Chapter 12 - Market behaviour

What is the relationship between risk and returns in asset classes?

Assets with the greatest risk have the potential for the greatest long-term returns.

What factors influence an investor's risk appetite?

An investor's risk appetite is influenced by their level of free capital.

What risks are associated with fixed-interest government bonds?

Fixed-interest government bonds are exposed to inflation risk.

List the risks associated with corporate bonds.

Corporate bonds are exposed to default risk, inflation risk, marketability risk, and liquidity risk.

What risks do equities face?

Equities are exposed to default risk, marketability risk, inflation risks, and the risk of an uncertain dividend stream.

How does demand for an asset affect its price?

As demand for an asset rises, the price of the asset will rise.

What is the elasticity of demand for most investments?

Demand for most investments is very price elastic due to close substitutes.

What primarily determines short-term interest rates?

Short-term interest rates are largely determined by government policy.

What three needs does the government balance when setting interest rates?

The government balances the need to control inflation, encourage economic growth, and manage the level of the exchange rate.

How is the level of interest rates typically related to inflation?

The level of interest rates is usually a little above the rate of inflation.

What does the yield curve represent?

The yield curve is a plot of yields against term to redemption.

What does expectations theory suggest about yields?

Expectations theory suggests that yields reflect expectations of future short-term interest rates and inflation.

How does liquidity preference theory explain yields?

Liquidity preference theory states that investors require an additional yield on less liquid (longer-term) bonds.

What is the inflation risk premium theory?

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

What determines yields according to market segmentation theory?

Market segmentation theory states that yields at each term are determined by supply and demand at that term, primarily driven by institutional investors.

What characterizes the real yield curve?

The real yield curve plots real gross redemption yields on index-linked bonds against term to maturity.

What are the principal economic factors affecting bond yields?

The principal economic factors are inflation, short-term interest rates, public sector borrowing (fiscal deficit), exchange rate, institutional cashflow, returns on alternative investments, and other economic factors.

Why might investors switch from government bonds to corporate bonds?

If government bonds are offering poor returns, some investors may switch to corporate bonds, which can narrow the yield gap between them.

What influences the general level of the equity market?

The general level of the equity market is influenced by investors' expectations of future corporate profitability and the value of those profits.

List the main economic influences affecting demand in equity markets.

Expectations of real interest rates and inflation, perceptions of riskiness of equity investment, real level of economic growth, and expectations of currency movements.

What factors affect supply in equity markets?

Supply in equity markets is affected by the number of rights issues, share buy-backs, and privatizations.

What economic factors can affect the property market?

Key factors include economic growth, inflation, real interest rates, occupational demand and supply, and the investment market.

How does the inelastic supply of property impact its market values?

The inelastic supply of property magnifies the impact of economic factors on overall property values.

What factors can change demand for an asset?

Changes in investor perceptions about the asset, cash flows, preferences, and external factors like the price of substitute assets.

What are supply factors that influence asset prices?

An increase/decrease in supply can lead to downward/upward pressure on the price of the asset.

How can technological innovation affect asset supply?

Technological innovation can increase the supply of a financial asset, particularly in derivatives markets.