C11 - Behavior of Markets

Question 1

Four main risk of corporate bonds

How are these risks allowed in price

Answer 1

Four main risk of corporate bonds
1. Default
2. Inflation
3. Marketability
4. Liquidity

• Premium for these risks is factored in price
• Spread = CB - Gilt Yield

Question 2

How Corp bond market can help financial product providers to match assets and liabilities

Answer 2

1. Match asset proceeds to a stream of benefit outgo
2. Structure a portfolio of bonds so that the assets can be held to maturity.
3. ‘Buy and hold’ investors retain the marketability and liquidity premium.

Question 3

Example of Contagion risk in equity markets

Answer 3

Event that lead to to fall in one market (US ) can trigger immediate fall in other markets, despite having no direct impact in other countries.

Question 4

What determines the level of prices for an asset class?

Answer 4

-Determined by the interaction of buyers(demand) and sellers(supply).
- Rise in demand - > Rise in price
-Factor affecting Demand: Investor’s expectation for the level and riskiness of return

Question 5

Main factors affecting short term interest rates

Answer 5

• Controlled by the govt through central bank’s intervention in the money market
• Govt sets interest rates to meet its policy objectives

Question 6

Describe the effects of low short term interest rates

Answer 6

Low real interest rates:
+ Encourage Investment spending by firms
+ Increase the level of consumer spending
+ Increases the rate of growth in short term
- Decrease deposit by international investors
- Decrease in demand for domestic currency
- Decrease in Exchange rates

Inflation – low interest rates => increased demand for money, which may be met by increased money supply => higher inflation

Question 7

Quantity Theory of money

Answer 7

Quantity Theory of money: If the amount of money in the economy were to double, then level of prices would also double, causing inflation

Question 8

4 theories used to explain the shape of yield curve
1. Expectation Theory
2. Liquidity preference theory
3. Inflation Risk premium theory
4. Market Segmentation theory

Answer 8

1. Expectation Theory: Shape of the YC is determined by economic factors, which drives the market expectation of short term interest rates
2. Liquidity preference theory:
   - Investors prefer liquid assets to illiquid ones
   - Investors require greater return to commit fund for longer period
   - Long-dated stock are less liquid than short-dated stocks, so yields should be higher for long dated stocks
   - YC should have a slope greater than that predicted by the pure expectation theory
3. Inflation Risk premium theory:
   - YC will tend to slope upwards
   - Longer dated stocks more vulnerable to inflation
   - Investor need a higher return to compensate them for holding longer-dated stocks
4. Market Segmentation theory
   - Yield at each term to redemption are determined by supply and demand by investors with liability of that term
   - Demand: Short (bank and GI), Long (Pen funds and LI)
   - Supply: Fiscal deficit

Question 9

What is a real YC?

Answer 9

Reach Yield Curve: Curve of real yields on index linked bonds against term to maturity

Question 10

What factors influence shape of real YC?

Answer 10

Factors influencing shape of real YC?
1. Supply and demand at each maturity duration
2. Investors’ views on future real yields modified according to market segmentation theory and liquidity preference theory
3. Government funding policy

Question 11

Economic factors influencing bond Yields

Answer 11

Economic factors influencing bond Yields
Supply
Government fiscal deficit
Government funding policy
Demand
Expectations of future short- term interest rates
Expectation of inflation
Expectation of inflation risk premium
Institutional cashflow, liabilities and investment policy
Exchange rate – affects overseas demand
Returns on alternative investments
Other economic factors (e.g. tax, political climate)

Question 12

Factors affecting gap b/w Govt and corp bond yield

Answer 12

Yield gap affected by:
Differences in security
Differences in marketability
Relative supply of government and corporate bonds
Economic factors that affect profitability

Question 13

Factors Affecting Level of the Equity Market

Answer 13

Supply
Relative attractiveness of debt and equity financing
Rights issues
Buy-backs
Privatisations

Demand
Expectations of real economic growth
Expectation of real interest rates
Expectation of inflation
Expectation of equity risk premium (Riskiness)
Institutional cashflow, liabilities and investment policy
Exchange rate – affects overseas demand
Returns on alternative investments
Other economic factors (e.g. tax, political climate)

