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Chapter 3 notes 2012 08 02


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Chapter 3 notes 2012 08 02

  1. 1. finlogIQ Knowledge for financial IQ STRICTLY PRIVATE AND CONFIDENTIALChapter 3Fundamental AnalysisAugust 2012
  2. 2. Chapter summary and outlineThis chapter explains how fundamental analysis is the study ofeconomic, political or social factors which affect demand andsupply for a commodity or financial instrument. Key factorsinclude fiscal policy and treasury operations, monetary policy andcentral bank operations, as well as factors that affect interestrates, yield curves, foreign exchange rates and stock markets.Chapter outline:• Fiscal policy and treasury operations• Monetary policy and central bank operations• Factors affecting interest rates and yield curves• Factors affecting foreign exchange rates• Factors affecting stock marketsfinlogIQ 2
  3. 3. Introduction• Fundamental analysis is a study of basic factors - economic, political or social - which affect demand and supply for a commodity or financial instrument• Production indicators – Gross national product (“GNP”) • Measures market value of total output of goods and services and is published in real and current dollar terms • GNP = Consumption + Investment + Government Expenditure + Net Exports – Industrial production (“IP”) • Measures activities among manufacturers, miners and utility concerns but excludes production in farms, trade or service industries, construction or transportation• Consumption indicators: – Housing Starts • Measures the total number of private housing units that started in a period • Leading indicator of residential construction activity, demand for mortgage money and construction loans – Retail Sales • Measures net sales (cash and credit) of major establishments in retail tradefinlogIQ 3
  4. 4. Introduction - 2• Income indicators – Personal income • Wages, salary, rent, dividends, interest earnings and transfer payments • May reflect underlying economic conditions and foretell future consumption level – Unemployment • Data on total civilian employment, non-farm payroll, manufacturing hours worked, number of jobless workers and percentage unemployed• Inflation indicators – Consumer Price Index (“CPI”) • the average change in prices of a basket of goods and represents inflation at the consumer level • the focus is on the core inflation which excludes food and energy from the basket of goods – Producer Price Index (“PPI”) • Reflects the costs of resources to manufacture goods and measures price changes of goods that are completely processed and ready for sale to the final user • Implicit price deflator is a broader measure of current inflationary pressuresfinlogIQ 4
  5. 5. Fiscal Policy and Treasury Operations• The objectives of policy makers are to maintain output near the full employment levels and to maintain price stability.• Fiscal policy - use of government expenditure and taxation to try to influence the level of economic activity to achieve these objectives – Excess demand will cause inflation and insufficient demand will cause unemployment and deflation – If demand could be stabilized and maintained at a level close to the full employment levels, then excessive fluctuations between low periods and inflationary periods could be eliminated• The government uses its budget to change the government‟s expenditures and revenues through taxes• Expansionary fiscal policy: – Either through increases in government expenditure and/or transfer payments or tax cuts – Adopted when the economy is experiencing high unemployment and poor business sentimentfinlogIQ 5
  6. 6. Fiscal Policy and Treasury Operations - 2• Restrictive fiscal policy – When the level of demand exceeds the operating capacity of the economy – The government should increase taxes and reduce spending – Generally, spending can be targeted at specific sectors while taxation can have a widespread or specific impact. – Main impediment of fiscal policy - normally it takes a long time to be approved and implemented.finlogIQ 6
  7. 7. Monetary Policy and Central Bank Operations• Monetary policies are the domain of central banks• Interest rates are adjusted upwards or downward: – to help the economy achieve sustainable economic growth and price stability• Central bank has the main role in formulating the monetary policy of a country and to participate in the monitoring and regulating of domestic economic activities• Uses monetary tools to influence the reserves in the banking system, credit and money to attain the nation‟s economic goalsfinlogIQ 7
  8. 8. Monetary Policy and Central Bank Operations -2• Quantitative Theory of Money – Money supply is a major determinant of changes in prices, output and employment – Monetary instability is the major cause of fluctuations in real output and income and that rapid growth of money supply will lead to inflation – Changes in the money supply will affect the interest rates and hence, the savings and spending levels of households and businesses, the credit conditions for borrowers and expectations of investors• Money supply can be controlled in three major ways:- – Vary the level of reserve requirement in depository institutions – Vary the level of reserves through open market operations – Set the level of key interest ratesfinlogIQ 8
