Ch 12: Behaviour of the Markets

Question 1

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

Answer 1

1. Conventional government bonds – Inflation risk
2. Corporate bonds – default, inflation, marketability and liquidity risk.
3. Equities – non-payment of dividends, dividend / price volatility, marketability, liquidity and 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 of 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 for the level or riskiness of returns on an asset class

Question 4

List the key economic influences on long-term government bond yields

Answer 4

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 5

List the key economic influences on the equity market

Answer 5

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 6

Fiscal deficit effects on bond yields

Answer 6

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

Question 7

Inflation effects

Answer 7

-Inflation erodes the real value of income and capital
payments on fixed coupon bonds.
-Expectations of a higher rate of inflation are likely to
lead to higher bond yields and vice versa

Question 8

Institutional cashflow effects on bond prices

Answer 8

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

Question 9

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

Answer 9

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

Question 10

List the main theories of the conventional bond yield curve

Answer 10

Expectations Theory
Liquidity Preference Theory
Inflation Risk Premium Theory
Market Segmentation Theory

Question 11

Describe Expectations Theory

Answer 11

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

Question 12

Describe Liquidity Preference Theory

Answer 12

Liquidity preference theory – 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 13

Describe Inflation Risk Premium Theory

Answer 13

Inflation risk premium theory – the yield curve will tend to be more upward sloping / less downward sloping than suggested by pure expectations theory alone because investors need a higher yield to compensate them for holding longer-dated stocks, which are more vulnerable to inflation

Question 14

Describe Market Segmentation Theory

Answer 14

Market segmentation theory – yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.

Question 15

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

Outline three such government policies and the link between them and low short-term interest rates.

Answer 15

1. Economic growth:
   low interest rates => increased consumer and investment 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 16

Explain how expectations of inflation may influence equity prices

Answer 16

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 the 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 government 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 17

List three factors affecting the size of the yield gap between fixed-interest government and corporate bonds

Answer 17

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

Question 18

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

Answer 18

1. Occupational market (demand for property for occupation by businesses)
2. Development cycles (supply of newly completed property developments)
3. Investment market (supply and demand for properties as investments)

Question 19

List the key factors affecting the supply of property

Answer 19

1. Development time (gaining consent and construction) – can be up to five years long
2. Economic growth – but the peak of the property development cycle lags behind the business cycle, often resulting in a surplus of new property as 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 20

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

Answer 20

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 21

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

Answer 21

The investment property market relies to a significant extent on the occupancy market as this provides the rental income and 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 these 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 22

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 22

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 this ratio is high, the number of individuals who can access adequate mortgage funds to make a purchase is restricted, even if interest rates are low

Question 23

List seven examples of factors that may affect investors’ preferences

Answer 23

1. A change in their liabilities
2. A change in the regulators 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