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Investment - Economic Growth
The rise or improvement in the inflation-adjusted market value of the goods and services generated by an economy over a specific period of time is best described as economic growth. Economists generally measure such growth as the percentage rate of increase in the real gross domestic product, or real GDP.
Economic growth is assessed by the percentage change in real output, usually real GDP, for a country. Real GDP quantifies the products and services accessible to the population of that country, and real GDP per capita is a helpful indicator to examine changes in wealth and living standards.
The trend rate of GDP growth is determined at its most simplistic level by growth in the labour force plus productivity gains, subject to the availability of capital for manufacturing more items and services.
GDP growth is determined by the following:
The growth of the labour force, which signifies the increase of labour in the market
Productivity improvements, which represent growth in production per unit of labour
The availability of capital, which reflects inputs other than labour that are necessary for production.
The GDP growth rate depends to a considerable extent on productivity gains. If a worker assembles two cell phones in an hour instead of one, productivity has doubled. If that increase is implemented across the economy, the economy will grow more rapidly, assuming that there is a demand for the additional items and services created.
Developed countries often have ageing populations and low birth rates, therefore their prospective labour force will expand slowly or even fall. This means GDP will increase slower unless this slowing labour force expansion is offset by productivity gains. The table below displays the annual GDP growth rate for a sample of nations from 1971 to 2021.
The growth rate in the developed countries shown, such as Germany, the United Kingdom, and Japan, was in the 2.0%–3.0% range. However, the growth rate in the emerging countries of Brazil, India, and China, where productivity increases are generally considerable, was much greater. Over time, as economies grow and make the transition from emerging to developed status, GDP growth rates are predicted to converge towards the 2.0%–3.0% range.
Some wealthy countries, such as Japan, are seeing a fall in population. Such decreases will require increases in productivity or a technology revolution if GDP is to maintain at the long-term trend rate.
Demographic change is another reason why GDP per capita may be a more helpful statistic than GDP for measuring the economic well-being of a country. If GDP rises at a faster rate than the population growth rate or if GDP shrinks at a lower rate than the population shrinkage rate, it will result in higher GDP per capita.
The rise or improvement in the inflation-adjusted market value of the goods and services generated by an economy over a specific period of time is best described as economic growth. Economists generally measure such growth as the percentage rate of increase in the real gross domestic product, or real GDP.
Economic growth is assessed by the percentage change in real output, usually real GDP, for a country. Real GDP quantifies the products and services accessible to the population of that country, and real GDP per capita is a helpful indicator to examine changes in wealth and living standards.
The trend rate of GDP growth is determined at its most simplistic level by growth in the labour force plus productivity gains, subject to the availability of capital for manufacturing more items and services.
GDP growth is determined by the following:
The growth of the labour force, which signifies the increase of labour in the market
Productivity improvements, which represent growth in production per unit of labour
The availability of capital, which reflects inputs other than labour that are necessary for production.
The GDP growth rate depends to a considerable extent on productivity gains. If a worker assembles two cell phones in an hour instead of one, productivity has doubled. If that increase is implemented across the economy, the economy will grow more rapidly, assuming that there is a demand for the additional items and services created.
Developed countries often have ageing populations and low birth rates, therefore their prospective labour force will expand slowly or even fall. This means GDP will increase slower unless this slowing labour force expansion is offset by productivity gains. The table below displays the annual GDP growth rate for a sample of nations from 1971 to 2021.
The growth rate in the developed countries shown, such as Germany, the United Kingdom, and Japan, was in the 2.0%–3.0% range. However, the growth rate in the emerging countries of Brazil, India, and China, where productivity increases are generally considerable, was much greater. Over time, as economies grow and make the transition from emerging to developed status, GDP growth rates are predicted to converge towards the 2.0%–3.0% range.
Some wealthy countries, such as Japan, are seeing a fall in population. Such decreases will require increases in productivity or a technology revolution if GDP is to maintain at the long-term trend rate.
Demographic change is another reason why GDP per capita may be a more helpful statistic than GDP for measuring the economic well-being of a country. If GDP rises at a faster rate than the population growth rate or if GDP shrinks at a lower rate than the population shrinkage rate, it will result in higher GDP per capita.
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Investment -Business Cycle
The business or economic cycle refers to the swings of the economy between periods of growth and recession.
The Business (or Economic) Cycle
As indicated earlier, analysts and economists spend a considerable deal of energy trying to anticipate real GDP, which is affected by business cycles. Economy-wide swings in economic activity are called business cycles.
A business cycle is a cycle of fluctuations in the GDP around its long-term, natural growth rate. It is typified by the expansion and contraction in economic activity that an economy experiences over time.
Phases of an economic cycle may include the following:
Expansion
Peak Contraction
Trough
Recovery
The business or economic cycle refers to the swings of the economy between periods of growth and recession.
The Business (or Economic) Cycle
As indicated earlier, analysts and economists spend a considerable deal of energy trying to anticipate real GDP, which is affected by business cycles. Economy-wide swings in economic activity are called business cycles.
A business cycle is a cycle of fluctuations in the GDP around its long-term, natural growth rate. It is typified by the expansion and contraction in economic activity that an economy experiences over time.
Phases of an economic cycle may include the following:
Expansion
Peak Contraction
Trough
Recovery
There is no universal agreement on what the phases of business cycles are or when they begin and terminate. Some economists consider recovery as the start of an expansion phase, whilst others view recovery as the end of a trough phase.
Representation of a Business Cycle
The exhibit on the left illustrates a stylised picture of a business cycle. The degree of national economic activity is assessed by the GDP growth rate.
Exploring characteristics of expansions, peaks, contractions, troughs, and recovery stages will help us think creatively about business cycles.
During an economic growth, production increases, and both interest rates and inflation (a general rise in prices for items and services) tend to rise. A high rate of employment, which is the same as a low rate of unemployment, means that employees can demand greater wages, placing upward pressure on costs and prices.
Interest rates grow as more people and companies need loans to support their spending or investments. When an economy is developing faster than its resources could allow, inflation often arises, and unemployment tends to diminish; the increasing demand for products, services, and labor can create inflationary pressures.
At a peak, economic growth reaches a maximum level and begins to decelerate, or contract. Each country has a central bank that serves as the banker for the government and other banks. Central banks may employ policies to slow the economy and manage inflation.
Other reasons leading to the end of an expansion include a loss in consumer confidence or corporate confidence triggered by such events as rising oil prices, dropping real estate values, or declining equities markets. Shocks, such as natural disasters, or geopolitical events, such as war, can also lead to the end of an expansion.
During a contraction, the rate of economic growth declines. If economic activity, as measured by real GDP or any other measure, drops, this is negative growth, and a recession may develop. In a contraction, inflation and interest rates tend to reduce because of market forces and central bank policies, whereas unemployment tends to increase. In this scenario, central banks often employ policies to try to encourage economic growth. Federal governments may strive to stimulate the economy through direct spending measures.
What is a Recession?
There are numerous definitions linked with the term ‘recession’. In Europe, a recession is commonly defined as two consecutive quarters of negative growth. In the United States, the National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale–retail sales.
Trough signals the conclusion of the contraction phase and the beginning of recovery. In a trough, the rate of economic growth stabilises, and there is no further reduction. Eventually, firms need to replace antiquated equipment, and people need to acquire new home products, prompting more expenditure. Lower interest rates may promote more borrowing to finance consumption. Finally, the economic growth rate begins to improve, and the economy enters a recovery phase.
Why does GDP go through cycles rather than rising in a straight line? To answer that, recall the four main components of GDP:
Consumer spending
Business expenditure
Government spending
Net exports (exports minus imports)
A contraction in any of these components can induce a fall in the economic growth rate. Furthermore, the effect of a change in one component is generally exacerbated since the components are linked. The example below demonstrates how some of these components may be affected by changes in the housing sector.
Example: The Housing Sector and the Business Cycle
When consumer confidence is high, consumer expenditure improves, especially spending on homes. Because of rising demand, house costs increase. This increases wealth, and further consumer (household) spending and investing takes place.
As consumer spending increases, company spending increases too because of the increased demand for products and services and the increased availability of cash emerging from increasing consumer investing. The economy expands and pushes towards a peak. If the demand for housing stabilises or drops, and customers begin to consider that home prices are too high, the price of homes may decline. A period of contraction begins. Consumer confidence and wealth both drop along with the decline in property values. This fall results in less consumer spending and investing, and corporations observe a decline in the demand for goods and services and a reduction in the availability of capital. Meanwhile, governments see a drop in tax revenues and an increasing demand for social services as unemployment rises.
Governments and central banks will then normally take steps to try to stimulate the economy. When that happens, consumer confidence improves again along with consumer spending, and the economy begins a phase of recovery (growth).
As described in the example, during periods of economic downturn, governments may engage in fiscal stimulus measures to stimulate demand. Central banks may improve access to credit and cut borrowing costs to help the economy stabilise and recover. By adopting these acts, central banks infuse money into the economy, which encourages consumers and companies to increase spending. Those who gain from this greater spending, in turn, boost their own expenditure. This is known as the multiplier effect.
As the economy shifts from trough to boom, companies begin to hire. Other consumers who observe job growth may become more confidence in their own employment prospects, even if they are already employed. With unemployment dropping and confidence soaring, consumers boost their spending. Psychology and consumer confidence can play a considerable influence on spending decisions.
Representation of a Business Cycle
The exhibit on the left illustrates a stylised picture of a business cycle. The degree of national economic activity is assessed by the GDP growth rate.
Exploring characteristics of expansions, peaks, contractions, troughs, and recovery stages will help us think creatively about business cycles.
During an economic growth, production increases, and both interest rates and inflation (a general rise in prices for items and services) tend to rise. A high rate of employment, which is the same as a low rate of unemployment, means that employees can demand greater wages, placing upward pressure on costs and prices.
Interest rates grow as more people and companies need loans to support their spending or investments. When an economy is developing faster than its resources could allow, inflation often arises, and unemployment tends to diminish; the increasing demand for products, services, and labor can create inflationary pressures.
At a peak, economic growth reaches a maximum level and begins to decelerate, or contract. Each country has a central bank that serves as the banker for the government and other banks. Central banks may employ policies to slow the economy and manage inflation.
Other reasons leading to the end of an expansion include a loss in consumer confidence or corporate confidence triggered by such events as rising oil prices, dropping real estate values, or declining equities markets. Shocks, such as natural disasters, or geopolitical events, such as war, can also lead to the end of an expansion.
During a contraction, the rate of economic growth declines. If economic activity, as measured by real GDP or any other measure, drops, this is negative growth, and a recession may develop. In a contraction, inflation and interest rates tend to reduce because of market forces and central bank policies, whereas unemployment tends to increase. In this scenario, central banks often employ policies to try to encourage economic growth. Federal governments may strive to stimulate the economy through direct spending measures.
