11 - Behaviour of the markets Flashcards
What is the goal of this chapter?
To understand how economic factors affect asset prices
What are the main market drivers of assets in the economy?
- Attractiveness of asset values are linked to the interest rates:
-> Asset returns are calculated as returns on
risk free assets + premium for risk factors eg.
unknown expenses, liquidity, inflation etc. - Interest rates are determined majorly by:
-> Govt. policy ie. setting base rates - Investors’ view on the risk environment (views on specific assets as well as the general economy) :
-> Major determinant of appropriate prices are
acceptable to each investment
-> Supply and demand balance out to set prices
for the investments
Why do interest rates change?
- Government’s primary tool to control the economy is setting SHORT-TERM interest rates. In particular to control:
-> Economic growth
-> To control inflation (demand-pull inflation)
-> Cost of imports by controlling exchange rates
(cost-push inflation) - Govt policy sets the base lending rate for central to commercial bank lending
How do changes in interest rates affect inflation?
- Short-term real interest rate increase => encouragement to save/ discouragement to borrow => reduction in consumer expenditure (demand) => decreased short-term economic growth rate => reduced upward pressure on prices
- Short-term real interest rate decrease => encourages spending/borrowing/general investment => increased short-term economic growth rate => increased upward pressure on general prices
- Notice the LAG between inflation and interest rates
How do changes in interest rates affect exchange rates? and what are the knock on effects on businesses?
- If interest rates are low in a country, investors are less inclined to invest in that country as oppose to others => reduced demand for domestic currency => weakened domestic currency
- Cost-push inflation for importing businesses because foreign goods appear more expensive & prices go up
- This is good for exporting businesses because overseas investors find goods more cheap and affordable
- This can be controlled by increasing interest rates
Decision making process for base rates set by central bank:
- Inflation and levels of economic activity influence base rate decisions:
-> If inflation appears as if it will “take off” base rates
are increased - Mkt. supply & demand validates the rates set (or not) eg. if mkt. still keeps borrowing and inflation increases more, govt. may increase base rates further
- Central bank resets & adjusts if desired outcomes not achieved
What affects LONG-TERM interest rates?
- Mkt. supply & demand of bonds affect the rest of the yield curve (medium & long-term)
- Specific factors include:
–> Inflation long-term expectations
–> Government interventions
–> Risk management by investors eg. pension
schemes
–> Overseas rates, exchange rates
Govt influence on long term interest rates
- Set the price for govt. bonds at each duration
–> They can exercise muscle as dominant bond
supplier - Quantitative easing, buying back gilts, reducing supply
to increase prices - Communication -> announcements for short-term
interest rates over the medium term
What makes the price of an investment price elastic?
- Many alternative close substitutes for the investments
Which has primary influence on investment mkts supply or demand?
- Under most conditions, demand changes more rapidly than supply
-> Sudden change in legislation on how statutory
valuations are done wrt. gilts for instance
-> This could cause a sudden surge in demand for
certain gilts
What are the main factors affecting the demand for assets?
- Riskiness of the asset
- Need for fin. institutions to match liabilities
- Expected investment returns from holding asset
–> Is the increased risk of corp. bonds commensurate
with the added yield over gilts?
Supply, demand and hence the prices of bonds are driven by:
- INFLATION EXPECTATIONS and inflation risk premium
-> A sudden increase in inflation expectation
decreases bond prices => risk of A/L mismatch - SHORT-TERM INTEREST rates BUT this is:
-> Basically uncorrelated with long-term bond yields - BORROWING REQUIREMENTS
-> Private sector - for investment into businesses
-> Public sector - to raise money for public
infrastructure/social welfare - INSTITUTIONAL cashflow (pension schemes matching liab.)
- INTERNATIONAL context
-> Exchange rates
-> Foreign interest rates - Returns on ALTERNATIVE investments eg. property may be particularly cheap
- Any economic VIEWS/ OPINIONS/ NEWS eg. covid
pandemic announcement
How does inflation affect bond prices?
- Investors buy bonds @ price which they expect will have a particular real return over inflation
- If current inflation expectations are higher in future, required yields will be higher @ the longer terms (investors require a particular maintained real return regardless of future inflation)
- Prices change right when the information comes out
- If inflation is higher than expected, demand for certain bonds will reduce because they do not provide required real returns (investors will not buy them).
- Investor views of inflation will have major impact on bond prices & the yield curve
Increased inflation expectations might lead to increase in unemployment rates. Why?
- Increase in inflation expectation => increase in interest rate expectation => savings expected to increase => reduced spending => reduced demand => less need for workers => reduction in wages by layoffs (otherwise company will make losses)
How do short-term interest rates affect bond prices?
- If base-rate increases, the short-term bond prices reduce in response because they are highly correlated with base-rates eg.
- > 1 yr & 2 yr prices highly correlated
- Longer term bonds further down the yield curve however eg. 10 yr are uncorrelated w short-term rates (empirically observed fact)
- Uncorrelated in the sense that 10yr bonds will react to the news, but whether they move up or down will be uncorrelated to the movement of the base rate