CH 12: Behaviour of the markets Flashcards
Risk profiles
2,3,3
Gov Bonds:
* Low risk, good marketability used for matching.
* Exposed to inflation risk
Corporate Bonds:
* Exposed to default, inflation,marketability, liquidity risk
* Reflected in the spread in yields
* Buy and hold strategy: retain extra risk premiums for marketability and liquidity.
Increase the overall value
Equities:
* Exposed to default,marketability, liquidity, systemic risk
* Protected from inflation
* Contagion risk: driven by market sentiment
Supply and Demand
4
- Level of all markets are determined by S&D, main method of price altering
- Demand is elastic due to close substitutes
Price of A + over similar B ~> +demand for B - Price of similar securities stay close
Small + price ~> Large + Demand
Large + Supply ~> small - price - Expectation of risk main factor change demand
Factors affecting Short term rates
1,4
- Central bank sets benchmark rate that it lends @. eg Prime rate~> all othe rates are linked to this.
Main reasons for changing rates:
* Economic growth:
low interest rates => increased consumer spending => + economic growth
* Inflation:
low interest rates => increased demand for credit, which may be met by increased supply of money => higher inflation
* Exchange rate:
low interest rates relative to other countries => less investment from international investors => depreciation of domestic currency
* Quantitative easing:
Decr ST rate to promote economic growth
CB buys bonds(created money), incre money supply,incr lending banks, decr ST rate
EEIQ
Main factors affecting bond yield
6
- Inflation
- Short-term interest rates
- Institutional cashflow
- fiscal Deficit
- Exchange rate
- Returns on alternative investments, both domestic and overseas
List the main theories of the conventional bond yield curve
4
Liquidity Preference Theory
Inflation Risk Premium Theory
Market Segmentation Theory
Expectations Theory
LIME
Describe Liquidity Preference Theory
3
- 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. (slope is greater)
Describe Inflation Risk Premium Theory
2
- Investors want real returns and req higher nomianl yields to compensate for inflation risk in longer term.( higher than expected)
- 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.
Describe Market Segmentation Theory
3
- Market segmentation theory – yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
- Demand:
ST bonds bought by banks
LT bonds bought by insurance/ pension comp - Supply: Gov bonds affected by demand @ certain durations
Describe Expectations Theory
4
- Expectations theory – the yield curve is determined by economic factors, which drive the market’s expectations for future short-term interest rates.
- Yield curve changes shape represent change of investors view on ST rate
- Inflation main factor in expectation of ST rate
High inflation~> Gov incr ST rate to reduce it. opp true - Upward slope on yield curve indicates expect inflation to incr in future
Theories of real yield curve
2
- Det by investors views on future real yields (expectations) modified according to mkt seg and liq pref
- Inflation risk theory not relevant as index linked bonds
What is the key determinant of short-term government bond yields?
1
- 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.
List the key economic influences on long-term government bond yields
1,7
Factors affecting supply:
1. The government’s fiscal deficit and funding policy
Factors affecting demand (expected return and risk):
- Expectations of future short-term real interest rates
- Expectations of inflation
- The inflation risk premium
- The exchange rate, which affects overseas demand
- Institutional cashflow, liabilities and investment policy
- Returns on alternative investments
- Other economic factors (e.g. tax, political climate)
Fiscal deficit effects on bond yields
1,1
Fiscal deficit is funded by borrowing:
* greater supply of bonds => puts upward pressure on bond yields, especially at the durations in which the government is concentrating most of its funding.
Fiscal deficit fully funded:
* Aims to fund entire deficit by borrowing (no printing money)
Supply of bonds
Short-term interest rate effects on bond yields
2,2
ST:
* Yields on short-term bonds are closely related to returns on money market instruments (substitues)
* So a reduction in short-term interest rates will incr prices of short bonds=> decr prices
LT:
* Decr in ST rates (monetary easing with potentially inflationary consequences over the longer term). so revise LT rate expectation upwards to account for inflation
* OR Decr ST => Decr LT
Inflation effects on bond yield
- 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 (inflation risk premium)
