Chapter 12: Behaviour of the markets

Question 1

Discuss the risk profile and return of different investment classes.

Answer 1

The risk profile of different investment classes:

• Asset classes with greatest risk also have potential for greatest return over the long term
• Price fluctuations can depress values in the short term

Government bond markets:

• Issuing government bonds is the main way governments finance the fiscal deficit
• Very secure, low risk forms of debt – suitable for matching guaranteed payments arising from selling annuity business
• Good marketability due to large issues
• Fixed-interest bonds will expose
  investors to inflation

Corporate bond markets:

• Expose investors to default, inflation, marketability and liquidity risk - higher return than government bonds of equal term.
• Unless not concerned with marketability and liquidity because will hold bond to redemption—then extra return to reflect risk of those two is pure reward for investor
• Actual return will depend upon experience

Equity markets:

• Expose investors to default, marketability and liquidity risk and risk of uncertain dividend stream and resale price
• Real investment—over long term protects investors from inflation risk
• Heavily influenced by contagion risk driven by market sentiment and risks directly connected to economy and business

Guarantees and investment choices:

• Offer guarantees and to ensure customers are not disadvantaged, regulators require providers to hold capital against guarantees
• Risk of being unable to pay benefits is small IF provider can show that assets held are good match for guarantees offered—capital required can be lower
• The extent to which investors seek a matched position depends on their risk appetite, which relates to their level of free capital
• The greater the level of free assets the greater the scope the provider has to depart from a well-match position

Question 2

Discuss how general level of all markets are determined by the interaction of supply and demand.

Answer 2

Supply and demand:

• General level of all markets is determined by interaction of buyers & sellers
• As demand for asset rises the general level of market in that asset type will rise
• If demand falls then prices will fall
• Demand is very price elastic because of existence of close substitutes-if price of A rises a little above price of similar B, then investors will want to sell A and buy B
• This leads to:

o Prices of any two similar securities should stay very close—two identical securities should have identical prices otherwise arbitrage

o Small changes in prices are sufficient to make large changes in quantity demanded of investment

o Large changes in supply have small effect on price on investment

• Demand changes more quickly and more dramatically than supply—demand has primary influence on price
• Main factor affecting demand is investors’ expectations for level and riskiness of returns on an asset type
• Real assets—property and equity—returns linked directly to state of economy
• Also applies to financial instruments like bonds
• Example: nominal return on conventional bond is fixed but real return depends directly upon inflation rate over lifetime—thus investors’ expectations of inflation will influence demand for bonds
• Increase in demand increases prices. Reduction in demand reduces prices
• Increase in supply reduces price. Reduction in supply increases price
• In free market, price will move so supply equals demand

Question 3

What are the factors affecting short-term interest rates?

Answer 3

Factors affecting short-term interest rates:

• Largely controlled by government through central bank’s intervention in money market
• Sets interest rates, directly or indirectly, in attempt to meet its policy objectives
• Central bank sets benchmark short-term rate at which prepared to lend—all other short-term interest rates will relate to benchmark
• Central bank able to influence level of short-term interest rates through economy by controlling benchmark rate
• Relationship between government and central bank will vary between countries:

o CB could enjoy complete independence from G in carrying out monetary policy

o Decisions could be exclusive domain of G

o CB may enjoy degree of independence when setting short-term interest rates while remaining subject to certain constraints

Question 4

Whay are the main reasons for altering interest rates

Answer 4

1. Controlling economic growth
2. Controlling inflation
3. Controlling the exchange rate

Question 5

How are interest rates altered to control economic growth?

Answer 5

Main reasons for altering interest rates -Controlling economic growth:

• Low real interest rates encourage investment spending by firms & increase level of consumer spending
• Cutting interest rates increases rate of growth in short term

o Low interest rates reduce cost of investment and consumption financed by borrowing thus encourage investment and consumption

o This increases demand and thus short-term economic growth

Question 6

How are interest rates altered to control inflation?

