CH11 - Behaviour of the markets

Question 1

Risk profile of asset classes like government bonds, corporate bonds and equities

Answer 1

Assets with the greatest risk have the potential for the greatest long-term returns.

The extent to which investors seek a matched position depends on their risk appetite, which relates to their level of free capital.

• Fixed interest government bonds are exposed to inflation risk
• Corporate bonds are exposed to default, inflation, marketability and liquidity risk
• Equities are exposed to default, marketability, inflation risks and the risk of an uncertain dividend stream.

Question 2

Supply and demand (asset prices)

Answer 2

As demand for an asset rises, the price of the asset will rise.
Demand for most investments is very price elastic due to close substitutes.

Question 3

Interest rates and the government

Answer 3

Short-term interest rates are determined largely by government policy, as the government balances:
1. the need to control inflation
2. the need to encourage economic growth
3. management of the level of the exchange rate
The level of interest rates is usually a little above the rate of inflation

Question 4

What determines the level of the equity market

Answer 4

The level of the equity market is determined by investor’s expectations of future corporate profitability and the value of those profits.

Question 5

Economic influences affecting demand in equity markets (4)

Answer 5

The main economic influences affecting demand in equity markets are:

1. expectations of real interest rates and inflation
2. investors’ perceptions of the riskiness of equity investment
3. the real level of economic growth in the economy
4. expectations of currency movements

Question 6

Factors affecting supply in equity markets (3)

Answer 6

Factors affecting supply in equity markets include:

1. the number of rights issues
2. share-buy backs
3. privatisations

Question 7

Economic factors that can affect the level of the property market (3)

Answer 7

1. Occupation
2. Development cycles
3. The investment market

Interaction between occupational demand and supply determines the market level of rents.
The capital value is determined by the investment markets.

Question 8

Key factors affecting demand of the property markets (3)

Answer 8

Economic factors have a big impact on the property market.

1. Economic growth
2. Inflation
3. Real interest rates

Institutional cashflow and exchange rates are relevant to a lesses degree.

Question 9

Supply of property markets

Answer 9

• The inelastic supply of property, e.g. due to planning restrictions, magnifies the impact of the factors on overall property values.
• Residential property values are driven by supply and demand. Supply can be influenced by government policy.

Question 10

Other influences on the investment markets - Demand factors (2)

Answer 10

Demand for an asset will change if either:

1. Investors’ perceptions of the characteristics of the asset, principally risk and expected return, alter
2. Investors’ opinions of the properties of the asset remain unchanged but external factors alter the demand for that asset. These external factors include:
   - investors’ cashflows
   - investors’ preferences
   - the price of other assets (which may be substitute goods)

Question 11

Other influences on the investment markets - Investors’ preferences are influenced by (7)

Answer 11

1. a change in their liabilities
2. a change in the regulatory or tax regimes
3. uncertainty in the political climate
4. ‘fashion’ or sentiment altering, sometimes for no discernible reason
5. marketing
6. investor education undertaken by the suppliers of a particular asset class
7. sometimes for no discernible reason

Question 12

Other influences on the investment markets - Supply factors (4)

Answer 12

1. An increase / decrease in the supply of an asset will lead to downward / upward pressure on the price of the asset.
2. The supply of a financial asset will be increased by the new issues of that asset and decreased by redemptions
3. Supply of government bonds is influenced by the fiscal deficit and the Government’s strategy for financing the deficit.
4. Supply may also be increased by technological innovation. This is particularly true of derivatives markets.

Question 13

Yield curve theories (4) LIME

Answer 13

The yield curve is a plot of yields against term to redemption. Several theories have been put forward to try and explain the shape of the yield curve.

1. Expectations theory - yields reflect expectations of future short-term interest rates and inflation
2. Liquidity preference theory - investors require an additional yield on less liquid (longer-term) bonds
3. Inflation-risk premium theory - investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated
4. Market segmentation theory - yields at each term are determined by supply and demand at that term. Demand comes principally from institutional investors trying to match liabilities.

Question 14

Real yield curve theories

Answer 14

The real yield curve is a plot of real gross redemption yields on index-linked bonds against term to maturity. The difference between the conventional yield curve and the real yield curve is approximately the market’s expectations of future inflation.

Question 15

Principal economic factors affecting bond yields (7)

Answer 15

1. Inflation
2. Short-term interest rates
3. Public sector borrowing - the fiscal deficit
4. The exchange rate
5. Institutional cashflow
6. Returns on alternative investments
7. Other economic factors

Question 16

Comparison of government and corporate bonds

Answer 16

Economic factors affecting the prospects of company will increase the perceived riskiness of corporate bonds and hence the yield margin of corporate bonds over government bonds.
If government bonds are offering poor returns, some investors may switch to corporate bonds, narrowing the gap in yields between government and corporate bonds.