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to the victims of the Asian currency crises that the speculative attacks of the 1990s led to the identification of problems in the economic fundamentals and the crises forced the economies to try to address these economic weaknesses and problems (for more on this topic, see Further Reading and Research). It is also unfortunate that speculative attacks on a currency can cause effects over very short periods and can be passed quickly onto neighbours and trading partners yet the time required to rebuild a shattered economy in which investors have little confidence takes years.

A possible solution to the potential cost of currency speculation, facilitated by the ease with which capital can flow internationally, would be to set limits on such flows (such as existed until the 1980s in many countries) or impose taxes on such flows. However, not all speculation is bad and some speculation, as we see above, leads to stability in currency prices, hence using taxes or limits on speculation could create the very price differences that speculators try to exploit and therefore it is difficult to know how to deal with the issue. What we can say with certainty is that:

•Speculators dealing with uncertainties are experts in their fields and they have the incentive to be as well informed as possible before investing in uncertain future events.

•Society benefits when specific information is used by economic decision-makers and when speculators ‘get it right’.

•Speculators who are consistently incorrect are pushed out of business by their losses.

•There are both costs and benefits associated with speculative activity.

7.8.1INVESTMENT IN BOND MARKETS

Speculation takes place in markets where uncertainty prevails regarding the returns on speculative activity. An alternative, safer investment strategy exists by investing in bonds.

A bond represents an agreement between two parties in a transaction where one party lends money to the other for an agreed rate of interest (usually) over a specified period and where the lender receives back the total value of their investment when the bond matures.

Both governments and companies issue bonds when they wish to raise funds for investments they could not otherwise afford. When attempting to raise funds, businesses have the option of debt or equity financing.

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Debt financing results in borrowing money that must usually be repaid with interest.

Debt financing is described as short-term if repayments are made within one year or else is denoted as long-term debt.

Equity financing involves selling a share of the business (‘shares’) in exchange for finance where no specific future payment is defined.

With equity financing there is often a fear that ownership interests will be reduced and that a certain amount of control reverts to the additional shareholders. Clearly, governments do not have the option of equity financing; however, they use bonds to finance some of their activities. Clearly, while companies can become bankrupt, countries cannot (notwithstanding financial problems experienced by some developed and developing countries). This implies that riskier corporate bonds must offer higher returns than government bonds. The extent of the difference in bond returns depends on the belief that market participants have in the ability of a corporation to repay the purchaser of the bond.

In the same way as shares are traded on the stock exchange, a market for bonds also exists, which is known as the securities market. As with any other market, demand and supply analysis allows us a framework for considering how the prices of bonds are determined.

Bonds are less risky investments than shares but as a consequence generate lower returns for this lower risk. Some bonds must be retained until maturity while others may be sold before that date, depending on the initial agreement. Different bonds have different regulations attached to them.

•Convertible bonds can be exchanged for a predetermined number of common stocks in a company although once converted, stocks cannot be reconverted back into bonds.

•Zero-coupon bonds do not pay interest. They are purchased at a deep discount from their face value. On maturity investors receive a sum equal to the initial investment plus interest that has accrued.

•Foreign (or international) bonds generate returns in foreign currency, which means the value of the bond issuer’s currency must also be considered when thinking of making such investments.

•In some countries municipal bonds are sold to finance public works (i.e. street lights, fountains, etc.).

In attempting to decide between investing in various bonds it is possible to consider their relative rankings.

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Companies such as Moody’s and Standard & Poor’s provide rankings of bonds that are determined by their expected ability to generate interest payments and repay the principal. The best ratings is triple A (AAA), next is double A, next A followed by BAA, BA, B, CAA, CA and C.

Any changes in rankings by these companies clearly have repercussions for investors’ willingness to buy them.

In terms of its size the bond market has a similar market value to the stock market (around $31 000 bn in 1999). Government bonds represent 45% of US and euro zone bonds but in 1999 were over 70% of the Japanese bond market. Together the USA, euro zone and Japan represent over 88% of the world bond market with shares of 47%, 23% and 18% respectively.

A substantial amount of businesses’ corporate investment is made through selling bonds and, hence, businesses’ desire to sell bonds (the supply of bonds) is related to the amount of investment they plan. The flip side of the price of bonds, both government and corporate, is the return that investors are willing to earn on their investments, i.e. the interest rate.

Hence, the demand for bonds is dependent on their rate of return or interest.

Remembering that people have the choice between saving and consumption, the demand for bonds is a mirror image of individuals’ planned savings. Therefore, firms’ investment decisions, the supply of bonds, households’ savings decisions and the return on bonds versus other financial assets feed into the determination of equilibrium bond quantities and prices. Firms’ investment decisions include their analysis of the marginal revenue product of investment which is the revenueproducing potential of additional investment (and this is analytically similar to the marginal revenue product of labour examined in Chapter 2).

