week 4

Question 1

o Bubble

Answer 1

 Not justified by market fundamentals, overvalued and ‘novelty’
 Difficult to pin down what economic fundamentals are
 Most people believe they can recognize a bubble if they see it
 Need to consider both arguments for and against bubbles

Question 2

 Historical and expected returns to stocks and bonds

Answer 2

o So why invest in bonds?
 Depends on risk aversion, and short-term vs long-term rates?
 Equity risk premium puzzle
• Describes the anomalously higher historical real returns of stocks over government bonds
• The premium is supposed to reflect the relative risk of stocks compared to ‘risk free’ government bonds, but the puzzle arises because this unexpectedly large percentage implies an unreasonably high level of risk aversion among investors
 In the long run, you are better off investing in stocks

Question 3

 Fixed Income securities

Answer 3

o Promise defined stream of income over fixed number of periods with repayment of principal at the end
o Nominal payments are fixed
 But if expected inflation / perceived risk changes
 Leads to discount rate, E(R), changes and affects price

Question 4

 Interest rates and bonds

Answer 4

o Inverse relationship
o A bond’s change in value is driven largely by current and forecasted interest rates
o Interest rate decrease -> value of a fixed coupon increasing
 Increase in bond value would mean the fixed coupon, as a percentage of bond value, would decrease to be in line with interest rates
o Market interest rates increase
 Value of bonds would typically decrease

Question 5

 Credit stress and bonds

Answer 5

o Inverse relationship
o If a bond issuer becomes financially stressed, may propose varying the terms of their borrowing
 E.g. reducing the periodic coupon, extending maturity, reducing FV

Question 6

 Retail investors and bond markets

Answer 6

o Bond markets are less liquid, as bonds are sold in large parcels
o Bonds are sold in the OTC market
o Less volatility in return
o They are still affected by this because
 Investing in the index
 Investing in equities

Question 7

 How a bond Fund Works

Answer 7

 Trading to capture capital appreciation
 Duration strategy
• Interest rate changes affect the price of a bond
• Price of bonds with longer maturity are more sensitive to changes in interest rate
 Yield Curve
• Interest rates on bonds are expressed on an annual basis
• Yield curve plots the interest rates of bonds having different maturities but same credit risk
• Charge higher interest rate for a longer period of time
o Due to more risk and tied up / giving up other opportunities
• However, you might give someone a lower interest rate
o Due to believing the economy will not do well in the future
o Lower interest rate to keep them
o Harder to find a buyer
• Gives an indication on what the market will be like in the future

Question 8

 Bond market: valuation and macroeconomics

Answer 8

o Financial assets are priced relative to each other
o Economic conditions and financial policies that influence bond prices also affect the value of other assets
o Are bonds in a bubble?
 Bonds being in a bubble reflect bond yields being very low, people are not requiring a high ROR in investing in bonds
 Low consumer confidence, highly risk averse, fearful that there is some event in the future? More fearful than they need to be

Question 9

 Which is a safer investment: bonds or equities?

Answer 9

o Bonds are safer / low risk = get your money back almost guaranteed, but will the REAL return be positive or negative?
o Inflation higher -> bond value decreases dramatically, price of bonds fall
o Equities are more responsive to inflation
 Profits of a company earns will be a function of inflation -> companies’ profits increase
 Equities are hedged, in the longer-run, equities could be safer investment than bonds if you expect inflation

Question 10

 Risk and return in a low rate environment

Answer 10

o Asset prices which might look expensive are more reasonably priced given that the rate structure currently is at historically low levels
 Relative interest rates
o Will the current rate structure remain at these levels or return to higher levels?
 If interest rates increase -> prices will drop

Question 11

 Why are bond yields so low?

Answer 11

o Interest rates are a function of demand and supply of cash
o Demand for cash depends on investment opportunities
o Aggregate demand for goods and services is low so companies don’t invest
 Fear there is insufficient demand

Question 12

 Why is aggregate demand low?

Answer 12

o Large scale outsourcing of production of goods and services
o Efficient use of capital -> increased wealth inequality and lowered spending power of middle age
o Aging population has reduced overall demand
o Secular stagnation
 New innovation does not have as much impact as it did before
 We are stuck in a period of secular growth
• Will not see the same big growth as we have seen in the years before
o Excess savings glut
 East-Asian countries accumulating USD

Question 13

 Why isn’t there sufficient aggregate demand for G+S?

Answer 13

o Changes in nature of modern economies
o Concerns: will the decline be long-lasting?
o Expect rates to be lower because the existing capacity is sufficient to reach demand
 Economies are becoming efficient, banks have little choice but to keep interest rates low
 E.g. price of technology decreased
 Decline in manpower requirements

Question 14

 QE

Answer 14

o Increase in money supply when bank interest rates are close to 0
o Central bank credits its own account with money
o Purchases government and corporate bonds from banks
o Gives banks excess reserves required to create new money
o Risks include the policy spurring hyperinflation, or banks using the additional cash to increase their capital reserves
 If they fear increasing defaults in their present loan portfolio