Chapter 12: Behaviour of the markets Flashcards
Discuss the government bond markets
Issuing government bonds is the main way governments finance the fiscal deficit.
The demands of the purchasers can influence the terms on which debt is issued.
Government bonds issued in most developed countries are a very secure, low risk form of debt, and so suitable for matching the guaranteed payments arising from selling annuity business
As issues are large, marketability tends to be good.
Conventional fixed-interest government bonds will expose inverstors mainly to inflation risk.
Discuss the corporate bond markets
Corporate bonds expose the investor to default, inflation, marketability and liquidity risk.
The premiums for accepting these risks are factored into the market price of the bonds - in particular the spread, which is the difference between the yield on a corporate bond compared with the equivalent government bond.
If the investor holds the bond to maturity, the marketability and liquidity premiums will never be retained, increasing the value of the bond for the investor.
Discuss the equity markets
Equities expose investors to default, marketability and liquidity risk of an uncertain dividend stream and resale price.
Equity is considered a real investment, so over the long term it should protect investors from inflation risk.
These markets are also exposed to systemic risk (driven by market sentiment)
Discuss guarantees and investment choices
Financial products generally offer guarantees and to ensure customers are not disadvantaged, regulators require providers to hold capital against guarantees.
If product guarantees are covered by guaranteed returns from assets held, the amount of capital earmarked against the product guarantees is reduced.
What determines the general level of the market in any asset class?
The interaction of buyers and sellers, i.e. demand and supply.
What are the two main factors affecting demand for any asset class?
- Investors’ expectations for the level of returns on an asset class
- Investors’ expectations for the riskiness of returns on an asset class.
The main economic influences on short-term interest rates are government policies.
Outline 3 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
What is the quantity theory of money?
The quantity theory of money states that 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.
What is demand-pull inflation?
Demand-pull inflation refers to a situation in which there is excess demand within the economy so that firms are able to increase their prices. As a consequence, the general level of prices may be pulled up.
What is cost-push inflation?
Cost-push inflation refers to a situation where if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices.
Discuss the role of quantitative easing
Where short-term rates are already close to zero, governments have limited scope to reduce interest rates further. Governments and central banks must then consider other means of influencing the rate of growth in an economy.
An alternative approach is called quantitative easing (QE).
QE works as follows:
* The central bank creates money electronically and uses it to buy assets, usually government bonds, from the market
* This purchase of assets directly increases the supply of money in the financial system, which encourages banks to lend more and can push interest rates lower.
* The purchase of assets can also reduce the returns on money market assets and bonds, reducing the appeal of those asset types.
Discuss the role of negative interest rates
Negative interest rates are possible. This is where borrowers are credited with interest, rather than having to pau the lender interest.
This is a very unusual scenario.
It can occur in situations where the central bank has already lowered short-term interest rates to zero to stimulate the economy.
What is a yield curve?
A yield curve is a plot of yield against term to redemption.
Usually the yield plotted is the gross redemption yield on coupon paying bonds but other yields can be used.
List the main theories of the conventional bond yield curve
LIME
Liquidity preference theory
Inflation risk premium theory
Market Segmentation theory
Expectations theory
Describe 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.
If we expect future short-term interest rates to fall (rise), then we would expect gross redemption yields to fall (rise), and the yield curve to slope downwards (upwards).
One of the biggest influences on investors’ expectations of future short-term interest rates is the expected level of future inflation.
An upward-sloping yield curve may indicate that investors expect inflation and hence short-term interest rates to rise in the future, and vice versa for a downward-sloping yield curve.
Describe liquidity preference theory
The liquidity preference theory is based on the generally accepted belief that investors prefer liquid assets to illiquid assets.
Investors require a greater return to encourage them to commit funds for a longer period.
This causes the yield curve to be more upward sloping / less downward sloping than suggested by pure expectations theory.
Describe 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.
Describe market segmentation theory
Market segmentation theory says that yield at each term to redemption are determined by supply and demand from investors with liabilities of that term.
Discuss the theories of the real yield curve
The real yield on an investment is the yield after allowing for inflation.
