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Flashcards in 11 - Behaviour of the markets Deck (31)
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1
Q

What is the goal of this chapter?

A

To understand how economic factors affect asset prices

2
Q

What are the main market drivers of assets in the economy?

A
  • Attractiveness of asset values are linked to the interest rates:
    -> Asset returns are calculated as returns on
    risk free assets + premium for risk factors eg.
    unknown expenses, liquidity, inflation etc.
  • Interest rates are determined majorly by:
    -> Govt. policy ie. setting base rates
  • Investors’ view on the risk environment (views on specific assets as well as the general economy) :
    -> Major determinant of appropriate prices are
    acceptable to each investment
    -> Supply and demand balance out to set prices
    for the investments
3
Q

Why do interest rates change?

A
  • Government’s primary tool to control the economy is setting SHORT-TERM interest rates. In particular to control:
    -> Economic growth
    -> To control inflation (demand-pull inflation)
    -> Cost of imports by controlling exchange rates
    (cost-push inflation)
  • Govt policy sets the base lending rate for central to commercial bank lending
4
Q

How do changes in interest rates affect inflation?

A
  • Short-term real interest rate increase => encouragement to save/ discouragement to borrow => reduction in consumer expenditure (demand) => decreased short-term economic growth rate => reduced upward pressure on prices
  • Short-term real interest rate decrease => encourages spending/borrowing/general investment => increased short-term economic growth rate => increased upward pressure on general prices
  • Notice the LAG between inflation and interest rates
5
Q

How do changes in interest rates affect exchange rates? and what are the knock on effects on businesses?

A
  • If interest rates are low in a country, investors are less inclined to invest in that country as oppose to others => reduced demand for domestic currency => weakened domestic currency
  • Cost-push inflation for importing businesses because foreign goods appear more expensive & prices go up
  • This is good for exporting businesses because overseas investors find goods more cheap and affordable
  • This can be controlled by increasing interest rates
6
Q

Decision making process for base rates set by central bank:

A
  • Inflation and levels of economic activity influence base rate decisions:
    -> If inflation appears as if it will “take off” base rates
    are increased
  • Mkt. supply & demand validates the rates set (or not) eg. if mkt. still keeps borrowing and inflation increases more, govt. may increase base rates further
  • Central bank resets & adjusts if desired outcomes not achieved
7
Q

What affects LONG-TERM interest rates?

A
  • Mkt. supply & demand of bonds affect the rest of the yield curve (medium & long-term)
  • Specific factors include:
    –> Inflation long-term expectations
    –> Government interventions
    –> Risk management by investors eg. pension
    schemes
    –> Overseas rates, exchange rates
8
Q

Govt influence on long term interest rates

A
  • Set the price for govt. bonds at each duration
    –> They can exercise muscle as dominant bond
    supplier
  • Quantitative easing, buying back gilts, reducing supply
    to increase prices
  • Communication -> announcements for short-term
    interest rates over the medium term
9
Q

What makes the price of an investment price elastic?

A
  • Many alternative close substitutes for the investments
10
Q

Which has primary influence on investment mkts supply or demand?

A
  • Under most conditions, demand changes more rapidly than supply
    -> Sudden change in legislation on how statutory
    valuations are done wrt. gilts for instance
    -> This could cause a sudden surge in demand for
    certain gilts
11
Q

What are the main factors affecting the demand for assets?

A
  • Riskiness of the asset
  • Need for fin. institutions to match liabilities
  • Expected investment returns from holding asset
    –> Is the increased risk of corp. bonds commensurate
    with the added yield over gilts?
12
Q

Supply, demand and hence the prices of bonds are driven by:

A
  • INFLATION EXPECTATIONS and inflation risk premium
    -> A sudden increase in inflation expectation
    decreases bond prices => risk of A/L mismatch
  • SHORT-TERM INTEREST rates BUT this is:
    -> Basically uncorrelated with long-term bond yields
  • BORROWING REQUIREMENTS
    -> Private sector - for investment into businesses
    -> Public sector - to raise money for public
    infrastructure/social welfare
  • INSTITUTIONAL cashflow (pension schemes matching liab.)
  • INTERNATIONAL context
    -> Exchange rates
    -> Foreign interest rates
  • Returns on ALTERNATIVE investments eg. property may be particularly cheap
  • Any economic VIEWS/ OPINIONS/ NEWS eg. covid
    pandemic announcement
13
Q

How does inflation affect bond prices?

A
  • Investors buy bonds @ price which they expect will have a particular real return over inflation
  • If current inflation expectations are higher in future, required yields will be higher @ the longer terms (investors require a particular maintained real return regardless of future inflation)
  • Prices change right when the information comes out
  • If inflation is higher than expected, demand for certain bonds will reduce because they do not provide required real returns (investors will not buy them).
  • Investor views of inflation will have major impact on bond prices & the yield curve
14
Q

Increased inflation expectations might lead to increase in unemployment rates. Why?

A
  • Increase in inflation expectation => increase in interest rate expectation => savings expected to increase => reduced spending => reduced demand => less need for workers => reduction in wages by layoffs (otherwise company will make losses)
15
Q

How do short-term interest rates affect bond prices?

