Chapter 12: Behaviour of the markets

Question 1

Short-term interest rates are determined largely by government policy, as the government balances… (3)

Answer 1

• the need to control inflation
• the need to encourage economic growth
• management of the level of the exchange rate.

Question 2

6 Main factors affecting bond yield

Answer 2

• Inflation
• Short-term interest rates
• Institutional cashflow
• fiscal Deficit
• Exchange rate
• Returns on alternative investments, both domestic and overseas

Question 3

Level of the equity market is determined by ….

Answer 3

investors’ expectations of future corporate profitability and the value of those profits.

Question 4

Main influences on the level of equity (5)

Answer 4

• expectations of real interest rates & inflation
• the real level of economic growth in the economy
• investors’ perceptions of the riskiness of equity
  investment
• equity risk premium (ERP)
• expectations of currency movements

Question 5

Other factors influencing the level of equity in the market (6)

Answer 5

• POLITICAL climate
• ALTERNATIVE investments
• TAXATION
• institutional cashflow
• OVERSEAS equity markets
• SUPPLY factors

Question 6

How does demand and supply affect price?

What is the demand elasticity for most investments and why?

Answer 6

• Increase demand => Increase price
• Increase supply => Decrease price
• Demand for most investments are very price elastic due to the existence of close substitutes

Question 7

Key economic factors affecting the property market

Answer 7

• economic growth
• real interest rates
• inflation
• institutional cashflow
• exchange rates

Question 8

Inelastic supply of property is caused by: (5)

Answer 8

• time required to develop new properties
• planning permission rules and the limited physical space in some areas
• fixity of location
• high transaction costs
• segmented markets

Question 9

Inflation effects on bond yield

Answer 9

-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

Question 10

Short-term interest rate effects on bond yields

Answer 10

Yields on short-term bonds are closely related to returns on money market instruments so a reduction in short-term interest rates will almost certainly boost prices of short bonds.

Investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the longer term. so the yield on long bonds might decline by a smaller amount, or even rise.

Question 11

Fiscal deficit effects on bond yields

Answer 11

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.

Question 12

Full funding policy

Answer 12

-The government tries to meet the whole of the deficit
through borrowing.
-The alternative to full funding is to print money.

Question 13

2 Components to returns from investments in a foreign country

Answer 13

• return achieved by the investment as measured in the
  local currency
• profit/loss from exchange rate movements

Question 14

Institutional cashflow effects on bond prices

Answer 14

-If institutions have an inflow of funds because of
increased levels of savings, they are likely to increase
their demand for bonds.
-Changes in investment philosophy can also affect
institutional demand for bonds.

Question 15

2 Important effects of real interest rates on the equity market

Answer 15

• Low real interest rates should help to stimulate
  economic activity, increase the level of corporate
  profitability, and hence raise the general level of the
  equity market.
• Rate of return required by investors should be lower,
  so the present value of future dividends will be higher.

Question 16

Inflation effect on equity market

Answer 16

-Equity markets should be reasonably indifferent
towards high nominal interest rates and high 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.

Question 17

3 Indirect effects from inflation

Answer 17

• It might be argued that high interest rates and high inflation are unfavourable for strong economic growth, so fears of inflation will have a depressing effect on equity prices
• Investors expecting high inflation may also expect the government to increase real interest rates in response.
• Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Might result in an increase in equity investment, as equities should provide a hedge against inflation.

Question 18

Equity risk premium

Answer 18

Additional return that investors require from equity investment to compensate for the risks relative to the risk-free rates of return.

Question 19

Effects of a weaker domestic currency

Answer 19

• makes exports more competitive (increase profits, and profits earned in other countries are more valuable when converted)
• makes imports more expensive (bad for corporate profits to the extent that firms cannot pass higher costs of imported raw materials to customers)
• Higher costs of imported materials may lead to inflation, (however, if manufactured imports are more expensive, the domestic market share should increase)

Question 20

Areas of economic influence on the property market (3)

Answer 20

• occupation market
• development cycles
• investment market

Question 21

occupation market

Answer 21

demand for property for occupation by businesses

Question 22

development cycles

Answer 22

supply of newly completed property developments

Question 23

investment market

Answer 23

supply and demand for properties as investments.

