12. Behaviour of the markets Flashcards
What are the keys risks that investors are exposed to in conventional GB, CB, equities
- Conventional government bond – inflation risk
- Corporate bond – default risk + inflation risk + marketability + liquidity
- Equities – non-payment of dividends + dividend or price volatility + marketability + liquidity + contagion risk (market collapse)
What are the main factors affecting the demand for an asset class
- Investors’ expectations for the level of returns on an asset class
- Investors’ expectations for the riskness of returns on an asset class
Economic influences on short-term interest rates
Government policies
* Economic growth – Low interest rates lead to increased consumer and investment spending => economic growth
* Exchange rate – Low exchange rates relative to other countries => decreased investment from international investors => depreciation of domestic currency
* Inflation – Low interest rates => increased demand for money, which may be met by increased money supply => Higher inflation
Explain how quantitative easing works (part of short-term rates influences)
- The central bank creates money electronically and uses it to buy assets from the market (usually government bonds)
- This purchase increases money supply which encourages bank lending and can push interest rates lower
- Purchase of assets also reduces the returns on money market and bonds, reducing appeal to those asset types
1. This is because the price of remaining bonds will rise (there are fewer), and so return falls because interest earned on deposits (MM) will be lower
Expalin how quantitative easing can be reversed and what the impact of doing this might be
- Central bank sells the purchased assets back into the market
- AKA Quantitative tightening
- Leads to higher interest rates and lower inflation
What are the 4 main theories of the conventional bond (nominal) yield curve
4
LIME
The yield curve shows the relationship between bond yields (interest rates) and their maturities
- Liquidity preference theory – investors prefer liquid assets to illiquid ones. Investors require higher returns for holding longer dated stocks which are less liquid. Upward sloping yield curve
- Inflation risk premium theory – Yield curve is more upward sloping than suggested by pure expectation theory => investors need to be compensated for holding longer-dated stocks because they are more vulnerable to inflation risk.
- Market segmentation theory – yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
1. Demand: short-term bonds – banks and general insurers, long-term bonds – pension funds and life assurance companies
2. Supply: GB supply depends on fiscal deficit - Expectations theory – the yield curve is determined by economic factors, which drive the market’s expectations for future short-term interest rates.
i. If we expect short-term interest rates to FALL (lower returns on short-term investments expected) then GRY will FALL and yield curve slopes downwards.
ii. When high inflation - expected government to increase ST interest rates => Investors require interest above inflation (real return) => Upward sloping curve
what are the factors affecting real yield curve of index-linked bonds/investment (yield after inflation)
real yield curve is the curve of real yields on index-linked bonds against term to maturity
- liquity preference theory
- expectation that real yields are going to rise due to: (expectation theory modified for market segmentation and liquidity)
1. demand for investments falling in future
2. demand for index-linked stocks in particular falling
3. increase supply of investments (level of borrowing because of government deficit)
4. supply of index-linked stocks increasing (Government no longer sells conventional bonds)
Economic influences on long-term government bond yields
Supply factors
* Fiscal deficit and funding policy
* Relative attractiveness of debt and equity financing
* Rights issues, buybacks, privatisations
Demand factors
* Expectations of future short-term real interest rates
* Expectations on real and economic growth
* Expectations of inflation
* Exchange rate (affecting overseas demand)
* Inflation risk premium
* Institutional cash flow, liabilities and investment policy
* Other economic factors (eg tax, political climate)
* Return on alternative investments.
Economic influences on the equity market
- Relative attractiveness of debt and equity financing
- Rights issues, buy-backs, privatization
- Expectations of real economic growth
- Expectations of real interest rates and inflation
- Expectation of the equity risk premium
- Exchange rate (affecting overseas demand)
- Institutional cashflow, liabilities and investment policy
- Other economic factors (eg tax, political climate)
- Return on alternative investments.
How can expectation of inflation influence equity prices
- Equity Markets are generally relatively indifferent from high inflation and high interest rates
- high inflation→ investors require higher dividends → Investors required return will also increase or adjusted discount rate used to value dividends
- Indirect effects of inflation:
1. High inflation → high interest rates → unfavourable for economic growth
2. Expectation of high inflation rates → government to raise real interest rates → reduce equity prices
3. High inflation → greater uncertainty around inflation → investors increase demand for real assets such as equities -> hence price increases
In what three main inter-related areas do economic influences have an impact on the
property market?
- Occupational market
- Development cycles
- Investment market
What are the key economic influences affecting demand in the occupational property
- E(real interest rates)
- Structural changes => changes work locations
- E(real economic growth + buoyance (flexibility) of trading conditions + employment levels)
Whatt are the key factors affecting the supply of property?
- Developing time=> gaining consent+ construction
- Economic growth=> Peak of the property cycle lags behind the peak of the business cycle=> surplus of property as the economy slows down
- Real interest rates=> cost of borrowing in order to develop property
- Statutory control=> local planning authorities may frequently restrict development
- Fixity of location, high transaction cost + segmented markets
What are the key economic influences affecting demand in the investment property
market?
- Investment property market depends on the occupancy market
- Provides the rental income and potential for growth
- Other factors include:
1. Inflation
2. Real interest rates
3. Institutional cashflow, liabilities and investment principles
4. Demand from public/private property companies
5. Exchange rate=> overseas demand
6. Return on alternative investments
7. Other economic factors
Factors affecting Investors’ preferences
CC MENUS
- Change in their liabilities
- Change in the regulatory or tax regime
- Marketing
- Education provided by the suppliers of a particular assets class
- No discernible reason
- Uncertainty in the political climate
- Sentiment or ‘Fashion’ altering
What additional supply and demand considerations could apply to residential property
market where many owners occupy their own property?
3
- State impose restrictions in high demand areas=> planning restrictions or zonal
prohibitions - Demand influenced by House prices: earning levels
- High ratio=> # of individuals who can access mortgage funds to make a purchase
is restricted even if interest rates are low
What factors influence demand for an asset class?
- Expected return
- Riskiness of the asset
- Investors preferences=> change can cause demand of asset class to change
- Investors income=> change can cause demand of asset class to change
- Price of alternative investments=> change can cause demand of asset class tochange
