The shape of the UK Yield curve can be broadly described as a normal yield curve with a flatter rise witnessed for gilts with shorter term maturities. From then on, the rise is much more constant and steeper
The theoretical explanation of a normal yield curve points to an increase in required return by investors for an instrument of the same credit quality over time. The word normal is used to point to the adherence of the curve to the risk return trade off, that is, the market expects a higher return for higher risk. Longer-term bonds are exposed to more risks such as changes in interest rates and an increased exposure to potential defaults. Also, investing money for a long period of time means an investor is unable to use the money in other ways, so the investor is compensated for this through the time value of money component of the yield
The flatter nature of the yield curve witnessed for short term maturities is theoretically explained as a situation where the difference in yield between longer term and short term instruments is very small and hence investors gain little from investing in longer term instruments as there is no excess compensation for the extra risk taken over time
Putting the above in perspective, we see that the battering that the UK financial system took as a result of the sub prime mortgage crisis resulting in the nationalization of top of the line UK banking companies and the systematic weaknesses witnessed by the UK economy (due to its over reliance on trade in services which have been severely hit by the downturn in industry and commerce globally), the yield curve, with its sharp and constant rise over time, suggests an increased sovereign risk that the UK economy now poses for investors. The recessionary nature of the economy with falls in GDP expected over the next couple of years (Economist.com, 2009) coupled with the strain on UK public finances due to large equity stakes taken in bruised and battered organizations reinforces the increase in sovereign risk argument. The flatter structure for early maturities is a non issue as normally, return for short term instruments does not vary by much.
The state of the UK public finances also points to this normal yield curve shape. The UK government is in dire requirement of funds to bridge the funding gap that has arisen due to the need to finance the equity injections in troubled institutions and at the same time keep up its spending plans to fiscally stimulate the economy. In this respect, with the government constrained for funds, the yield curve in essence represents the higher yield offered as a result of fund requirement.
To conclude, the normal shape of the UK yield curve is a result of two factors, the higher fund requirement by the UK government and the higher sovereign risk that the economy exhibits at the moment over time.
Task Two
Next plc is a United Kingdom-based retailer offering products in clothing, footwear, accessories and home products. Next distributes through three main channels Next Retail, a chain of more than 500 stores in the United Kingdom and Eire the Next Directory, a direct mail catalogue and transactional Website with more than two million active customers, and Next International, with more than 150 stores overseas. Its other businesses include Next Sourcing, which designs, sources and buys Next branded products Ventura, which provides customer services management to clients wishing to outsource their customer contact administration and fulfillment activities, and Lipsy, which designs and sells its own branded younger women s fashion products through wholesale, retail and Internet channels. Other Activities also includes profits from its Property Management Division, and its associated companies, Choice and Cotton Traders (Google Finance, 2009). The five year share performance is as under (Reuters, 2009)
The 50 day moving average on the firms shares over the past five years show that price and momentum signals as depicted by the moving average mechanism point to 99 accuracy and anyone following this strategy on stock selection may end up timing the market effectively with regard to shares of NEXT PLC.
The effectiveness of a moving average strategy stems from the fact that it, in essence, allows investors to put contrarian investing in practice. Contrarian investing employs the use of doing the opposite of what the market does (BPP, 2009), that is, buy when others are selling (average down) and sell when others are buying (average up). Taking the example of NEXT PLC shares, we see that anyone employing this strategy over a five year period would have timed the market effectively to buy cheap and sell expensive without giving into what may be termed as a herd effect. In essence, this market timing is aided by the use of technical analysis techniques such as moving averages for they allow investors who are following a contrarian approach to investing to effectively know when it is time to buy and when it is time to sell. Even for investors that do not follow a contratian approach to investing, the usage of simple averages allows market timing and from a stock selection perspective, a fair idea of the relative over pricing under pricing of a share (Schweser, 2009).
However, it must be noted that employing a moving average strategy to compliment any investing style requires a lot of skill and knowledge and hence investor education is a must here. Thus, the trade off between time spent and benefits reaped should be size able (Scheweser, 2009).
