Chapter 12: Behaviour of the markets Flashcards
(28 cards)
State the key risks to which an investor in the following asset classes is exposed:
1. Conventional government bonds
2. Corporate bonds
3. Equities
- Conventional government bonds - inflation risk
- Corporate bonds - default, inflation, marketability and liquidity risk
- Equities - non-payment of dividends, dividend / price volatility, marketability, liquidity and systematic risk (driven by market sentiment)
What is the yield spread?
The premiums for accepting the additional risks of corporate bonds are factored into the market price of the bonds - in particular the spread.
The spread is the difference between the yield on a corporate bond compared with the equivalent government bond.
This leads to a higher expected return on a corporate bond than on a government bond of the same terms.
How is the general level of the market in any asset class determined?
By the interaction of buyers and sellers, i.e. supply and demand.
What are the main factors affecting the demand for any asset class?
- Investors’ expectations for the level of returns on an asset class
- Investors’ expectations for the level of riskiness of returns on an asset class
The main economic influences on short-term interest rates are government policies.
Outline 3 such government policies and the link between them and low short-term interest rates
- Economic growth:
Low real interest rates encourage investment spending by firms and increases the level of consumer spending. Cutting interest rates increases the rate of growth in the short term. - Controlling inflation:
Reducing interest rates encourages the demand for credit from bank customers. The supply of money in circulation increases, which can lead to inflation. - Exchange rate:
If interest rates are low relative to other countries, international investors will be less inclined to deposit money in that country. This decreases demand for the domestic currency and tends to decrease the exchange rate.
Discuss the quantity theory of money
The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services in that economy. If the amount of money in an economy were to double, then price levels would also double, causing inflation.
M x V = P x Y
M is the nominal money supply
V is the velocity of circulation
P is the price
Y is the number of transactions
If V and Y are fixed, then an increase of money in circulation will cause an increase in prices.
What is demand-pull inflation?
Demand-pull inflation refers to a situation in which there is excess demand within the economy so that firms are able to increase their prices. As a consequence, the general level of prices may be pulled up.
What is cost-push inflation?
Cost-push inflation refers to a situation where if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices.
What is quantitative easing and what is its role?
Where short-term interest rates are already close to zero, governments have limited scope to reduce interest rates further. Governments and central banks must then consider other means of influencing the rate of growth in an economy.
An alternative approach is called quantitative easying (QE). QE works as follows:
* The central bank creates money electronically and uses it to buy assets, usually government bonds, from the market
* This purchase of assets directly increases the money supply in the financial system, which encourages banks to lend more and can push interest rates lower.
* The purchase of assets can also reduce the returns on money market assets and bonds reducing the appeal of those asset types.
* Investors may look to rebalance their portfolios by investing in other assets with a higher yield such as equities and property.
Lower interest rates also reduce the cost of borrowing for businesses and households. If businesses use the money to invest and consumers spend more, this can boost the economy.
Stock markets therefore typically respond to news of quantitative easying, with stock markets tending to rise when the central bank announces increased quantitative easing and fall when the central bank announces a contraction in quantitative easing.
What is a yield curve?
A yield curve is a plot of yield against term to redemption. Usually the yield plotted is the gross redemption yield on coupon paying bonds but other yields can be used.
List the main theories of the conventional bond yield curve
LIME
- Liquidity preference theory
- Inflation risk premium theory
- Market segmentation theory
- Expectations theory
Describe Expectations theory
Expectations theory describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for future short-term interest rates.
If we expect future short-term interest rates to fall (rise), then we would expect gross redemption yields to fall (rise) and the yield curve to slope downwards (upwards).
One of the biggest influences on investors’ expectations of future short-term interest rates is the expected level of future inflation.
If inflation is high, the government is likely to force up short-term interest rates in an attempt to reduce future inflation.
Describe Liquidity preference theory
The liquidity preference theory is based on the generally accepted belief that investors prefer liquid assets to illiquid ones.
Investors require a greater return to encourage them to commit funds for a longer period.
Long-dated stocks are less liquid than short-dated stocks, so yields should be higher for long-dated stocks.
According to liquidity preference theory, the yield curve should have a slope greater than that predicted by the pure expectations theory.
