Chapter 12: Behaviour of the markets Flashcards
State the key risks to which an investor in the following asset classes is exposed:
- Conventional government bonds
- Corporate bonds
- Equities
- Conventional government bonds – Inflation risk
- Corporate bonds – default, inflation, marketability and liquidity risk.
- Equities – non-payment of dividends, dividend / price volatility, marketability, liquidity and systemic risk (driven by market sentiment)
How is the general level of the market in any asset class determined?
By the interaction of buyers and sellers, i.e. supply and demand
- Price ↑ (i.e. Yield ↓) when demand ↑ or supply ↓
- Price ↓ (i.e. Yield ↑) when demand ↓ or supply ↑
- Demand for most investments is very price elastic due to close substitutes being available (small slope)
What are the two main factors affecting the demand for any asset class
- Investors’ expectations for the level of returns on an asset class
- Investors’ expectations for the level or riskiness of returns on an asset class
The main economic influences on short-term interest rates are government policies.
Outline three such government policies and the link between them and low short-term interest rates.
- Economic growth:
low interest rates => increased consumer and investment spending => economic growth - Inflation:
low interest rates => increased demand for money, which may be met by increased supply of money => higher inflation - Exchange rate:
low interest rates relative to other countries => less investment from international investors => depreciation of domestic currency
Yield Curves
Yield Curve (YC) is a reflection of how demand and supply translate into bond prices (and yields);
- YC = best fit curve through a plot of yields and durations for individual bonds (usually of similar credit quality);
- YC is a useful tool for investors (e.g. for valuations and for portfolio management) and provides a good overview of yields and of supply/demand;
- YC need not be based on GRY – it could be based on zero coupon yields.
List the main theories of the conventional bond yield curve
Expectations Theory
Liquidity Preference Theory
Inflation Risk Premium Theory
Market Segmentation Theory
Expectations theory
Yield curve reflects market’s expectations of (economic factors - mainly inflation - which drive) future short-term interest rates.
The market’s CURRENT view of future short-term interest rates is reflected in TODAY’S forward yields / interest rates.
Define forward rate = rate of interest which investors TODAY think will apply in future e.g. F1,2 = forward yield
between year 1 and year 2. The actual interest rate over that time might be different, but it is what investors TODAY believe will be the rate over that future period.
GRY required on a bond is a function of current forward interest rates
Liquidity Preference Theory
Investors prefer liquid assets to illiquid assets – long-dated stocks are less liquid (with more volatile prices) than short-dated ones. Investors require greater
return to commit for longer term.
Inflation Risk Premium Theory
Inflation risk premium theory – the yield curve will tend to be more upward sloping / less downward sloping than suggested by pure expectations theory alone because investors need a higher yield to compensate them for holding longer-dated stocks, which are more vulnerable to inflation.
Required yield (risk free FI bond) = RFR (real risk free yield) + E(infl) + IRP
Market Segmentation (or Preferred Habitat) Theory
Supply and demand factors at specific durations may cause prices (yields) to vary from yields normally required by investors
Economic influences on bond yield
- Inflation (expected level, and uncertainty)
- Short-term (MM) interest rates
- Exchange rate
- Public sector borrowing (fiscal deficit)
- Institutional cashflows
- Returns on alternative investments (Both domestic and overseas)
- Other economic factors
Bond yields: inflation expectations
Required yield = RFR + E(infl) + IRP for risk-free bonds + default and illiquidity spread
Inflation
o Inflation erodes the real value of fixed coupons and redemption payments
o Expectations of higher inflation will lead to higher bond yields
Inflation risk premium
o Greatest when outlook of future inflation most uncertain
Economic shocks / political uncertainty / monetary and fiscal policy uncertainty
Exchange rate volatility
o Variability of inflation is higher when level of inflation is higher
Bond yields: changes in MM rates
Long bond yields are a function of expected future short-term interest rates (expectations theory).
But how are bond yields impacted by unexpected changes to short term (MM) interest rates?
* Short-term bonds => Money market interest influences the short end of the yield curve (e.g. up to 3-5years)
* Effect on long-dated rates (of ↓ in short-term rates)
Could fall (↓ entire yield curve if fall was unexpected and all else remains equal)
Could rise (if expect higher inflation in future)
Bond yields: exchange rate
If investors are free to invest in local and foreign bonds, an allowance for
expected exchange rate movements are needed to compare bond values:
Bond yields: Fiscal deficit
- Increase in supply, ↑ yields (↓ price)
- Printing money, ↑ inflation expectation, ↑ yields (despite initial
fall in short-term interest rates) - I.e. ↑ in fiscal deficit, ↑ in bond yields (regardless of funding
method)
