Ch12: Behaviour of the markets

Question 1

Reasons the government may alter short term interest rates (3)

Answer 1

• To control inflation
• To control economic growth
• To control the exchange rate

Question 2

Bond yield curve theories

Answer 2

• Expectations theory
  * Describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for future short-term interest rates
  * I.e. if yield curve changes shape -> reflects change in investor’s view of future short-term interest rates
  * Biggest influence on investor’s expectations is future expected inflation
• Liquidity preference theory
  * Based on the generally accepted belief that investors prefer liquid assets to illiquid ones - investors require greater return to encourage them to commit funds for a longer period
• Inflation risk premium
  * Based on the uncertainty surrounding future expected inflation
  * Greater uncertainty about future inflation over longer periods -> risk premium should be greater for longer-dated stocks
• Market segmentation theory
  * Yields at each term to maturity are determined by supply and demand from investors with liabilities of that term
  * Demand: Short term bonds wanted by banks and general insurers; long term bonds wanted by pension funds and life insurance companies
  * Supply: Influenced by size of fiscal deficit; at certain durations may be cheaper to raise capital

Question 3

Economic factors influencing bond yields (7)

Answer 3

• Inflation
• Short-term interest rates
• Exchange rate
• Fiscal deficit
• Institutional cashflow
• Returns on alternative investments
• other economic factors

Question 4

Factors affecting the level of the equity market

Answer 4

Price = d/(i-g) ; where i = required return = RFR + E[infl] + ERP
Price affected by expectations of:
* Future profits (affects dividends)
* Real interest rates
* Inflation
* Perception of riskiness
* Currency movements -> impact on profits

Factors affecting supply:
* Rights issues
* Share buy-backs
* Privatisations

Factors affecting demand:
* Changes to tax rules
* Institutional flow of funds
* Attractiveness of alternative investments

Question 5

Economic factors affecting the level of the property market

Answer 5

• Occupation market - demand for property for occupation
• Development cycles - supply of newly completed property developments
• Investment markets - Supply and demand for properties as investments

Question 6

Other influences on investor’s demand between investment classes

Answer 6

• Investor’s opinions of characteristics remain unchanged but external factors influence demand:
  * Investor’s cashflows
  * Investor’s preferences
  * Change in liabilities
  * Change in regulatory or tax regimes
  * Uncertainty in political climate
  * Fashion or sentiment altering
  * Marketing
  * Investor education
  * Price of other investment classes
• Investor’s perceptions of the characteristics of the asset - risk and expected return alter.