What is a Recession?
There are numerous definitions linked with the term ‘recession’. In Europe, a recession is commonly defined as two consecutive quarters of negative growth. In the United States, the National Bureau of Economic Research (NBER) defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale–retail sales.
Trough signals the conclusion of the contraction phase and the beginning of recovery. In a trough, the rate of economic growth stabilises, and there is no further reduction. Eventually, firms need to replace antiquated equipment, and people need to acquire new home products, prompting more expenditure. Lower interest rates may promote more borrowing to finance consumption. Finally, the economic growth rate begins to improve, and the economy enters a recovery phase.
Why does GDP go through cycles rather than rising in a straight line? To answer that, recall the four main components of GDP:
Consumer spending
Business expenditure
Government spending
Net exports (exports minus imports)
A contraction in any of these components can induce a fall in the economic growth rate. Furthermore, the effect of a change in one component is generally exacerbated since the components are linked. The example below demonstrates how some of these components may be affected by changes in the housing sector.
Example: The Housing Sector and the Business Cycle
When consumer confidence is high, consumer expenditure improves, especially spending on homes. Because of rising demand, house costs increase. This increases wealth, and further consumer (household) spending and investing takes place.
As consumer spending increases, company spending increases too because of the increased demand for products and services and the increased availability of cash emerging from increasing consumer investing. The economy expands and pushes towards a peak. If the demand for housing stabilises or drops, and customers begin to consider that home prices are too high, the price of homes may decline. A period of contraction begins. Consumer confidence and wealth both drop along with the decline in property values. This fall results in less consumer spending and investing, and corporations observe a decline in the demand for goods and services and a reduction in the availability of capital. Meanwhile, governments see a drop in tax revenues and an increasing demand for social services as unemployment rises.
Governments and central banks will then normally take steps to try to stimulate the economy. When that happens, consumer confidence improves again along with consumer spending, and the economy begins a phase of recovery (growth).
As described in the example, during periods of economic downturn, governments may engage in fiscal stimulus measures to stimulate demand. Central banks may improve access to credit and cut borrowing costs to help the economy stabilise and recover. By adopting these acts, central banks infuse money into the economy, which encourages consumers and companies to increase spending. Those who gain from this greater spending, in turn, boost their own expenditure. This is known as the multiplier effect.
As the economy shifts from trough to boom, companies begin to hire. Other consumers who observe job growth may become more confidence in their own employment prospects, even if they are already employed. With unemployment dropping and confidence soaring, consumers boost their spending. Psychology and consumer confidence can play a considerable influence on spending decisions.
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Investment -Economic Indicators
Indicators focus on a small, manageable set of facts that gives a sense of the wider picture. Economic indicators provide examination of economic performance and predictions of future performance.
Economic Indicators
We observed earlier that economic growth is not straightforward to quantify. Real GDP is normally measured quarterly and is an important measure of the wealth of a country. However, it is rarely 100% correct when it is published because all the essential information is not yet available. It is estimated with a large time lag and is subject to modifications over time as additional data become available. In fact, modifications might occur well over a year after the original report date.
Economic indicators are metrics that offer insight into economic activity and are reported with more regularity than GDP. They are estimated and reported by governments and commercial groups. Economic indicators can be used to influence projections of economic activity, financial market performance, and currency rates.
In the United States, for example, the Institute for Supply Management’s Purchasing Managers’ Index, or PMI, one of the most followed economic indicators, is a survey sent to businesses covering all North American industry categories to collect information on production levels, new orders, inventories, backlogs, and employment. The information is used to forecast total business confidence.
The following are other indices of economic activity:
Consumer purchasing indexes
Average weekly hours of production workers
Initial claims for unemployment insurance
Retail sales Spending on the building of residential and commercial properties
Sentiment surveys spanning the manufacturing and consumer sectors
Sentiment surveys seek to quantify the confidence that economic entities, such as manufacturers and consumers, have in the economy and their expected levels of activity. Sentiment surveys may be valuable as predictors of spending plans, but they have limitations:
They measure just overall sentiments about economic conditions rather than actual spending or output.
The sample may not be representative. For example, only large enterprises may be sampled, or the sample of consumers may be passersby at a single street corner. Because of sampling error, these surveys might not fairly reflect the broad view of the entire economy.
The poll may just ask respondents to pick between more, the same, or fewer sales, employment, output, and so on. As such, the replies may reveal the direction of the projected shift but not its amount.
Economic indicators are frequently classed as trailing, coincident, or leading; based on whether they signify changes in economic activity that have already happened, that are under way, or that are likely to happen in the future.
Leading indicators signal future changes in the economy and are considered important for economic forecast and policy formation. Examples include the following:
Stock market indices
Retail sales
Building permits
Housing starts (new residential construction)
Manufacturing activity levels
Lagging indicators reflect a change in economic activity after output has already altered. Examples include the following:
GDP growth
Unemployment rate
Inflation rate (the consumer price index or CPI)
Income and wage growth
Coincident Indicators
Coincident indicators show present economic situations, but do not have forecasting relevance. Examples include the following:
Employment
Personal income statistics
Indicators focus on a small, manageable set of facts that gives a sense of the wider picture. Economic indicators provide examination of economic performance and predictions of future performance.
Economic Indicators
We observed earlier that economic growth is not straightforward to quantify. Real GDP is normally measured quarterly and is an important measure of the wealth of a country. However, it is rarely 100% correct when it is published because all the essential information is not yet available. It is estimated with a large time lag and is subject to modifications over time as additional data become available. In fact, modifications might occur well over a year after the original report date.
Economic indicators are metrics that offer insight into economic activity and are reported with more regularity than GDP. They are estimated and reported by governments and commercial groups. Economic indicators can be used to influence projections of economic activity, financial market performance, and currency rates.
In the United States, for example, the Institute for Supply Management’s Purchasing Managers’ Index, or PMI, one of the most followed economic indicators, is a survey sent to businesses covering all North American industry categories to collect information on production levels, new orders, inventories, backlogs, and employment. The information is used to forecast total business confidence.
The following are other indices of economic activity:
Consumer purchasing indexes
Average weekly hours of production workers
Initial claims for unemployment insurance
Retail sales Spending on the building of residential and commercial properties
Sentiment surveys spanning the manufacturing and consumer sectors
Sentiment surveys seek to quantify the confidence that economic entities, such as manufacturers and consumers, have in the economy and their expected levels of activity. Sentiment surveys may be valuable as predictors of spending plans, but they have limitations:
They measure just overall sentiments about economic conditions rather than actual spending or output.
The sample may not be representative. For example, only large enterprises may be sampled, or the sample of consumers may be passersby at a single street corner. Because of sampling error, these surveys might not fairly reflect the broad view of the entire economy.
The poll may just ask respondents to pick between more, the same, or fewer sales, employment, output, and so on. As such, the replies may reveal the direction of the projected shift but not its amount.
Economic indicators are frequently classed as trailing, coincident, or leading; based on whether they signify changes in economic activity that have already happened, that are under way, or that are likely to happen in the future.
Leading indicators signal future changes in the economy and are considered important for economic forecast and policy formation. Examples include the following:
Stock market indices
Retail sales
Building permits
Housing starts (new residential construction)
Manufacturing activity levels
Lagging indicators reflect a change in economic activity after output has already altered. Examples include the following:
GDP growth
Unemployment rate
Inflation rate (the consumer price index or CPI)
Income and wage growth
Coincident Indicators
Coincident indicators show present economic situations, but do not have forecasting relevance. Examples include the following:
Employment
Personal income statistics
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Investment -Inflation
Understanding inflation is key to investing since inflation can diminish the value of investment returns. Inflation affects all parts of the economy.
Inflation
Inflation is a general rise in prices for items and services. Changing inflation has ramifications for economic activity and national competitiveness. Companies must monitor increases in expenses and pricing, and they examine their competitive environment to decide how to respond to these changes. Consumers use changes in prices to make their purchase decisions. Accurate measuring of inflation is vital.
Measuring Inflation
There are numerous different measures of inflation based on different price indexes. A price index measures the price of a commodity or service, or a basket of items and services (usually referred to as a basket of goods), over time. The simplest metric of inflation is the percentage change in an index from one period to another.
Consumer Price Index
A consumer price index (CPI) assumes a basket of items matches a typical household’s spending, and it tracks the price of that basket over time.
Weights of the components of this index can be adjusted when long-term consumer trends shift. Computers and technology may not have been found in normal households in the past, therefore they were not included in the basket of commodities. Today their weighting may be relatively high. Inflation recorded by a CPI may overestimate or understate inflation for a given consumer or household, depending on how their spending patterns compare with the basket of items.
The basket of commodities is likely to vary in different countries. In the United Kingdom, at least two CPIs are reported: a retail price index (RPI) based on a basket of goods that includes housing expenses, and a CPI with a narrower basket of items that does not include housing. Inflation rates as measured by the UK RPI and CPI are often not the same.
Price volatility can involve sudden jumps up or down; food and energy costs can change in this fashion. There are indices based on core inflation, such as the US Core CPI, that eliminate the effects of momentary volatility in prices, even if the consequences are felt by households and companies. Policymakers, such as governments and central banks, find these indicators useful.
Producer Price Index
Another indicator of inflation is a producer price index (PPI). PPIs measure the average selling price of products. They are larger than CPIs in that they include the price of investment items, but they are also narrower in that they do not cover services. PPI numbers can be informed by reports from specific industries, from changing commodity prices, or from reporting on certain stages of processing, such as raw materials or completed goods.
Inflation Rates and Price Indices
Different indices can give different inflation measures, even in the same country during the same period. As you can see in the example below, which illustrates inflation rates based on the CPI and PPI indices for the United States, inflation rates over the same period can differ considerably depending on the price index utilized.
The link between CPIs and PPIs is frequently used to determine the degree to which producers’ costs are passed on to consumers. If consumer prices (or costs to consumers) remain steady while producer prices (or costs to producers) are growing, then producers seem unable to pass on the costs to consumers. Examining increases in manufacturing costs relative to consumer price increases can show if profit margins are rising or narrowing.
Effects of Inflation on Consumers, Businesses, and Investments
Changes in price levels can affect economic growth because people and businesses may modify the timing of their purchases, the quantity of their spending, and their saving and borrowing decisions based on the changes in prices they anticipate. The value of investments may also be altered by changes in price levels.
CONSUMERS
If customers expect prices to increase, they may buy now rather than save. Or they may choose to borrow to expand spending. Borrowers benefit from inflation because they repay loans with money that is worth less; in other words, the money has decreased purchasing power.
