Financial Markets
To successfully invest $200m of funds into short term securities with the highest possible yield in order to maximise our return on profit. 10% of our funds are required to be invested in the overnight market and 50% should be available over the next 3 months.
To speculate in the market according to interest rate movements over the next 6 months by buying and selling securities in order to achieve maximum profit from interest rate returns.
Due to the fact that we expect interest rates to rise in the next 6 months we plan to invest our money in short term securities such as (30, 60 and 90) day bank bills, as well as overnight cash. Investing short term provides us with the opportunity to benefit from any rises in interest rates when the securities are “rolled over” which will increase the yield of our return. In comparison to long term investment where the interest rate will be fixed and we will not be able to receive additional profit from an interest rate increase.
It is important that we first investigate the market in order to find the deficit economic units which offer the highest bid so we can obtain the maximum return on investment.
While it would be wise to invest most of our money in a corporation or bank which provides the highest bid we should also consider their credit rating in order to minimise the risk of losing our money. We have set a counter party limit of $20m to a corporation or bank with a credit rating below (A but above C) and we plan to increase the limit if the bid or credit rating increases. Similarly we will decrease the limit if the credit rating has decreased as the risk of return has increased. We will also increase our offer to corporations with low credit ratings in order to compensate for the increase in risk.
Once we have successfully invested all our money we will attempt to sell the short term bank bills in order to benefit from the increase in interest rates and maximise the return on the investment.
Our market view is that the Australian economy will expand from its recent slow down causing interest rates to rise over the next 6 months. Even though there has been uncertainty with the US and the current war in Iraq, since interest rates are currently at a 30 year low we are expecting an increase. Interest rate increases are due to two main factors Development of Inflationary expectations and Central Bank action.
Development of inflationary expectations causes suppliers of loanable funds to increase their interest rate as inflation increases in order to maintain the real level of return from the borrower. This is actually a decrease in supply and movement of the supply curve to the left as there is actually less funds supplied at a given level of interest rates. Demand will actually increase as consumers are willing to spend more money now at lower interest rates than purchase later and pay more as the value of their will increase in value.
In our view the Australian economy is currently in the recovery phase of the business cycle and due to this there will be upward pressure for the general price level to increase. Growth in domestic demand as and increase in the consumer price index by .7 supports the expected rise in interest rates. The increase in demand pull inflation will push the economy towards full employment and output increasing current prices. The CPI is currently at 3 percent and is likely to increase due to influences such as increase in oil prices, insurance costs, airfares and the impact of the drought on food prices. Recently we have seen that the drought has caused a price increase in bread, cereal products , fruits and spreads but the full effects has not yet settled and so we expect further increases. Due to the war in Iraq oil prices have risen extremely since December and these costs directly affect the cost of output which would cause a further increase in price of goods and serves. The latest NAB survey shows that businesses are expecting inflation in retail and other final product prices by .4 percent with GDP increasing by .2 percent.
We believe that the RBA will move its interest rates to a moderate contraction period of monetary policy due to non cyclical factors and the recovery phase of the Australian economy. This means that the RBA will sell government bonds in order to reduce the supply of loanable funds. Therefore less money is available at a given level of interest which will cause the supply curve to shift to the left as supply decreases and the new equilibrium level of interest rates has also increased.
The monetary policy is necessary in order for the government to achieve economic growth, price level stability and monitor inflation. Government spending in defence and fact that the $7000 first home owners grant will continue will not prevent the Federal Government in providing a moderately sized surplus budget in order to prevent the economy from expanding at a fast rate. According to the Bureau of statistics credit cards and car loans have increased by 5 percent and loans for investment properties have risen by 14 percent.
Non cyclical factors such as the current increase in oil prices increase in the Australian dollar due to poor outcomes in the US stock market, which will reduce the demand for Australian exports because of price competitiveness and the overall uncertainty with the war in Iraq, would cause an interest rate increase.
At the start of the session we decided to complete our primary objectives as soon as possible. We had to have 10% of our funds in the overnight market and 50% of our funds had to be available within the next 3 months.
Given our prediction of a rise in the general level of interest rates, we invested our funds mainly in overnight cash and 30 day bank bills. This enabled our corporation to reinvest our funds within a short period of time at a higher interest rate if our predictions were correct.
We used the Telerate quotes of the major banks as a guide to the current market yield we should expect to pay. At the beginning of the session we focused our attention on buying $20M bundles of primarily 30 day bank bills and overnight cash at a yield equal to, or slightly better than the going market rate. We also invested 25% of our funds in 150 and 180 day bank bills because we felt it might be dangerous to have all our funds invested in the short term, if interest rates didn’t rise as predicted.
Once we had completed our primary objectives we considered speculating the market.
We attempted to make a profit by means of buying bills while rates are at their high and then selling the bills once rates decreased to benefit from the change in yields.
Our corporation finished the dealing session with a bank balance of $AUD 1,516,154.00 which was very close to our target figure of $0. We managed to adhere to our pre-session strategy very successfully. As planned we were able to invest our funds accordingly. At the close of trade the future value of our position revealed:
Once we had invested the greater proportion of our $200M we considered speculating the market to take advantage of predicted interest rate increases. We tried to sell our bank bills at a lower interest rate for what we bought them for. It was very hard to achieve this as there were only 2 banks and 2 other corporations who seemed to have finished their objectives and were offering us unattractive quotes.
However, we were able to achieve a very small profit through selling 30 day BB’s at yield below that we had previously bought them for.
For example: we bought $20M worth of 30 day BB’s to Bank D at a rate of 4.83% and then later sold $20M worth of the same bills to Bank D at a cost of borrowing of 4.80%, giving us a 3 base spread (or $489 profit). This is the only profit making arbitrage trade we undertook.
Communication and performance amongst the team was generally successful. Responsibilities were divided so that at all times we had two team members on the phones and a third person responsible for entering transactions on The Generator. In order to achieve our goal of investing $200M we broke the task into $20M, $10M and $5M blocks. This enabled the two phone operators to ring around the banks and gain quotes for the desired security and then confer as a to whether to enter into any transactions. If we were ‘hit’ for a quote it was agreed that given that fact that we were in the market to lend our funds, we would quote a reasonable buy and encourage the banks or corporations wanting us to buy their bank bills.
Our dealing team was successful in achieving our primary objective of investing $200M as well as producing a profit in speculating the market. An RBA board meeting next week will determine whether or not our interest rate speculation was correct.