Question 24

Property: Effects of Development time lags

Answer 24

Peak of the property development cycle does not coincide with the peak of the business cycle.
time lag between gaining consent for a property development, and completing the construction on it, frequently results in a substantial amount of the supply of stock coming into the market as the economy slows down.
A slow down in the economy, coupled with rising real interest rates, is harmful to the property development industry.

Question 25

Characteristics affecting supply/demand for the property occupation market

Answer 25

• fixity of location
• high transaction costs
• segmented markets

Question 26

Cost-push inflation

Answer 26

Refers to a situation if firms’ costs go up, they will tend to pass on at least part of the increase to consumers through higher prices.
The average price level can be “pushed” up by an increase in costs.

Question 27

3 Possible sources of cost-push inflation

Answer 27

• higher import prices due to a weakening of the domestic currency
• higher import prices for some other reason (eg rise in the oil price)
• higher wage demands not met by productivity increases

Question 28

Quantity theory of money: Identity

Answer 28

M x V ≡ P x Y

• M is the nominal money supply
• V is the velocity of circulation
• P is the price level
• Y is the number of transactions

Question 29

Quantity theory of money: Interpretation

Answer 29

If we assume that V (velocity of money) and Y (number of transactions) are fixed - as may approximately be true in the short run - then the quantity theory of money suggests that:

an increase in the (nominal) money in circulation will cause an increase in prices.

Question 30

Demand-pull inflation

Answer 30

Refers to a situation in which there is excess demand with the economy so that firms are able (and more likely) to increase their prices.
As a consequence, the general level of prices may be pulled up.

Question 31

3 Distinct ways in which increases in short-term interest rates can influence yields on either short- or long-dated bonds

Answer 31

• Higher short-term interest rates directly increase short-term bond yields because they should always be similar to each other.
• Expectations of higher future short-term interest rates can increase long-term bond yields according to the expectations theory of the yield curve.
• Higher short-term interest rates can reduce inflationary expectations and so tend to reduce long-term yields.

Question 32

Why does selling Treasury bills increase short-term interest rates?

Answer 32

To sell more Treasury bills, the central bank needs to reduce their price.
This increase in their “discount” corresponds to a rise in one of the measures of short-term interest rates.
Rates on other money market instruments will move broadly in line.

Question 33

Why selling Treasury bills might cause bond yields to rise

Answer 33

To sell more Treasury bills, the central bank needs to reduce their price.
This makes Treasury bills seem relatively attractive compared with bonds.
Bond prices may subsequently fall and yields rise.

Question 34

Why printing money results in lower short-term interest rates

Answer 34

More money in circulation makes more money available for placing on short-term deposit.
It is therefore easier for banks to attract deposits.
Consequently, they can reduce interest rates on deposits.

Question 35

Why printing money increases expectations of inflation

Answer 35

The quantity theory of money tells us that there is a direct relationship between the money supply and the level of prices.
More money chasing the same quantity of goods must cause prices to rise.

Question 36

Why printing money causes bond yields to rise.

Answer 36

The increased expectations of inflation will make investors demand higher nominal yields in order to maintain the required level of real yields.

Question 37

Expectation theory

Answer 37

Describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for the future short-term interest rates.

Question 38

Liquidity preference theory

Answer 38

Based on the 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.

Question 39

Inflation risk premium theory

Answer 39

Inflation risk is greater in the long term so yields should be higher than expected for long-dated stocks

Question 40

Market segmentation / Preferred habitat theory

Answer 40

Yields at each term are determined by supply and demand from investors with liabilities of that term, so yields on short and long bonds may therefore move somewhat independently

Question 41

Demand for an asset will change in 1 of 2 circumstances

Answer 41

1. Investors’ opinions of the characteristics of the asset remain unchanged but external factors alter the demand for that asset. These external factors include:
   • Investors’ cashflows
   • Investors’ preferences
   • The price of other investment assets
2. Investors’ perceptions of the characteristics of the assets, principally risk and expected return, alter.