The real yield curve is the curve of real yields on index-linked bonds against term to maturity.
The real yield curve is also determined by forces of supply and demand at each maturity duration.
Thus it can be views as being determined by investors’ views on future real yields modified according to market segmentation theory and liquidity preference theory.
Inflation risk premium theory is irrelevant to index-linked bonds.
List the key economic factors influencing bond yields
- Inflation
- Short-term interest rates
- The exchange rate
- Public sector borrowing - the fiscal deficit
- Institutional cashflow
- Returns on alternative investments
- Other economic factors
Discuss the effect of inflation on bond yields
Inflation erodes the real value of income and capital payments on fixed coupon bonds.
Expectations of a higher rate of inflation are likely to lead to higher bond yields and vice versa.
Discuss the effect of short-term interest rates on bond yields
The yields on short-term bonds are closely retlated to returns on money market instruments, so a reduction in short-term interest rates will almost certainly boost prices of short bonds.
The effect of changes in short-term interest rates on yield on long-dated stocks is not clear-cut.
Expectations theory predicts that if there was a cut in short-term interest rates, and if the market also revised downwards its estimate of future short-term interest rates at all terms, then long-dated bond yields would fall.
However, investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the long term. So, the yields on long bonds might decline by a smaller amount or even rise.
Discuss the effect of the exchange rate on bond yields
A significant part of the demand for government bonds in many markets comes from overseas.
Changes in expectations of future movements in the exchange rate will affect the demand from overseas investors.
It will also alter the relative attractiveness of domestic and overseas bonds for local investors.
Discuss the effect of the fiscal deficit on bond yields
If the government’s fiscal deficit is funded by borrowing, the greater supply of bonds is likely to put upward pressure on bond yields, especially at the durations in which the government is concentrating most of its funding.
As well as affecting particular maturities, the choice of which bonds to sell may affect yields on conventional bonds and index-linked bonds differently.
Selling Treasury bills would increase short-term interest rates, while printing money will lower rates but increase expectations of inflation.
Discuss the effect of institutional cashflow on bond yields
If institutions have an inflow of funds because of increased levels of savings they are likely to increase their demand for bonds.
Changes in regulations and investment philosophy can also affect institutional demand for bonds.
Discuss the effect of returns on alternative investments on bond yields
The relative attractiveness of alternative investments both at home and overseas, will influence the demand for bonds, and hence the yields that they offer.
Discuss the effect of other economic factors on bond yields
Almost any piece of economic news that has implications for inflation and short-term interest rates will influence the level and shape of the yield curve.
The impact of other economic factors can therefore usually be understood in terms of these two quantities.
Compare government and corporate bond yields
Economic factors which adversely affect prospects for corporate profitability are likely to increase the perceived risk of corporate bonds relative to government bonds.
This will increase the general level of the yield margin of corporate over government debt.
The availability and price of government debt might affect the actions of otherwise risk-averse investors.
Supply side issues also have an impact. If equity market conditions are depressed, companies may find it easier to raise funds through issues of corporate debt than through equity issues.
Oversupply of corporate debt reduces prices and increases yields
What is the yield margin?
The yield margin primarily reflects the differences in marketability risk and deafult risk of corporate over government bonds.
Investors’ perceptions of default risk may increase in times of recession, so the size of the yield margin is expected to increase (fall) as the economy moves into (out of) recession.
List 3 factors affecting the size of the yield gap between fixed-interest government and corporate bonds
- Differences in security
- Differences in marketability and liquidity
- The relative supply of and demand for government and corporate bonds
List the key economic influences on the equity market
Factors affecting supply:
1. The relative attractiveness of debt and equity finance
2. Rights issues
3. Share buy-backs
4. Privatisations
Factors affecting demand (expected return and risk):
1. Expectations of real economic growth
2. Expectations of real interest rates and inflation
3. Expectations of the equity risk premium
4. The exchange rate, which affects overseas demand
5. Institutional cashflow, liabilities and investment policy
6. Returns on alternative investments
7. Other economic factors
Explain how expectations of inflation may influence equity prices
Equity markets should be relatively indifferent towards inflation. If the rate of inflation is high, the rate of dividend growth would be expected to increase in line with the return demanded by investors (or discount rate used to discount the dividends)
There are some indirect effects from inflation:
1. High inflation is often associated with high interest rates, which can be unfavorable for economic growth, which would reduce equity prices.