Answer 6

Main reasons for altering interest rates -Controlling inflation:

• Quantity theory of money states that there is direct relationship between quantity of money and level of prices of goods and services
• According to theory, if amount of money in economy were to double, then price levels would also double, causing inflation
• Reducing interest rates encourages demand for credit from bank customers
• If banks meet this increase in demand they increase supply of money in circulation which can lead to inflation
• Low real interest rates can also lead to inflationary pressures by increasing demand
• Increase in demand may lead to demand-pull inflation

o Excess demand within economy so firms are able to increase their prices

o Thus general level of prices may be pulled up

Question 7

How are interest rates altered to control the exchange rate?

Answer 7

Controlling 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
• Decreases demand for domestic currency and decreases exchange rate
• High interest rates relative to other countries used to support value of domestic currency
• Decrease in exchange rate induced by cut in short-term interest rates may lead to cost-push inflation

o If firms’ costs go up they tend to pass on at least part of increase to consumers through higher prices

o Sources of cost-push inflation include:

  	Higher import prices due to weakening of domestic currency

  	Higher import prices for other reason (rise in price of oil)

  	Higher wage demands no met by productivity increases

Question 8

What is a yield curve and what are the theories that try to explain the shape of the yield curve?

Answer 8

Factors affecting the level of the bond market:

NOTE: not necessarily actual changes in factors that will cause yield to change, just investors expecting change is enough

REMEMBER: bond yield and bond prices are inversely related – increase in demand which leads to increase in bond prices will result in reduction in bond yields

• Yield curve is plot of yield against term to redemption
• Several theories that try to explain the shape of the yield curve:

1. Expectation theory
2. Liquidity preference theory
3. Inflation risk premium theory
4. Market segmentation theory

Question 9

Discuss the expectation theory.

Answer 9

1. Expectation theory:

 Yields reflect expectations of future short-term interest rates and inflation

 Expect future short-term interest rates to fall (rise) then expect gross redemption yield to fall (rise) and yield curve to slope downwards (up)

 Yield curve changes shape – reflects change in investors view of future interest rates

 Big influence on expectations of future short-term interest rates is expected level of future inflation

 High inflation government likely to force up short-term interest rates to reduce future inflation

 Investors require positive real returns—interest rates higher than inflation—to avoid investments being eroded by inflation

 Upward-sloping yield curve—investors expect inflation and hence short-term interest rates to rise in future

Question 10

Discuss the liquidity preference theory.

Answer 10

2. Liquidity preference theory:

 Based on 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-date stocks are less liquid than short-dated stocks so yield should be higher—LD more volatile

 Yield curve should have slope GREATER than that predicted by pure expectations theory

Question 11

Discuss the inflation risk premium theory.

Answer 11

3. Inflation risk premium theory:

 Investors require higher nominal yield on longer-tern conventional bonds to compensate for the risk that inflation is higher than expected and real return lower than expected

 Uncertainty about future inflation is greater in long term

 Thus, risk premium should be greater for longer-dated stocks to compensate investors for risk

 Yield curve will tend to slope upwards because investors need higher yields to compensate for holding longer-dated stocks which are more vulnerable to inflation risk

 Index-linked bonds are protected against inflation thus theory doesn’t apply

Question 12

Discuss the market segmentation theory.

Answer 12

4. Market segmentation theory:

 Yields at each term to redemption are determined by supply and demand from investors with liabilities of that term – demand comes from investors trying to match liabilities

Concept of market segmentation is based on these fundamental ideas:

 Different providers and investors have different needs-liabilities of different terms so active at different terms on yield curve

 Price is function of supply & demand and yields function of price-S&D determine yields

 Suppliers want to supply investments of different terms so will be more active at different terms on yield curve

Demand:

 Principal buyers of short bonds are banks and general insurers with short-term liabilities to match

 Major investors in long-term bonds are pension funds and life assurance companies who have long-term liabilities

Supply:

 Supply features relating to G.bonds are influenced by size of fiscal deficit and acting taken to finance the deficit

 If demand at certain duration—cheaper for issuers to raise capital at those durations

 Supply of C.bonds will reflect companies’ requirements for additional finance and relative cost of raising finance via new issues of shares and bonds

Question 13

What are the theories of the real yield curve?

