11 - Behaviour of the markets Flashcards
1
Q
What is the goal of this chapter?
A
To understand how economic factors affect asset prices
2
Q
What are the main market drivers of assets in the economy?
A
- 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
3
Q
Why do interest rates change?
A
- 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
4
Q
How do changes in interest rates affect inflation?
A
- 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
5
Q
How do changes in interest rates affect exchange rates? and what are the knock on effects on businesses?
A
- 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
6
Q
Decision making process for base rates set by central bank:
A
- 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
7
Q
What affects LONG-TERM interest rates?
A
- 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
8
Q
Govt influence on long term interest rates
A
- 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
9
Q
What makes the price of an investment price elastic?
A
- Many alternative close substitutes for the investments
10
Q
Which has primary influence on investment mkts supply or demand?
A
- 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
11
Q
What are the main factors affecting the demand for assets?
A
- 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?
12
Q
Supply, demand and hence the prices of bonds are driven by:
A
- 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
13
Q
How does inflation affect bond prices?
A
- 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
14
Q
Increased inflation expectations might lead to increase in unemployment rates. Why?
A
- 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)
15
Q
How do short-term interest rates affect bond prices?
A
- 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
