Chapter 12: Behaviour of the markets Flashcards
Comment on the following statement: Investors always seek to perfectly match liabilities to assets
- The extent to which investors match assets to liabilities will depend on their risk appettite
- Investors with a high risk appetite may depart from exactly matching liabilities in pursuit of higher returns
- In this case, the regulatory capital requirement might be higehr
Describe the risk profile profile of the following asset classes:
* Government bond market
* Corporate bond market
* Equity markets
* Guarantees
Government Bond Markets
* Fixed interest bonds usually have inflation risk for investors requiring a real return, who typically have real liabilities
* Index-linked bonds have monetary risk for investors with nominal liabilities, or generally requiring a nominal return.
* Bonds from most developed economies are usually very secure and low risk. Bonds from developing or underdeveloped economies typically have default risk.
Corporate bond market
* Exposed to marketibility, liquidity, inflation(when not index linked) and default risk
* Marketibility: Issues may be small
* Value of the bond is high for investors utilising the buy-and-hold strategy, since they are not exposed to the liquidity and marketibility risk.
Equity markets
* Exposed to liquidity, marketibility and uncertain dividend stream risks.
* Also highly influenced by contagion risks driven by market sentiment
Guarantees
* Regulators require capital to be set aside for guarantess
* If guarantees are matched by similar assets, then the capital required is lower.
Describe the risk profile profile of the following asset classes:
* Government bond market
* Corporate bond market
* Equity markets
* Guarantees
Government Bond Markets
* Fixed interest bonds usually have inflation risk for investors requiring a real return, who typically have real liabilities
* Index-linked bonds have monetary risk for investors with nominal liabilities, or generally requiring a nominal return.
* Bonds from most developed economies are usually very secure and low risk. Bonds from developing or underdeveloped economies typically have default risk.
Corporate bond market
* Exposed to marketibility, liquidity, inflation(when not index linked) and default risk
* Marketibility: Issues may be small
* Value of the bond is high for investors utilising the buy-and-hold strategy, since they are not exposed to the liquidity and marketibility risk.
Equity markets
* Exposed to liquidity, marketibility and uncertain dividend stream risks.
* Also highly influenced by contagion risks driven by market sentiment
Guarantees
* Regulators require capital to be set aside for guarantess
* If guarantees are matched by similar assets, then the capital required is lower.
Describe the risk profile profile of the following asset classes:
* Government bond market
* Corporate bond market
* Equity markets
* Guarantees
Government Bond Markets
* Fixed interest bonds usually have inflation risk for investors requiring a real return, who typically have real liabilities
* Index-linked bonds have monetary risk for investors with nominal liabilities, or generally requiring a nominal return.
* Bonds from most developed economies are usually very secure and low risk. Bonds from developing or underdeveloped economies typically have default risk.
Corporate bond market
* Exposed to marketibility, liquidity, inflation(when not index linked) and default risk
* Marketibility: Issues may be small
* Value of the bond is high for investors utilising the buy-and-hold strategy, since they are not exposed to the liquidity and marketibility risk.
Equity markets
* Exposed to liquidity, marketibility and uncertain dividend stream risks.
* Also highly influenced by contagion risks driven by market sentiment
Guarantees
* Regulators require capital to be set aside for guarantess
* If guarantees are matched by similar assets, then the capital required is lower.
Describe the risk profile profile of the following asset classes:
* Government bond market
* Corporate bond market
* Equity markets
* Guarantees
Government Bond Markets
* Fixed interest bonds usually have inflation risk for investors requiring a real return, who typically have real liabilities
* Index-linked bonds have monetary risk for investors with nominal liabilities, or generally requiring a nominal return.
* Bonds from most developed economies are usually very secure and low risk. Bonds from developing or underdeveloped economies typically have default risk.
