6.5 The behaviour of security prices

Box 6.8

Ination data push up yields

By Richard Beales in New York, Paul J

Davies in London and Daniel Turner in

Tokyo.

The recent bearish trend resumed

for US, European and UK govern-

ment bond markets yesterday,

with prices falling and yields

rising across the board after two

days of price rallies.

US Treasury yields jumped as

the latest data suggested ination

was running higher than ex-

pected, raising the odds of further

rate rises by the Federal Reserve.

...In the UK, the gilt marketwas hit by news that one memberof the Bank of England’s interestrate setting committee had votedfor an immediate rise at its ses-sion two weeks ago.

The minutes of the committee’smeeting, when it kept rates un-changed at 4.5 per cent, showedDavid Walton voted for a quarter-point rise in rates while one other member voted for a cut andthe others voted for no change. The news surprised markets andsuggested UK rates could rise

sooner than expected if other

members begin to swing round to

Mr Walton’s view.

The yield on the two-year gilt

rose 2.3bp to 4.756 per cent, while

the yield on the 10 year was 2bp

higher at 4.636 per cent.

European government bond

prices slumped after data showed

core consumer price ination in

the Eurozone ticked up in April

and an auction of German 10-

year bunds met with a lukewarm

reception.

FT

Source:Financial Times, 18 May 2006

With equities, though, there is wide scope for rm-specic events and economy-

wide ones to play a part. Running through the possibilities outlined in Figure 6.4,

we can see rst of all that equity prices, like the price of all assets, will respond to

changes in interest rates. If the central bank raises rates, for example, the rate avail-

able on risk-free assets goes up, and if more can be earned on risk-free assets, the

holders of risky shares will want a higher return as well. Share prices will also fall

if the equity market as a whole becomes more risk averse and demands a higher

premium for any level of risk.

Of all the shocks that occur to equity prices, changes in general attitudes to risk

(‘risk-aversion’), and therefore the price charged for bearing risk, are perhaps the

least frequent. In the UK and US the market risk premium has been fairly stable at

around 8 per cent for many years. But major upheavals with uncertain outcomes,

such as the Iraq War and its threat to oil supplies, have occasionally seen the required

return on equities as a whole increase relative to the return on risk-free assets.

Changes in the riskiness of individual shares result from changes in the rm

itself. This may happen because of a change in business plans, especially if the plan

involves diversication into a new line of activity. More frequently, it happens as

a result of changes in the rm’s capital structure. As we have seen, increasing the

proportion of debt relative to equity means that prots available for distribution,

after interest payments to bondholders, become more variable. Changes in capital

structure are likely to cause changes in .

Changes in dividend payments result from either, or both, changes in the level of

prots or earnings, or changes in the ‘payout ratio’, the fraction of earnings paid out

as dividends. Many rms operate a dividend policy which features a stable payout ratio.

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Chapter 6 • The capital markets

In this case, uctuations in earnings will be reected directly in dividend payments.

Fluctuations in earnings will sometimes be the result of rm-specic events, expensive

marketing campaigns which fail to generate the hoped-for additional demand, for

example. But they can also occur as the result of changes in general trading conditions.

In a slump, for example, most rms will nd prots at a standstill or even falling,

though even in this case some rms are likely to be more affected than others.

Changes in estimates of the future growth of prots will likewise sometimes involve

rm-specic events and sometimes economy- or at least industry-wide trends. On

19 May 2006, for example, when stock markets across the world were coming to the

end of a week of considerable volatility and when share prices generally had fallen

by around 10 per cent, the price of British Airways shares rose by 9 per cent. This

followed news that BA had managed to increase its prots by 21 per cent in a period

when many airlines were making a loss as a result of a steep rise in fuel prices. It also

announced that it expected its prots to rise more rapidly in 2006/07.

Just to make matters a little more complicated still, it will often be the case that

single events will have multiple effects. An obvious example is an increase in interest

rates. As we saw above, this will cause the risk-free rate and thus the return on all

assets to rise. But for rms, it is likely to depress the rate of prot growth, especially

if the rm is making goods which are usually bought on credit. If the rm has a large

overdraft, which charges a variable rate of interest, this year’s prots after interest

will be hit; and if it is sufciently highly geared that extra interest payments may

drive it into bankruptcy, its -coefcient increases too!

Exercise 6.4 invites you to try to design a box similar to Box 6.7, but showing this

time the inuences on share prices. On the left-hand side of the box, we have put

the immediate determinants of share prices. Remember that what will cause people

to buy and sell shares, and their prices to move, will be events which lead people

to expect a change in one or more of these determinants. What you have to do is to

make a list on the right-hand side of the box of the types of event that you think

cause people to expect changes in risk, prot, interest rates, etc. We have started the

list. You will quickly nd that you have a spider’s web of lines and arrows!

Exercise	6.4	Inuences on share	prices:
		Asset-specic risk		Capital structure
		Risk aversion		Business activity
		Interest rates		Senior management
		Next dividend
		Prot growth

Valuing shares, or other assets, by discounting their future earnings by a factor

which incorporates the current level of interest rates plus a risk premium, may be

theoretically correct, but it requires a lot of information and a certain amount of

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