  9. 9. Monetary Policy and Central Bank Operations -3• An increase in the money supply, given the same level of demand for money, – will lower interest rates which means the cost of current investment and consumption relative to future spending is lower – producers will increase investment and consumers will increase spending – In the short run, prices of final consumption goods will rise and businesses will respond to the higher demand, prices and margins and employment will increase – In the long run or at full capacity, suppliers of factors of production will have a chance to raise prices, rentals and wages and so the general price level will rise• A continual increase in the rate of growth of money will lead to inflation if it is not checked: – Producers face higher costs of production as they operate at full capacity and hence, lower margins – Beyond optimal levels of production, employment and output cannot be expanded further – Rising costs will eventually force a cutback in employment and output – Prices of final consumption goods will rise further due to a contraction of supply and erode the purchasing power of money – Nominal interest rates will rise with the expectation of greater price inflationfinlogIQ 9
  10. 10. Monetary Policy and Central Bank Operations -4• In the final analysis, rapid money growth for a prolonged period of time will result in inflation and high nominal interest rates without increasing the level of output and employment.• In an economy with excess capacity an expansionary monetary policy will bring about a desired rise in output and employment through stimulating investment and spending in an environment where the price of money is lowered – When the demand for money is stimulated, interest rate levels will climb back up – The economy is then at a higher level of output and employment. – The use of monetary tools to lower interest rates to indirectly stimulate economic activity may sometimes be ineffective, particularly when business prospects are dim and investors and consumers are pessimistic about the futurefinlogIQ 10
  11. 11. Monetary Policy and Central Bank Operations -5• Typically, monetary policy has its maximum effectiveness when the economy is at its peak and interest rates are high as almost all of its money supply is used to support the output level. – A reduction of money supply at this time will see an actual contraction of credit supply and through higher interest rates, a contraction in the demand for credit. – The higher cost or price of money will encourage less borrowing and greater savings and investment, and consumption will decline – The use of monetary policy is normally more effective as the process is normally faster and involves less bureaucratic red tape – However, in lowering interest rates to stimulate the economy, it is only effective as long as banks are willing to lend and pass on the savings in cheaper funds to borrowers – Normally it benefits those sectors that are interest rate sensitivefinlogIQ 11
  12. 12. Factors Affecting Interest Rates and YieldCurves• To forecast interest rates using fundamental analysis – need to study factors affecting demand and supply of money. – The point at which supply and demand reach equilibrium will be the price of money as represented by the interest rates. – Interest rate on a financial instrument, and hence its price, varies according to the maturity, credit risk and taxability. – The longer the maturity, the higher the rate of return will be expected for foregoing the use of the funds for a longer period. – An issue with a higher credit risk will have a correspondingly higher interest rate to reflect the credit premium required from this issue compared to another issue of the same maturity. – Marketability of the instrument depends on the amount, maturity and issuer/borrower. Larger issues tend to have better liquidity and hence better marketability. – The legal framework in which the instrument is issued or held is important as the tax laws will determine the net returns derived from the instrument.finlogIQ 12
  13. 13. Yield Curve• To predict and identify interest rate movement, need to study relationship between a security‟s interest rate and its term to maturity: – Yield curves are graphical plots of interest rates on the vertical axis against term to maturity on the horizontal axis. – They are useful tools for studying the term structure of interest rates. – Generally, short-term instruments command a liquidity premium i.e. lower interest rates and higher prices while long-term instruments involve greater risks and so higher yields are required.finlogIQ 13
  14. 14. Yield Curve - 2• There are three types of yield curves: – Positive (normal or upward sloping) yield curve • Normal shape • Long term rates involve greater risks and therefore, the rates are higher • Builds in inflation expectations and occurs during economic expansion. – Negative (inverted or downward sloping) yield curve • Rates are expected to fall and so long-term rates are lower than short-term rates, • Inflation is not expected • Occurs when economy is expected to slow or enter recession. – Flat yield curve • Transition period between recession and expansion • Signifies a steady interest rate outlook• There are three hypotheses to explain the yield curve: – Liquidity hypothesis – Expectations hypothesis, and – Segmentation hypothesisfinlogIQ 14
  15. 15. Yield Curve - 3Liquidity Hypothesis• Under this hypothesis, when maturity increases, risks become greater and hence liquidity falls.• Therefore, investors will require higher yields to compensate for greater risks accompanying long-term instruments.Expectation Hypothesis• Lenders aim to maximize returns while borrowers seek to minimize costs. – The expectation hypothesis explains how both achieve their objectives over a period of time. – It explains why current long-term rates equal the average of current and expected future short-term rates. – Yield curve will be positive when the future rates are expected to be higher than current rates; – Yield curve will be negative when future rates are expected to be lower than current rates; – Yield curve will be flat when future rates are expected to be unchanged from current ones.finlogIQ 15
