Chapter 12: Behavior of the market Flashcards
What are the key risks that investors are exposed to for the following asset classes?
Conventional government bonds
Corporate bonds
Equities
a> Conventional Government bonds - inflation risk
b> Corporate bonds - default risk, inflation, marketability, liquidity
c) Equities
1> Default - non-payment of dividends
- Dividend or price volatility
- marketability
- liquidity risk
- risk of uncertain dividend stream
- Resale price
- Contagion risk - driven by market sentiments
How is the general level of the market of an asset class determined?
> General level of all markets is determined by the Interaction of buyers and seller
Altering price of supply and demand
What are the two main factors affecting the demand for an asset class?
0> Demand of most investments is very price elastic because of existence of close substitutes
1> Investors expectations for the level of returns on an asset class
2> Investors expectations for the riskiness of returns on asset class
What are the main influences on short term interest rates?
Short term rates are largely influenced 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 exchange rates
What are three government policies and what is the link between them and low short-term interest rates?
- Controlling economic growth
- Low interest rates => Increased consumer + investment spending => economic growth - Controlling inflation
- lower interest rates => increased demand for credit; banks increase money supply => higher inflation
Quantity theory of money - There is a direct relationship between the quantity of money in an economy and the level of prices of goods and services in that economy
- Controlling the exchange rate
- lower interest rates relative to other countries => less investment from foreign countries => Decreases the demand for the domestic currency => decrease in exchange rate
What are the 4 main theories of the conventional bond yield curve? (LIME)
- Expectation theory
- shape of the yield curve is determined by economic factors
- which drives the market’s expectation for future short-term interest rates - Liquidity preference theory
- Investors prefer liquid assets to illiquid ones
- investors require greater returns for holding longer-dated stocks (they are illiquid)
- Yields should be higher for longer dated stocks - Inflation risk premium theory
- Yield curve is more upward sloping than suggested by pure expectations theory
- investors require a higher nominal yield to compensate them for holding longer dated stock => more vulnerable to inflation risk - Market segmentation theory
- Yield at each term to redemption are determined by supply and demand from investors with liabilities of that term
- i.e. short term bonds and long-term bonds move independently
What influences the yield on short term government bonds?
1> Short term government bonds & money markets instruments are close substitutes
2> Hence short-term government are influenced by short term interest rates
What are the economic influences on long term government bond yields?
a> Factors affecting supply
- Government fiscal debt + funding policy
b> Factors affecting demand
1> E[inflation rates]
2> E[short-term real interest rates]
3> Exchange rates - overseas demand
4> Institutional cashflow - Liabilities and investment policy
5> Returns of alternative investments
6> Other economic factors - tax, political, rating status of bonds
What affects the size of the yield curve between fixed interest government and corporate bonds?
1> Difference in security
2> Difference in liquidity and marketability
3> Relative supply and demand of government and corporate bonds
- Oversupply of corporate debt reduces prices and increase yields
What are the key economic influences on the equity market?
a> Main factors (FIREC)
1> Expectations of real interest rates and inflation
2> Investors’ perception of the riskiness of equity investment
3> the real level of economic growth in the economy
4> expectations of currency movements
b) Factors affecting demand
1> Changes to tax rules
2> institutional flow of funds
3> attractiveness of alternative investments
c) Factors affecting supply
1> Number of rights issies
2> share buy-backs
3> privatisation
11) How can expectation of inflation influence equity prices?
1> Equity markets should be relatively indifferent towards high nominal rates and high inflation
2> High inflation => Higher dividends => Investor required return will also increase or discount rates used to value dividends will increase
b> Indirect effects of inflation
1> Higher inflation & higher interest rates -> are unfavorable for strong economic growth
- fears of inflation will have a depressing effect on equity prices
2> Expectation of high inflation rates => expect government to increase real interest rates => reduce equity prices
3> High inflation => greater uncertainty around inflation.
Investors increase demand for real assets such as equities => Increase in demand and hence price
In what three main inter-related areas do economic influences have an impact on the property market?
1> Occupation market- the demand for property for occupation
2> Development cycles - supply of newly completed property developments
3> Investment market - supply and demand for properties as investment
13) What are the key economic influences affecting demand in the occupational property market?
a) E[real interest rates]
b) Structural changes => move to out of town working
c) Expectation of real economic growth + bouyancy of trading conditions + employment levels
What are the key economic influences affecting demand in the investment property market?
a> Investment property market depends on the occupancy market
b) Provides the real income and potential for growth
c) Other factors include:
1> Inflation
2> Real interest rates
3> Institutional cashflow, liabilities and investment principles
4> Demand from public/private property companies
5> Exchange rate => overseas demand
6> Return on alternative investment
7> Other economic factors
15) What are the key factors affecting the supply of property?
a) Developing time => gaining consent + construction
b) Economic growth => Peak of the property cycle lags behind the peak of business cycle => surplus of property as the economy slows down
c) Real interest rates => cost of borrowing in order to develop property
d) Statutory control => local planning authorities may frequently restrict development
e) Fixity of location, high transaction cost + segmented markets
