CHP 20 Flashcards
Economic influences Supply and demand
In most investment markets, demand changes more drastically and quickly than supply and is thus the major driver for price.
The main factors that affect demand is investors’ expectations for the level and riskiness of returns on an asset type.
The demand for most investment products are very price elastic because of existence of close substitutes.
- Factors affecting short-term interest rates
Over the long term, interest rates are linked to both inflation and to the way demand for money varies with the business cycle. In the short-term government actions are generally the dominant factor.
Short-term interest rates are largely controlled by government through central bank intervention in the money market.
Government sets interest rates (directly or indirectly) in an attempt to meet its (often conflicting) policy objectives.
2.2. Meeting policy objectives – controlling economic growth
Low real interest rates encourage investment spending by firms and increase level of consumer spending. So cutting interest rates results in an increase in growth in the short term.
2.3. Meeting policy objectives – controlling inflation
Lower real interest rates means an increased quantity of money is demanded which is met by an increase in money supply. This can lead to inflation.
Low real interest rates can also lead to inflation because of an increase in demand.
2.4. Meeting policy objectives – controlling the exchange rate
If interest rates in one country are relatively low compared to other countries, investors will be less likely to deposit money there. This decreases the demand for that currency and thus the exchange rate will be impacted.
2.5. Other factors affecting short-term interest rates
- Inflation
* Pure supply and demand
3.3. Government versus corporate bond yields
Economic factors that negatively affect prospects for corporate profitability are likely to increase the perceived risk of corporate bonds relative to government bonds. This will increase the general yield margin of corporate over government bonds.
The availability and price of government debt might affect the actions of otherwise risk-averse investors. E.g. if government was offering very poor returns when compared to high quality corporate bonds, some investors might revise their risk profile and invest in corporate bonds. This will narrow the gap between gov and corp bonds.
Supply side issues could influence – e.g. if equity markets are depressed, it may be easier for companies to raise debt. Oversupply of corporate debt reduces the prices and increases the yield.
3.2. Principle economic factors
• Inflation
Inflation erodes the real value on income and capital payments on fixed coupon bonds. Expectation of higher inflation will lead to higher bond yields and vice versa.
3.2. Principle economic factors
• Short-term interest rates
Yields on short-term bonds are closely related to returns on money market instruments. Thus a reduction in short-term interest rates will almost certainly boost prices on short bond.
Investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potential inflationary consequences over the longer term. So the yield on long bonds might decline by a smaller amount, or even rise.
3.2. Principle economic factors
• Public sector borrowing – the fiscal deficit
Fiscal deficit is funded by borrowing, the greater the supply of bonds is likely to put upward pressure on bond yields. This will be especially true for durations in which government is concentrating most of its funding.
Selling treasury bills will increase short-term interest rates, printing money will lower rates but increase inflation expectation.
3.2. Principle economic factors
• The exchange rate
Significant portion of the demand for government bonds comes from overseas markets. Thus changes in expectations of exchange rates will affect demand from overseas investors. It will alter the relative attractiveness of domestic and overseas bonds for investors.
3.2. Principle economic factors
• Institutional cashflow
The demand for bonds can be affected by institutional cashflow. If institutions experience an inflow of funds due to increased saving, this will likely increase their demand for bonds. Changes of investment philosophy can also affect institutional demand for bonds.
3.2. Principle economic factors
• Returns on alternative investments and other factors
Almost any piece of economic news has implications for inflation and short-term interest rates. The impact of other economic factors can therefor usually be understood in terms of these two quantities.
- Factors affecting the level of the equity market
4. 2. Expectations of profits
Investors’ expectation of future corporate profitability and the value of those profits that largely determines the general level of the equity market.
Some main factors that influence the general level of the equity markets:
• Expectations of real interest rates and inflation
• Investors’ perceptions of the riskiness of equity investment
• The real level of economic growth in the economy
• Expectations of currency movements
- Factors affecting the level of the equity market
4. 3. Real interest rates
Real interest rates have two important effects:
- Low real interest rates should 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 present value of future dividends should be higher.
