Assignment No. 1

            Financial Markets and Institutions

              Assignment No. 1

            Marks = 5       

           Due Date for MBA 2nd Semester = November 16, 2009

Note: 

1. The assignment must be done in a group of two students. 

2. Your marks will depend not only on the comprehensiveness , but also on the originality of your work. Similarity between assignments

3.  will lead to cancellation of marks. Copy-paste from the internet or book should also be avoided. 

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The Assignment

Suppose you are working at Muslim Commercial Bank (MCB) as credit officer. Your job is to find the minimum interest rate that your bank will charge from the most credit-worthy customer. This rate is assumed to be sufficient to cover the cost of funds and the bank’s profit. The basis for your minimum interest rate calculations should be the most recent five-years Pakistan investment bonds (PIB) i.e. bonds issued by the government of Pakistan. MCB normally charges four percentage points more than the expected interest rate on PIB with five years of maturity. Moreover, MCB has known over the period of time the liquidity premium in case of credit worthy customers is 1.5%.

Given the above, you are required to find answer to the following questions:

A. Obtain information on government securities (most recent T-bills  and  PIBs ) of various maturities, plot maturities of these securities against their yields and draw a yield curve and then interpret the shape of the yield curve using:

• 1. The Pure Expectations Theory

  2. The Market Segmentation Theory

  3. The Liquidity Premium Theory

  4. Which theory do you think best describes the curve?

B. Given the above information, use the pure expectations theory to calculate and predict interest rates as follows:

• 1. If the one-year interest rate is expected to be the same as the yield curve over the next three years, what interest rate is expected on a two-year bond one year from now?

  2. What interest rate is expected on a three-year bond one year from now?

  3. What relationship do you find between interest rates and maturity?

  4. If investors attach liquidity premiums of 0.5%, 0.75% and 0.85% to the one-, two- and three- year bonds:

     1. What would be the interest rate on a two-year security?

     2. What would be the interest rate on a three-year security?

     3. What is the forward rate for one-year treasury bonds one year from now?

     4. What is the adjusted forward rate for one-year treasury bonds one year out?

C. After describing the current yield curve and forecasting interest rates using both the pure expectations and liquidity premium methods above,

• 1. What is your recommended minimum interest rate for the five-year fixed rate loans?

  2. How would this rate be adjusted for customers that have some credit risk?

     Data for the assignment

Note: The original data source is the website of the State Bank of Pakistan( www.sbp.org.pk ) .