Inflation can encourage economic growth if customers respond to predictions of price increases by making purchases now rather than deferring them. But the increased spending may only assist economic development in the near run because some of those purchases would have been made otherwise. Accordingly, inflation may simply transfer demand from the future to the present. This extra short-term demand can further boost inflationary pressure.
During periods of inflation, wages may not increase at the same rate as the prices of items and services. If salaries increase by a lesser amount, consumers may have less money to spend as their budgets are strained. Additionally, if unemployment is high, consumers’ bargaining power falls, and real consumer expenditure (consumer spending adjusted for inflation) may weaken. This scenario may help interrupt the inflationary cycle.
BUSINESS
Generally, inflation will have a negative influence on corporate planning and investment. Budgeting becomes more challenging because of the uncertainty produced by growing prices and costs. Consumers consume rather than invest, therefore access to finance is decreased for enterprises, which leads in less corporate spending on physical capital.
they’ earnings may drop as costs grow, particularly if they are unable to pass on the greater costs to consumers in the form of higher pricing. If inflation becomes entrenched, overall economic performance may decline as enterprises raise prices and are perhaps unable to invest in capital or pursue efficiency improvements.
assets Inflation impacts the value of financial assets. Any investment paying a set cash amount will drop in value if interest rates rise. As inflation grows, interest rates normally rise, hence rising inflation will lead to lower values for fixed-income investments, such as bonds. Inflation tends to help borrowers, as explained above, and penalize lenders.
But shares may be an excellent long-term hedge, or form of protection, against inflation; if corporations are able to increase the selling prices of their products when their input prices increase, a move which may enhance their stock price, if successful.
Other Changes in the Level of Prices
Inflation is an important economic issue for investors and is more usual than deflation, stagflation, and hyperinflation, which we cover here. These can be equally or even more harmful for consumers, firms, policymakers in central banks and governments, and economies.
A consistent and substantial fall in prices across most items and services in an economy is called deflation. Deflation was experienced in the 1930s during the Great Depression in the United States and more recently in Japan. If customers expect prices to decline, they may choose to save, even if they receive zero interest, and defer purchases until prices decrease more. As a result, demand diminishes, enterprises reduce production and labour, and unemployment grows.
Encouraging consumption and ending this vicious loop is quite tough. Japan, for instance, has endured deflation for much of the past 20 years.
STAGFLATION
Inflation frequently occurs in periods of rapid economic growth. However, excessive inflation can occur in periods of little or no economic development, and this scenario is stagflation. Stagflation is often associated with inflation that originates outside the domestic economy.
Many developed economies suffered stagflation in the 1970s and early 1980s because oil prices abruptly and significantly surged, generating inflation as costs of production rose. Investment spending by enterprises fell. Consumer spending declined as they acclimated to increasing oil prices. As a result, unemployment rates soared, and customers had even less money to spend.
HYPERINFLATION
Hyperinflation entails price increases so huge and rapid that customers find it impossible to afford numerous products and services. Consumers want to spend money as quickly as they acquire it, anticipating rises in pricing of items and services and preferring to possess real assets rather than money. Products and services are often not available because producers hold back, anticipating additional price increases.
Although most typically associated with emerging countries, Germany experienced hyperinflation following World War I. Hyperinflation causes tremendous damage to an economy and cannot be readily counteracted by governments or central banks. Fortunately, incidents of hyperinflation are rather rare.
Understanding inflation is key to investing since inflation can diminish the value of investment returns. Inflation affects all parts of the economy.
Inflation
Inflation is a general rise in prices for items and services. Changing inflation has ramifications for economic activity and national competitiveness. Companies must monitor increases in expenses and pricing, and they examine their competitive environment to decide how to respond to these changes. Consumers use changes in prices to make their purchase decisions. Accurate measuring of inflation is vital.
Measuring Inflation
There are numerous different measures of inflation based on different price indexes. A price index measures the price of a commodity or service, or a basket of items and services (usually referred to as a basket of goods), over time. The simplest metric of inflation is the percentage change in an index from one period to another.
Consumer Price Index
A consumer price index (CPI) assumes a basket of items matches a typical household’s spending, and it tracks the price of that basket over time.
Weights of the components of this index can be adjusted when long-term consumer trends shift. Computers and technology may not have been found in normal households in the past, therefore they were not included in the basket of commodities. Today their weighting may be relatively high. Inflation recorded by a CPI may overestimate or understate inflation for a given consumer or household, depending on how their spending patterns compare with the basket of items.
The basket of commodities is likely to vary in different countries. In the United Kingdom, at least two CPIs are reported: a retail price index (RPI) based on a basket of goods that includes housing expenses, and a CPI with a narrower basket of items that does not include housing. Inflation rates as measured by the UK RPI and CPI are often not the same.
Price volatility can involve sudden jumps up or down; food and energy costs can change in this fashion. There are indices based on core inflation, such as the US Core CPI, that eliminate the effects of momentary volatility in prices, even if the consequences are felt by households and companies. Policymakers, such as governments and central banks, find these indicators useful.
Producer Price Index
Another indicator of inflation is a producer price index (PPI). PPIs measure the average selling price of products. They are larger than CPIs in that they include the price of investment items, but they are also narrower in that they do not cover services. PPI numbers can be informed by reports from specific industries, from changing commodity prices, or from reporting on certain stages of processing, such as raw materials or completed goods.
Inflation Rates and Price Indices
Different indices can give different inflation measures, even in the same country during the same period. As you can see in the example below, which illustrates inflation rates based on the CPI and PPI indices for the United States, inflation rates over the same period can differ considerably depending on the price index utilized.
The link between CPIs and PPIs is frequently used to determine the degree to which producers’ costs are passed on to consumers. If consumer prices (or costs to consumers) remain steady while producer prices (or costs to producers) are growing, then producers seem unable to pass on the costs to consumers. Examining increases in manufacturing costs relative to consumer price increases can show if profit margins are rising or narrowing.
Effects of Inflation on Consumers, Businesses, and Investments
Changes in price levels can affect economic growth because people and businesses may modify the timing of their purchases, the quantity of their spending, and their saving and borrowing decisions based on the changes in prices they anticipate. The value of investments may also be altered by changes in price levels.
CONSUMERS
If customers expect prices to increase, they may buy now rather than save. Or they may choose to borrow to expand spending. Borrowers benefit from inflation because they repay loans with money that is worth less; in other words, the money has decreased purchasing power.
Inflation can encourage economic growth if customers respond to predictions of price increases by making purchases now rather than deferring them. But the increased spending may only assist economic development in the near run because some of those purchases would have been made otherwise. Accordingly, inflation may simply transfer demand from the future to the present. This extra short-term demand can further boost inflationary pressure.
During periods of inflation, wages may not increase at the same rate as the prices of items and services. If salaries increase by a lesser amount, consumers may have less money to spend as their budgets are strained. Additionally, if unemployment is high, consumers’ bargaining power falls, and real consumer expenditure (consumer spending adjusted for inflation) may weaken. This scenario may help interrupt the inflationary cycle.
BUSINESS
Generally, inflation will have a negative influence on corporate planning and investment. Budgeting becomes more challenging because of the uncertainty produced by growing prices and costs. Consumers consume rather than invest, therefore access to finance is decreased for enterprises, which leads in less corporate spending on physical capital.
they’ earnings may drop as costs grow, particularly if they are unable to pass on the greater costs to consumers in the form of higher pricing. If inflation becomes entrenched, overall economic performance may decline as enterprises raise prices and are perhaps unable to invest in capital or pursue efficiency improvements.
assets Inflation impacts the value of financial assets. Any investment paying a set cash amount will drop in value if interest rates rise. As inflation grows, interest rates normally rise, hence rising inflation will lead to lower values for fixed-income investments, such as bonds. Inflation tends to help borrowers, as explained above, and penalize lenders.
But shares may be an excellent long-term hedge, or form of protection, against inflation; if corporations are able to increase the selling prices of their products when their input prices increase, a move which may enhance their stock price, if successful.
Other Changes in the Level of Prices
Inflation is an important economic issue for investors and is more usual than deflation, stagflation, and hyperinflation, which we cover here. These can be equally or even more harmful for consumers, firms, policymakers in central banks and governments, and economies.
A consistent and substantial fall in prices across most items and services in an economy is called deflation. Deflation was experienced in the 1930s during the Great Depression in the United States and more recently in Japan. If customers expect prices to decline, they may choose to save, even if they receive zero interest, and defer purchases until prices decrease more. As a result, demand diminishes, enterprises reduce production and labour, and unemployment grows.
Encouraging consumption and ending this vicious loop is quite tough. Japan, for instance, has endured deflation for much of the past 20 years.
STAGFLATION
Inflation frequently occurs in periods of rapid economic growth. However, excessive inflation can occur in periods of little or no economic development, and this scenario is stagflation. Stagflation is often associated with inflation that originates outside the domestic economy.
Many developed economies suffered stagflation in the 1970s and early 1980s because oil prices abruptly and significantly surged, generating inflation as costs of production rose. Investment spending by enterprises fell. Consumer spending declined as they acclimated to increasing oil prices. As a result, unemployment rates soared, and customers had even less money to spend.
HYPERINFLATION
Hyperinflation entails price increases so huge and rapid that customers find it impossible to afford numerous products and services. Consumers want to spend money as quickly as they acquire it, anticipating rises in pricing of items and services and preferring to possess real assets rather than money. Products and services are often not available because producers hold back, anticipating additional price increases.
Although most typically associated with emerging countries, Germany experienced hyperinflation following World War I. Hyperinflation causes tremendous damage to an economy and cannot be readily counteracted by governments or central banks. Fortunately, incidents of hyperinflation are rather rare.
- Published on
Investment -Monetary and Fiscal Policies
Governments and central banks are inclined to act in reaction to economic conditions when economic conditions are exceptionally challenging. Monetary and fiscal policy affect the economy via distinct ways.
Monetary and Fiscal Policies
Economic growth, inflation, and unemployment are key issues for central banks and governments. They each utilize distinct financial tools to effect economic activity. Central banks, which are frequently independent of governments, use monetary policy. Governments utilize fiscal policy.
Monetary Policy
Monetary policy refers to central bank activities that are focused towards affecting the money supply — the amount of money in circulation — and credit — the amount of money available for borrowing and at the cost or interest rate. The purpose is to influence major macroeconomic targets:
Output or GDP Price stability Employment
Most central banks have a mission of maintaining price stability by regulating inflation while preventing deflation, which has indirect implications on other macroeconomic aims, such as employment and output. Many central banks strive to sustain employment levels and to encourage economic growth or slow it down. But by focused primarily on job levels and growth, it may leave opportunity for price volatility; increased employment and rapid economic growth is typically accompanied by inflation.
