Investor Behavior and the Demand for Bonds

PEMBIAYAAN Mekanisme Pasar

@JURUSAN ILMU EKONOMI

FAKULTAS EKONOMI

UNIVERSITAS HASANUDDIN

2015

--WHY DO PEOPLE DEMAND BONDS ?

--WHY DO PEOPLE SUPPLY BONDS?

-- WHAT ARE THE MOTIVATIONAL

FACTORS?

QUESTIONS TO BE

ANSWERED

PORTFOLIO CHOICE REPRESENTS THE SELECTION OF ASSETS.

ASSET 1 40 % WHAT

ASSET 2 40 % DETERMINES

ASSET 3 20 % THE RISK/

PORTFOLIO 1 RETURN

TRADE-OFF?

THEORY OF PORTFOLIO

CHOICE

PORTFOLIO CHOICE

REPRESENTS THE

SELECTION OF ASSETS.

ASSET 1 20% WHAT

ASSET 2 70 % DETERMINES

ASSET 3 10% THE RISK/

PORTFOLIO 2 RETURN

TRADE-OFF?

THEORY OF PORTFOLIO

CHOICE

WEALTH : SIZE EFFECT: THE QUANTITY OF ASSETS DEMANDED INCREASES WITH WEALTH -- OTHER THINGS THE SAME.

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

DISTRIBUTION EFFECT : WHICH ASSETS INCREASE THE MOST RELATIVELY DEPENDS ON THEIR WEALTH ELASTICITY OF DEMAND.

Ew < 1 NECESSITY ASSET Ew > 1 LUXURY ASSET

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

Ew < 1

Ew = [% CHANGE IN QUANTITY

OF THE ASSET]/ % CHANGE

IN WEALTH

= .5

(% CHANGE IN QUANTITY

DEMANDED) = .5 (% CHANGE IN

WEALTH )

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

FOR THIS CASE, WHAT HAPPENS TO

THE RELATIVE POSITION OF THIS

ASSET IN THE PORTFOLIO AS WEALTH INCREASE ?

GOES DOWN

Ew > 1

Ew = (% CHANGE IN QUANTITY

DEMANDED)/(% CHANGE IN

WEALTH) = 1.5

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

% CHANGE IN QUANTITY DEMANDED = 1.5(% CHANGE IN

WEALTH )

WHAT HAPPENS TO THE RELATIVE POSITION OF THIS ASSET IN THE PORTFOLIO AS WEALTH INCREASES?

GOES UP

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

EXPECTED RETURNS: AN INCREASE IN AN ASSETS EXPECTED RETURN RELATIVE TO THAT OF AN ALTERNATIVE ASSET INCREASES THE QUANTITY DEMANDED OF THE ASSET.

DEFINITION OF EXPECTED RETURNS:

E(R) = R1(Prob. R1) + R2 (Prob. R2 )

% RETURN PROBABILITY

WEIGHT AVERAGE OF % RETURN

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

EXAMPLE

STATE OF PROB. OF ASSET

WORLD STATE RETURN

UPTURN .75 .20 = R1

DOWNTURN .25 .08 = R2

E(R) = .75(.20) + .25(.08) = .17 OR 17%

RISK: FOR A RISK AVERSE INVESTOR , AN INCREASE IN AN ASSETS RISK RELATIVE TO THAT OF ALTERNATIVE ASSETS WILL REDUCE ITS QUANTITY DEMANDED .

HOW DO WE MEASURE RISK ?

RISK MEANS VOLATILITY . SO WE NEED SOME MEASURE OF AN ASSETS RETURN VARIABILITY.

VARIABILITY MEANS BOTH PLUS AND MINUS MOVEMENTS AWAY FROM THE MEAN OR CENTRAL TENDENCY

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

THE USUAL MEASURE OF VARIABILITY FROM A CENTRAL TENDENCY IS THE STANDARD DEVIATION (s) OR VARIANCE (s2)

LIQUIDITY : THE MORE LIQUID AN ASSET IS RELATIVE TO ALTERNATIVE ASSETS (HOLDING EVERYTHING ELSE UNCHANGED) THE MORE DESIRABLE IT IS AND THE GREATER WILL BE THE QUANTITY DEMANDED.

DETERMINANTS OF ASSET

SELECTION OR ASSET DEMAND

SUMMARY OF DETERMINANTS OF ASSET CHOICE

Qa = f ( W , E(R) , RISK , L)

W Qa OTHER THINGS CONSTANT

E(R) Qa OTHER THINGS CONSTANT

RISK Qa OTHER THINGS CONSTANT

L Qa OTHER THINGS CONSTANT

WHY DO RISK AVERSE INVESTORS HOLD MANY RISKY SECURITIES INSTEAD OF ONE OR A FEW RISKY SECURITIES ???

BENEFIT OF DIVERSIFICATION

1.DIVERSIFICATION IS ALWAYS BENEFICIAL TO A RISK-AVERSE INVESTOR SINCE IT REDUCES RISK UNLESS RETURNS ON SECURITIES MOVE PERFECTLY TOGETHER .

2. THE LESS THE RETURNS ON TWO SECURITIES MOVE TOGETHER , THE MORE BENEFIT--RISK REDUCTION -- THERE IS FROM DIVERSIFICATION

SOME POINTS ABOUT

DIVERSIFICATION

3. MAXIMUM DIVERSIFICATION OCCURS FOR TWO SECURITIES WHEN RETURNS ARE PERFECTLY NEGATIVELY CORRELATED . IF ASSETS ARE PERFECTLY POSITIVELY CORRELATED NO DIVERSIFICATION OCCURS.

