Chapter 12 - Behaviour of the markets Flashcards
Discuss the risk profile of government bonds.
Main risk fixed-interest bonds expose investors to is inflation risk
Normally very secure, low risk form of debt
- In developed countries, not necessarily small/developing countries
Cashflows and security make these appropriate for matching annuity payments
Marketability tends to be good as large amounts are issued
Discuss the risk profile of corporate bonds.
Investors exposed to several risks:
- Default risk
- inflation risk
- Marketability risk
- Liquidity risk
Premiums for accepting these risks are factored in to the market price of the bonds and result in a yield spread between corporate and government bonds.
Expected return on corporate bonds is higher than on similar government bonds, but actual return may be lower if risk events occur, e.g. default.
Can reduce/avoid marketability risk by structuring portfolio to match liabilities in a way that bonds can be held to maturity
- Increases value of bonds
- Extra premium for accepting liquidity risk becomes pure reward for investor if held to maturity
Discuss the risk profile of equity markets.
Investors exposed to several risks:
- Default risk
- Marketability risk
- Liquidity risk
- Volatility risk, i.e. size of dividends and capital value
- Contagion risk, i.e. market sentiment can drive share prices instead of actual underlying values of the shares
Equity is a real investment and protects investors from inflation risk in the long run
Contagion risk presents opportunity to buy when shares are low and then sell/keep when they revert to similar levels as prior to contagion event.
Discuss what influences investors’ demand for a certain asset type.
Main factors is investors’ expectations regarding
- level of cashflows (returns)
- riskiness of cashflows (returns)
Expectations reflect a variety of influences, mostly economic
Discuss the affect of changes in short-term interest rates on the economy. (slightly generalised question, just understand effect of changes in interest rates)
Short-term interest rates a usually controlled by the government through the central bank’s intervention in the money markets. Interest rates are directly/indirectly altered to meet policy objective by setting a benchmark rates (repo rate in SA) which will affect interbank lending rates.
Low real interest rates increase demand for investment spending by firms, as well as an increase in the level of consumer spending.
Low real interest rates lead to increased economic growth in the short term.
Reduced interest rates lead to inflation for 3 possible reasons
1) Increased demand for money markets and credit due to low interest rates (see QTM on p.7: M x V = P x Y)
2) Demand-pull inflation
3) Cost push inflation
- Higher import costs due to low interest rates causing weaker exchange rates.
If interest rates are relatively low in one-country compared to others, this may decrease demand for money markets and deposits from overseas investors and weaken the exchange rate.
Discuss factors affecting the level of the bond markets.
Bond yields can change when the following factors change, or expectations of them change:
SHORT-TERM INTEREST RATES
- Related to expectations theory
- If investors expect STIR to fall we would expect the yield of short-term bonds to fall, and vice versa.
- This is due to changes in demand for money market instruments
- Effect on long-term bond is unclear
>Decrease in (expected) STIR would lead to decrease in yields according to expectations theory
>but investors may also expect inflation to rise in the long-run, leading to an increase in yield according to inflation risk premium theory
INFLATION
- Also related to expectations theory
- Government/Central bank have some control over interest rates and will adjust them according to changes in inflation
- Changes in inflation have a knock on effect on STIR, and so a change in (expected) inflation would lead to a change in (expected) STIR would lead to a change in bond yields
- An increase in (expected) inflation usually leads to an increase in (expected) STIR and vice versa
TERM TO MATURITY
- Related to liquidity preference theory and market segmentation theory
- Generally investors prefer liquid assets to illiquid ones
- Long-dated stocks are less liquid than short-dated stocks and so we would expect them to have a higher yield
- Will also be different levels of supply and demand for bonds with different terms to maturity, which will affect the bond yields
INFLATION RISK PREMIUM
- Related to inflation risk premium theory
- Investors are usually concerned with the real return they will receive on an asset
- They will require higher nominal yield (i.e. the IRP) to compensate for the risk that inflation may be larger than expected, assuming liabilities are also real and therefore investors wish to match them appropriately
- This effect will be stronger the longer the term of the bond is, as longer dated bonds are more at risk to increases in inflation
- This does not apply to inflation-linked/index-linked bonds
EXCHANGE RATES
- Related to expectations theory
- Changes in expectations of future movements in the exchange rate will affect demand from overseas investors
- Will also change relative attractiveness of domestic and overseas bonds for local investors
- Relative interest rates of different countries will play a large role in determining the exchange rate
- Changes in inflation may offset changes in exchange rates in the long-run according to purchasing power parity
FISCAL DEFICIT
- Related to market segmentation theory and expectations theory
- Needs of government with regards to meeting future liabilities, as well as the funding policy and the form of government borrowing, will affect the bond yields
- The funding policy is related to the use of borrowing vs printing new money for funding, as well as the form of borrowing
- Funding policy will affect economic factors which will change bond yields according to expectations theory.