Consumers and firms should, in theory, be motivated by reduced interest rates to borrow and spend more and therefore stimulate the economy. As interest rates fall, the stock market may seem a more appealing place to invest, leading to gains in share prices and a broad impression of enhanced prosperity. This sensation of enhanced prosperity should motivate people to spend more and conserve less, and therefore further stimulate the economy.
Reducing interest rates may raise output and employment, so meeting two of the primary macroeconomic aims of policymakers. Similarly, increasing interest rates may slow the economy.
The tools used for monetary policy include open market operations, changes in the central bank lending rate, and changes in reserve requirements for commercial banks
Open Market Operations
The central bank can either purchase or sell securities issued by the government to effect the money supply. Open market activities involve the purchase and sale of government notes and bonds. If a central bank wants to expand the availability of money and credit to stimulate the economy, it can do so by purchasing financial assets, mainly short-term government instruments held by commercial banks.
The banks give up short-term government securities for cash from the central bank, which puts more money in circulation. The injection of money allows banks to decrease interest rates and offer more loans because they now have bigger cash reserves at the central bank.
By performing open market operations, the central bank produces a shortfall or surplus of money. Effectively, the central bank is pressuring commercial banks to modify their lending rates.
Central Bank Lending Rates
A central bank can impact interest rates by adjusting the discount rate. The discount rate is the rate at which banks borrow directly from the central bank of the country. It is used to effect short-term interest rates as well as to indirectly influence longer-term interest rates and other commercial rates.
The belief is that changes in interest rates can influence economic activity and affect inflation and economic growth. When a central bank wishes to stimulate the economy, it may cut its lending rate. When a central bank intends to slow the economy, it may increase its lending rate.
Reserve Requirements
Central banks can change the quantity of money available for borrowing in an economy by modifying bank reserve requirements. The reserve requirement is the proportion of deposits that must be retained by a bank rather than be lent to borrowers.
By increasing the reserve requirement, central banks decrease access to credit in the economy since bank lending is reduced. When they cut the reserve requirement, central banks boost access to credit because commercial banks are able to issue more loans. In practice, this instrument is not typically employed by central banks.
Quantitative Easing
The policy of quantitative easing (QE), employed in a number of nations during the financial crisis of 2008, is similar to open market operations, but on a considerably bigger scale and it entails the purchase of items other than short-term government instruments. In the United States, QE diverged from open market operations in that it entailed the purchase of mortgage bonds as well as large-scale purchases of longer-term US Treasury securities.
The objective was to cut longer-term interest rates on bonds and across a variety of credit products, promote bank lending, and thereby increase actual economic activity. It has proven difficult to measure the effectiveness of QE because other stimulus initiatives appeared at the same time in the wake of the financial crisis.
Limitations of Monetary Policy
The efficiency of monetary policy is subject to debate. Economists who challenge its effectiveness cite evidence of poor growth in some nations where interest rates are very low. This situation may occur because individuals and firms do not respond to reduced borrowing rates by spending more. Instead, they may opt to add to their cash holdings because they believe either that the economy will slow further and they need protection reserves or that prices may drop and offer better purchasing chances later. Alternatively, households and organizations respond to reduced interest rates by paying off debt, a process that is called deleveraging.
The psychology and expected responses of consumers and companies must be addressed while deciding on an effective monetary policy. Consider a scenario in which the central bank boosts interest rates to lower consumer spending and demand because it is concerned about inflationary pressures. If an economy is functioning well, overall optimism regarding income, employment, and business profits may be strong. In that instance, rises in borrowing costs are less efficient in restraining expenditure. At other times, an increase in interest rates may be useful since optimism is less established. The levels of consumer and business confidence determine the effectiveness of monetary policy.
Fiscal Policy
Governments utilize fiscal policy to effect economic activity. Fiscal policy involves the utilization of government spending and taxes. Fiscal policy may strive to stimulate a sluggish economy by greater spending or decreased taxes, or it may seek to moderate an overheating economy through decreased expenditure or increased taxes.
The Role and Tools of Fiscal Policy
One way that fiscal policy operates is by decreasing or increasing taxes. Governments can also affect GDP directly by spending more or less.
An expansionary strategy, which tries to boost a weak economy, will decrease taxes on consumers or corporations to increase consumer and company spending and the level of demand. Alternatively, it may raise public spending on social goods and infrastructure, such as hospitals and schools, which stimulates spending and demand directly.
An expansionary strategy can also stimulate spending and demand indirectly by increasing personal earnings and company revenues when it hires individuals and corporations to develop those public projects.
The success of these initiatives will vary over time and among countries. In a recession with rising unemployment, decreasing income taxes would not always promote consumer spending since people may desire to increase their savings in expectation of greater worsening in the economy.
Limitations of Fiscal Policy
The effectiveness of fiscal policy is constrained by the following:
Time lags
Unexpected responses by consumers and companies
Unintended consequences
Time Lags
There might be a large time lag between the understanding that intervention is required and observable fiscal policy impact. First, a recognition that the economy requires aid must arise, then a choice must be taken on what the adjustment in fiscal policy will be, then that decision has to be implemented, and then the economy has to have time to respond.
Unexpected Responses
As with monetary policy, consumers and corporations may not respond as expected to changes in fiscal policy. When a tax decrease is announced, private sector spending is likely to grow. But spending may remain unchanged or even fall if the private sector chooses to keep the income or pay down debt rather than spend.
Alternatively, spending may climb by more than planned. Similarly, if government spending increases, consumer and corporate responses may negate the effects of the change in government expenditure on GDP by reducing their own spending.
In other words, it takes time for policymakers to acknowledge that a problem exists, for decisions to be made and implemented, and for those efforts to have an influence on the economy. By the time the acts effect the economy, economic conditions may have already altered.
Unintended Consequences
Changes in fiscal policy may also have unforeseen repercussions. If the government raises expenditure with the purpose of increasing demand and GDP, the higher demand may increase employment and lead to a tightening labor market and rising wages and prices. This will allow the economy (GDP) to develop as anticipated, but inflation will also increase. Policymakers may be reluctant to adopt fiscal policy to stimulate an economy given the danger of causing inflation.
Crowding out, another example of unintended effects, is when the government borrows from a finite pool of savings and competes with the private sector for funding, crowding out private firms. As a result, the cost of borrowing may rise, and economic growth and investment created by the private sector may drop.
Fiscal or Monetary Policy?
Both governments and central banks are concerned with economic growth, inflation, and unemployment. Each has varied means at its disposal to effect economic activity. Government instruments include taxes and government spending. Central bank tools include open market operations, central bank lending rates, and reserve requirements.
Each entity is subject to much the same limitations: time lags between when a change in economic conditions occurs and when policy actions take effect; unexpected responses by consumers and companies; and unintended consequences, such as successfully stimulating the economy but at the same time increasing inflation. However, the time lag for monetary policy may be lower because central banks may be able to respond more swiftly than governments.
In actuality, both governments and central banks are likely to move in reaction to economic conditions. This is particularly true when economic conditions are exceptionally alarming, such as when a recession is diagnosed or when inflation or unemployment are high. The contemporary economy is a complex system of human conduct and connections.
To support growth in real GDP requires extensive insight into the effects of interest rate or tax changes on the decisions that will be thereafter taken by consumers and enterprises. After all, the economy represents the combined behavior of many millions of customers, firms, and governments around the globe.
Governments and central banks are inclined to act in reaction to economic conditions when economic conditions are exceptionally challenging. Monetary and fiscal policy affect the economy via distinct ways.
Monetary and Fiscal Policies
Economic growth, inflation, and unemployment are key issues for central banks and governments. They each utilize distinct financial tools to effect economic activity. Central banks, which are frequently independent of governments, use monetary policy. Governments utilize fiscal policy.
Monetary Policy
Monetary policy refers to central bank activities that are focused towards affecting the money supply — the amount of money in circulation — and credit — the amount of money available for borrowing and at the cost or interest rate. The purpose is to influence major macroeconomic targets:
Output or GDP Price stability Employment
Most central banks have a mission of maintaining price stability by regulating inflation while preventing deflation, which has indirect implications on other macroeconomic aims, such as employment and output. Many central banks strive to sustain employment levels and to encourage economic growth or slow it down. But by focused primarily on job levels and growth, it may leave opportunity for price volatility; increased employment and rapid economic growth is typically accompanied by inflation.
Consumers and firms should, in theory, be motivated by reduced interest rates to borrow and spend more and therefore stimulate the economy. As interest rates fall, the stock market may seem a more appealing place to invest, leading to gains in share prices and a broad impression of enhanced prosperity. This sensation of enhanced prosperity should motivate people to spend more and conserve less, and therefore further stimulate the economy.
Reducing interest rates may raise output and employment, so meeting two of the primary macroeconomic aims of policymakers. Similarly, increasing interest rates may slow the economy.
The tools used for monetary policy include open market operations, changes in the central bank lending rate, and changes in reserve requirements for commercial banks
Open Market Operations
The central bank can either purchase or sell securities issued by the government to effect the money supply. Open market activities involve the purchase and sale of government notes and bonds. If a central bank wants to expand the availability of money and credit to stimulate the economy, it can do so by purchasing financial assets, mainly short-term government instruments held by commercial banks.
The banks give up short-term government securities for cash from the central bank, which puts more money in circulation. The injection of money allows banks to decrease interest rates and offer more loans because they now have bigger cash reserves at the central bank.
By performing open market operations, the central bank produces a shortfall or surplus of money. Effectively, the central bank is pressuring commercial banks to modify their lending rates.
Central Bank Lending Rates
A central bank can impact interest rates by adjusting the discount rate. The discount rate is the rate at which banks borrow directly from the central bank of the country. It is used to effect short-term interest rates as well as to indirectly influence longer-term interest rates and other commercial rates.
The belief is that changes in interest rates can influence economic activity and affect inflation and economic growth. When a central bank wishes to stimulate the economy, it may cut its lending rate. When a central bank intends to slow the economy, it may increase its lending rate.
Reserve Requirements
Central banks can change the quantity of money available for borrowing in an economy by modifying bank reserve requirements. The reserve requirement is the proportion of deposits that must be retained by a bank rather than be lent to borrowers.
By increasing the reserve requirement, central banks decrease access to credit in the economy since bank lending is reduced. When they cut the reserve requirement, central banks boost access to credit because commercial banks are able to issue more loans. In practice, this instrument is not typically employed by central banks.
Quantitative Easing
The policy of quantitative easing (QE), employed in a number of nations during the financial crisis of 2008, is similar to open market operations, but on a considerably bigger scale and it entails the purchase of items other than short-term government instruments. In the United States, QE diverged from open market operations in that it entailed the purchase of mortgage bonds as well as large-scale purchases of longer-term US Treasury securities.
The objective was to cut longer-term interest rates on bonds and across a variety of credit products, promote bank lending, and thereby increase actual economic activity. It has proven difficult to measure the effectiveness of QE because other stimulus initiatives appeared at the same time in the wake of the financial crisis.