In terms of the main options for saving, bank deposits are one possibility while bond purchases are another. The return on either investment in a stable economic environment will have to be approximately similar, otherwise destabilizing movements of investment funds to the more profitable savings option (increasing its supply and pushing down its price/return) would occur. We can say, therefore, that interest rates on deposit accounts and returns on bonds, which are similar

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in risk level and for which the maturity period is similar (e.g. the purchase of a five-year bond and a savings deposit to be withdrawn in five years’ time) will be similar. If interest rates are high, so too are returns on bonds, also known as bond yields.

Bond yields are closely related to expectations of future interest rates. The reasons for this have to do with how central banks deal with inflation and use interest rates in conducting their monetary policy. If the Bank of England, which sets the interest rate for the UK, announces that it does not expect inflation to be a problem financial analysts expect no changes in the interest rate. (If the bank considers inflation to be too high it tries to reduce the amount of money in circulation, which leads to upward pressure on the interest rate.) If expectations are that interest rates are not going to change in the short run then bond yields will be assumed similarly not to change. Expectations about what future interest rates will be are important in the determination of bond yields.

7.8.2BONDS, INFLATION AND INTEREST RATES

Holders of ‘standard’ bonds receive an agreed fixed return over time on their investment. This agreed return is based on the market’s best guess of future economic conditions, which is uncertain. If the agreed return on the bond is 5% per annum and inflation unexpectedly jumps to 6% over one year of the life of the bond, the real rate of return – the nominal return less inflation – is negative and holders lose 1% of their return.

The real value of the fixed-income investment is reduced when inflation is greater than the rate of return.

Thus, anyone earning a fixed income dislikes inflation because the value of a fixed income is eroded. Index-linked earnings are preferable to fixed income payments because they are linked to the inflation rate and rise if inflation rises. An indexlinked pension, for example, has a built-in facility that ensures it increases by 4% if the general price level rises by 4%.

If an economy experiences inflation, higher interest rates usually follow as the monetary authority or central bank tries to deal with it by reducing money supply. We know that increased inflation reduces real earnings from fixed-income investments.

Interest rate reductions are often welcomed by bond-market analysis as they affect the present value of the investment. A £1000 bond to be repaid in 10 years is worth

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less than £1000 received today due to expected inflation and the cost of having to wait rather than use the money for consumption today.

To compare the future receipt of the bond with a current receipt of the same value requires a method for comparing benefits in different time periods known as the present value determination.

The present value of £1000 to be received in ten years’ time is the amount of money that would need to be set aside today to receive that specified amount at the specified future date. What must be determined is the amount of money that should be set aside to earn sufficient interest (or rate of return) to yield £1000 in ten years.

The standard formula used to determine present value is

PV =

£X

(1 + r )T

where PV denotes present value;

£X is the amount to be received in the future; r is the market interest rate;

T is the number of years before the investment is repaid.

If a bond of £1000 will be repaid in 10 years’ time, its present value can be calculated once the current interest rate is known. If r is 3% the present value is computed as £1000/(1 + 0.03)10. This is computed as £1000/1.34 = £744.09. Thus, the present value of a £1000 10-year bond is just over £744.

The present value of an investment varies with T and with r . If the bond is repaid in nine rather than ten years, this changes the present value, which is recalculated as £766.42. If the period is eight years the present value rises to £789.41 and if the period is two years the value is £952.50.

The present value increases as the period of the investment declines because of people’s preference for £1 today rather than one year, two years, etc. from now.

To undertake an investment a rational person must be paid for the inconvenience and risk of foregoing their money now for its use only in the future. The further away the return on the investment, the more we expect the purchasing power of money to decline, and hence the lower its present value (I would prefer £1000 next year to the same amount the following year and so on).

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As r varies so too does present value. If r is 2% rather than the 3% used in the above example the present value for T = 10 changes to £820.35. When interest rates fall, the present value of bonds rises representing a capital gain for holders of bonds, which is why bond market analysts often consider it positive news when interest rates fall.

A lower interest rate increases the present value of a bond.

7 . 9 M O N E T A R Y P O L I C Y

In recent times, monetary policy has largely become synonymous with central banks’ attempts to control inflation. Alternative targets for monetary policy include output growth and employment but since central banks deal with interest rates and reserve requirements, effects on real economic variables such as output and employment are indirect. A central bank’s influence on inflation is also indirect via changes to the money supply and through the monetary instrument of the setting of short-term interest rates. Central banks usually make the public explicitly aware of what their inflation target is and depending on whether it can be achieved and maintained they are judged to be credible or not. Credibility is a key characteristic required of a sound central bank. We know that expectations play a central role in the determination of interest rates and in the bond market and the extent to which a central bank can follow through on its stated objectives is considered as an important factor that allows markets to deal with some of the uncertainty with which they must deal.

Independence from government is another factor that is important for central bank credibility.

Central bank independence usually implies that a government has no direct input into the economic decisions taken by the central bank regarding money supply, interest rates and inflation.

However, some central banks are independent only in the choice of how they meet targets set by their government. Independence matters because traders in financial markets trade based on their best analyses of how supply and demand are determined. Any attempts by a government to manipulate supply or demand for their own purposes would create additional uncertainty in the market. There may be grounds to argue that governments should produce additional money in an economy to pay for deficits it runs but unfortunately any additional money just