- Supply of different types bonds will affect yields according to market segmentation theory
- See also question on p.18
INSTITUTIONAL DEMAND
- Related to market segmentation theory
- Increased levels of institutional free capital will increase demand for bonds
- Changes in regulation can affect institutional demand for bonds
- Changes in investment philosophy can affect institutional demand for bonds
RETURNS ON ALTERNATIVE INVESTMENTS
- Relative attractiveness of alternative investments, both locally and overseas, will influence the demand for bonds and hence the yields offered
- US government bond yields are particularly important, since the vast quantities of bonds offered allows for easy comparison
OTHER ECONOMIC FACTORS
- Any other economic factors which affects inflation or short-term interest rates will influence the level and shape of the yield curve
What is a bond yield curve.
Plot of bond yield against term to bond redemption.
Usually GRY is used but can use others, such as Zero-coupon yields.
Line will be the derived line of best fit based on observable bond yields in the market.
Discuss the factors affecting the yield spread on corporate and government issued bonds.
Main factors influencing yield spread are:
- Differences in marketability risk
- Differences in default risk
Economic factors which affect prospects for corporate profitability are likely to alter the perceived risk of corporate bonds relative to government bonds, and thereby influence the yield spread.
During a recession perceived default risk may be high on corporate bonds, leading to increased yield spreads.
Conversely, yield spread should decrease as economy moves out of recession.
Availability and price of government bonds relative to corporate bonds will affect perception from investors and may lead to increased/decreased relative demand
Discuss the factors influencing the level of equity markets.
PROFITS AND EXPECTATIONS OF PROFITS
- Simple way to value equities is discounted cashflow model
- Would expects dividends, i.e. cashflows, to increase with higher (expected) profits and so would increase the value of equities
EXPECTATIONS OF REAL INTEREST RATES
- Low real interest rates stimulate economic activity, increase corporate profitability and raise the general level of the equity market
- Required rate of return of investors should be lower in this scenario and so present value of cashflows will be higher
- Converse would occur during periods of high (expected) real interest rates
EXPECTATIONS OF INFLATION
- Relatively robust (in a direct sense) to expectation of high inflation and high interest rates, as rate of dividend growth would be expected to increase roughly in line with this
- Indirect effects of inflation will also have an effect:
1) High inflation and interest rates will depress economic growth and therefore equity values
2) May expect high expected inflation to results in high real interest rates, which leads to 1)
3) Uncertainty around inflation will lead to less demand for fixed-interest bonds and more demand for equities and other assets which are real in nature
INVESTORS PERCEPTIONS OF THE RISKINESS OF EQUITIES
- Results in what is known as the equity risk premium
- Additional return required by investors to compensate for the risks relative to the risk-free rates of return
- May include effects from marketability, default and liquidity risks
REAL ECONOMIC GROWTH
- Real dividends would be expected to grow roughly in line with real economic growth
- This would clearly influence the level of equity markets
EXPECTATIONS OF CURRENCY MOVEMENTS
- A weaker domestic currency results in exports being more competitive, and therefore companies that export goods will be expected to increase profits and therefore value of equities
- A weaker domestic currency makes imports more expensive, and will reduce profits of firms who import goods but cannot pass on these costs to consumers without losing significant market share
Apart from these main factors, others include:
(Any factors affecting supply of equities, such as)
- Number of rights issues
- Share buy-backs
- Privatisations
(Any factors affecting demand of equities, such as)
- Changes in taxation rules
- Institutional cashflows and availability of capital
- Attractiveness of alternative investments
Outline how economic factors affect the behaviour of property markets
Economic influences have an impact on three main interrelated areas
- Occupation
- Development cycles
- Investment market
Occupation refers to demand for property for occupation
Development cycle refers to supply of newly completed developments
Investment market refers to supply and demand for properties as investments
An important relationship:
Interaction between occupational demand and supply of property for rent (influenced by development cycle) determines the market level of rent.