Answer 13

Theories of the real yield curve:

• Real yield is yield after inflation—difference between nominal yield realised and average rate of inflation over period
• Real yield curve – real gross redemption yields on index-linked bonds against term to maturity
• Determined by forces of supply and demand at each maturity duration
• Thus, determined by investors’ views on future real yields (expectation theory) modified according to market segmentation theory and liquidity theory
• Government’s funding policy will also influence shape of curve
• Difference between conventional and real yield curve is approximately the market’s expectation of future inflation

Question 14

What are the economic factors influencing bond yield?

Answer 14

1. Inflation
2. Short-term interest rates
3. The exchange rate
4. Public sector borrowing - the fiscal deficit
5. Institutional cashflow
6. Returns on alternative investments
7. Other economic factors

Question 15

What are the economic factors influencing bond yield - Inflation

Answer 15

• Inflation

o Erodes real value of income and capital payments on fixed coupon bonds

o Expectations of higher inflation likely to lead to higher bond yields

o This reflects the expectations theory

o Investors will only buy bonds if redemption yields are higher that estimated inflation

o Monthly inflation figures useful to investors for refining estimates of future inflation (inflation over whole life of bond)

Question 16

What are the economic factors influencing bond yield - Short-term interest rates

Answer 16

• Short-term interest rates

o These points are closely related to the expectations theory and inflation risk premium theory.

o Yields on ST bonds closely related to returns on MM instruments

o So reduction in ST interest rates will boost prices of short bonds (decrease yields)—ST interest rates thus regarded as fixing short end of yield curve

o Nominal yield=risk-free real asset + expected inflation +inflation risk premium

o If inflation is expected to rise in longer terms then last two terms on RHS will increase leading to higher nominal yield and lower price of long-term bonds

Question 17

What are the economic factors influencing bond yield - Public sector borrowing - fiscal deficit

Answer 17

• Public sector borrowing – fiscal deficit

o If government’s fiscal deficit is funded by borrowing the greater supply of bonds will increase bond yields especially at time of most funding

o Impact of fiscal deficit depends upon funding policy used:

 Full funding policy- meeting whole of the deficit through borrowing rather than printing money

 The form the government borrowing takes-conventional or index-linked, treasury bills and/or borrowing from individual investors

o Selling treasury bills would increase short-term interest rates

o Printing money will lower rates but increase expectations of inflation

o Either way bond yield will rise

o So however it is funded, an increase in fiscal deficit will tend to cause bond yields to rise

Question 18

What are the economic factors influencing bond yield - The exchange rate

Answer 18

• The exchange rate:

o Changes in expectations of future movements in exchange rate will affect demand from overseas investors

o Alter relative attractiveness of domestic and overseas bonds for local investors

o If an investor invests in foreign country, return has two components:

 Return achieved as measured in local currency

 Profit or loss from exchange rate movements

o In short run interest rates are a key determinant of exchange rate – means for short-term interest rates a change in US interest rates may lead to change in dollar/pound exchange

o In long run, exchange rate will tend to follow its purchasing power parity path reflecting market’s view of relative levels of US and UK inflation

Question 19

What are the economic factors influencing bond yield - Institutional cashflow & Returns on alternative investments & Other economic factors

Answer 19

• Institutional cashflow:

o Can affect demand for bonds

o If institutions have inflow of funds because of increased levels of savings likely to increase their demand for bonds

o Changes in regulations and investment philosophy can also affect institutional demand for bonds

• Returns on alternative investments:

o Relative attractiveness of alternative investments will influence demand for bonds and hence yields that they offer

• Other economic factors:

o Almost any piece of economic or political news that has implications for inflation and short-term interest rates will influence level and shape of yield curve

Question 20

How do government and corporate bond yields compare?

Answer 20

Comparison of 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 general level of yield margin of corporate over government dept
• Yield margin of corporate over government bonds reflect differences in marketability and default risk
• The availability and price of government debt might affect actions of otherwise risk-averse investors
• Example: if G.bonds are offering poor returns compared to high quality C.bonds, some investors may switch to C.bonds, narrowing the gap in yields between G and C bonds
• Supply issues also have impact – if equity market conditions are depressed companies may raise funds through issues of corporate debt through equity issues
• Oversupply of corporate debt reduces prices and increases yields

Question 21

What are the factors affecting the level of the equity market?

