How interest rates are determined

Canada has a centralized banking model, thus the Bank of Canada determines the interest rate.
The interest rates are determination by the governments financial onlookers that make an
approach to help guarantee a stable liquidity and prices for the nation. This arrangement is
routinely checked to guarantee that the supply of cash inside the economy is not excessively
large or excessively little.

Canadian Zero-Coupon Bonds 2014

1.3
1.25
Interest-Rate Yield

1.2
1.15
1.1
1.05
1
0.95
0.9
0.85
0.8
3 months

6 months

9 months

1 year

2 year

3 year

Time to Maturity

(Bankofcanada.ca, 2014)

The Yield Curve

The yield curve can let us know a great deal about what financial specialists' desires for interest
rates and whether they expect that the economy is going to be contracting or growing.

The yield curve shows the positive relationship between yield and time to maturity of bonds
(Andersen, 2005). On the x-axis of the graph we plot the time to maturity value and on the y-axis
we plot the corresponding yields.

The Yield Curve slope

The slope of the yield curve gives out important information for the investors and analyst to look
at. Normally, there are three kinds of slopes on the yield curve:

Flat yield curve

Normal yield curve

Inverted yield curve

Flat Yield Curve

It tells us that the Central Bank is going to reduce the interest rates. Normally this happen when
the economy is contracting and the Central Bank cut down interest rates (Anderson, 1996). So
most of the time, a flat curve is a signal for slow economic growth (Haubrich and Dombrosky,
1996).

Normal Yield Curve

A normal yield curve is signal for investors that the Central Bank is going to increase the future
interest rates. Consequently, normal yield curves often pave the way for an economic expansion
(Haubrich and Dombrosky, 1996).

Inverted Yield Curve

This type of curve can be seen when it is believed by investors that the Central Bank is going to
drastically reduce the interest rates. It is mostly seen during a period of recession and Central

Banks have to cut down interest rates drastically. Therefore, it is a good signal for investors that
the economy is heading or is in recession (Cwik, 2005).

Augmented Expectation Theory

The augmented expectation theory states that the yields for different maturities at any point in
time are expected to give the same return. So basically this means that a 3 months yield will have
the same effect for a 6 month yield, if we compound this year's interest rate by next year's
interest rate.

Reading the Yield Curve

The yield curve above is of the Canadian Zero-Coupon Bonds 2014. The yield curve for zerocoupon bonds was generated using pricing data for Government of Canada bonds and treasury
bills (Bankofcanada.ca, 2014).
Zero-Coupon Bond is a bond purchased at a value lower than its face value, with the face value
reimbursed at the time of maturity (Mishkin, 2006).
I used these rates because it includes both the bond rate and T-bills rate. The yield curve is based
on rates of both of these maturities (Bankofcanada.ca, 2014).
In the graph above, I have plotted the average yield curves for zero-coupon bond for periods of 3
months to 3 years, and utilize those to compare the interest rates for the given time periods and to
watch patterns and moves in interest rates.
By looking at the Yield curve we can say that the future rate will increase with time, as it can be
seen that 3-year maturity yield is higher by 0.2 percent which is a significant increase from the
past. The Yield curve has a normal slope which indicates that the economy is stable and will

grow in the future along with the increase in future interest rates. We can see from the yield
curve that interest rate increased significantly for longer maturity bonds especially for 1 year or
longer held maturities.

Reference

Bankofcanada.ca, (2014). Yield Curves for Zero-Coupon Bonds. [online] Available at:
http://www.bankofcanada.ca/rates/interest-rates/bond-yield-curves/ [Accessed 7 Nov.
2014].

Financialpost.com, (2014). Canadian and U.S. Yields. Financial Post. [online] Available
at: http://www.financialpost.com/markets/data/money-yields-can_us.html [Accessed 7
Nov. 2014].

Haubrich, J. and Dombrosky, A. (1996). Predicting Real Growth Using the Yield
Curve. Economic Review, 32.

Anderson, N. (1996). Estimating and interpreting the yield curve. Chichester, Eng.:
Wiley.

Cwik, P. (2005). The Inverted Yield Curve and the Economic Downturn. New
Perspectives on Political Economy, 1(1), pp.1 37.

Andersen, L. (2005). Yield Curve Construction with Tension Splines. SSRN Journal.

Mishkin, F. (2006). The economics of money, banking, and financial markets. Boston:
Pearson/Addison Wesley.