Question 14

Influence of inflation on equity market

Answer 14

• Equity markets should be relatively indifferent to inflation
• If inflation is high, dividend growth would be expected to increase but so would investor’s required return
• Indirect effects on inflation include:
  >High inflation is often associated with high interest rates, which can be unfavourable for economic growth
  >Expectations of high inflation may cause the Government to raise real interest rates to control inflation
  >High inflation may cause greater uncertainty over inflation – may encourage investors to increase demand for real investments such as equities

Question 15

How will currency movements affect equity markets

Answer 15

-Exports more competitive
-Import more expensive

Question 16

Impact of economic influences of property market

Answer 16

Economic influences have impact on property market in three inter-related areas:
1. Occupation Market (Demand)
2. Development cycles (Supply)
3. Investment market

The interaction between the occupational demand and the supply for property for rent determines the market level of rents.
Capital value of rented property is determined by the investment market.

Question 17

Link between economic growth and tenant demand for property

Answer 17

• Economic growth increases the demand for commercial and industrial premises
• Impact will not be uniform across the different property sectors or regions
• Factors affecting economic growth will affect demand:
  Real Int Rates
  Inflation
  Employment in service sector
  New pattern of economic activity: Move out staff from expensive location, WFH.

Question 18

Explain the factors that affect the supply of property over the business cycle

Answer 18

-Development time (gaining consent and construction) can be up to five years long
- Economic growth – but the peak of the property development cycle lags behind peak of the business cycle, often resulting in a glut of new property as the economy slows down
- Real interest rates, which affect the cost of borrowing in order to develop property
- Statutory control – local planning authorities may frequently restrict development
- Fixity of location, high transaction costs and segmented markets

Question 19

Economic and other influences on property investment market.

Answer 19

Supply
Relies on occupancy market as this provides rental income and potential for rental growth

Demand
- Inflation: Good hedge against inflation, (in)frequent rent review.
- Real interest rates: High Int rate-> Lower valuation of future rents and lower capital value of property.
- Institutional cashflow, liabilities and investment policy
- Exchange rate – affects overseas demand
- Returns on alternative investments
- Other economic factors (e.g. tax, political climate)

Question 20

How can state influence the supply of residential property

Answer 20

Residential property values are entirely driven by supply and demand

State can influence the supply of residential property by:
1. Decrease :Constraints on development through planning restrictions or zonal prohibitions
2. Increase supply: By acquiring land and selling to developers

Question 21

What factors restrict demand of residential property

Answer 21

• High house prices compared to earning level

Question 22

How rental demand can affect the value of residential property?

Answer 22

1. Low demand to buy property may decrease prices.
2. However, if int rates are low, investor buy residential property to rent out.
3. The demand from investor may stabilise or increase the property value.

Question 23

What three factors cause the demand of asset to change

Answer 23

Factors causing a change in demand for an asset class

• A change in investors’ preferences
• A change in investors’ income
• A change in the price of alternative investments

Question 24

Effect of institutional investors income on demand of assets

Answer 24

Changes in investors’ incomes
- Some institutions have tightly specified investment objectives
- For example, if open-ended mutual funds investing in emerging markets receive a large inflow of cash they must invest it in the markets specified in their marketing literature. This can force up prices in the target markets. The good returns generated might then encourage further investment, setting off a spiral of growth.

Question 25

Seven factors that can affect investor’s preference for different asset classes.

Answer 25

Factors affecting investors’ preferences , NARUL ME (54231 67)
1. A change in their liabilities
2. A change in the regulatory or tax regimes
3. Uncertainty in the political climate
4. ‘Fashion’ or sentiment altering
5. Sometimes no discernible reason
6. Marketing
7. Education undertaken by the suppliers of a particular asset class

Question 26

How are the prices of alternate investment related?

Answer 26

Price of alternative investments
- All investment assets are, to a greater or lesser extent, substitute goods.
- There is a strong correlation between prices of different asset classes.

Question 27

Factors affect supply of assets

Answer 27

1. Equity Markets (rights issues, privatisations)
2. Bond Markets (govt fiscal deficit and strategy for financing)
3. Other Investment Markets (technological innovation, ex. Derivatives)