Limitations of Monetary Policy
The efficiency of monetary policy is subject to debate. Economists who challenge its effectiveness cite evidence of poor growth in some nations where interest rates are very low. This situation may occur because individuals and firms do not respond to reduced borrowing rates by spending more. Instead, they may opt to add to their cash holdings because they believe either that the economy will slow further and they need protection reserves or that prices may drop and offer better purchasing chances later. Alternatively, households and organizations respond to reduced interest rates by paying off debt, a process that is called deleveraging.
The psychology and expected responses of consumers and companies must be addressed while deciding on an effective monetary policy. Consider a scenario in which the central bank boosts interest rates to lower consumer spending and demand because it is concerned about inflationary pressures. If an economy is functioning well, overall optimism regarding income, employment, and business profits may be strong. In that instance, rises in borrowing costs are less efficient in restraining expenditure. At other times, an increase in interest rates may be useful since optimism is less established. The levels of consumer and business confidence determine the effectiveness of monetary policy.
Fiscal Policy
Governments utilize fiscal policy to effect economic activity. Fiscal policy involves the utilization of government spending and taxes. Fiscal policy may strive to stimulate a sluggish economy by greater spending or decreased taxes, or it may seek to moderate an overheating economy through decreased expenditure or increased taxes.
The Role and Tools of Fiscal Policy
One way that fiscal policy operates is by decreasing or increasing taxes. Governments can also affect GDP directly by spending more or less.
An expansionary strategy, which tries to boost a weak economy, will decrease taxes on consumers or corporations to increase consumer and company spending and the level of demand. Alternatively, it may raise public spending on social goods and infrastructure, such as hospitals and schools, which stimulates spending and demand directly.
An expansionary strategy can also stimulate spending and demand indirectly by increasing personal earnings and company revenues when it hires individuals and corporations to develop those public projects.
The success of these initiatives will vary over time and among countries. In a recession with rising unemployment, decreasing income taxes would not always promote consumer spending since people may desire to increase their savings in expectation of greater worsening in the economy.
Limitations of Fiscal Policy
The effectiveness of fiscal policy is constrained by the following:
Time lags
Unexpected responses by consumers and companies
Unintended consequences
Time Lags
There might be a large time lag between the understanding that intervention is required and observable fiscal policy impact. First, a recognition that the economy requires aid must arise, then a choice must be taken on what the adjustment in fiscal policy will be, then that decision has to be implemented, and then the economy has to have time to respond.
Unexpected Responses
As with monetary policy, consumers and corporations may not respond as expected to changes in fiscal policy. When a tax decrease is announced, private sector spending is likely to grow. But spending may remain unchanged or even fall if the private sector chooses to keep the income or pay down debt rather than spend.
Alternatively, spending may climb by more than planned. Similarly, if government spending increases, consumer and corporate responses may negate the effects of the change in government expenditure on GDP by reducing their own spending.
In other words, it takes time for policymakers to acknowledge that a problem exists, for decisions to be made and implemented, and for those efforts to have an influence on the economy. By the time the acts effect the economy, economic conditions may have already altered.
Unintended Consequences
Changes in fiscal policy may also have unforeseen repercussions. If the government raises expenditure with the purpose of increasing demand and GDP, the higher demand may increase employment and lead to a tightening labor market and rising wages and prices. This will allow the economy (GDP) to develop as anticipated, but inflation will also increase. Policymakers may be reluctant to adopt fiscal policy to stimulate an economy given the danger of causing inflation.
Crowding out, another example of unintended effects, is when the government borrows from a finite pool of savings and competes with the private sector for funding, crowding out private firms. As a result, the cost of borrowing may rise, and economic growth and investment created by the private sector may drop.
Fiscal or Monetary Policy?
Both governments and central banks are concerned with economic growth, inflation, and unemployment. Each has varied means at its disposal to effect economic activity. Government instruments include taxes and government spending. Central bank tools include open market operations, central bank lending rates, and reserve requirements.
Each entity is subject to much the same limitations: time lags between when a change in economic conditions occurs and when policy actions take effect; unexpected responses by consumers and companies; and unintended consequences, such as successfully stimulating the economy but at the same time increasing inflation. However, the time lag for monetary policy may be lower because central banks may be able to respond more swiftly than governments.
In actuality, both governments and central banks are likely to move in reaction to economic conditions. This is particularly true when economic conditions are exceptionally alarming, such as when a recession is diagnosed or when inflation or unemployment are high. The contemporary economy is a complex system of human conduct and connections.
To support growth in real GDP requires extensive insight into the effects of interest rate or tax changes on the decisions that will be thereafter taken by consumers and enterprises. After all, the economy represents the combined behavior of many millions of customers, firms, and governments around the globe.
- Published on
Investment - Imports and Exports
A demand is created by customer requirement. Imports and exports are ways utilized to address this need.
When you walk into a supermarket where you can buy Scottish salmon, Kenyan veggies, Thai rice, South African wine, and Colombian coffee, you are enjoying the benefits of international trade. Without international trade, consumers’ wants may not be fulfiled since people would only have access to products and services produced domestically. Some items and services have no domestic source, such as specific food, vaccines, and automobiles, for example.
International trade is the exchange of products, services, and capital between countries. The expansion in international trade, from USD296 billion in 1950 to USD22 trillion in 2020,1 can be considered as both a cause and result of globalization.
Consider the effect of international trade on a multinational firm such as Nestlé. At the end of 2013, the Switzerland-based corporation has plants in 79 countries and marketed its products in 186 nations.2 International trade has contributed greatly to Nestlé’s development in sales and profit, but it comes with problems.
One concern is the risk associated with foreign exchange rate variations or changes in the relative value of different countries’ currencies. Multinational corporations, such as Nestlé, do business in numerous currencies, therefore they are influenced by changes in currency exchange rates. Thus, investment professionals must include foreign exchange rate swings when they anticipate the future sales and earnings of international organizations.
Imports and Exports
The flow of commodities and services in international trade between countries is primarily measured by imports and exports.
Imports Products and services that are produced outside a country’s borders and are then brought into the country, or imported.
Exports Products and services that are produced within a country’s borders and then moved to another country, or exported. For example, Japan exports consumer electronics to the rest of the world.
International commerce gives countries access to resources for which there is no or insufficient supply domestically.
For example, since 2018, no automobiles have been built in Australia; they are entirely imported. Furthermore, international trade creates additional demand for products and services. If Japanese manufacturers could not sell consumer electronics abroad, they would have to limit their production to the number that is consumed in Japan, which is a rather limited market.
International trade also gives consumers with more choices and reduced pricing for goods and services. Again, picture the difficulty someone in Australia would have trying to buy a car if there were no automobile imports. The larger range of goods and services encourages competition amongst suppliers and leads to improved quality and reduced prices.
Two important trends have increased international trade:
Fewer trade barriers
Better transportation and communications
Trade barriers are constraints, generally imposed by governments, on the free trade of products and services. The table below gives descriptions of common sorts of trade barriers.
Common Forms of Trade Barriers Tariffs
Taxes (duties) levied on imported products and services. They allow governments not just to impose trade obstacles, frequently to protect domestic suppliers, but also to earn income.
Quotas Limits set on the quantity of products that can be imported.
Non-Tariff Barriers Measures, such as certification, licensing, sanctions, or embargoes, that make it more difficult and expensive for foreign producers to compete with domestic producers.
Embargoes Measures that prevent trade with a country.
A country, or group of countries, may apply economic penalties against a country or group of countries.
Economic sanctions are commercial and financial penalties that are aimed to restrict or reduce international trade with another country.
Sanctions may include entire trade embargoes, embargoes on certain commodities and services, prohibition on foreign investment in the sanctioned country, and asset freezes. They are aimed to impair the economic activity of the sanctioned country by decreasing its imports and exports.
In 2022, the European Union and the United States enacted severe economic sanctions against Russia in response to its military attacks on Ukraine. Sanctions can have substantial economic consequences: At the time they were imposed, many believed the economic sanctions against Russia would lead to soaring inflation and potentially wipe out Russia’s previous 15 years of economic success.
But in general, international trade barriers have steadily fallen since the signing of the General Agreement on Tariffs and Trade (GATT) in 1947 and the foundation of the World Trade Organisation (WTO) in 1995.
The WTO, with more than 150 member nations, is established to ensure adherence to trade agreements and to help countries negotiate new trade deals. The WTO also provides a dispute resolution process between countries. International trade has been further promoted by the creation of regional trade agreements, such as the Association of Southeast Asian Nations’ (ASEAN) Free Trade Area (AFTA), the United States-Mexico-Canada Agreement (USMCA), the Southern Common Market (Mercosur), and the African Continental Free Trade Area (AfCFTA).
Improvements in transportation and communications have helped international trade develop. Large shipping containers allow producers to move non-perishable products more easily on ships, trains, and trucks, while jumbo aircraft transport perishable products fast around the globe. The ability to communicate digitally has also contributed to the development in the worldwide trade of products and services.
A demand is created by customer requirement. Imports and exports are ways utilized to address this need.
When you walk into a supermarket where you can buy Scottish salmon, Kenyan veggies, Thai rice, South African wine, and Colombian coffee, you are enjoying the benefits of international trade. Without international trade, consumers’ wants may not be fulfiled since people would only have access to products and services produced domestically. Some items and services have no domestic source, such as specific food, vaccines, and automobiles, for example.
International trade is the exchange of products, services, and capital between countries. The expansion in international trade, from USD296 billion in 1950 to USD22 trillion in 2020,1 can be considered as both a cause and result of globalization.
Consider the effect of international trade on a multinational firm such as Nestlé. At the end of 2013, the Switzerland-based corporation has plants in 79 countries and marketed its products in 186 nations.2 International trade has contributed greatly to Nestlé’s development in sales and profit, but it comes with problems.
One concern is the risk associated with foreign exchange rate variations or changes in the relative value of different countries’ currencies. Multinational corporations, such as Nestlé, do business in numerous currencies, therefore they are influenced by changes in currency exchange rates. Thus, investment professionals must include foreign exchange rate swings when they anticipate the future sales and earnings of international organizations.
Imports and Exports
The flow of commodities and services in international trade between countries is primarily measured by imports and exports.
Imports Products and services that are produced outside a country’s borders and are then brought into the country, or imported.
Exports Products and services that are produced within a country’s borders and then moved to another country, or exported. For example, Japan exports consumer electronics to the rest of the world.
International commerce gives countries access to resources for which there is no or insufficient supply domestically.
For example, since 2018, no automobiles have been built in Australia; they are entirely imported. Furthermore, international trade creates additional demand for products and services. If Japanese manufacturers could not sell consumer electronics abroad, they would have to limit their production to the number that is consumed in Japan, which is a rather limited market.
