Economics: Investment Market - Case Study Example

Economics – Investment Market Table of Contents I. Effects of Increasing Interest Rates to Bond Prices ……………………. 3 II. The Best Time to Invest in Housing rather than in the Stock Market …. 6 III. Fundamentals Used in Determining Share Prices ……………………… 9 IV. Factors that Affect the Price of a Call Option ………………………….. 12 References …………………………………………………………………… 15 Effects of Increasing Interest Rates to Bond Prices The continuous changes in the supply and demand of credit, exchange rates, economic condition, inflation and Federal Reserve Policy among others affect the fluctuation of interest rates. Interest rate is “the cost of borrowing money.” (Heakal, 2003) It is used to compensate for the service and risk of lending money to the borrower. The rise and fall of interest rates directly affect the prices of bonds in the market. There is an opposite relationship between the interest rates and the prices of bond such that when the interest rates go down, the prices of bonds usually go up. On the other hand, when the interest rates go up, the prices of bonds usually go down. (RBC Asset Management, 2006) Let us consider the case of zero-coupon bonds. This type bond does not pay interests until the maturity period. The interest is computed by deducting the purchase price and the par value paid at maturity. (Investopedia, 2007a) For example, the trading price of a zero-coupon bond is at £100 and has a par value of £130 which is paid at the maturity period of 1year. The bond’s rate of return at the present time is approximately 30% ((130-100)/100 = 30%). Generally, the satisfaction of the investor receiving a 30% return depends a lot on the overall performances in the bond market. In case a new bond that gives a 35% yield is currently offered in the market, the investor receiving a 30% return from the zero-coupon bond will not be satisfied because the main interest of bond investors is to gain a bigger return on investment (ROI). The new bond will therefore make the zero-coupon bond less attractive causing its demand to decline. (See diagram below) In case the current interest rate of a zero-coupon bond increases up to a 35% yield, the said bond will be attractive and will increase its demand. In doing so, the price of the pre-existing zero-coupon bond will decrease up to such point that it matches the same return yielded by the prevailing interest rates. In this case, the price of bond would drop from £100 which gives a 30% yield down to £96 which gives a 35% yield ((130-96)/96 = 35%. (See diagram below) This is the reason why a bond price would increase in case the interest rate drops. In case the interest rate of other bonds decreased to 15%, the zero-coupon bond which gives a yield of 30% will be very attractive to bond investors. Therefore, more people will buy the zero-coupon bond. In this situation, the price of bond will push up until the bond’s yield matches the 15% rate. Therefore, the price of bond will now become approximately £112.9 ((130-112.9)/112.9 = 15%). At this point, when the bondholder decides to sell the zero-coupon bond, he/she will have an extra £12.9 from its original price of £100. Therefore, a decrease in the interest rate increases the price of bonds. The Best Time to Invest in Housing rather than in the Stock Market Economic indicators are used in determining the best time to invest in housing rather than in the stock market. The best time to buy a house is when the country’s economy is not doing well and is causing the London or UK stock market and the price of houses to slide down. In other words, there is a significant decline in the economic activity i across the country also known as ‘recession’. During the economic recession, the interest rates fall in order to encourage more business people to borrow money. (Investopedia, 2002) In times of recession, people tend to hold on to their cash. This is the time when investors slow down on investments. The huge gap between the supply and demand for houses is causing the price of houses to go down. Real estate owners have no other way but to decrease the price of housing establishments in order to attract investors. (See the diagram below) For example, a young man is offered to buy a condo unit around downtown. The building is newly constructed. The apartment for sale is a 2BR, 748SF unit amounting to £300K. The investment opportunity for renting out the unit is £1,300 per month less other expenses such as condo fees, property taxes, and insurance worth £400 a month. This yields a total of £900 each month as the net revenue for the investor. In a year, the revenue will have a total of £10,800 (£900 x 12 months = £10,800). The percent cost of the unit is 3.6% (£10,800/£300,000 = 3.6%). The yield on this investment is 3.6% nominal, before tax which is already considered to be a good investment opportunity. When the economy starts to grow, housing investments will