Answer 21

Factors affecting the level of the equity market:

Equity prices are determined by interaction of supply and demand—demand factors usually predominate

Expectations of profits:

• Equities can be valued by discounting the stream of future dividends that investor expects
• Dividends reflect the expected future profitability of the company
• Investors’ expectations of future corporate profitability and value of those profits largely determine general level of the equity market
• Main economic factors that influence general level of equity market are:

o Expectations of real interest rates and inflation

o Investors’ perceptions of the riskiness of equity investment

o Real level of economic growth in the economy

o Expectations of currency movements

Question 22

What are the factors affecting the supply and demand in the equity markets?

Answer 22

• Factors affecting supply in equity markets are:

o Number of rights issues

o Share buy-backs

o Privatisation

• Factors affecting demand in equity markets are:

o Changes to tax rules

o Institutional flow of funds

o Attractiveness of alternative investments

Question 23

Discuss the factors affecting the level of the equity market.

Answer 23

1. Inflation:

o Equity markets should be reasonably indifferent towards high nominal interest rates and high inflation

o If high inflation rate, rate of dividend growth would be expected to increase in line with the return demanded by investors

o More on page 23

2. Equity risk premium:

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

o Fluctuates, depending on overall level of confidence of investors and their views on risk

3. Real economic growth:

o Real dividends and thus the fundamental value of companies would be expected to grow roughly in line with real economic growth

o Changes in investors’ views on economic growth have a major effect on level of equity market

4. Currency:

o Weaker domestic currency = exports more competitive so profits of export companies should increase

o Profits earned in other currencies are more valuable when converted into domestic currency

o Weaker currency = imports more expensive

o Reduces corporate profits if firms cannot pass the higher costs of imported raw material to consumers

o Leads to inflation

o BUT, if manufactured imports are more expensive – market share of domestic producers of same good should increase

o In UK where high proportion of profits earned abroad, sterling depreciation should raise the general level of the equity market

Question 24

What are the factors affecting the level of the property market?

Answer 24

Factors affecting the level of the property market:

Economic influences have an impact on the property market in three main areas:

• Occupation - demand for property for occupation
• Development cycle – the supply of newly completed property developments
• The investment market – supply and demand for properties as investments

Interaction between occupational demand and supply of property for rent determines the market level of rent

Capital value of rented property is determined by the investment market – CV will reflect the market level of rental income

Question 25

Discuss the factors affecting the level of the commercial property market?

Answer 25

1. Commercial property and occupation
   - Economic growth:

o Economic growth increases demand for commercial and industrial premises – increases demand = higher rents and higher property values

o Impact of economic growth will not necessarily be uniform across the different property sectors or regions of a country

o Any factor that affects economic activity, e.g. real interest rates, will affect occupational demand for property

o Lower real interest rate should stimulate economic activity and therefore have positive effect on rental and property value

• Structural changes in the demand for property:

o New patterns of economic activity, domestically and globally, change demand patterns

o Example: trend for firms to move staff out of expensive capital city locations to cheaper areas

2. Commercial property and development cycles

o Property is in fixed location and takes time to develop

o Markets can be viewed as existing stock plus forecast additions to stock – but there are supply-side lags, and these can be difficult to forecast

o Development pipeline can be up to five years long – result in surpluses of available property when economic cycle is in downturn and shortages as economy improves

o May be subject to statutory control

o Local planning authorities may restrict development

o This makes supply of property relatively inelastic/ fixed – thus, when demand changes supply does not change with it = big movements in property values

o This makes property values more volatile

3. Commercial property and the investment market
   - Inflation

o Property investment returns have been a good hedge in the long run against unexpected inflation

o Should be able to increase rents with inflation so that real value of rent is maintained

o But for properties with infrequent rent reviews, inflation erodes the real value of the rental stream between reviews – prices of such properties will be more like prices of conventional bonds = if investor expects higher future inflation prices should fall

• Real interest rates

o Higher real interest rates should lead to lower valuation of future rents and thus lower capital values

o This assumes that capital values represent discounted PV of future rents yielded by property

o Relationship between interest rates and rental yields is unclear in short term

o In long term, high long-term bond yields tend to push up property investment yields – increase in bond yield leads to decrease in demand for property and increase in property yields

• Other factors

o Main sources of investment:

 Institutional investors

 Public/ private property companies using bank debt

 International investors

o Where overseas investors are big purchases of property, the exchange rate will influence demand levels

Question 26

Discuss the factors affecting the level of the residential property market?

