Chapter 12 - Behaviour of the Markets Flashcards
1 Main factor affecting demand for asset type by investor
Investor’s EXPECTATIONS surrounding the LEVEL and RISKINESS of the returns of the asset
Short-term interest rates are determined largely by government policy, as the government balances… (3)
- the need to control inflation
- relates to quantity theory of money
- the need to encourage economic growth
- low real interest rates encourage investment spending by firms and increase the level of consumer spending. Cutting interest rates increases the rate of growth in the short term.
- management of the level of the exchange rate.
- -if interest rates in one country are low relative to other countries, the international investors will be less inclined to deposit money in that country. This decreases demand for local currency and tends to weaken the exchange rate
Describe 3 factors influencing short term interest rates
- monetary policy
- fiscal policy
- Inflation + supply and demand due to business cycle
6 principle economic factors affecting bond yield
- Inflation
- Short-term interest rates
- nominal yield = risk free real rate + E(infl) + Inflation Risk Premium
- Institutional cashflow
- fiscal Deficit
- Exchange rate
- Returns on alternative investments, both domestic and overseas
Level of the equity market is determined by ….
investors’ expectations of future corporate profitability and the value of those profits.
4 Theories put forward to explain the shape of the yield curve
L - Liquidity preference theory
I - Inflation risk premium theory
M - Market segmentation theory
E - Expectations theory
Expectations theory
demand facing
Describes the shape of the yield curve is determined by economic factors, which drive the market’s EXPECTATIONS for future short-term interest rates
Used to explain the general trend of the YC
Liquidity preference theory
demand facing
Investors require an additional yield on less liquid (longer-term) bonds.
Inflation risk premium theory
demand facing
Investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.
Market segmentation theory
supply and demand
Yields at each term are determined by supply and demand at that term. (since price is a function of supply and demand - recall that price and yield are inversely related).
Demand comes principally from institutional investors trying to match liabilities.
Used to explain the bumps and irregular shape of the YC
DEMAND SIDE
Long term investors:
- pension funds
- life assurance companies
Short term investors
- banks
- GI companies
Two areas of the bond market may move independently.
SUPPLY SIDE:
supply side is determined by gvmt bonds and the size of the fiscal deficit. If certain durations have high demand, it will be cheaper for issuers to raise capital at that duration.
Real yield curve
Plot of real gross redemption yields on index-linked bonds against term to maturity.
Approximate market expectation of future inflation
Difference between the conventional yield curve and the real yield curve.
Main influences on the level of equity (5)
- expectations of profits (Price = PV(dividends) = d/(i-g))
- 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
How does demand and supply affect price?
What is the demand elasticity for most investments and why?
- Increase demand => Increase price
- Increase supply => Decrease price
- Demand for most investments are very price elastic due to the existence of close substitutes
3 areas affecting in the property market affected by Economic Factors
- Occupation
- demand for occupation/rentals)
- Developmental Cycles
- supply of new developments
- the investment market
- supply&demand for investment property by investors
6 Key economic factors affecting the property market
- economic growth (influences occupation)
- structural economic changes ex. semi-migration (influences occupation)
- real interest rates (influences investment market)
- inflation (influences investment market)
- institutional cashflow (influences investment market)
- exchange rates (influences investment market)
Inelastic supply of property is caused by: (5)
- 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
Inflation effects on bond yield
-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.
Short-term interest rate effects on bond yields
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.
Fiscal deficit effects 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.
Full funding policy
-The government tries to meet the whole of the deficit
through borrowing.
-The alternative to full funding is to print money.
2 Components to returns from investments in a foreign country
- return achieved by the investment as measured in the
local currency - profit/loss from exchange rate movements
Institutional cashflow effects on bond prices
-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.
2 Important effects of real interest rates on the equity market
- 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. (pv = d/(i-g))