Solutions 1
Suggested for Tutorial 10
Please note that following suggested solutions are only very basic points and you need (b)
1. (b) Explain why the Commonwealth government issues Treasury bonds into the capital
markets. In your answer, discuss Treasury-bond-related issues of fiscal policy and economic
activity.
all governments need to fund their capital expenditure programs
fiscal policy relates to the annual incomes and expenditures of a government
if government income, from taxes and other sources, exceeds forecast expenditures the budget is
said to be in surplus; if expenditures exceed income the budget is in deficit
accumulated deficits need to be funded through the issue of Treasury bonds
fiscal policy impacts economic activity, investment and the business cycle
changes in budget outcomes affect interest rates, exchange rates, and the flow of funds within the
markets as government demand for debt funding fluctuates
when the government deficit is high, the government demand for debt funding will reduce the
amount of funds available for investment in the business sector and therefore limit growth within
the economy: this is the so called crowding-out effect
The current government policy of budget surpluses and government debt reduction has introduced an
unusual situation into the markets:
there was concern that the reduced supply of government securities may result in there not being
an adequate quantity of the paper to meet the markets demands
to resolve this situation, the government maintains a debt issuance program in Treasury bonds
this program will ensure there are sufficient Treasury bonds on issue to maintain a liquid market
the current global sub-prime/credit/economic crisis may result in the Australian government
returning to a period of budget deficits, thereby issuing more Treasury bonds
3. (a) Within the capital markets, who are the main investors in Commonwealth government
securities?
commercial banks
insurance offices
funds managers
Reserve Bank of Australia
other central banks
overseas institutional investors
(b) From the perspective of a commercial bank, discuss why a bank holds CGS in its
investment portfolio.
government securities represent highly liquid assets that a bank can hold as part of its liquidity
management strategies. For example, a bank will have surplus funds to invest for a period before
it will need to sell the securities to provide funds for lending. An active secondary market in
government securities facilitates this strategy
2
banks will typically hold a percentage of their investments in government securities. These
securities provide a lower yield, but also assist the bank to balance the overall level of risk
associated with the loan portfolio. For example, the level of overall default risk will be lower if
government securities are held within the loan portfolio
government securities are held by participants in the payments system in order to generate
exchange settlement account funds through repurchase agreements with the central bank
the prudential regulator requires banks to ensure they implement appropriate liquidity
management strategies. These strategies will generally include holding government securities
within a banks securities portfolio
5. The Commonwealth government has announced a $500 million Treasury bond issue by
competitive tender. The ten-year bonds have a fixed coupon of 6.50 per cent per annum.
The Reserve Bank plans to take $100 million of the allocation and the remaining $400
million be will allocated according to bids received. The following bids are received:
Bank A $150 million Yield 6.75% p.a.
Bank B $150 million Yield 6.70% p.a.
Bank C $175 million Yield 6.80% p.a.
Bank D $250 million Yield 6.50% p.a.
Bank E $100 million Yield 8.50% p.a.
Allocate the competitive bids. At what yield will the Reserve Bank obtain its $100 million
allocation?
Bid
D
B
A
C
E
Reserve Bank
(weighted average yield)
Total
Yield
(% p.a.)
6.50
6.70
6.75
6.80
8.50
6.58
Competitive
bids
($ millions)
250
150
150
175
100
Competitive
allotment
($ millions)
250
150
nil
nil
nil
Reserve Bank
allotment
($ millions)
100
825
400
100
6. You are considering the purchase of a Treasury bond in the secondary market. Bonds with
exactly five years to maturity, paying a half-yearly coupon of 12 per cent per annum, are
currently yielding 10 per cent per annum. You wish to purchase a bond with a face value at
maturity of $1 million.
(a) What price should you pay for the bond today? (Note: the previous coupon has been paid
today to the present holder of the bond.)
1 1 i n
n
P C
A1 i
i
3
1 1 0.05 10
10
P 60 000
1 000 0001 0.05
0.05
$463 304 .10 $613 913 .25
$1 077 217 .35
(b) What will happen to the price of the bond today if the current yield immediately falls to 9
per cent per annum? Show your calculations.
the price of the bond will increase as current market rates have fallen further to 9% per annum,
whereas the bond continues to pay the fixed coupon at 12% per annum
1 1 0.045 10
10
P 60 000
1 000 0001 0.045
0.045
$474 763 .09 $643 927 .68
$1118 690.77
12. (b) The Reserve Bank seeks to implement monetary policy by influencing the level of
interest rates through its open market operations. Describe the process whereby the
Reserve Bank may seek to increase the level of interest rates.
the Reserve Bank uses its market operations to manage the overall supply of cash to the money
markets in order to keep the overnight cash rate consistent with the desired stance of monetary
policy
market operations are conducted primarily in Commonwealth government securities (CGS)
the financial system comprises financial institutions, instruments and markets through which
there is a continuous flow of funds (cash). The Reserve Bank stands outside the system and is
able to use its market operations to change the amount of cash flowing through the system
if the Reserve Bank decides to put upward pressure on interest rates then it will sell CGS to
participants in the financial system
sales of CGS reduce the supply of cash to the money market as participants need to pay cash to
purchase the CGS from the Reserve Bank
the Reserve Bank takes the cash and holds it outside the financial system
a reduction in the money supply will place an upward pressure on the overnight cash rate to a
level targeted by the Reserve Bank
to conduct these operations the Reserve Bank holds a portfolio of CGS
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