in the paying bank.
Note that the balance sheets still have to balance after every transaction.
Bank A
Assets Liabilities
Reserves 15 + 10 = 25 Deposits 475 + 10 = 485
Securities 45 Capital 25
Loans 440
Total 500 + 10 = 510 Total 500 + 10 = 510
Bank B
Assets Liabilities
Reserves 16 – 10 = 6 Deposits 368 – 10 = 358
Securities 4 Capital 32
Loans 380
Total 400 – 10 = 390 Total 400 – 10 = 390
8. If there is a regulation requiring banks to hold reserves equal to at least 2 per cent of their
assets, what action could Bank B take to meet this requirement following the outflow
described in the previous question? If the reserve requirement was 3 per cent of assets,
what additional action might Bank B have to take?
To meet the reserve requirement, Bank B needs reserves of 0.02*390 = $7.8m. It only has reserves
of $6m after the outflow. However, Bank B has $4m of other liquid assets (securities), some of
which could be sold to build up enough reserves to meet the requirement.
If the reserve requirement was 3 per cent of assets, Bank B would need 0.03*390 = $11.7m in
reserves. If it sells all the securities it can lift reserves to $10m but still has a shortfall of $1.7m.
Hence, it would have to take further, more costly, action to meet the requirement. It could:
• Sell some of its loans at a discount to another bank
• Try to borrow funds from another bank (which may be expensive)
• Seek an emergency loan from the central bank (probably at a penalty interest rate)
9. Return to the balance sheets for the two banks as constructed in question 6. Suppose there
is an economic recession which results in both banks experiencing loan defaults equivalent
to 5 per cent of the value of their loans. Show the effects on both balance sheets. If there
was a regulation requiring banks to have capital equal to at least 3 per cent of assets, what
actions would be needed from either bank in this situation?
Bank A
Assets Liabilities
Reserves 15 Deposits 475
Securities 45 Capital 25 – 22 = 3
Loans 440 – 22 = 418
Total 500 – 22 = 478 Total 500 – 22 = 478
Bank B
Assets Liabilities
Reserves 16 Deposits 368
Securities 4 Capital 32 – 19 = 13
Loans 380 – 19 = 361
Total 400 – 19 = 379 Total 400 – 19 = 379
Loan defaults reduce the value of loans on the asset side of the balance sheet. The corresponding
change on the liabilities side is a reduction in Capital.
A minimum capital requirement of 3 per cent of assets would require capital of:
• 0.03*478 = $14.24m for Bank A
• 0.03*379 = $11.37m for Bank B
After incurring these losses Bank B still has sufficient capital to meet the requirement, so no further
action is needed.
Bank A has a significant capital shortfall. It would need to raise additional capital from shareholders
to meet the requirement. The bank is at risk of failing (capital falls below zero) if it incurs further
losses.
10. Based on your answers to questions 6 – 9, which of the two banks started out in a better
position to absorb loan losses and which was in a better position to withstand unexpected
deposit outflows? Why?
Bank B was in a stronger position to absorb loan losses because it had a higher capital ratio.
Bank A was in a stronger position to withstand unexpected deposit outflows. Even though its reserve
ratio was quite low, it had a large amount of other liquid assets (securities) that could be converted
to reserves at short notice if needed. In contrast, Bank B was more vulnerable to the risk of an
unexpected deposit outflow because its total liquid assets ratio was quite low.