  16. 16. Yield Curve – 4Segmentation Hypothesis• Contrasts with the expectation hypothesis• Assumes that lenders and borrowers are constrained by institutional/ legal reasons to certain market segments: – It changes the demand and supply for a particular segment and affects the interest rates for that segment alone.finlogIQ 16
  17. 17. Market tone• Another factor that affects yield curve is market tone: – Traders constantly look for indications of interest rates movements by studying the economic indicators, the government‟s fiscal policy and activities as well as the central bank‟s monetary policy and activities. – The mood that prevails in the market can cause prices and interest rates on financial instruments to lead in the direction that anticipates the changes in the economic, fiscal or monetary stance of the country. – In a bearish market which anticipates prices of financial instruments to fall due to higher interest rates, the yield curve steepens. – The reverse is true in bullish market, where the yield curve flattens or inverts.finlogIQ 17
  18. 18. Key rates•Traders watch key interest rates for hints of future rate movements: – Fed funds rate is the rate charged for interbank borrowing usually for overnight purposes and will largely determine the cost of funds for banks. – Discount rate is the rate charged by the Fed as a lender of last resort for banks who cannot meet their borrowing needs via the interbank market. – T-bill rate is the rate for 3-month treasury bills and forms the basis for 3-month rates whereby other instruments will be priced off the T-bill rates plus a certain spread. During a crisis there is frequent „flights to quality‟ and investors will normally buy T-bills. – Commercial paper rate is the rate charged for corporate borrowing that is unsecured. – Prime rate is the rate charged by a bank to its best customers. It is a lagging indicator for interest rates movements as it is normally determined by market rates and not vice versa.finlogIQ 18
  19. 19. Economic indicators• Traders also watch following economic indicators for hints of changes in fiscal and monetary policies: – Money supply • M1 includes currency in circulation, demand deposits, other checkable deposits and traveler cheques. • M2 on the other hand, covers M1 plus savings deposits, time deposits (less than USD100,000), money market mutual funds and money market deposit accounts – Treasury auctions • Timing, amounts, maturities and coupon rates all have an impact on level of interest rates, particularly on that segment affected. • Normally, treasury will give advance indications of the cash needs and type of financing required to avoid disrupting the market. • Major refunding occurs quarterly during February, May, August and November.finlogIQ 19
  20. 20. Yield curve changes• Changes in yield curves can happen in two waysShifting of yield curves• Rates change across the board such as when there is a change in official interest rates.• Whole yield curve will then shift in a parallel manner upward or downward.Steepening/inverting of yield curves• Shape of the yield curve changes in this instance.• Long-term rates move faster than the short-term rates resulting in a change in the shape of the yield curve.• Interest rates are also used to influence exchange rates but effect of an increase in interest rates can be unpredictable.finlogIQ 20
  21. 21. Yield curve changes - 2Steepening/inverting of yield curves (cont)• While in most cases we would expect that a hike in interest rates will cause a currency to appreciate, there are instances where the effect may contradict this expectation.• For example, when the interest rates hike is expected to slow down the economy, the currency will weaken instead.• While the cost of money has always affected the corporate performance and stock markets, the stock market performance in recent years has also exerted more influence on interest rates.• Through the wealth effect, a prolonged stock market decline will affect aggregate demand for goods and services.• Central banks, fearing the effects of a stock market decline, may adjust interest rates lower to help support the stock markets.finlogIQ 21
  22. 22. Factors Affecting Foreign Exchange Rates• Foreign exchange rates are the price of one country‟s money in terms of other countries‟ money – Reflect the fair conversion value between two currenciesPrice Levels• Purchasing power parity (“PPP”) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries• The exchange rate between two countries should equal the ratio of the two countries‟ price level of a fixed basket of goods and services• Domestic price level is increasing (i.e. a country experiences inflation), that country‟s exchange rate must depreciate in order to return to PPPInflation Rate• Relative PPP refers to rates of changes of price levels, that is, inflation rates• Rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home countryfinlogIQ 22
  23. 23. Factors Affecting Foreign Exchange Rates - 2Balance of Payments• Is the statistical presentation of all commercial and financial transactions between a country‟s residents and the rest of the world• BOP = Current Account + Capital Account Official Reserve Account• Current Account = Merchandise Trade + Invisible Account• Capital Account = Inflow of Foreign Capital – Outflow of Domestic CapitalfinlogIQ 23