The capital value of rented property in investment markets reflects the market level of rent, similar to how dividends influence share values.
Discuss the behaviour of commercial property markets.
FACTORS AFFECTING OCCUPATIONAL DEMAND:
Economic growth
- Higher economic growth leads to increased demand and appreciation in capital values
- Any factors which affect level of economic activity, e.g. real interest rates, will affect occupational demand
- Also affected by stage of the business cycle
> Won’t be the same across all property sectors and geographical locations
Structural changes in demand
- New patterns of economic activity, domestically and globally, change occupational demand (think of examples)
FACTORS AFFECTING DEVELOPMENT CYCLES
- Peak of property development cycle lags behind peak of business cycle due to supply-side lags (takes long to build stuff)
- Supply of property is price inelastic and demand inelastic due to
> Required planning permission
> Fixed location of existing properties
> Segmented markets
> High building costs and associated costs
FACTORS AFFECTING INVESTMENT MARKET
- Also depends on state of occupational demand and development cycles
DCF approach:
Capital value of property = rent * capitalisation factor
- capitalisation factor is combination of discount factors and potential for property growth
- similar to annuity factor
Inflation
- Impacts rental growth
- Rate of rent review will affect how often property value changes due to inflation
Real interest rates (RIR)
- Also affects occupational demand and development cycles which affect investment markets
- Higher RIR Increase discount factors and lowers capital values (unless other method used to value property which does not depend on rent)
Other factors
- High long-term bond yields decrease demand for property and push up long-term property yields.
- Exchange rate will influence demand from overseas investors, especially property in financial centres of cities
Read through effects on residential property on page 28
Any factors affecting supply and demand
- Mortgage rates are very important factor
Discuss other influences on the demand in investment markets.
Two main scenarios influence demand: - Change in investor perception of asset characteristics, such as expected return and risk - External factors change > Investor cashflows/income > Investor preferences > Price of other investment classes
Investor cashflows
- Increased cashflows -> increased demand
- Especially in markets appropriate for investors with tightly specified investment objectives
Investor preferences - Affected by: > Change in liabilities (matching needs) > Regulatory changes (solvency admissions, provisioning requirements) > Tax changes > Political climate > Marketing and education
Price of alternatives
- Depends how good price of assets with similar characteristics (perceived or otherwise) is
Discuss other influences on supply in investment markets
EQUITY MARKETS
- Supply affected by
> rights issues
> privatisations
> new share issues
> buy-backs
- Rights issues/new share issues likely when
> stock market is buoyant (i.e. high demand and ability to raise capital)
> capital required for growth operations (especially if balance sheet is weak)
> Raise capital during a recession
BOND MARKETS
- Supply controlled by
> Strategy for financing fiscal deficit (i.e. bonds or loans from other countries/world bank)
> Redemption of bonds
- Will typically issue more bonds when yields are low
OTHER INVESTMENT MARKETS
- Supply increased by technological innovation
- Also innovative and wide possibility for types of derivatives marketed which increases possibilities for substitution
