Ch 12: Behavior of the markets

Question 1

State the key risks to which an investor in the following asset classes is exposed:
1) Conventional gov bonds
2) Corporate bonds
3) Equities

Answer 1

1) Conventional gov bonds
- inflation risk

2) Corporate bonds
- default risk
- inflation risk (if the shares are not increasing with inflation)
- marketability risk
- liquidity risk

3)Equities
- Non-payment of dividends
- Dividend or price volatility
- marketability risk
systemic risk (driven by market sentiment)

Question 2

How is the general level of the market in any asset class determined

Answer 2

By the interaction between buyers and sellers,
i.e. supply and demand

Question 3

What are the two main factors affecting the demand for any asset class

Answer 3

1) Investors’ expectations for the level of returns on an asset class
2) Investors’ expectations on the riskiness of returns on an asset class

Question 4

The main economic influences on short-term interest rates are government policies.

Outline 3 such gov policies and the link between them and low short-term interest rates

Answer 4

1) Economic growth:
- Low interest rates -> increased consumer spending -> economic growth

2) Inflation:
- Low interest rates -> increased demand for money, which may be met by increased supply of money -> higher inflation

3)Exchange rate:
- Low interest rates relative to other countries -> less investment from international investors >- depreciation of domestic currency

Question 5

List the main theories off the conventional bond yield curve

Answer 5

LIME

• Liquidity preference theory
• Inflation risk premium theory
• Market segmentation theory
• Expectations theory

Question 6

Describe liquidity preference theory

Answer 6

Investors prefer liquid assets to illiquid ones.

Therefore, investors require a greater return on long-term, less liquid stocks.

This causes the yield curve to be more upward sloping/less downward sloping than suggested by pure expectations theory

Question 7

Describe market segmentation theory

Answer 7

Yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.

Question 8

Explain how the expectations on inflation may influence equity prices

Answer 8

Equity markets should be relatively indifferent to inflation. This is because, if inflation is high, dividend growth would be expected to increase but so would the investor’s required return (or discount rate used to discount dividends).

Indirect effects of inflation:
1) High inflation is often associated with high interest rates, which can be unfavorable for economic growth, which would reduce equity prices.
2) Expectations of high inflation may cause the gov to raise real interest rates (to control inflation), which would reduce equity prices.
3) High inflation may cause greater uncertainty over inflation. This may encourage investors to increase their demand for real assets such as equities, which would increase equity prices.

Question 9

In what 3 inter-related areas do economic influences have an impact on the property market.

Answer 9

1) Occupational market
2) Development cycles
3) Investment market

Question 10

List the key factors affecting the supply of property

Answer 10

1) Development time
- gaining consent and construction can be up to 5 years long
2) Economic growth
- the peak of property development cycle lags behind the business cycle, often resulting in a surplus of new property when the economy slows down
3) Real interest rates, which affect the cost of borrowing in order to develop property
4) Statutory control
- local planning authorities may frequently restrict development
5) Fixity of location, high transaction costs and segmented markets

Question 11

Why can a change in price of alternative investment affect the price of a given investment?

Answer 11

All assets are, to a greater or lesser extent, substitute goods. There is a strong correlation between the prices of different asset groups.

Question 13

Demand elasticity

Answer 13

Demand for most investments are very price elastic due to the existence of close substitutes

Question 14

Fiscal deficit effects on bond yields

Answer 14

If the government’s fiscal deficit is funded by borrowing, the greater the supply of bods is likely to put upward pressure on bond yields, especially at the durations in which the government is concentrating most of its funding.

Question 15

Institutional cashflow effects on bond prices.

Answer 15

• If institutions have an inflow of funds because of increased levels of savings, they are likely to increase their demand for bonds, thus causing an increase in the price of bonds.
• Changes in investment philosophy can also affect institutional demand for bonds.

Question 16

Why does selling Treasury bills increase short-term interest rates?

Answer 16

To sell more treasury bills, the central bank needs to reduce their price.

This increase in their “discount” corresponds to a rise in one of the measures of short-term interest rates. Rates on other money market instruments will move broadly in line.

