Question

Q5:

Global financial markets have exhibited increased volatility this year, with large fall in asset prices followed by large rises.

a) If equities arbitrage with bonds and other assets so, overall, their yields tend to move up and down together, briefly offer an explanation as to why the initial declines in US and Australian equity prices were accompanied by declines in llong maturity bond yields.

b) When pessimism about future yields or borrower defaults sees funds with drawn from equity and bond markets, briefly explain to which asset markets you think portfolio managers retreat.

This all of the question detail

Answer 1

a) The bond is a fixed asset instrument which is comparatively less risky than equities and in recent times because of the spread of the epidemic the market has been extremely volatile and the portfolio managers have increased their asset to allocation to fixed income instruments. The appropriate term that is used is flight to safety which is described when because of too much uncertainty in the equity market they overweight the assets like treasury bonds, AAA rated bonds and other high-quality instruments. When there is sudden spike in the demand for these types of bonds then the required yield on these instruments decreases that is why we see that in times of uncertainties like recession the required yield on bonds fall. The long-term yield on bonds have reduced because most portfolio managers believe that it will take some time for the global economy to recover fully from the impact of corona virus and their allocation to fixed income securities have increased.

b) Managers retreating from an asset class can be seen from the perspective of the volatility in that instruments and expected return from that asset class. Equity as in general produces high returns but comes with high volatility, bond produce low returns but their income comes with a certain level of low volatility. In times of economic uncertainty or recession or epidemic managers underweight their allocation to equities because in these circumstances the performance of equity can go negative and you can lose your capital gains. In time when the economy is expected to do well, the current account deficit is low and the overall factors of the economic indicators are showing positive momentum then most portfolio managers reduce their asset allocation to bonds and overweight their allocation to small cap stocks or large cap stocks because the performance of these assets can beat the bond return by a large margins.