Chapter 12 - Behaviour of the Markets

Question 1

Describe how the risk profile of the principal investment assets affects the market in such assets.

Answer 1

• Price is the main influence on the attractiveness of specific investments
• government bonds are lower in price compared to corporate bonds as they do not have associated default , liquidity , marketability and inflation risk
• In addition to the risks directly connected with the economy and business that affect companies’ share values, equity markets are heavily influenced by contagion risk, driven by market sentiment.

Question 2

Supply and Demand in Investment Markets

Answer 2

Supply and Demand
- Demand for most investments is very price elastic due to the existence of loose substitutes
- The main factor affecting demand is investors’ expectations for the level and riskiness of returns on an asset type.

Question 3

Factors affecting short term interest rates ( money market )

Answer 3

• short term interest rates largely controlled by central bank intervention in money market
• government sets interest rates , directly or indirectly , in an attempt to meet its own (often conflicting) policy objectives
• central bank sets benchmark short term rate and then banks and financial use the benchmark when lending

Question 4

Why the need to alter interest rates ?

Answer 4

Controlling Economic Growth
- Lower rates encourage investment spending by firms and increases level of consumer spending

Controlling Inflation
- Quantity theory of money states that there is a direct relationship between amount of money in an economy and level of prices of goods and services in that economy

eg. Interest rates can be interpreted as the ‘price’ of money or credit. Reducing interest rates encourages the demand for credit from bank customers. Assuming banks meet this increase in demand, they increase the supply of money in circulation, which can lead to inflation. This is an application of the quantity theory of money.

Controlling the Exchange Rate
- If interest rates in one country are low relative to other countries, international investors will be less inclined to deposit money in that country. This decreases demand for the domestic currency and tends to decrease the exchange rate

Question 5

Factors affecting level of Bond markets

Answer 5

Yield Curve Theories:

1. Expectations Theory
   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
2. Liquidity Preference Theory
   Based on generally accepted belief that investors prefer liquid assets to illiquid ones. Investors require a greater return to encourage them to commit funds for a longer period.
   Long-dated stocks are less liquid than short-dated stocks, so yields should be higher for long-dated stocks.
3. Inflation Risk Premium Theory
   Under the inflation risk premium theory, the yield curve will tend to slope upwards because investors need a higher yield to compensate them for holding longer-dated stocks which are more vulnerable to inflation risk than shorter-dated stocks
4. Market Segmentation Theory
   Market segmentation (or preferred habitat) theory says that yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.

Question 6

Factors affecting bond market

Answer 6

The economic factors influencing bond yields include:
- inflation
- short-term interest rates
- exchange rate
- public sector borrowing
– fiscal deficit
- institutional cashflow
- returns on alternative investments
- other economic factors

Question 7

Factors affecting level of the equity market

Answer 7

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

In addition to the factors listed above, any factor affecting supply e.g.
- the number of rights issues
- share buy-backs
- privatisations

and any factor affecting demand e.g.: ·
- changes to tax rules
- institutional flow of funds
- the attractiveness of alternative investments

Question 8

Factors affecting level of the property market

Answer 8

Economic influences have an impact on the property market in three main interrelated areas:
- occupation
- development cycles
- the investment market

The interaction between occupational demand and the supply of property for rent determines the market level of rents. The capital value of rented property is determined by the investment markets