start to boom. During this point, the demand for houses increases. The increasing demand for houses will bring the price of houses to increase. (See diagram below) Investing in houses is considered as a safe investment rather than investing in the stock market. A stock market investor can lose every cent when the stock market goes down. (Regnier, 2007) There are many ways on how house investors can earn profit. Some investors borrow money from banks to buy a house at the time when the economy is at a point of recession and selling these houses at the time when the economy gets better is an act of ‘leverage’ ii. The difference between the purchase and selling price of the house is known as a ‘capital gain’ (Selling Price – Purchase Price = Capital Gain). A portion of the capital gain that goes to the government is called the ‘capital gain tax’. As a general rule, the investor need not pay any taxes until he has received the cash from the capital gain. (Investopedia, 2000) A short-term investment is usually taxed at a higher rate than in long-term investments. Therefore, it is wiser to hold on the house as a long-term investment and allow the housing investments to a compounded tax free in retirement-savings accounts. Fundamentals Used in Determining Share Prices Analysts analyses a company’s fundamentals to determine stocks’ intrinsic value iii as opposed to the value wherein the stock is being traded in the stock market. (Investopedia, 2007b) If the value of the stock is more than its price, then the stock is worth buying. It is not worth buying the stock if the value of the stock is lower than its price. Fundamental analysis measures intrinsic value of a stock by examining closely all related economic, financial and other qualitative and quantitative factors. It includes studying the macroeconomic factors like the overall economic condition and a specific industry condition and/or an individually specific factor like a company’s financial condition and company management. It is possible to determine the current market price of a company shares traded in the stock market. For example, the demand and supply of sugar determines the market price of sugar. Based on the past data in the trend of the supply and demand for sugar, it is possible to forecast the future supply, demand, costs, and price of sugar. The price of sugar increases during winter season because the supply of sugar is less than its demand. This is an example of seasonality trend in the sugar industry. Using the same forecasting method, analysts can determine the supply and demand of shares of a sugar company. It is possible to link the expected future profits with the expected capital gains in sugar shares through the use of the present value iv formula for a sugar company and with the use of rate to discount the future expected profits to the current market price of shares. (Harvey, 2007) The analyst can foretell what may happen to share prices in case the forecast of sugar profitability proves to be wrong. We simply link the increase in the share prices with the additional funds invested in the sugar company in case a new equity is issued for the expansion of sugar production. To determine the present value of price shares, each future cash flow is multiplied by a present value factor. For example: given that the future value of £100 having a growth rate of 12; the present value of £ to be received in one year is £89.29. (£100 x [1 / (1 + 0.12)] = £89.29) (See chart below) Since the nominal rates of return and the corporate performance of a sugar company are reflected in the stock prices, the share prices are considered as a reliable source of determining the fundamental economic value of a stock investment. The price-earning ratio can also be used in calculating the past or recent company earnings. It is used to compute for the future returns of share by assuming that the share prices can be used in reflecting information regarding the future profit of the sugar company. The future profit can be assumed to increase at a fixed rate (g > 0) or will remain constant at a fixed nominal value wherein (g = 0). (See graph on page 11) Other factors used in determining the current market share prices of the sugar company in the stock market include price guessing, speculations or manipulation of the capital gains, and interest rates on alternative options. Earnings per Share (Sample of Computed EPS) Factors that Affect the Price of a Call Option Option, a type of security, is considered as an investment world for sophisticated investors. These are complex securities which gives the buyer the right to buy or sell an asset at a specific price on or before a certain date. This type of security can really be very risky. (Investopedia, 2007c) The stock price, time, interest rates, political factors, and natural calamity are some examples of external factors which can affect the price of a call option. (Graham, 2003) Let us consider