Behavior Of The Markets Flashcards
Risk profile of asset classes
Assets with the greatest risk have the potential for the greatest long-term returns
The extent to which investors seek a matched position depends on their risk appetite, which relates to their level of free assets
Fixed-interest government bonds are exposed to inflation risk
Corporate bonds are exposed to default, inflation, marketability and liquidity risk
Equities are exposed to default, marketability, inflation risks and risk of an uncertain dividend stream
Supply and demand
As demand for an asset increases, price of that asset will rise
Demand for most investments are very price elastic - as price goes down, demand goes up
Interest rates
Short-term interest rates are determined largely by government policy, as government balances:
The need to control inflation
The need to encourage economic growth
Management of the level of the exchange rates
The level of interest rates is usually a little above the rate of inflation
Theories affecting the yield curve (plot of yields against term to redemption)
Expectations theory - yields reflect expectations of future short-term interest rates and inflation
Liquidity preference theory - investors require an additional yield in less liquid (longer-term) bonds
Inflation risk premium theory - investors require an additional yield in longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated (doesn’t apply to index-linked bonds)
Market segmentation theory - yields at each term are determined by supply and demand at that term. Demand comes principally from institutional investors trying to match liabilities
Theories of the real yield curve
Real yield curve: a plot of real redemption yields on index-linked bonds against term to maturity.
The difference between the conventional yield curve and the real yield curve is approximately the market’s expectation of future inflation
Principal economic factors affecting bond yields
Inflation
Short-term interest rates
Public sector borrowing - the fiscal deficit
The exchange rate
Institutional cashflow
Returns on alternative investments
Other economic factors
Government and corporate bond yields
Economic factors affecting the prospects of a company will increase the perceived riskiness of corporate bonds and hence the yield margin of corporate bonds over government bonds
If government bonds are offering poor returns, some investors may switch to corporate bonds, narrowing the gap in yields between government and corporate bonds
Level of the equity market
The general level of the equity market is determined by investors’ expectations of future corporate profitability and the value of those profits
Main economic influences affect demand in equity markets:
Expectation 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 in equity markets:
The number of rights issues
Share buy-backs
Privatizations
Factors influencing investors’ preferences
A change in their liabilities
A change in the regulatory or tax regimes
Uncertainty in the political climate
“Fashion” or sentiment altering, sometimes for no discernible reason
Marketing
Investor education undertaken by the suppliers of a particular asset class
Sometimes for no discernible reason
Supply factors
An increase/decrease in the supply of an asset will lead to downward/upward pressure in the price of the asset
The supply of a financial asset will be increased by new issues of that asset and decreased by redemptions
Supply of government bonds is influenced by the fiscal deficit and the government’s strategy to financing the debt (which bind to sell)
Supply may also be increased by technological innovation. This is particularly true of the derivatives market
Demand factors
Demand for an asset changes if:
Investors’ perceptions of the characteristics of the asset, principally risk and expected return, alter
Investors’ opinions of the properties of the asset remain unchanged but external factors alert the demand for that asset. These external factors include:
Investors’ cashflows
Investors’ preferences
The price of other assets (which may be substitute goods)
