Economics and Investment Markets Flashcards
According to CFA. Why are interest rates higher when future conditions are expected to be better
Because we delay consumption, our utility to consume, so we have to be compensated for the higher rate of return.
Good economics = Higher interest rates = Encourage people to save
As market conditions improve, bonds decrease in price, and the yield increases. Remember the inverse relationship.
What happens when income rises
Lower Risk aversion
Higher investments in risky assets
Low premiums for a given risk
One interpretation of an upward-sloping yield curve is that the returns to short-dated bonds are
One interpretation of an upward-sloping yield curve is that returns to short-dated bonds are more negatively correlated with bad times than are returns to long-dated bonds. This interpretation is based on the notion that investors are willing to pay a premium and accept a lower return for short-dated bonds if they believe that long-dated bonds are not a good hedge against economic “bad times.”
The covariance between a risk-averse investor’s inter-temporal rate of substitution and the expected future price of a risky asset is typically
Negative
Explain the relationship between Real short-term interest rates and GDP
Real short-term interest rates are positively related to both real GDP growth and the volatility of real GDP growth.
If GDP volatility is high, so too is the Real-Short term interest rates.
Break-even rate of inflation (BEI)
The difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.
Is composed of the expected rate of inflation plus a risk premium for the uncertainty of future inflation.
Explain Why PE, CF, or other factors can increase in regards to the Economics and Investment Markets
One of the factors in the denominator, Real interest rates, inflation, expected inflation, credit risk decrease.
Default-free real interest rates tend to be relatively high in countries with high expected economic growth because investors
Increase current borrowing
Positive output gaps are usually associated with
Economic growth beyond sustainable capacity
One interpretation of an upward sloping yield curve is that the returns to short-dated bonds are
More negatively correlated with bad times than are returns to long-dated bonds.
This interpretation is based on the notion that investors are willing to pay a premium and accept a lower return for short-dated bonds if they believe that long-dated bonds are not a good hedge against economic “bad times.”
A decrease in the prices of AAA-rated corporate bonds during a recession would most likely be the result of
Increases in credit risk premiums
When will higher corporate rated bonds outperform lower rated corporate bonds.
During recession
Risk-averse investors demanding a large equity risk premium are most likely expecting their future consumption outcomes and equity returns to be
Positively correlated
If investors demand high equity risk premiums, they are likely expecting their future consumption and equity returns to be positively correlated. The positive correlation indicates that equities will exhibit poor hedging properties, because equity returns will be high (i.e., pay off) during “good times” and will be low (i.e., not pay off) during “bad times.” In other words, the covariance between risk-averse investors’ inter-temporal rates of substitution and the expected future prices of equities is highly negative, resulting in a positive and large equity risk premium. This is the case because in good times, when equity returns are high, the marginal value of consumption is low. Similarly, in bad times, when equity returns are low, the marginal value of consumption is high. Holding all else constant, the larger the magnitude of the negative covariance term, the larger the risk premium.
Are interest rates and marginal rate inter-temporal rate of substitution directly or inversely related
Inversely related
Higher Mt - Lower Interest rates
Lower Mt - Higher interest rates
Are future asset prices and marginal rate inter-temporal rate of substitution directly or inversely related?
Inversely related
Higher future asset prices -> Lower Mt - Higher interest rates
Lower future asset prices -> Higher Mt - Lower interest rates