foreign-exchange trading. Given that the economy of Japan goes up; the purchasing power of Yen (JPY) over US dollar (USD) also increases. In the forex trading, at the time the purchasing power of Yen increases, traders that ‘calls’ or ‘buys’ Yen are the ones who earn profits. Traders that ‘sells’ or ‘puts’ Yen currency are the ones that loses money in the trade. Time also affects the price of an option. Once a currency increases, at a given time it will eventually decline and then go up again. Fluctuation of the currencies are inevitable specially in the case of short-term investments because there are a lot of political/government, economic, and environmental factors which can directly affects the economy of a country. Speculations and other bad news also directly affect the price of an option. The terrorist attacks that hit London rush hour sometime in July 7, 2005 is a good example wherein the value of EUR went down the slope within a few minutes after the incident. (Springer, 2005) London Stocks Exchange was badly affected by the news. According to Springer of Scotsman.com (2005), ‘the FTSE 100 index plunged 160.4 points to 5069.2 in morning trading; the pound weakened by almost a cent to 1.741 against the US dollar; and the sterling also declines.’ Below is an example of a downward trend of a currency. The interest rate indirectly affects the price of a call option. In case a bank’s interest rate is low, there will be more people who would borrow money and invest it somewhere else. This will have a good impact on the country’s overall economy. A strong economy would also affect the strengthening of its currency. On the other hand, when the interest rate is high, there will be lesser individuals who would borrow money to start up a business. People holding onto their cash is another factor that could affect the price of call option negatively. Political issue such as having a country’s president being impeached for moral issues would eventually affect foreign investors to withdraw their investments from the said country. Another example of political factor is the presidential election of a country. A riot is likely to be present in case the winning president is proven to have cheated in the presidential election. These are some situation which could greatly affect the country’s economy negatively. Speculations is expected to happen which directly affects the stock market, the over all economy of the country, and the price of a call option. Natural calamity can hurt a country’s economy. For example, the flood risk due to global warming in London has affected a lot of people. Many businesses were badly damage by flooding; many people lost their lives, while the rest lost their home. The Association of British Insurers (ABI) reported that a one-time incident of a major flood could damage roughly £16 billion (US$30.2 billion) worth of properties. (Challis, 2006) This kind of tragedy including the terrorist attack that hit London last July 7, 2005 has caused a great impact in the U.K. economy. *** End *** References: 1 Challis, S. (2006) ‘Analysis: UK Insurers Fret Over Rising Flood Risk’ Retrieved: March 19, 2007 < http://www.planetark.org/ > path: news 2 Graham, J. (2003) ‘Trading a Stock Versus Trading Stock Options – Part II’ Investopedia Retrieved: March 18, 2007 < http://www.investopedia.com/ > path: article 3 Harper, D. (2004) ‘The Impact of Interest Rates on Real Estate Investment Trusts’ Investopedia Retrieved: March 18, 2007 < http://www.investopedia.com/ > path: article 4 Harvey, C. (2007) ‘Hypertextual Finance Glossary’ Retrieved: March 18, 2007 < http://www.duke.edu/ > 5 Heakal, R. (2003) ‘Forces Behind Interest Rates’ Investopedia Retrieved: March 17, 2007 < http://www.investopedia.com/ > path: article 6 Investopedia (2000) ‘A Long-Term Mindset Meets Dreaded Capital- Gains Tax’ Retrieved: March 18, 2007 < http://www.investopedia.com/ > path: article 7 Investopedia (2002) ‘Recession: What does it mean to Investors?’ Retrieved: March 17, 2007 < http://www.investopedia.com/ > path: article 8 Investopedia (2007a) ‘Zero-Coupon Bond’ Retrieved: March 17, 2007 < http://www.investopedia.com/ > path: terms 9 Investopedia (2007b) ‘Stock-Picking Strategies: Fundamental Analysis’ Retrieved: March 18, 2007 < http://www.investopedia.com/ > 10 Investopedia (2007c) ‘Options Basics: Introduction’ Retrieved: March 18, 2007 < http://www.investopedia.com/ > 11 RBC Asset Management (2006) ‘Fixed-Income Investing’ Retrieved: March 17, 2007 < http://www.rbcam.com/ > 12 Regnier, P. (2007) ‘Real Estate Can Only Fall 10% to 20%’ CNN Money Retrieved: March 17, 2007 < http://money.cnn.com/ > 13 Robinson, D. (2005) ‘US Political Debate Heats Up Over How to Pay for Katrina’ VOA news Retrieved: March 18, 2007 < http://www.voanews.com/ > path: archive 14 Springer, W. (2005) ‘Terrorist Attacks Hit London Rush Hour’ News.Scotsman.com Retrieved: March 19, 2007 < http://news.scotsman.com/ > Read More