International trade also gives consumers with more choices and reduced pricing for goods and services. Again, picture the difficulty someone in Australia would have trying to buy a car if there were no automobile imports. The larger range of goods and services encourages competition amongst suppliers and leads to improved quality and reduced prices.
Two important trends have increased international trade:
Fewer trade barriers
Better transportation and communications
Trade barriers are constraints, generally imposed by governments, on the free trade of products and services. The table below gives descriptions of common sorts of trade barriers.
Common Forms of Trade Barriers Tariffs
Taxes (duties) levied on imported products and services. They allow governments not just to impose trade obstacles, frequently to protect domestic suppliers, but also to earn income.
Quotas Limits set on the quantity of products that can be imported.
Non-Tariff Barriers Measures, such as certification, licensing, sanctions, or embargoes, that make it more difficult and expensive for foreign producers to compete with domestic producers.
Embargoes Measures that prevent trade with a country.
A country, or group of countries, may apply economic penalties against a country or group of countries.
Economic sanctions are commercial and financial penalties that are aimed to restrict or reduce international trade with another country.
Sanctions may include entire trade embargoes, embargoes on certain commodities and services, prohibition on foreign investment in the sanctioned country, and asset freezes. They are aimed to impair the economic activity of the sanctioned country by decreasing its imports and exports.
In 2022, the European Union and the United States enacted severe economic sanctions against Russia in response to its military attacks on Ukraine. Sanctions can have substantial economic consequences: At the time they were imposed, many believed the economic sanctions against Russia would lead to soaring inflation and potentially wipe out Russia’s previous 15 years of economic success.
But in general, international trade barriers have steadily fallen since the signing of the General Agreement on Tariffs and Trade (GATT) in 1947 and the foundation of the World Trade Organisation (WTO) in 1995.
The WTO, with more than 150 member nations, is established to ensure adherence to trade agreements and to help countries negotiate new trade deals. The WTO also provides a dispute resolution process between countries. International trade has been further promoted by the creation of regional trade agreements, such as the Association of Southeast Asian Nations’ (ASEAN) Free Trade Area (AFTA), the United States-Mexico-Canada Agreement (USMCA), the Southern Common Market (Mercosur), and the African Continental Free Trade Area (AfCFTA).
Improvements in transportation and communications have helped international trade develop. Large shipping containers allow producers to move non-perishable products more easily on ships, trains, and trucks, while jumbo aircraft transport perishable products fast around the globe. The ability to communicate digitally has also contributed to the development in the worldwide trade of products and services.
- Published on
Investment - Comparative Advantages Among Countries
Rather of manufacturing everything within the bounds of their own borders, countries frequently specialise in items and services for which they have a comparative advantage – that is, the products and services that they can manufacture substantially more effectively than other countries.
According to the principle of comparative advantage, countries should export items and services in which they have a comparative advantage and import things and services in which they do not have a comparative advantage.
The source of a competitive advantage might be tied to natural, human, or capital resources. Some countries have access to natural resources, such as fossil fuels, metals, or minerals, that are not available or are in restricted supply in other countries. Some countries can create products and services less expensively than others or make products that demand more expertise. The United States imports apparel and toys, for example, but exports complex technology, such as aeroplanes and turbines.
The combination of comparative advantage and international commerce ultimately helps all countries, leading to a better allocation of resources and increased prosperity.
Rather of manufacturing everything within the bounds of their own borders, countries frequently specialise in items and services for which they have a comparative advantage – that is, the products and services that they can manufacture substantially more effectively than other countries.
According to the principle of comparative advantage, countries should export items and services in which they have a comparative advantage and import things and services in which they do not have a comparative advantage.
The source of a competitive advantage might be tied to natural, human, or capital resources. Some countries have access to natural resources, such as fossil fuels, metals, or minerals, that are not available or are in restricted supply in other countries. Some countries can create products and services less expensively than others or make products that demand more expertise. The United States imports apparel and toys, for example, but exports complex technology, such as aeroplanes and turbines.
The combination of comparative advantage and international commerce ultimately helps all countries, leading to a better allocation of resources and increased prosperity.
- Published on
Investment - Valuation of Debt Securities
valuing debt securities is more straightforward than pricing equity securities because bonds have a defined life and fairly predictable cash flows. The value of a debt instrument is commonly calculated by utilizing the discounted cash flow (DCF) technique
The DCF valuation approach estimates the value of a security as the present value of all future cash flows that the investor anticipates to receive from the asset. The cash flows for a debt instrument are typically the future coupon payments and the final principal payment.
For fixed-rate bonds and zero-coupon bonds, the timing and guaranteed amount of all interest payments and ultimate principal payment are known.
For floating-rate bonds, the interest payments are not known in advance, but can be adequately estimated.
It is crucial to understand that the projected payments may not occur if the issuer defaults. Therefore, while calculating the value of a debt security using the DCF approach, an analyst or investor must estimate and use an appropriate discount rate that represents the riskiness of the bond’s cash flows.
This discount rate shows the investor’s necessary rate of return on the bond given its riskiness. The predicted cash flows of bonds with higher credit risk should be discounted at proportionally higher discount rates, which results in lower estimations of value. The following example gives an example of valuing a fixed-rate bond.
Example: Valuing a Fixed-Rate Bond
Consider a three-year fixed-rate bond with a par value of USD1,000 and a coupon rate of 6%, with coupon payments issued semiannually.
The bond will make six coupon payments of USD30 (one coupon payment every six months for the life of the bond) and a final principal payment of USD1,000 on the maturity date.
The value of the bond can be calculated by discounting the bond’s guaranteed payments using an appropriate discount rate that represents the riskiness of the cash flows. Assume that an investor determines that a discount rate of 7% per year, or 3.5% semiannually, is reasonable for this bond given its risk. Thus, the value of the bond can be determined as follows:
valuing debt securities is more straightforward than pricing equity securities because bonds have a defined life and fairly predictable cash flows. The value of a debt instrument is commonly calculated by utilizing the discounted cash flow (DCF) technique
The DCF valuation approach estimates the value of a security as the present value of all future cash flows that the investor anticipates to receive from the asset. The cash flows for a debt instrument are typically the future coupon payments and the final principal payment.
For fixed-rate bonds and zero-coupon bonds, the timing and guaranteed amount of all interest payments and ultimate principal payment are known.
For floating-rate bonds, the interest payments are not known in advance, but can be adequately estimated.
It is crucial to understand that the projected payments may not occur if the issuer defaults. Therefore, while calculating the value of a debt security using the DCF approach, an analyst or investor must estimate and use an appropriate discount rate that represents the riskiness of the bond’s cash flows.
This discount rate shows the investor’s necessary rate of return on the bond given its riskiness. The predicted cash flows of bonds with higher credit risk should be discounted at proportionally higher discount rates, which results in lower estimations of value. The following example gives an example of valuing a fixed-rate bond.
Example: Valuing a Fixed-Rate Bond
Consider a three-year fixed-rate bond with a par value of USD1,000 and a coupon rate of 6%, with coupon payments issued semiannually.
The bond will make six coupon payments of USD30 (one coupon payment every six months for the life of the bond) and a final principal payment of USD1,000 on the maturity date.
The value of the bond can be calculated by discounting the bond’s guaranteed payments using an appropriate discount rate that represents the riskiness of the cash flows. Assume that an investor determines that a discount rate of 7% per year, or 3.5% semiannually, is reasonable for this bond given its risk. Thus, the value of the bond can be determined as follows:
Now, explore two possible circumstances. Suppose that soon after issue, there is a spike in interest rates in the economy. Consequently, the investor recognizes that a suitable discount is now 8%. Using this greater discount rate results in a bond value as follows:
Next, imagine that soon after issue, there is a drop in interest rates in the economy. Consequently, the investor sees that a fair discount is 6%. Using this reduced discount rate results in a bond value as follows:
Bond Yield Measures
In financial markets, bond investors commonly refer to two basic yield measures to represent a bond’s predicted return. Those yield measurements are a bond’s current yield and yield to maturity.
Current Yield
A bond’s current yield is computed as the annual coupon payment divided by the current market price. This metric is simple to calculate and is widely quoted. A bond’s current yield provides bondholders with an estimate of the annualised return from coupon income solely, without consideration for the effect of any capital gain or loss stemming from changes in the bond’s value over time.
Yield to Maturity
Investors can use the DCF approach to evaluate the discount rate implied by a bond’s market price. The discount rate that corresponds the present value of a bond’s guaranteed cash flows to its market price is the bond’s yield to maturity (YTM), or yield. An investor can compare this yield to maturity with their necessary rate of return on the bond considering its riskiness to decide whether to purchase it.
A bond’s yield to maturity can be stated as indicated in the graphic below,
where P0 indicates the current market price of the bond, and rytm represents the bond’s yield to maturity. By inserting the projected interest payments and par value payment for the numerator cash flows, and inputting the bond’s current price for P0, the bond’s YTM may be determined.
Many investors use a bond’s yield to maturity to estimate the annualised return from buying the bond at the current market price and holding it until maturity, assuming that all guaranteed payments are fulfilled on schedule and in full. When a bond’s payments are known, as in the case of fixed-rate bonds and zero-coupon bonds, the yield to maturity can be estimated by utilizing the current market price.
In financial markets, bond investors commonly refer to two basic yield measures to represent a bond’s predicted return. Those yield measurements are a bond’s current yield and yield to maturity.
Current Yield
A bond’s current yield is computed as the annual coupon payment divided by the current market price. This metric is simple to calculate and is widely quoted. A bond’s current yield provides bondholders with an estimate of the annualised return from coupon income solely, without consideration for the effect of any capital gain or loss stemming from changes in the bond’s value over time.
Yield to Maturity
Investors can use the DCF approach to evaluate the discount rate implied by a bond’s market price. The discount rate that corresponds the present value of a bond’s guaranteed cash flows to its market price is the bond’s yield to maturity (YTM), or yield. An investor can compare this yield to maturity with their necessary rate of return on the bond considering its riskiness to decide whether to purchase it.
A bond’s yield to maturity can be stated as indicated in the graphic below,
where P0 indicates the current market price of the bond, and rytm represents the bond’s yield to maturity. By inserting the projected interest payments and par value payment for the numerator cash flows, and inputting the bond’s current price for P0, the bond’s YTM may be determined.
Many investors use a bond’s yield to maturity to estimate the annualised return from buying the bond at the current market price and holding it until maturity, assuming that all guaranteed payments are fulfilled on schedule and in full. When a bond’s payments are known, as in the case of fixed-rate bonds and zero-coupon bonds, the yield to maturity can be estimated by utilizing the current market price.
Example: Yield to Maturity
In the following example, we will study the calculation of a bond’s yield to maturity.
