Chapter 12 - Behaviour of the Markets

Question 1

1 Main factor affecting demand for asset type by investor

Answer 1

Investor’s EXPECTATIONS surrounding the LEVEL and RISKINESS of the returns of the asset

Question 2

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

Answer 2

• 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

Question 3

Describe 3 factors influencing short term interest rates

Answer 3

• monetary policy
• fiscal policy
• Inflation + supply and demand due to business cycle

Question 4

6 principle economic factors affecting bond yield

Answer 4

• 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

Question 5

Level of the equity market is determined by ….

Answer 5

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

Question 6

4 Theories put forward to explain the shape of the yield curve

Answer 6

L - Liquidity preference theory
I - Inflation risk premium theory
M - Market segmentation theory
E - Expectations theory

Question 7

Expectations theory

demand facing

Answer 7

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

Question 8

Liquidity preference theory

demand facing

Answer 8

Investors require an additional yield on less liquid (longer-term) bonds.

Question 9

Inflation risk premium theory

demand facing

Answer 9

Investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.

Question 10

Market segmentation theory

supply and demand

Answer 10

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.

Question 11

Real yield curve

Answer 11

Plot of real gross redemption yields on index-linked bonds against term to maturity.

Question 12

Approximate market expectation of future inflation

Answer 12

Difference between the conventional yield curve and the real yield curve.

Question 13

Main influences on the level of equity (5)

Answer 13

• 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

Question 14

How does demand and supply affect price?

What is the demand elasticity for most investments and why?

Answer 14

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

Question 15

3 areas affecting in the property market affected by Economic Factors

Answer 15

• Occupation
• • demand for occupation/rentals)
• Developmental Cycles
• • supply of new developments
• the investment market
• • supply&demand for investment property by investors

Question 16

6 Key economic factors affecting the property market

Answer 16

• 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)

Question 17

Inelastic supply of property is caused by: (5)

Answer 17

• 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 18

Inflation effects on bond yield

Answer 18

-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 19

Short-term interest rate effects on bond yields

Answer 19

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 20

Fiscal deficit effects on bond yields

Answer 20

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 21

Full funding policy

Answer 21

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

Question 22

2 Components to returns from investments in a foreign country

Answer 22

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

Question 23

Institutional cashflow effects on bond prices

Answer 23

-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 24

2 Important effects of real interest rates on the equity market

Answer 24

• 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))

Question 25

Inflation effect on equity market

Answer 25

-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 26

3 Indirect effects from inflation

Answer 26

• 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 27

Equity risk premium

Answer 27

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

Question 28

Effects of a weaker domestic currency

Answer 28

• 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 29

Areas of economic influence on the property market (3)

Answer 29

• occupation market
• development cycles
• investment market

Question 30

occupation market

Answer 30

demand for property for occupation by businesses

Question 31

development cycles

Answer 31

supply of newly completed property developments

Question 32

investment market

Answer 32

supply and demand for properties as investments.

Question 33

Property: Effects of Development time lags

Answer 33

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 34

Characteristics affecting supply/demand for the property occupation market

Answer 34

• fixity of location
• high transaction costs
• segmented markets

Question 35

Cost-push inflation

Answer 35

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 36

3 Possible sources of cost-push inflation

Answer 36

• 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 37

Quantity theory of money: Identity

Answer 37

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 38

Quantity theory of money: Interpretation

Answer 38

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 39

Demand-pull inflation

Answer 39

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 40

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

Answer 40

• 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 41

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

Answer 41

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 42

Why selling Treasury bills might cause bond yields to rise

Answer 42

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 43

Why printing money results in lower short-term interest rates

Answer 43

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 44

Why printing money increases expectations of inflation

Answer 44

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 45

Why printing money causes bond yields to rise.

Answer 45

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