Describe Inflation risk premium theory
Investors are interested in achieving a real return. Therefore, they require a higher nominal yield to compensate for the risk that inflation is higher than expected and the real return lower than expected.
Crucially, the uncertainty about future inflation is greater over longer periods. Consequently, the risk premium should be greater for longer-dated stocks to compensate investors for the fact that long-term estimates of inflation are much less certain than short-term estimates.
Under the inflation risk premium theory, the yield curve will tend to slope upwards because investors need a higher yield to compensate them for holding longer-dated stocks which are more vulnerable to inflation risk than shorter-dated stocks.
Describe Market segmentation theory
Market segmentation theory says that yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
The concept is based on the following fundamental ideas:
* Different providers and investors have different needs
* Price is a function of supply and demand, and yields are simply a function of price
* Suppliers will wish to supply investments of different terms, and so will be more active at different terms in the yield curve.
This leads to the market segmentation theory: the yields at different segments of the curve are set by the supply and demand from providers and investors active in that segment.
Theories of the real yield curve
The real yield on an investment is the yield after allowing for inflation.
The real yield curve is the curve or real yields on index-linked bonds against term to maturity
The real yield curve, is also determined by the forces of supply and demand at each maturity duration.
Thus, it can be viewed as being determined by investors’ views on future real yields modified according to market segmentation theory and liquidty preference theory.
The government’s funding policy will also influence the shape of the curve.
List the key economic factors influencing long-term government bond yields
Factors affecting supply:
1. The government’s fiscal deficit and funding policy
Factors affecting demand (expected return and risk):
1. Expectations of future short-term real interest rates
2. Expectations of inflation
3. The inflation risk premium
4. The exchange rate, which affect overseas demand
5. Institutional cashflow, liabilities and investment policy
6. Returns on alternative investments
7. Other economic factors.
List 3 factors affecting the size of the yield gap between fixed-interest government and corporate bonds
- Differences in security
- Differences in marketability and liquidity
- The relative supply of and demand for government and corporate bonds.
List the key economic influences on the equity market
- Expectations of real interest rates and inflation
- Investors’ perceptions of the riskiness of equity investment
- The real level of economic growth in the economy
- Expectations of currency movements
Factors affecting supply:
* The number of rights issues
* Share buy-backs
* Privatisations
Factors affecting demand:
* Changes in tax rules
* Institutional flow of funds
* The attractiveness of alternative investments
Explain how expectations of inflation may influence equity prices.
Equity markets should be relatively indifferent towards high nominal interest rates and high inflation. If the rate of inflation is high, the rate of dividend growth would be expected to increase in line with the return demanded by investors.
Indirect effects of inflation:
* It might be argued that high interest rates and high inflation are unfavourable for strong economic growth, so fears of inflation will have a depressing effect on equity prices.
* Real interest rates are probably more important than nominal interest rates for investors. Investors expecting high inflation may also expect the government to increase real interest rates in response.
* Often a rise in inflation makes the prospects for inflation less certain. Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Nervousness in the bond market might result in an increase in equity investment, as equities should provide a hedge against inflation.
What is the equity risk premium?
The equity risk premium is the additional return that investors require from equity investment to compensate for the risks relative to risk-free rates of return. The equity risk premium fluctuates from time to time, depending on the overall level of confidence of investors and their views on risk.
State the main factors that would lead us to require a higher return from equities than from government bonds
- Greater risk of default
- Lower marketability of equities compared to government bonds
- Greater volatility of income and capital values
In what 3 inter-related areas do economic influences have an impact on the property market?
- Occupation
- Development cycles
- The investment market
List the key economic influences affecting demand in the occupational property market
- Expectations of economic growth: Tenant demand is closely linked to the buoyancy of trading conditions and GDP. Other things being equal, economic growth increases demand for commercial and industrial premises
- Expectations of real interest rates: Lower real interest rates should stimulate economic activity and should therefore have a positive effect on rental and property values.
- Structural changes in demand for property: New patterns of economic activity, domestically and globally, change demand patterns, for example, a trend of firms moving staff out of expensive capital city locations to cheaper areas.
