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

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 4

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 5

List the main theories of 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

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 7

Describe Inflation Risk Premium Theory

Answer 7

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 8

Describe Market Segmentation Theory

Answer 8

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

Question 9

Describe Expectations Theory

Answer 9

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

Question 10

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

Answer 10

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

Question 11

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

Answer 11

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 12

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

Answer 12

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

Question 13

List the key economic influences on the equity market

Answer 13

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 14

Explain how expectations of inflation may influence equity prices

Answer 14

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 15

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

Answer 15

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

Question 16

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

Answer 16

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 17

List three 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 17

1. A change in investors’ preferences
2. A change in investors’ income
3. A change in the price of alternative investments

Question 18

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

Answer 18

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 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

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 20

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 21

List seven examples of factors that may affect investors’ preferences

Answer 21

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

Question 22

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

Answer 22

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 target markets. The good returns generated might then encourage further investment, setting off a spiral of growth

Question 23

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

Answer 23

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 24

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

Answer 24

Derivatives

Question 25

6 Main factors affecting bond yield

Answer 25

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

Question 26

How does demand and supply affect price?

What is the demand elasticity for most investments and why?

Answer 26

• Increase demand => Increase price
• Increase supply => Decrease price
• Demand for most investments are very price elastic due to the existence of close substitutes

Question 27

Inelastic supply of property is caused by: (5)

Answer 27

• time required to develop new properties
• planning permission rules and the limited physical space in some areas
• fixity of location
• high transaction costs
• segmented markets

Question 28

Inflation effects on bond yield

Answer 28

-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 29

Fiscal deficit effects on bond yields

Answer 29

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 30

Full funding policy

Answer 30

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

Question 31

Institutional cashflow effects on bond prices

Answer 31

-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 32

3 Indirect effects from inflation

Answer 32

• 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
• Investors expecting high inflation may also expect the government to increase real interest rates in response.
• Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Might result in an increase in equity investment, as equities should provide a hedge against inflation.

Question 33

Effects of a weaker domestic currency

Answer 33

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

Question 34

occupation market

Answer 34

demand for property for occupation by businesses

Question 35

development cycles

Answer 35

supply of newly completed property developments

Question 36

investment market

Answer 36

supply and demand for properties as investments.

Question 37

Property: Effects of Development time lags

Answer 37

Peak of the property development cycle does not coincide with the peak of the business cycle.
time lag between gaining consent for a property development, and completing the construction on it, frequently results in a substantial amount of the 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 38

Cost-push inflation

Answer 38

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 39

3 Possible sources of cost-push inflation

Answer 39

• higher import prices due to a weakening of the domestic currency
• higher import prices for some other reason (eg rise in the oil price)
• higher wage demands not met by productivity increases

Question 40

Quantity theory of money: Identity

Answer 40

M x V ≡ P x Y

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

Question 41

Quantity theory of money: Interpretation

Answer 41

If we assume that V (velocity of money) 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 42

Demand-pull inflation

Answer 42

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 43

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

Answer 43

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 44

Why printing money results in lower short-term interest rates

Answer 44

More money in circulation makes more money available for placing on short-term deposit.
It is therefore easier for banks to attract deposits.
Consequently, they can reduce interest rates on deposits.

Question 45

Why printing money increases expectations of inflation

Answer 45

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.

Question 46

Why printing money causes bond yields to rise.

Answer 46

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