CH:12 Behaviour of the markets

Question 1

What are the main economic variables to consider (5)

Answer 1

• Short-term interest rates
• Economic growth
• Unemployment
• Inflation
• Exchange rates

Question 2

Name and explain the four theories of the yield curve

LIME

Answer 2

1. Liquidity preference theory
* Investors prefer liquid assets to illiquid ones. Long-dated stocks are less liquid than short-dated stocks.
* Therefore, investors require a liquidity risk premium to compensate them for investing in longer-dated stocks
* The yield curve should be more upwards sloping (or less downwards sloping than of the expectation theory alone

2. Inflation risk premium theory
* Yield curve will slope upwards or be less downwards sloping because investors need a higher yield to compensate them for holding longer-dated stocks which are more vulnerable to inflation risk than short-dated stocks

3. Market segmentation theory
* Yields at each term to redemption are determined by supply and demand from investors with liabilities of than term
* Banks and GI influence demand for short-term bonds
* Pension funds and LI influence demand for long-term bonds

4. Expectation theory
* Describes the shape of the yield curve being determined by economic factors, which drive the market’s expectation for future short-term interest rates. * The government uses the short-term interest to influence inflation.
* If short-term interest rates are expected to increase, the yield curve will be upwards sloping

Question 3

What factors influence the demand for assets

Answer 3

• External factors (although investors’ perception of the asset remains unchanged)
• Investor’s income
• Investor’s circumstances (liabilities, tax regime, regulatory regime, political climate, marketing, education, fashion)
• Price of alternative assets
  Investors’ perception of the asset has changed (risk and return)

Question 4

What factors influence the supply of assets

Answer 4

Bonds

Government bonds: supply of gov bonds is determined by the government fiscal deficit and its strategy for financing the deficit
Corporate bonds: supply depends on the need or desire of a company to raise finance and the relative attractiveness of debt to equity financing

Equities
- Supply depends on the number of rights issued, the number of new companies and the number of privatisation of previously state-owned companies

Property
- Supply is relatively inelastic - there may be delays and restrictions on construction

Derivatives
- Supply depends on technological innovation and a greater understanding of reserving and pricing of complex products

Question 5

What are the main reasons for altering interest rates

Answer 5

• controlling economic growth
• controlling inflation
• controlling the exchange rate
• role of quantitive easing

Question 6

How does quantitive easing work

Answer 6

• central bank creates money electronically and uses it to buy assets, usually government bonds from the market
• this purchase of assets directly increase supply of money which encourages banks to lend more and push interest rates lower
• the purchase of assets can also reduce the returns on money market assets and bonds

Question 7

Economic factors influencing bond yields

7

Answer 7

1. inflation
2. short-term interest rates
3. exchange rate
4. public sector borrowing
5. institutional cashflow
6. returns on alternative investment
7. other economic factors

Question 8

What are the factors that influence the general level of the equity market

Answer 8

• expectations of real interest rates and inflation
• investors perceptions of riskiness of equity investment
• real level of economic growth in the economy
• expectations of currency movements
• factors affecting supply
• factors affecting demand

Question 9

What are the factors that influence the level of the property market

Answer 9

• occupation
• development cycle
• investment market