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))
Inflation effect on equity market
-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.
3 Indirect effects from inflation
- 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.
Equity risk premium
Additional return that investors require from equity investment to compensate for the risks relative to the risk-free rates of return.
Effects of a weaker domestic currency
- 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)
Areas of economic influence on the property market (3)
- occupation market
- development cycles
- investment market
occupation market
demand for property for occupation by businesses
development cycles
supply of newly completed property developments
investment market
supply and demand for properties as investments.
Property: Effects of Development time lags
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.
Characteristics affecting supply/demand for the property occupation market
- fixity of location
- high transaction costs
- segmented markets
Cost-push inflation
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.
3 Possible sources of cost-push inflation
- 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
Quantity theory of money: Identity
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
Quantity theory of money: Interpretation
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.
Demand-pull inflation
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.
3 Distinct ways in which increases in short-term interest rates can influence yields on either short- or long-dated bonds
- 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.
Why does selling Treasury bills increase short-term interest rates?
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.
Why selling Treasury bills might cause bond yields to rise
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.
Why printing money results in lower short-term interest rates
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.
Why printing money increases expectations of inflation
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.
Why printing money causes bond yields to rise.
The increased expectations of inflation will make investors demand higher nominal yields in order to maintain the required level of real yields.