Consider a fixed-rate bond with exactly five years remaining until maturity, a par value of USD1,000 per unit, and a coupon rate of 4% with semiannual payments. The bond is presently selling at a price of USD914.70. With this information, the bond’s yield to maturity can be determined by solving for rytm
In the following example, we will study the calculation of a bond’s yield to maturity.
Consider a fixed-rate bond with exactly five years remaining until maturity, a par value of USD1,000 per unit, and a coupon rate of 4% with semiannual payments. The bond is presently selling at a price of USD914.70. With this information, the bond’s yield to maturity can be determined by solving for rytm
The bond’s yield to maturity is the discount rate that makes the present value of the bond’s promised cash flows equal to its market price. The bond’s anticipated cash flows consist of 10 semiannual coupon payments of USD20 occurring every 6 months and a final principal payment of USD1,000 on the maturity date in 5 years, or 10 semiannual periods.
In this situation, rytm is 3% on a semiannual basis, or 6% annualised. Thus, at a price of USD914.70, the bond’s yield to maturity is 6%.
The current yield is computed as $40 ÷ $914.70 = 4.37%. You can observe that the current yield and the yield to maturity differ.
It is crucial to recognize that bond prices and bond yields to maturity are inversely connected. That is, as bond prices fall, their yields to maturity increase, and as bond prices rise, their yields to maturity decrease.
If the bond’s coupon rate and the yield to maturity are the same, the bond’s value is equal to its par value.
In the example, the bond’s coupon rate was 6%, and in the last scenario, the yield to maturity was assumed likewise to be 6%. In that circumstance, the computed bond price was exactly equal to its par value of USD1,000. In financial markets, a fixed-rate bond with a current price equal to par value is referred to as a par bond.
If the bond’s coupon rate is lower than the yield to maturity, as was initially the case in the example, the bond’s value will be less than its par value. A fixed-rate bond with a current price below par value is referred to as a discount bond.
Lastly, if the bond’s coupon rate is more than the yield to maturity, the bond’s value will be higher than its par value. A fixed-rate bond with a current price over par value is referred to as a premium bond.
As stated previously and illustrated by the examples, it is crucial to realize that bond prices and bond yields to maturity are inversely associated. That is, as bond prices fall, their yields to maturity increase, and as bond prices rise, their yields to maturity decrease.
In this situation, rytm is 3% on a semiannual basis, or 6% annualised. Thus, at a price of USD914.70, the bond’s yield to maturity is 6%.
The current yield is computed as $40 ÷ $914.70 = 4.37%. You can observe that the current yield and the yield to maturity differ.
It is crucial to recognize that bond prices and bond yields to maturity are inversely connected. That is, as bond prices fall, their yields to maturity increase, and as bond prices rise, their yields to maturity decrease.
If the bond’s coupon rate and the yield to maturity are the same, the bond’s value is equal to its par value.
In the example, the bond’s coupon rate was 6%, and in the last scenario, the yield to maturity was assumed likewise to be 6%. In that circumstance, the computed bond price was exactly equal to its par value of USD1,000. In financial markets, a fixed-rate bond with a current price equal to par value is referred to as a par bond.
If the bond’s coupon rate is lower than the yield to maturity, as was initially the case in the example, the bond’s value will be less than its par value. A fixed-rate bond with a current price below par value is referred to as a discount bond.
Lastly, if the bond’s coupon rate is more than the yield to maturity, the bond’s value will be higher than its par value. A fixed-rate bond with a current price over par value is referred to as a premium bond.
As stated previously and illustrated by the examples, it is crucial to realize that bond prices and bond yields to maturity are inversely associated. That is, as bond prices fall, their yields to maturity increase, and as bond prices rise, their yields to maturity decrease.
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Investment - Risk of Investing in Debt Securities
Investing in bonds comes with a lot of dangers, but how do these risks affect the price of a bond on the market? The yield to maturity on a bond is a function of its maturity and risk.
In principle, two bonds with the same maturity and risk should trade at prices that offer nearly the same yield to maturity. For example, two five-year bonds with the same liquidity and the same credit rating will trade at essentially identical yields to maturity.
Low-risk bonds, such as many government bonds, trade at substantially lower yields to maturity, which suggest relatively higher prices. Similarly, high-risk bonds, such as high-yield (or non-investment-grade) bonds, trade at substantially higher yields to maturity, which suggest significantly lower prices. Relative to secured debt, subordinated debt securities offer higher yields to maturity, which reflect their increased default risk.
Credit Risk
The risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal.
Interest Rate Risk
The danger that interest rates may climb, leading the price of fixed-rate and zero-coupon bonds to decline.
Inflation Risk
The danger that the purchasing power of the coupon payments and final principal payment would diminish with inflation.
Liquidity Risk
The risk of being unable to sell a bond before to the maturity date without having to accept a considerable discount to market value.
Reinvestment Risk
The risk that coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
Call Risk
The risk that the issuer will buy back (or call) the bond issue prior to maturity through the exercise of a call clause.
Credit Risk
Credit risk, commonly referred to as default risk, is the risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal. The issuer may encounter financial trouble and consequently not have the money available to make the promised interest and/or principal payments. In this circumstance, bondholders may lose a large proportion of their invested capital.
It is vital to highlight that credit risk can damage bondholders even when the company does not actually default on its payments.
For example, if market participants fear that a particular bond issuer will not be able to make its promised bond payments because of unfavorable business or general economic conditions, the probability of future default would grow, and the bond price will likely decline in the market.
Consequently, investors owning that particular bond will be vulnerable to a price decrease and a potential loss of money if they seek to sell the bond.
Credit Rating
Investors may be able to estimate the credit risk of a bond by checking its credit rating. Independent credit rating agencies examine the credit quality of certain bonds and assign them ratings depending on the creditworthiness of the issuer.
The following display presents the credit ratings systems of Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings.
Based on credit risk, bonds are classified as investment-grade bonds (those in the shaded part of the exhibit) or non-investment-grade bonds (those in the non-shaded area of the exhibit).
Many government regulators often mandate that certain investors, such as insurance companies and pension funds, largely restrict their investments to bonds that are investment grade (e.g., bonds with a high degree of creditworthiness and minimal risk of default).
Non-investment-grade bonds are frequently referred to as high-yield bonds or junk bonds. They are dubbed trash bonds because they are less creditworthy and have a greater probability of default. Investors in these bonds prefer the name high-yield bonds, which acknowledges the higher yields (anticipated profits) on these bonds due of the higher level of risk. Recall that the riskier the borrower — or the less assured the borrower’s apparent capacity to repay the loan — the greater the level of interest demanded by the lender.
Credit rating agencies award a bond rating at the time of issue, but they also assess the rating and may change a bond’s credit rating over time depending on the issuer’s perceived creditworthiness. An improvement in credit rating is referred to as an upgrade, and a fall in credit rating is referred to as a downgrade.
A high credit rating affords a bond issuer two primary benefits: the capacity to issue debt securities at a cheaper interest rate and the opportunity to access a bigger pool of investors.
The wider pool of investors will include institutional investors that must hold major amounts of their investment assets in investment-grade bonds.
Credit Spreads
US Treasuries and government bonds of some developed and emerging countries are considered safe instruments that bear minimal default risk. Consequently, relative to these government bonds, rates on other bonds are often greater.
Investors usually refer to the difference between a hazardous bond’s yield to maturity and the yield to maturity on a government bond with the same maturity as the risky bond’s credit spread. The credit spread tells the investor how much extra yield is being offered for investing in a bond that has a higher likelihood of default.
The following is an example of calculating and analyzing a credit spread.
Consider a corporate bond with a remaining maturity of 30 years. The bond’s coupon rate is 5.2%. Currently, the bond is selling at a price of USD1,185.32, providing a yield to maturity of 4.10%. The yield to maturity on a 30-year Treasury bond is 3.22%
The corporate bond’s credit spread over a 30-year Treasury is 4.10% – 3.22% = 0.88%, or 88 bps. The extra yield, or credit spread, supplied by the corporate bond acts as compensation to the investor for incurring a higher risk for investing in the corporate bond relative to the safer Treasury bond.
Higher-risk bonds, such as trash bonds, trade at wider credit spreads because of their higher default risk. Similarly, lower-risk bonds trade at narrower credit spreads relative to high-risk bonds. Credit spreads enable investors to analyze yield disparities across bonds of various credit quality.
If a bond is judged to have gotten riskier, its price will fall and its yield will rise, which will likely result in a widening of the bond’s credit spread relative to a government bond with the same term. Similarly, a bond seen to have experienced an increase in credit quality may have its price rise and its yield fall, possibly resulting in a narrower credit spread relative to a comparable government bond.
Interest Rate Risk
Interest rate risk is the risk that interest rates will vary. Interest rate risk usually refers to the risk associated with drops in bond prices coming from rises in interest rates (i.e., yields to maturity). This risk is particularly important to fixed-rate bonds and zero-coupon bonds.
Bond prices and interest rates are inversely connected; that is, bond prices increase as interest rates decrease, and bond prices decrease as interest rates increase.
Prices of zero-coupon and fixed-rate bonds can decrease dramatically in an environment of rising interest rates. But because coupon rates on floating-rate bonds are reset to current market interest rates at each payment date, floating-rate bonds exhibit less interest rate risk while interest rates are rising. But a floating-rate bond may display interest rate risk in an environment of dropping interest rates because investors receive less coupon income when the bond’s coupon rate is reset to a lower rate.
A commonly used metric of interest rate risk is duration, which quantifies the sensitivity of a bond’s price to changes in its yield to maturity.
Specifically, a bond’s duration is the estimated percentage change in price for a 100 basis point change in the bond’s yield to maturity.
For example, if a bond’s length is 7.0, then the bond’s price is projected to increase by 7% for every 100 basis point fall in its yield to maturity (or conversely, to decline by 7% for every 100 basis point increase).
Inflation Risk
Nearly all debt securities expose investors to inflation risk because the promised interest payments and final principal payment from most debt securities are nominal quantities – that is, the amounts do not vary with inflation.
Unfortunately, as inflation makes things and services more expensive over time, the purchasing power of the coupon payments and the final principal payment on most bonds falls with time.
Floating-rate bonds partially guard against inflation because the coupon rate fluctuates over time.
They provide no protection, however, against the loss of purchasing power of the principal payment.
Investors that are concerned about inflation and seek protection against it may want to invest in inflation-linked bonds, which adjust the main (par) value for inflation. Because the coupon payment is based on the par value, the coupon payment also changes with inflation. Call Risk
Call risk, commonly referred to as prepayment risk, refers to the risk that the issuer will purchase back (redeem or call) the bond issuance prior to maturity through the execution of a call provision.