4. REMEMBER , MOST BUT NOT ALL, ASSET COMBINATIONS PRODUCE DIVERSIFICATION EFFECTS . THIS IS BECAUSE , WHILE CORRELATED , MOST ASSETS ARE NOT PERFECTLY POSITIVELY CORRELATED

SOME POINTS ABOUT

DIVERSIFICATION

EXPECTATION ADAPTIVE EXPECTATIONS RATIONAL EXPECTATIONS NEW INFORMATION BEST GUESS OPTIMAL FORECAST EFFICIENT MARKETS RANDOM WALK UNEXPLOITED PROFITS

BEGINNING TERMS

EXPECTATION FORMED ON THE BASIS OF PAST MOVEMENTS IN AN ECONOMIC VARIABLE.

E(P) = W1 Pt + W2 Pt-1 + W3 Pt-2 + .....

LET W1 = .60 , W2 = .30 , W3 = .10

P = INFLATION RATE

Pt = .10 , Pt-1 = .05 , Pt-2=.05

ADAPTIVE EXPECTATIONS

E(P) = .60(.10) + .30(.05) + .10(.05)

= .06 + .015 + .005

E(P) = .08 OR 8%

WHAT IS THE INFLATION RATE NEXT PERIOD ASSUMING THAT THE ACTUAL RATE OF INFLATION REMAINS AT 10%.

E(P) = .60(.10) + .30(.10) + .10(.05)

= .095 OR 9.5 %

10%

1 2 3 TIME

8% 9.5%

ADAPTIVE EXPECTATIONS

RATIONAL EXPECTATIONS MEANS THAT EXPECTATIONS WILL NOT DIFFER FROM OPTIMAL FORECASTS -

THE BEST GUESS OF THE FUTURE - USING ALL AVAILABLE INFORMATION

NEW INFORMATION CAUSES A CHANGE IN EXPECTATION ;

THUS THE OLD ADAGE THAT NEW INFORMATION MOVES THE MARKET.

RATIONAL EXPECTATIONS

APPROACH

THE MARKET RESPONSE TO UNEXPECTED (i.e., NEW ) EVENTS OR INFORMATION FLOWS -- EXPECTED EVENTS OR INFORMATION ARE ALREADY BUILT INTO ASSETS.

IMPLICATION OF RATIONAL EXPECTATIONS THEORY

1. IF THERE IS A CHANGE IN THE WAY A VARIABLE MOVES , EXPECTATIONS ABOUT THIS VARIABLE WILL CHANGE AS WELL.

RATIONAL EXPECTATIONS

APPROACH

2. THE FORECAST ERRORS OF EXPECTATIONS WILL ON AVERAGE BE ZERO AND CANNOT BE PREDICTED AHEAD OF TIME -- RANDOM WALK.

3. THERE ARE TWO REASONS WHY AN EXPECTATION MAY FAIL TO BE RATIONAL.

a. PEOPLE MIGHT BE AWARE OF

ALL AVAILABLE INFORMATION

BUT ARE TOO LAZY TO MAKE

RATIONAL EXPECTATIONS

APPROACH

THEIR EXPECTATION THE BEST

GUESS POSSIBLE ; i.e., THEY DO

NOT USE AVAILABLE

INFORMATION.

b. PEOPLE MIGHT BE UNAWARE OF

SOME AVAILABLE RELEVENT

INFORMATION , SO THEIR BEST

GUESS OF THE FUTURE WILL

NOT BE CORRECT ON AVERAGE.

RATIONAL EXPECTATIONS

APPROACH

EXPECTATIONS IN THE FINANCIAL MARKETS ARE EQUAL TO OPTIMAL FORECASTS USING ALL AVAILABLE INFORMATION.

Xe = Xof

WHERE e = EXPECTED

of = OPTIMAL FORECAST

X= VARIABLE BEING FORECAST

EFFICIENT MARKETS

THEORY

EFFICIENT MARKET THEORY IS BASED ON THE ASSUMPTION THAT PRICES OF SECURITIES IN FINANCIAL MARKETS FULLY REFLECT ALL AVAILABLE INFORMATION.

RET % = [ P t+1 - P t + R ] / Pt

Pt AND R ARE KNOWN

Pt+1 IS UNCERTAIN

EFFICIENT MARKETS

THEORY

RETe = [ Pet+1 - Pt + R ] / Pt

Pet+1 = Pof

t+1

OPTIMAL

FORECAST

( BEST GUESS )

EFFICIENT MARKETS

THEORY

THIS IMPLIES THAT RETe = RET* MARKET CLEARING RETURN FURTHERMORE , AT ANY GIVEN TIME

THE EXPECTED RETURN (RETe) EQUALS THE MARKET CLEARING

RETURN (RET*) WHICH EQUATES THE QUANTITY DEMANDED OF A SECURITY TO THE QUANTITY SUPPLIED.

EFFICIENT MARKETS

THEORY

RETe = RET* MARKET

CLEARING RETURN

BUT RETe = RETof SO

RETof = RET*

CURRENT PRICES IN A FINANCIAL MARKET WILL BE SET SO THAT THE OPTIMAL FORECAST OF A SECURITYS RETURN USING ALL AVAILABLE INFORMATION EQUALS THE SECURITYS MARKET CLEARING RETURN.

EFFICIENT MARKETS

THEORY

WEAK FORM MARKET EFFICIENCY

SEMISTRONG FORM MARKET EFFICIENCY

STRONG FORM MARKET

EFFICIENCY

EFFICIENT MARKETS

THEORY