A
  • If base-rate increases, the short-term bond prices reduce in response because they are highly correlated with base-rates eg.
    • > 1 yr & 2 yr prices highly correlated
  • Longer term bonds further down the yield curve however eg. 10 yr are uncorrelated w short-term rates (empirically observed fact)
  • Uncorrelated in the sense that 10yr bonds will react to the news, but whether they move up or down will be uncorrelated to the movement of the base rate
16
Q

Effects of government borrowing on bond prices and interest rates:

A
  • Taxes raised by govt might be insufficient to pay welfare benefits, build roads etc.
  • The govt issues bonds to borrow money as a result
  • Bond supply rises & their prices fall resulting in higher interest rates
17
Q

Institutional cashflows effects on bond prices:

A
  • If institution incomes rise, they will invest more in bonds, increasing demand and prices of bonds
  • Change in investment strategy also affect bond prices similarly (de-risking strategies for pension schemes)
18
Q

How may corporate bond and gilt prices/yields react to news of a recession?

A
  • Investors who bought corporate bonds may choose to sell these in light of a recession to buy gilts which are more stable
  • Because the company might go bust if nobody buys their products => investors lose all their money possibly
  • Investors EXPECT lower profits from companies
  • Demand for corporate bonds decreases => yield increases
  • Demand for gilts increases => yield decreases
  • The credit spread between the two yields increases
19
Q

Factors affecting equity market levels:

A
  • Expectations of FUTURE profits/dividends
  • REAL level of EXPECTED economic growth (because equities are real assets not concerned with inflation)
  • Employment figures are key indicators of real level of expected economic growth
  • General level of business outlook:
    - > Recession/boom
    - > Uncertainty
    - > Stability
20
Q

What factors influence supply of bonds?

A
  • Govt supply: Falling tax receipts and increased govt spending on public amenities leading to increased public sector borrowing => increased gilt supply => fall in gilt prices
  • Corporate bond supply: Comparative attractiveness of raising money from debt or equity
  • Attractiveness of interest rate environment: low yields mean cheap loans
21
Q

How is the supply of shares be influenced?

A

Supply of shares can be from:

  • Privatisation of govt. organisations eg. railways
  • Initial Public Offerings
  • Rights issues
  • Offering of overseas shares on domestic exchange

Note: These are relatively minor effects

22
Q

How is the supply of property influenced?

A

Supply of property can be significantly influenced by:

  • Changes in planning law (councils agree to more building)
  • Lower interest rates (lower cost to builders who will borrow, and also to potential house buyers)
  • Lower building costs eg. steel prices
  • Growing economy
  • Change of use of property (if lease structure and planning law allows) eg. agricultural to housing, warehouse to flats, tear downs
23
Q

Supply influences on “other” markets:

A
  • Technological advances facilitating design of complex derivative instruments & fast computer trading increased the supply of derivative instruments
  • Increased the range of derivative products
  • New markets can emerge
24
Q

Non-economic drivers of demand for assets:

A
  • External context has changed even if investors’ view of assets remain unaltered
    –> Investors’ incomes changing
    –> Investors’ preferences changing (maybe due to tax
    laws)
    –> Competing assets becoming more favourably
    viewed
  • Investors’ views of asset’s risk and future returns have changed
25
Q

Impact of investors’ incomes changing on demand for assets:

A
  • If investors have more income => more to save
  • More money passed onto insurance companies/ pension schemes/unit-trusts etc
  • These institutions invest in more bonds/equities
  • Companies may use their increased profits to support their DB pension schemes => large inflows to equity/bond markets eg. increased demand for long bonds by pension schemes
  • Essentially more money all round to buy market assets so demand for them increases while the supply does not shift as much => price increases all round
26
Q

Reasons for investors’ preferences changing on demand for assets:

A
  • Changes in TAX regimes
  • Changes in REGULATION eg. minimum requirement of bond investments in pension schemes, incentives to invest in green industries
  • Changes in investors’ own LIABILITIES and matching required eg. LPI statutory req. to increase pension pmts by MIN(RPI% , 2.5%)
  • EDUCATION of investors
  • MARKETING
  • Uncertainty in POLITICAL climate
  • JOURNALISTIC influences bidding up prices, fashion, mkt. sentiment, herd behaviour
27
Q

Influence of competing assets on asset demand:

A
  • Competing assets may become more favourably viewed
  • > eg. Pension schemes bid up the value of long-term bonds to match their long term liabs and other investors see shorter corporate bonds as better value for money
28
Q

Impact of a change in investors’ views on future risk & return of assets on demand for assets:

A
  • Investor more concerned about risk and less optimistic about future returns
  • Lots of close substitutes in most investment mkts

Examples:

  • > If company’s competitor is doing well, share price of the company can reduce
  • > Respected CEO resigns
  • > Political climate
  • > Revised strategy for the future
  • > Poor performance in recent years
29
Q

What is a yield curve?

A

The yield curve is a plot of yields of zero coupon bonds against term to redemption of zero coupon bonds

30
Q

Theories of the yield curve:

A

o Expectations theory – yields reflect expectations of future short-term interest rates and inflation

o Liquidity preference theory – investors require an additional yield on less liquid (longer-term) bonds

o Inflation risk premium theory – investors require an additional yield on longer-term conventional bonds to compensate for the risk of inflation being higher than anticipated.

o Market segmentation theory – yields at each term are determined by supply and demand at that term. Demand comes principally from institutional investors trying to match liabilities.

31
Q

Theories of the real yield curve:

A
  • Real yield curve is a plot of real GRYs on zero coupon index-linked bonds against term to maturity
  • Difference b/w conventional yield curve & real yield curve is approx. the mkt expectation of future inflation