  24. 24. Factors Affecting Foreign Exchange Rates - 3Current account• Records net flow of goods, services, and unilateral transactions (gifts) between countries• Relative competitiveness of the country in each of these products and services would drive the balance in the account• In recent years, currencies tend to be more affected by capital account flows than current account flows• Net inflow of capital benefits the currency as demand for the currency increases. – Net inflows achieved via a stable political climate, healthy economic growth and attractive investment environment will see sustained strength of the currency. – However, net inflows achieved through artificially high interest rates or heavy borrowing may see short-term strengthening of currency, but eventual depreciation of the currency.finlogIQ 24
  25. 25. Factors Affecting Foreign Exchange Rates - 4Official Reserve Account• Consist of domestic official reserve asset and foreign official asset in the country• Any net flows from the current and capital accounts will add to or drain reserves from this account• The impact of these flows on the country‟s reserves will impact the value of its currency• Countries with chronic trade deficits will see their currencies depreciate against the others and hence, the relative price and income trends also have direct impact on trade balances• Where current account deficits can be made up by capital account surpluses, the reserves will grow and its currency will appreciate.finlogIQ 25
  26. 26. Factors Affecting Foreign Exchange Rates - 5Interest Rates• Principle by which forward currency exchange rates change reflects relative interest rates on default risk-free instruments denominated in alternative currencies• Currencies of countries with high interest rates are expected by the market to depreciate over time• Currencies of countries with low interest rates are expected to appreciate over time, reflecting (amongst other things) implied differences in inflation• Any opportunity to earn a certain profit from interest rate discrepancies will be arbitraged away by hedging the currency.• If interest rate parity holds, an investor cannot profit by borrowing in a low interest rate country and lending in a high interest rate country• For most major currencies, interest rate parity has not held during the modern floating rate regimefinlogIQ 26
  27. 27. Factors Affecting Foreign Exchange Rates - 6Economic Performance• Measured by the indicators discussed at the beginning of this chapter, affects the current and capital accounts and eventually the exchange rate.• Strong growth will initially boost the currency value as it attracts more capital inflows while strong domestic demand necessitates high interest rates which may attract short-term capital inflowsMonetary Policy• Aimed at helping the economy achieve sustainable economic growth and price stability• Success of this in turn affects the factors discussed above and hence, the value of the currency• Policies that are too tight or too accommodative normally do more harm to the currency.finlogIQ 27
  28. 28. Factors Affecting Foreign Exchange Rates - 7Fiscal Policy• Objectives of policy makers are to maintain output near the full employment levels and to maintain price stability• Imprudent fiscal policies will lead to a budget deficit which needs to be financed by the private sector. This will crowd out private investmentPolitical Environment• External environment refers to developments in neighbouring countries or involvement in foreign conflictsSeasonal Factors• Strong demand for USD during December and for JPY during March due to accounting book closure at fiscal year end and window dressing• leads to higher interest rates and• higher values of the respective currenciesfinlogIQ 28
  29. 29. Factors Affecting Foreign Exchange Rates - 8Central Bank Intervention In Foreign Exchange Markets• Objective of central bank interventions is to smooth excessive volatility in the foreign exchange markets rather than to go against or reverse the trend of the value of any currency• Traditionally, such action is more effective if there is concerted action by the other central banksOpen Mouth Policies• Verbal intervention by officials• Statements aimed at weakening or strengthening the currencies, are often ineffective unless the economic fundamentals support such statementsRumors• can cause violent reactions in the market, especially those related to the revaluation or devaluation and monetary policiesfinlogIQ 29
  30. 30. Factors Affecting Foreign Exchange Rates - 9Market Expectations• Expectations of market participants are often reflected through the prices, very often fully discounting the market forecasts of statistical releases.• Other expectations like central bank interventions or policy changes also will affect foreign exchange rates in a significant waySpeculation• Apart from the real commercial flows, increasingly speculative flows are exerting greater influence on foreign exchange rates.finlogIQ 30
  31. 31. Factors Affecting Stock Markets• Stock market deals with the ownership of a corporation indicated by shares which represent a piece of the corporation‟s assets and earnings. – Appraisal of macroeconomic data (levels and trends), and the interaction of economic data with information from company financial statements and operations are necessary to meet the objectives of predicting the company‟s cash flow and earnings and the investment value of its securities – Some of the factors that affect the stock market are common to those that affect the interest rates and foreign exchange markets. – These three markets are more closely intertwined, sometimes making the analysis of cause and effect difficult.• In general, there are certain factors that will affect the stock market to a greater extent. These include: – news or forecasts of companies‟ earnings, valuation such as price earnings ratio, dividend payouts, mergers and acquisitions, interest rates changes, and accounting rule changes.finlogIQ 31