Question 17

Why does printing money result in lower short-term interest rates?

Answer 17

More money in circulation makes more money available for placing in short-term deposits.
It is therefore easier for banks to attract deposits, and a greater demand for short-term deposits. Consequently, banks will reduce the interest rates on short-term deposits.

Question 18

Why does printing money increase expectations of inflation?

Answer 18

The quantity theory of money tells us that there is a direct relationship between the money supply and the level of prices.

More money chasing the same quantity of goods must cause prices to rise. This printing money increases expectations of inflation

Question 19

Why does printing money cause bond yields to rise?

Answer 19

The increased expectations of inflation will make investors demand higher higher nominal yields in order to maintain the required level of real yields.

Question 20

Demand-pull inflation

Answer 20

Refers to a situation in which there is excess demand with the economy so that firms are able (and more likely) to increase their prices.

As a consequence, the general level of prices may be pulled up.

Question 21

Quantity theory of money: Interpretation

Answer 21

If we assume that V (velocity of money in circulation) and Y (number of transactions) are fixed, as may approximately be true in the short run, then the quantity theory of money suggests that:

An increase in the (nominal) money in circulation will cause an increase in prices

Question 22

Quantity theory of money: Identity

Answer 22

MV = PY

• M is the nominal supply of money
• V is the velocity of circulation
• P is the price level
• Y is the number of transactions

Question 23

3 Possible sources of cost-push inflation

Answer 23

1) Higher import prices due to a weakening domestic currency
2) Higher import prices for some other reason (e.g. higher oil prices due to wars)
3) Higher wage demands not met by productivity increase, and thus needs to increase cost of goods to build in margins for wage increases

Question 24

Cost-push inflation

Answer 24

Refers to a situation if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices. The average price level can be “pushed” up by an increase in costs.

Question 25

Property: Effects of development time lags

Answer 25

Peak of property development cycle does not coincide with the peak of business cycle.
Time lag between gaining consent for property development, and completing the construction on it, frequently results in a substantial amount of supply of stock coming into the market as the economy slows down. A slow down in the economy, coupled with rising real interest rates, is harmful to the property development industry.

Question 26

Investment market

Answer 26

Supply and demand for properties as investments

Question 27

Development cycles

Answer 27

Supply of newly completed property developments

Question 28

Occupation market

Answer 28

Demand for property for occupation by business

Question 29

Effects of a weaker domestic currency

Answer 29

1) Makes exports more competitive (increase profits, and profits earned in other countries/or other currencies are more valuable when converted.
2) Makes imports more expensive (bad for corporate profits to the extent that firms cannot pass higher costs of imported raw materials to customers)
3) Higher costs of imported materials may lead to inflation, however, if manufactured imports are more expensive, the domestic market share should increase

Question 30

3 Indirect effects from inflation

Answer 30

1) It might be argued that high interest rates and high inflation are unfavourable for strong economic growth, so fears of inflation will have a depressing effect on equity prices.
2) Investors expecting high inflation may also expect the government to increase real interest rates in response.
3) Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Might result in an increase in equity investments, as equities should provide a hedge against inflation.

Question 31

Full funding policy

Answer 31

• The government tries to meet the whole of the deficit through borrowing.
• The alternative to full funding is to print money.

Question 32

Inflation effect on bond yield

Answer 32

Inflation erodes the real value of income and capital payments on payments on fixed coupon bonds.

Expectations of a higher rate of inflation are likely to lead to higher bond yields and vice versa

Question 33

Inelastic supply of property is caused by…(5)

Answer 33

1) Time required to develop new properties
2) Planning permission rules and the limited physical space in some areas
3) Fixity of location
4) High transactional costs
5) Segmented markets

Question 34

6 Main factors affecting bond yields

Answer 34

• Inflation
• Short-term interest rates
• Institutional cashflow
• Fiscal deficit
• Exchange rate
• Returns on alternative investments, both domestic and overseas

Question 36

For what asset class has a technical innovation helped increase supply?