Corporate bond market
* Exposed to marketibility, liquidity, inflation(when not index linked) and default risk
* Marketibility: Issues may be small
* Value of the bond is high for investors utilising the buy-and-hold strategy, since they are not exposed to the liquidity and marketibility risk.
Equity markets
* Exposed to liquidity, marketibility and uncertain dividend stream risks.
* Also highly influenced by contagion risks driven by market sentiment
Guarantees
* Regulators require capital to be set aside for guarantess
* If guarantees are matched by similar assets, then the capital required is lower.
Relationship between price and demand
Inverse relationship.
Discuss the price elasticy of demand for financial markets and its implications
Financial assets have a high price elasticity of demand due to the presence of close subsititutes in the market. This implies that:
* Similar assets will have similar price levels
* Small changes in price are sufficient to make large changes in quantity demanded (if price increases slightly, investors can buy a close substitute)
* Large changes in supply need only have a small impact in the price of an investment.
Thus demand has the primary effect on price
Main factor affecting investor’s demand of an assets type
Expectations of the level of returns and riskiness
Main reasons for the controlling of short term interest rates
- Controlling economic growth
- Controlling inflation rate
- Controlling the exchange rate
Explain the following in relation to short-term interest rates:
* Controlling economic growth
* Controlling inflation rate
* Controlling the exchange rate
Controlling economic growth
* Low interest rates
* Encourage investment spending as firms could finance expansions at low interest rates
* And increases the level of consumer spending
* Which increases short-term economic growth
Controlling inflation rate
* Low interest rates
* Increases the demand for credit from bank customers
* Which increases the money supply in ciculation
* By the quantity theory of money
* This increases the general level of prices
* Which causes an increase in inflation
Low interest rates can also increase the demand, leading to demand pull inflation
Controlling the exchange rate
* High interest rates
* Make it profitable for foreign investors to invest in the country
* Which increases the demand for rand
* Which then causes the rand to appreciate
A decrease in the exchange rate due to low interest rates can lead to an increase in the cost-push inflation
Explain the following in relation to short-term interest rates:
* Controlling economic growth
* Controlling inflation rate
* Controlling the exchange rate
Controlling economic growth
* Low interest rates
* Encourage investment spending as firms could finance expansions at low interest rates
* And increases the level of consumer spending
* Which increases short-term economic growth
Controlling inflation rate
* Low interest rates
* Increases the demand for credit from bank customers
* Which increases the money supply in ciculation
* By the quantity theory of money
* This increases the general level of prices
* Which causes an increase in inflation
Low interest rates can also increase the demand, leading to demand pull inflation
Controlling the exchange rate
* High interest rates
* Make it profitable for foreign investors to invest in the country
* Which increases the demand for rand
* Which then causes the rand to appreciate
A decrease in the exchange rate due to low interest rates can lead to an increase in the cost-push inflation
Explain the following in relation to short-term interest rates:
* Controlling economic growth
* Controlling inflation rate
* Controlling the exchange rate
Controlling economic growth
* Low interest rates
* Encourage investment spending as firms could finance expansions at low interest rates
* And increases the level of consumer spending
* Which increases short-term economic growth
Controlling inflation rate
* Low interest rates
* Increases the demand for credit from bank customers
* Which increases the money supply in ciculation
* By the quantity theory of money
* This increases the general level of prices
* Which causes an increase in inflation
Low interest rates can also increase the demand, leading to demand pull inflation
Controlling the exchange rate
* High interest rates
* Make it profitable for foreign investors to invest in the country
* Which increases the demand for rand
* Which then causes the rand to appreciate
A decrease in the exchange rate due to low interest rates can lead to an increase in the cost-push inflation
Demand-pull inflation
There is excess demand in the economy so firms can push prices up
Cost-push inflation
if firms’ costs go up, they will typically pass on the cost to consumers through higher prices
Quantitative easiing
- Buying back government bonds from the market
- Which increases money supply
- Which encourages banks to lend more
- And decreaes the interest rate
