Chapter 12 Flashcards
Behaviour of the markets (18 cards)
Describe how the risk profile of the principal investment assets affects the market in such assets.
- Assets with the greatest risk have the potential for the greatest long-term returns.
- The extent to which investors seek a matched position depends on their risk appetite, which relates to their level of free capital.
- Fixed-interest government bonds:
▪ Inflation risk. - Corporate bonds:
▪ Default risk.
▪ Marketability risk.
▪ Liquidity risk.
▪ Inflation risk. - Equities:
▪ Default risk.
▪ Marketability risk.
▪ Risk of an uncertain dividend stream.
▪ Contagion risk
How does supply and demand affect prices: (7)
- As demand for an asset rises, so does the price of the asset
- Demand is very price elastic due to close substitutes (a small change in price could lead to large changes in demand)
- increase in supply decreases the price of the asset
- supply will be increased by
-new issue of that asset and be decreased by redemptions
-supply of government bonds is influenced by the fiscal deficit (gov. spending more than the revenue) and the government issuing bonds to cover this deficit
-technology (derivative markets) - What changes demand for an asset class?
-investor’s expectations for the level and riskiness of returns on the asset class
-change in investor preferences
-change in investor income
-change in price alternatives investment
Short-term interest rates are determined largely by government policy, as the government balances:
▪ The need to control inflation.
* low interest rates => increased demand for money, which may
be met by increased supply of money => higher inflation
▪ The need to encourage economic growth.
* low interest rates => increased consumer and investment
spending => economic growth
▪ Management of the level of the exchange rates.
* low interest rates relative to other countries => less investment
from international investors => depreciation of domestic
currency
Effects of weaker domestic currency: (3)
- makes exports more competitive (increase profits, and profits earned in other
countries are more valuable when converted) - makes imports more expensive (bad for corporate profits to the extent that firms
cannot pass higher costs of imported raw materials to customers) - Higher costs of imported materials may lead to inflation, (however, if manufactured
imports are more expensive, the domestic market share should increase)
Indirect effects from inflation:
BONDS
1. high inflation are unfavourable for strong economic growth
2. inflation will have a depressing effect on equity prices.
3. Uncertainty about future inflation would make investors more nervous about fixed interest bonds. Might result in an increase in equity, property, index-linked investments that hedge against inflation
4. high inflation may cause the government to raise real interest rates (to control inflation), which would reduce equity prices.
Cost-push inflation vs demand-pull inflation
Cost-push inflation
-if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices.
-The average price level can be “pushed” up by an increase in costs.
Demand-pull inflation
-there is excess demand with the economy so that firms are able (and more likely) to increase their prices.
-As a consequence, the general level of prices may be pulled up.
The sources of cost-push inflation: (3)
- higher import prices due to a weakening of the domestic currency
- higher import prices for some other reason (e.g. rise in the oil price)
- higher wage demands not met by productivity increases
The 3 effects of printing money:
- bond yields rises
-The increased expectations of inflation will make investors demand higher nominal yields in order to maintain the required level of real yields. - increased expectations of inflation
-quantity theory of money tells us that there is a direct relationship between the money supply and the level of prices. - lower short-term interest rates
-More money in circulation makes more money available for placing on short-term deposit. It is therefore easier for banks to attract deposits. Consequently, they can reduce interest rates on deposits.
The level of the bond market: Theories of the yield curve:
- Expectations theory
-yields reflect expectations of future short-term interest rates ad inflation - Liquidity preference theory
-Investors require an additional yield on less liquid (longer term) bonds. - Inflation risk premium theory
-Investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated. - Market segmentation theory
-Yields at each term are determined by supply and demand at that term. Demand comes principally from institutional investors trying to match liabilities.
Principal economic factors affecting bond yields: (7)
- Inflation
-erodes real value of income and capital
-expectation of higher rate of inflation are likely to lead to higher bond yields - Short term interest rates
- Public sector borrowing - fiscal deficit
-greater supply of bonds, lower prices, increasing bond yields - The exchange rate
- Institutional cashflow
-If institutions have an inflow of funds because of increased levels of savings, they are likely to increase their demand for bonds.
-Changes in investment philosophy can also affect institutional demand for bonds. - Returns on alternative investments, both domestic and overseas
-All investment assets are, to a greater or lesser extent, substitute goods. There is a strong correlation between the prices of different asset classes. - Other economic factors
Main economic influences affecting demand in equity markets:
- Expectations of real interest rates and inflation
-Equity markets should be relatively indifferent to inflation. This is because, if inflation is high, dividend growth would be expected to increase but so would the investor’s required return (or discount rate used to discount the dividends) but experience indirect effects of inflation - Investors’ perception of the riskiness of equity investment.
- The real level of economic growth in the economy.
- Expectations of currency movements.
- Expectations of real economic growth.
- Institutional cashflow, liabilities and investment policy.
- Returns on alternative investments.
-All investment assets are, to a greater or lesser extent, substitute goods. There is a strong correlation between the prices of different asset classes. - Tax
- Political climate
Factors affecting supply in equity markets: (3)
▪ The number of rights issues.
▪ Share buy-backs.
▪ Privatisations.
Influences on investor’s preferences: (7)
▪ A change in their liabilities.
▪ A change in the regulatory or tax regimes
▪ Uncertainty in the political climate.
▪ ‘fashion’ or sentiment altering, sometimes for no discernible reason.
▪ Marketing
▪ Investor education undertaken by the suppliers of a particular asset class.
▪ Sometimes for no discernible reason.
Quantity theory of money (interpretation):
-M x V ≡ P x Y
* M is the nominal money supply
* V is the velocity of circulation
* P is the price level
* Y is the number of transactions
-If we assume that V (velocity of money) and Y (number of transactions) are fixed - as may approximately be true in the short run - then the quantity theory of money suggests that: an increase in the (nominal) money in circulation will cause an increase in prices.
Other influences on the investment markets:
- Demand factors
-investor perception
-investor opinion
-investor cashflows (properties NTCC)
-the price of other assets (price elasticity - substitute goods) - Economic influences affecting demand in the investment property market:
-occupancy market as this provides the rental income and potential for growth
-rent inflation
-real interest rates (lower valuation of future rents)
-institutional cashflow, liabilities and investment policy
-demand from public/private property companies
-the exchange rate, which affects overseas demand
returns on alternative investments
-tax
-political climate - Economic influences affecting demand in the occupational property market
-Expectations of economic growth, buoyancy of trading conditions and employment levels
-Expectations of real interest rates
-Structural changes (e.g. a move to out-of-town working)
List the key factors affecting the supply of property: (5)
▪ Development time (gaining consent and construction) – can be up to
five years long
▪ Economic growth – but the peak of the property development cycle
lags behind the business cycle, often resulting in a surplus of new
property as the economy slows down.
▪ Real interest rates, which affect the cost of borrowing in order to
develop property
▪ Statutory control – local planning authorities may frequently restrict
development
▪ Fixity of location, high transaction costs and segmented markets
In what three inter-related areas do economic influences have an impact on the property market:
▪ Occupational market.
▪ Development cycles.
▪ Investment market.
Inelastic supply of property is caused by:
▪ time required to develop new properties
▪ planning permission rules and the limited physical space in some areas
▪ fixity of location
▪ high transaction costs
▪ segmented markets