Answer 26

Residential property

o Entirely driven by supply and demand

o State can influence supply by constraints on new development in high demand areas – planning restrictions or zonal prohibitions

o High house prices compared to earnings levels restrict number of individuals who can access adequate mortgage funds even at low interest rates

o In theory, constraint on demand should cause prices to fall

o BUT if interest rates are low there is alternative demand from investors to buy residential property and rent it out

o Continuing demand for places to live drives up rental levels

o Rents more than can be earned on fixed-interest investments and rental income is relatively secure in times of high demand

o SO if there are sufficient investors to replace individual buyers, capital values are maintained

Question 27

What are the factors affecting the demand for different asset classes?

Answer 27

Other influences on the investment markets-demand

Demand for an asset will change in one of two main circumstances:

1. Investors’ opinions of the characteristics of the asset remain unchanged but external factors alter demand for that asset, like:

o Investors’ cashflow
o Investors’ preference
o Price of other investment assets

2. Investors’ perceptions of the characteristics of the asset, principally risk and expected return alter

Question 28

Discuss the factors affecting the demand for different asset classes.

Answer 28

1. Investors’ cashflow:
   - amount of money available for investment by investors can have significant impact on market prices
   - level of cashflow into and out of, the main financial institutions has major impact on demand for assets and hence market price
   - level of net cashflow reflects level of saving throughout economy
2. Investors’ preference:
   - investors’ preference for a particular asset class can be altered by:

o change in their liabilities

 example: pension scheme that has closed to new entrants and offers fixed increases in deferment may now prefer short-term fixed assets, but previously may have preferred long-term real assets

o change in the regulatory or tax regimes

 will have effect if the change is so as to specify the actual investments in which the institution can invest

 even if less onerous, may still influence the relative attractiveness of different asset classes to the institutions

 if investors are taxed less heavily on income than capital gains, they will prefer investments with high running yields

 change in tax rules for particular investment will change relative attractiveness producing consequent change in demand for that investment

o uncertainty in political climate

 prefer to invest in economies that are politically stable

 in time of political uncertainty increase in demand for safer investments

o fashion or sentiment altering

o marketing

 if there is marketing campaign to help investors better understand investments, they may be more attractive

o investor education undertaken by the suppliers of an asset class

 for new types of investment, investors will need to be educated about their existence, potential uses and relevance

o sometimes for no discernible reason

3. The price of alternative investments:
   - The greater the similarity, the degree of correlation if investment returns, between different assets, the greater will be the extent to which they can be viewed as substitutes

Question 29

Discuss the factors affecting the supply for different asset classes.

Answer 29

Other influences on the investment markets-supply

Supply means the amount of investment in issue

Equity markets:

• Increase in supply, a lot of new issues, will cause downward pressure on share prices
• Supply of shares increases as a result of:

o Rights issues by existing share-based companies

  	Company directors think the stock market is unusually buoyant

  	Company balance sheets too weak to support the scale of operations desired by the directors

o Privatisations of previously nationalised companies

o New share issues by companies moving to a shareholder structure

• Might be expected that during a recession there will be more rights issues aiming to raise additional finance for companies that are in financial difficulty
• Additional supply of shares should depress the general share price, although it could increase price if there is prevailing mood of optimism
• Conversely, share buy-backs or re-nationalisations reduce supply of equities

Bond markets:

• In government bond market, the supply is largely controlled by:

o Governments fiscal deficit

o Strategy for financing strategy

o Redemption of existing government bonds

• Non-government borrowers will prefer to issue debt when the bond market is performing well and so borrowing is cheaper

Other investment markets:

• Occasionally, supply is increases by technological innovation.