The theoretical explanation of a normal yield curve points to an increase in required return by investors for an instrument of the same credit quality over time. The word normal is used to point to the adherence of the curve to the risk return trade off, that is, the market expects a higher return for higher risk. Longer-term bonds are exposed to more risks such as changes in interest rates and an increased exposure to potential defaults. Also, investing money for a long period of time means an investor is unable to use the money in other ways, so the investor is compensated for this through the time value of money component of the yield
The flatter nature of the yield curve witnessed for short term maturities is theoretically explained as a situation where the difference in yield between longer term and short term instruments is very small and hence investors gain little from investing in longer term instruments as there is no excess compensation for the extra risk taken over time
Putting the above in perspective, we see that the battering that the UK financial system took as a result of the sub prime mortgage crisis resulting in the nationalization of top of the line UK banking companies and the systematic weaknesses witnessed by the UK economy (due to its over reliance on trade in services which have been severely hit by the downturn in industry and commerce globally), the yield curve, with its sharp and constant rise over time, suggests an increased sovereign risk that the UK economy now poses for investors. The recessionary nature of the economy with falls in GDP expected over the next couple of years (Economist.com, 2009) coupled with the strain on UK public finances due to large equity stakes taken in bruised and battered organizations reinforces the increase in sovereign risk argument. The flatter structure for early maturities is a non issue as normally, return for short term instruments does not vary by much.
The state of the UK public finances also points to this normal yield curve shape. The UK government is in dire requirement of funds to bridge the funding gap that has arisen due to the need to finance the equity injections in troubled institutions and at the same time keep up its spending plans to fiscally stimulate the economy. In this respect, with the government constrained for funds, the yield curve in essence represents the higher yield offered as a result of fund requirement.
To conclude, the normal shape of the UK yield curve is a result of two factors, the higher fund requirement by the UK government and the higher sovereign risk that the economy exhibits at the moment over time.
Task Two
Next plc is a United Kingdom-based retailer offering products in clothing, footwear, accessories and home products. Next distributes through three main channels Next Retail, a chain of more than 500 stores in the United Kingdom and Eire the Next Directory, a direct mail catalogue and transactional Website with more than two million active customers, and Next International, with more than 150 stores overseas. Its other businesses include Next Sourcing, which designs, sources and buys Next branded products Ventura, which provides customer services management to clients wishing to outsource their customer contact administration and fulfillment activities, and Lipsy, which designs and sells its own branded younger women s fashion products through wholesale, retail and Internet channels. Other Activities also includes profits from its Property Management Division, and its associated companies, Choice and Cotton Traders (Google Finance, 2009). The five year share performance is as under (Reuters, 2009)
The 50 day moving average on the firms shares over the past five years show that price and momentum signals as depicted by the moving average mechanism point to 99 accuracy and anyone following this strategy on stock selection may end up timing the market effectively with regard to shares of NEXT PLC.
The effectiveness of a moving average strategy stems from the fact that it, in essence, allows investors to put contrarian investing in practice. Contrarian investing employs the use of doing the opposite of what the market does (BPP, 2009), that is, buy when others are selling (average down) and sell when others are buying (average up). Taking the example of NEXT PLC shares, we see that anyone employing this strategy over a five year period would have timed the market effectively to buy cheap and sell expensive without giving into what may be termed as a herd effect. In essence, this market timing is aided by the use of technical analysis techniques such as moving averages for they allow investors who are following a contrarian approach to investing to effectively know when it is time to buy and when it is time to sell. Even for investors that do not follow a contratian approach to investing, the usage of simple averages allows market timing and from a stock selection perspective, a fair idea of the relative over pricing under pricing of a share (Schweser, 2009).
However, it must be noted that employing a moving average strategy to compliment any investing style requires a lot of skill and knowledge and hence investor education is a must here. Thus, the trade off between time spent and benefits reaped should be size able (Scheweser, 2009).
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