If interest rates fall, issuers may execute the call provision, therefore bondholders will have to reinvest the funds in bonds with lower coupon rates. Callable bonds, and most mortgage-backed securities based on loans that allow the borrowers to make loan prepayments in advance of their maturity date, are exposed to prepayment risk.
Liquidity Risk
Liquidity risk refers to the risk of being unable to sell a bond prior to the maturity date without having to accept a large discount to market value. Bonds that do not trade regularly display high liquidity risk.
Investors who want to sell their somewhat illiquid bonds face higher liquidity risk than investors with bonds that trade more regularly.
Reinvestment Risk
Reinvestment risk refers to the fact that in a period of decreasing interest rates, the coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
If market interest rates fall after a bond is issued, bondholders will most likely have to reinvest the income received on the bond (the coupon payment) at the current lower interest rates.
Investing in bonds comes with a lot of dangers, but how do these risks affect the price of a bond on the market? The yield to maturity on a bond is a function of its maturity and risk.
In principle, two bonds with the same maturity and risk should trade at prices that offer nearly the same yield to maturity. For example, two five-year bonds with the same liquidity and the same credit rating will trade at essentially identical yields to maturity.
Low-risk bonds, such as many government bonds, trade at substantially lower yields to maturity, which suggest relatively higher prices. Similarly, high-risk bonds, such as high-yield (or non-investment-grade) bonds, trade at substantially higher yields to maturity, which suggest significantly lower prices. Relative to secured debt, subordinated debt securities offer higher yields to maturity, which reflect their increased default risk.
Credit Risk
The risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal.
Interest Rate Risk
The danger that interest rates may climb, leading the price of fixed-rate and zero-coupon bonds to decline.
Inflation Risk
The danger that the purchasing power of the coupon payments and final principal payment would diminish with inflation.
Liquidity Risk
The risk of being unable to sell a bond before to the maturity date without having to accept a considerable discount to market value.
Reinvestment Risk
The risk that coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
Call Risk
The risk that the issuer will buy back (or call) the bond issue prior to maturity through the exercise of a call clause.
Credit Risk
Credit risk, commonly referred to as default risk, is the risk of loss if the borrower, or bond issuer, fails to make full and timely payments of interest and/or principal. The issuer may encounter financial trouble and consequently not have the money available to make the promised interest and/or principal payments. In this circumstance, bondholders may lose a large proportion of their invested capital.
It is vital to highlight that credit risk can damage bondholders even when the company does not actually default on its payments.
For example, if market participants fear that a particular bond issuer will not be able to make its promised bond payments because of unfavorable business or general economic conditions, the probability of future default would grow, and the bond price will likely decline in the market.
Consequently, investors owning that particular bond will be vulnerable to a price decrease and a potential loss of money if they seek to sell the bond.
Credit Rating
Investors may be able to estimate the credit risk of a bond by checking its credit rating. Independent credit rating agencies examine the credit quality of certain bonds and assign them ratings depending on the creditworthiness of the issuer.
The following display presents the credit ratings systems of Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings.
Based on credit risk, bonds are classified as investment-grade bonds (those in the shaded part of the exhibit) or non-investment-grade bonds (those in the non-shaded area of the exhibit).
Many government regulators often mandate that certain investors, such as insurance companies and pension funds, largely restrict their investments to bonds that are investment grade (e.g., bonds with a high degree of creditworthiness and minimal risk of default).
Non-investment-grade bonds are frequently referred to as high-yield bonds or junk bonds. They are dubbed trash bonds because they are less creditworthy and have a greater probability of default. Investors in these bonds prefer the name high-yield bonds, which acknowledges the higher yields (anticipated profits) on these bonds due of the higher level of risk. Recall that the riskier the borrower — or the less assured the borrower’s apparent capacity to repay the loan — the greater the level of interest demanded by the lender.
Credit rating agencies award a bond rating at the time of issue, but they also assess the rating and may change a bond’s credit rating over time depending on the issuer’s perceived creditworthiness. An improvement in credit rating is referred to as an upgrade, and a fall in credit rating is referred to as a downgrade.
A high credit rating affords a bond issuer two primary benefits: the capacity to issue debt securities at a cheaper interest rate and the opportunity to access a bigger pool of investors.
The wider pool of investors will include institutional investors that must hold major amounts of their investment assets in investment-grade bonds.
Credit Spreads
US Treasuries and government bonds of some developed and emerging countries are considered safe instruments that bear minimal default risk. Consequently, relative to these government bonds, rates on other bonds are often greater.
Investors usually refer to the difference between a hazardous bond’s yield to maturity and the yield to maturity on a government bond with the same maturity as the risky bond’s credit spread. The credit spread tells the investor how much extra yield is being offered for investing in a bond that has a higher likelihood of default.
The following is an example of calculating and analyzing a credit spread.
Consider a corporate bond with a remaining maturity of 30 years. The bond’s coupon rate is 5.2%. Currently, the bond is selling at a price of USD1,185.32, providing a yield to maturity of 4.10%. The yield to maturity on a 30-year Treasury bond is 3.22%
The corporate bond’s credit spread over a 30-year Treasury is 4.10% – 3.22% = 0.88%, or 88 bps. The extra yield, or credit spread, supplied by the corporate bond acts as compensation to the investor for incurring a higher risk for investing in the corporate bond relative to the safer Treasury bond.
Higher-risk bonds, such as trash bonds, trade at wider credit spreads because of their higher default risk. Similarly, lower-risk bonds trade at narrower credit spreads relative to high-risk bonds. Credit spreads enable investors to analyze yield disparities across bonds of various credit quality.
If a bond is judged to have gotten riskier, its price will fall and its yield will rise, which will likely result in a widening of the bond’s credit spread relative to a government bond with the same term. Similarly, a bond seen to have experienced an increase in credit quality may have its price rise and its yield fall, possibly resulting in a narrower credit spread relative to a comparable government bond.
Interest Rate Risk
Interest rate risk is the risk that interest rates will vary. Interest rate risk usually refers to the risk associated with drops in bond prices coming from rises in interest rates (i.e., yields to maturity). This risk is particularly important to fixed-rate bonds and zero-coupon bonds.
Bond prices and interest rates are inversely connected; that is, bond prices increase as interest rates decrease, and bond prices decrease as interest rates increase.
Prices of zero-coupon and fixed-rate bonds can decrease dramatically in an environment of rising interest rates. But because coupon rates on floating-rate bonds are reset to current market interest rates at each payment date, floating-rate bonds exhibit less interest rate risk while interest rates are rising. But a floating-rate bond may display interest rate risk in an environment of dropping interest rates because investors receive less coupon income when the bond’s coupon rate is reset to a lower rate.
A commonly used metric of interest rate risk is duration, which quantifies the sensitivity of a bond’s price to changes in its yield to maturity.
Specifically, a bond’s duration is the estimated percentage change in price for a 100 basis point change in the bond’s yield to maturity.
For example, if a bond’s length is 7.0, then the bond’s price is projected to increase by 7% for every 100 basis point fall in its yield to maturity (or conversely, to decline by 7% for every 100 basis point increase).
Inflation Risk
Nearly all debt securities expose investors to inflation risk because the promised interest payments and final principal payment from most debt securities are nominal quantities – that is, the amounts do not vary with inflation.
Unfortunately, as inflation makes things and services more expensive over time, the purchasing power of the coupon payments and the final principal payment on most bonds falls with time.
Floating-rate bonds partially guard against inflation because the coupon rate fluctuates over time.
They provide no protection, however, against the loss of purchasing power of the principal payment.
Investors that are concerned about inflation and seek protection against it may want to invest in inflation-linked bonds, which adjust the main (par) value for inflation. Because the coupon payment is based on the par value, the coupon payment also changes with inflation. Call Risk
Call risk, commonly referred to as prepayment risk, refers to the risk that the issuer will purchase back (redeem or call) the bond issuance prior to maturity through the execution of a call provision.
If interest rates fall, issuers may execute the call provision, therefore bondholders will have to reinvest the funds in bonds with lower coupon rates. Callable bonds, and most mortgage-backed securities based on loans that allow the borrowers to make loan prepayments in advance of their maturity date, are exposed to prepayment risk.
Liquidity Risk
Liquidity risk refers to the risk of being unable to sell a bond prior to the maturity date without having to accept a large discount to market value. Bonds that do not trade regularly display high liquidity risk.
Investors who want to sell their somewhat illiquid bonds face higher liquidity risk than investors with bonds that trade more regularly.
Reinvestment Risk
Reinvestment risk refers to the fact that in a period of decreasing interest rates, the coupon payments received over the life of a bond, and/or the principal payment received from a bond that is called early, must be reinvested at a lower interest rate than the bond’s original coupon rate.
If market interest rates fall after a bond is issued, bondholders will most likely have to reinvest the income received on the bond (the coupon payment) at the current lower interest rates.
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Investment - Yield Curve
When investors try to estimate the right discount rate (yield to maturity or necessary rate of return) to value a particular corporate bond, they generally begin by looking at the yields to maturity offered by government bonds.
The term structure of interest rates, frequently referred to simply as the term structure, depicts how interest rates on government bonds fluctuate with maturity. The term structure is commonly displayed in graphical form, referred to as the yield curve.
The yield curve compares the yield to maturity of government bonds (y-axis) versus the maturity of these bonds (x-axis). It is vital when building a yield curve to ensure that bonds have similar features other than their maturity. In other words, the bonds assessed should simply differ in maturity.
A yield curve applied to US debt instruments is the US Treasury yield curve, which graphs yields on US government bonds by maturity.
Shown below is the US Treasury yield curve as of 19 July 2022. In this scenario, the yield curve is upward sloping in the short-term maturities before flattening off in the longer maturities.
When investors try to estimate the right discount rate (yield to maturity or necessary rate of return) to value a particular corporate bond, they generally begin by looking at the yields to maturity offered by government bonds.
The term structure of interest rates, frequently referred to simply as the term structure, depicts how interest rates on government bonds fluctuate with maturity. The term structure is commonly displayed in graphical form, referred to as the yield curve.
The yield curve compares the yield to maturity of government bonds (y-axis) versus the maturity of these bonds (x-axis). It is vital when building a yield curve to ensure that bonds have similar features other than their maturity. In other words, the bonds assessed should simply differ in maturity.
A yield curve applied to US debt instruments is the US Treasury yield curve, which graphs yields on US government bonds by maturity.
Shown below is the US Treasury yield curve as of 19 July 2022. In this scenario, the yield curve is upward sloping in the short-term maturities before flattening off in the longer maturities.
The term structure for government bonds, such as Treasury bonds, offers investors with a base yield to maturity, which serves as a basis to compare yields to maturity offered by riskier bonds. Relative to Treasury bonds, riskier bonds should pay higher yields to maturity to compensate investors for the increased credit or default risk.