2. Expectations of high inflation may cause the government to raise real interest rates (to control inflation), which would reduce equity prices.
3. High inflation may cause greater uncertainty over inflation. This may encourage investors to increase their demand for real assets such as equities, which would increase equity prices.
In which 3 inter-related areas do economic influences have an impact on the property market
- Occupation
- Development cycles
- The investment market
List the key economic influences affecting demand in the occupational property market
- Expectations of economic growth, buoyance of trading conditions and employment levels
- Expectations of real interest rates
- Structural changes
List 3 factors, other than investors’ expectations for the level and riskiness of returns on an asset class, which will cause demand for an asset class to change
- A change in investors’ preferences
- A change in investors’ income
- A change in the price of alternative investments
List the key economic influences affecting demand in the investment property market
The investment property market relies to a significant extent on the occupancy market as this provides the investment income and the potential for rental growth.
Other factors to consider include:
1. Inflation: rents should increase broadly in line with inflation, although infrequent rent reviews could lead to inflation eroding rental value.
2. Real interest rates - as these should lead to lower valuation of future rents
3. Institutional cashflow, liabilities and investment policy
4. Demand from public / private property companies
5. The exchange rate, which affect overseas demand
6. Returns on alternative investments
7. Other economic factors
Discuss considerations that apply on the residential property market where many owners occupy their own property rather than renting
Residential property values are entirely driver by supply and demand.
The state can influence supply by constraints on new development in high demand areas.
High house prices compared to earnings levels restrict the number of individuals who can access adequate mortgage funds to make a purchase even at low interest rates.
In theory, this constraint on demand should cause prices to fall.
However, if interest rates are low, there is an alternative demand from investors to buy residential property, and rent it out.
The counting demand for places to live drives up rental levels.
Rents are substantially more than can be earned on fixed-interest investments and rental income is relatively secure in times of high demand.
If there are sufficient investors to replace the individual buyers who cannot raise funds, capital values are maintained.
List 2 circumstances that will change the demand for an asset
- Investor’s opinions of the characteristics of the asset remain unchanged but external factors alter the demand for the asset. These external factors include investors’ cashflows, investors’ preferences and the price of other investment assets
- Investors’ perceptions of the characteristics of the asset, principally risk and expected return, alter.
Discuss how investors’ cashflows can change demand for an asset
The amount of money available for investment by institutional investors can have a significant impact on market prices.
This is especially true of changes in the flow of funds into institutions with tightly specified investment objectives.
This can force up prices in the target markets.
The good returns generated might then encourage further investment, setting off a spiral of growth.
Equally, if investors decide to withdraw their money from emerging markets due to worries about falling market levels, then this withdrawal of funds will exacerbate the original problem.
Which factors related to investors’ preferences alter the demand for a particular asset class?
- A change in their liabilities
- A change in the regulatory or tax regimes
- Uncertainty in the political climate
- “Fashion” or sentiment altering
- Marketing
- Investor education undertaken by the suppliers of an asset class
- Sometimes for no discernible reason.
Discuss the correlation between the price of different asset classes
All investment assets are, to a greater or lesser extent, substitute goods.
This is particularly so if we consider investment at the individual security level, but it is also true across asset classes or across international markets.
The greater the similarity between different assets, the greater will be the extent to which they can be viewed as substitutes.
Therefore, there is a strong correlation between the prices of different asset classes.
Discuss the influence of supply on the investment markets
- An increase in supply will cause downward pressure on shares.
- In government bond markets, the supply is largely controlled by:
* the government’s fiscal deficit
* its strategy for financing the deficit
* the redemption of exsiting government bonds - Occasionally, supply is increased by technological innovation. It can be argued that this is the case in the derivatives markets where a greater understanding of hte pricing of and reserving for complex products has allowed investment banks to supply them to end users more cheaply, thus increasing the quantity demanded.