Answer 36

Derivatives

Question 37

List 7 examples of factors that may affect investors’ preferences

Answer 37

1) A change in their liabilities
2) A change in the regulation or tax regimes
3) Uncertainty in the political climate
4) “Fashion” or sentiment altering
5) Marketing
6) Education provided by the suppliers of a particular asset class
7) No discernible reason

Question 38

Give an example of how a change in investors’ income can affect the demand for an asset class

Answer 38

Some institutions have tightly specified investment objectives.

For example, if an open ended fund investing in emerging markets receives a large inflow of cash, the managers must invest it in the markets specified in the marketing literature. This can force prices up in the market. The good returns generated might then encourage further investment, setting off a spiral of growth.

Question 39

Outline the additional supply and demand considerations that apply to the residential property market in territories where many owners occupy their own property rather than renting

Answer 39

1) The State can influence the supply through imposing constraints on new development in high demand areas, e.g., through planning restrictions or zonal prohibitions around major cities.
2) Demand can be influenced by the ratio of house prices to earnings levels. If the ratio is high, the number of individuals who can access adequate mortgage funds to make a purchase is restrictive, even if interest rates are low.

Question 40

List the key economic influences affecting demand in the investment property market

Answer 40

The investment property market relies to a significant extent on the occupancy market as this provides the rental income and the potential for growth.

Other factors to consider include:
1) Inflation
- rents should increase broadly in line with inflation, although infrequent rent reviews could lead to inflation eroding rental value.
2) Real interest rates
- as higher real interest rates should lead to lower valuation of future rents
3) Institutional cashflow, liabilities and investment policy
4) Demand from public/private property companies
5) The exchange rate, which affects overseas demand
6) Returns on alternative investments
7) Other economic factors (e.g. tax, political climate)

Question 41

List the key economic influences affecting demand in the occupational property market

Answer 41

1) Expectations of economic growth, buoyancy of trading conditions and employment levels
2) Expectations of real interest rates
3) Structural changes (e.g. a move to out-of-town working)

Question 42

List the key economic influences on the equity market

Answer 42

Factors affecting supply:
1) Relative attractiveness of debt and equity financing
2) Rights issues, buy-backs and privatizations

Factors affecting demand (expected return and risk):
1) Expectations of real economic growth
2) Expectations of real interest rates and inflation
3) Expectations of the equity risk premium
4) The exchange rate, which affects overseas demand
5) Institutional cashflow, liabilities and investment policy
6) Returns on alternative investments
7) Other economic factors (e.g. tax, political climate)

Question 43

Describe expectations theory

Answer 43

The yield curve is determined by economic factors, which drive the market’s expectations for future short-term interest rates.

Question 44

List 3 factors affecting the size of the yield gap between fixed interest gov bonds and corporate bonds

Answer 44

1) Differences in security
2) Differences in marketability and security
3) The relative supply of and demand for gov and corporate bonds.

Question 45

List 3 factors, other than investors’ expectations for the level and riskiness of returns on an asset class, which will cause demand for an asset class to change.

Answer 45

1) A change in the investor’s preferences
2) A change in investor’s income
3) A change in the price of alternative investments

Question 46

Describe inflation risk premium theory

Answer 46

The yield curve will tend to be more upward sloping/less downwards sloping than suggested by pure expectation theory alone because investors need a higher yield to compensate them for holding longer-dated stocks, which are more vulnerable to inflation.

Question 47

List the economic influences on long-term gov bond yields

Answer 47

Factors affecting supply:
1) The government’s fiscal deficit and funding policy

Factors affecting demand (expected return and risk):
1) Expectations of future short-term real interest rates
2) Expectations of inflation
3) The inflation risk premium
4) The exchange rate, which affects overseas demand.
5) Institutional cashflow, liabilities and investment policy.
6) Returns on alternative investments
7) Other economic factors (e.g. tax, political climate)

Question 48

What is the key determinant of short-term gov bond yields?

Answer 48

Short-term gov bond yields are closely related to short-term interest rates because short-term gov bonds and money market instruments are close substitutes.