12. Behaviour of the markets

Question 1

Reasons for changing interest rates

Answer 1

Controlling

• Economic growth
• Inflation
• Exchange rate

Question 2

Yield curve theories

[LIME]

Answer 2

Liquidity preference
Inflation risk premium
Market segmentation
Expectations theory

Question 3

Liquidity preference

Answer 3

• Investors prefer liquid assets
• Require greater return to hold long-dated stocks
• Yield curve has a greater slope than that of pure expectation theory due to liquidity premium

Question 4

Inflation risk premium

Answer 4

• Investors require higher nominal yield to compensate for inflation
• Yield curve slopes upwards: investors require a higher yield to compensate for longer-term stocks because they are more vulnerable to inflation risk

Question 5

Market segmentation

Answer 5

• AKA habitat theory
• Yields at each term are determined by S+D from investors with liabilities of that term.

Demand:

• Short bonds: Banks and GI
• Long bonds: Pension funds and LI

Supply:
- Depends on fiscal deficit and govt’s financing decisions

Question 6

Expectations theory

Answer 6

• Shape is determined by economic factors derived from market’s expectations for future short-term interest rates.
• A change in shape reflects a change in market view.

Question 7

Theories of real yield curve

[ET modified by MST and LPT]

Answer 7

• Curve of real yields on index-linked bonds against term to maturity
• Determined by forces of D + S
• So, it can be viewed as a reflection on investor’s views on future real yields (ET) …
• … modified according to MST + LPT.
• Govt’s funding policy will also influence the shape.

Question 8

Factors affecting bonds

Answer 8

• Inflation
• Short term interest rates
• Exchange rates
• Public sector borrowing-fiscal deficit

Question 9

Factors affecting equity markets

Answer 9

Main

• Expected real interest rates and inflations
• Investors’ perceptions of risk
• Real level of economic growth
• Expected currency movements

Supply

• Number of rights issues
• Share buy-backs
• Privatisations

Demand
- See other demand factors flashcard

Question 10

Areas in which the economy influences property

Answer 10

Occupation- demand for property occupation
Development cycle- supply of new properties
Investment market- S + D for properties as investments

Question 11

Factors affecting commercial property

Answer 11

Occupation

• Economic growth
• Structural changes in demand

Development cycles
- Takes time to develop&raquo_space;> may be supply-side lags

Investment market

• Inflation
• Real interest rates

Question 12

Factors affecting residential property

Answer 12

• Driven by S+D
• Individuals: Access to mortgage loan is constrained by earnings level
• Investors: Can buy property and rent it out if there’s demand.

Question 13

Negative real yields

Answer 13

• Loose monetary policy
  
  • CB maintaining artificially low short term interest rates, through large scale bond purchases elevating prices (increase demand)
• Extreme economic uncertainty
  
  • Prefer risk free assets at risk of negative real returns
• Excessive demand relative to supply
  
  • Institutional investors being compelled to buy ILB regardless of price
  • State not issuing ILBs regardless of demand