So let's start our discussion on the global nature of capital markets by taking a closer look at market linkages. What are they? Why are they there? What are they telling us? As it turns out, all prices are connected. So let's start with share prices, the equity market. And let's focus on Kellogg's again, as compared to the share price movements in its competitor craft. Of course, share price movements reflect the companies' unique changing earnings forecast. But it wouldn't come as a major surprise to you that the earnings forecast of Kellogg's have got something to do with the earnings forecast over direct competitors like Kraft. There is a set of simple reasons for that. Similar inputs are beings used to produce cereals. Similar technologies, similar machinery, similar outputs. Same regulation might apply to Kraft and Kellogg's foodstuffs. Similar global exposure. And last, but certainly not least, having similar consumers. When conditions change in any of these similar variables, that will have a direct impact on the forecast of earnings for both companies. Hence, we see a close relationship. So what you see in this graph is what I labeled The Food Chain. What I've given you here is the share price for about three-and-a-half years of Kellogg's, the blue line, Kraft, the red line, and another competitor Mondelez, the green line. Looking at this graph, it's striking how closely the share price of Kellogg's is related to the share price of Kraft. You almost see every movement in the share price replicated in the competitor's move. Not so, though, for Mondelez. So we see in this graph that whereas Kellogg's and Kraft closely move together, Mondelez does have some similar movements, but also a lot of unique movements. It's also worth noting, of course, that there is one very unique movement in the share price of Kraft, not replicated at all in the share price of Kellogg's, that steep rise that you see early 2015. Another way of visualizing the close relationship between the share price of Kellogg's and the share price of Kraft is by plotting the returns, the share price movements on a daily basis, in this diagram, which we'll label as a scatter diagram. We plot on the horizontal axis the returns on shares of Kellogg's, the daily share price change in a share of Kellogg's. Against on the vertical axis, the return on the share price of Kraft, the change in the price of Kraft on a daily basis. So, take for example the daily increase in the price of Kellogg's of about 3.5%. You can see from this diagram that the increase in the share price of Kraft was only about 1%. Hence, not a very close relationship at all. But I can see a whole raft of observations on a daily basis, where that relationship is much closer. We can capture how close that relationship really is by computing the correlation. The correlation is indicated in this diagram. And it tells you that the correlation is .2425. We call that the r squared of the relationship. It tells you that 24% of the return on Kraft shares can be explained by the return in Kellogg’s shares. So maybe that close relationship in share prices between Kellogg's and Kraft shares did not come as a surprise to you. But what might come as a surprise is that the relationship between share prices is much more widespread, well beyond direct competitors. Some, or some would say even a lot, of daily share price movements are in fact shared with many other corporations, often in entirely different industries as well. So what could that be? What is tying them together? What are the binding forces in share price movements? Well first, there's a set of macro economic factors. All corporations are affected by changes in inflation, exchange rates, and the economic growth, higher economic growth, better forecast earnings for many corporations in the economy. Then there are the common exposures that corporations share, through interest rate changes, to energy prices, all kinds of costs to the corporations. Or it could be investor demand, could, for example, be driven by a tax break given to pension funds, who need to diversify their portfolio and therefore decide to demand shares of many corporations, not just one. It could be overseas demand, a sudden quest for overseas investors to find a safe haven in the middle of a global financial crisis, whereby they would invest in many different corporations in that safe haven. Or it could be the allocation of institutional investor portfolios. Many of these binding forces will cause the share prices of many corporations to move together. One example here is given for Kellogg's again, the blue line, against Walmart, not a direct competitor, but may be related through consumer demand. You can see that the relationship is not nearly as tight, as close, as it was between Kraft and Kellogg's, but there is a relationship. Knowing that many corporations' share prices are related, we can now try to actually express that relationship. So we can tie the price movements for individual corporation's stocks, to what we call the market movement, the conglomerate of all corporations traded on a particular equity market. So for example, we could relate the returns, the price movement in Kellogg's shares, to the returns on the Standard & Poor's 500 index. It's expressed in this relationship here. Whether returns on Kellogg's are a function, and the function is expressed by this beta parameter of the returns of the Standard & Poor's 500. It's not going to be a perfect relationship. That's why we add another variable, the little E, the epsilon at the end, which expresses the noise surrounding that relationship. When we estimate a relationship like this, we get an estimate for that functional parameter, the beta, which is a measure of the risk or the availability if you want, in the returns of Kellogg's shares that can be explained by Kellogg's exposure to the variability in the market at large. As distinct from a series of Kellogg specific returned drivers, Kellogg's specific return explanation would be captured by that noise turn, the epsilon. So just to illustrate this, in the graph here, blue line, Kellogg share price, the red line, the Standard & Poor's 500 index, as measured by index point on the right hand side. You can, again, see a fairly significant relationship between the share price of Kellogg's and the movements in the Standard and Poor's, the market-wide index of the New York Stock Exchange. And, again, expressing this in a scatter diagram, where we plot an x variable against a y variable, the x variable on the horizontal axis, being the return on the Standard and Poor's 500 index. Measuring the change in the index level on a daily basis against the daily return, the y variable, on the vertical axis, the daily return on the share of Kellogg's. So for example, if we take a 1% movement in the Standard and Poor's index, we observe that the price of Kellogg's would increase by about two and a half percent. So, as you can see, that is not exactly a perfect fit, but again, you can see that the cluster of points would indicate that the relationship is actually quite tight, close. And we see that the beta is actually estimated in this relationship between Y returns on Standard & Poor's against X returns on Kellogg's share price is 0.68. So we see that that would not exactly be a close fit. But again, we see that the cluster of points indicates that the relationship is actually quite tight. So if we estimate the relationship between returns on the Standard and Poor's 500, and the returns on Kellogg's share price, we find an estimate of the beta parameter of 0.68. So how do we interpret the 0.68? Well if x, that's the return on the Standard and Poor's 500, increases by say 1%, then we predict an increase in the share price of Kellogg's, y of 0.68%. The R squared of this relationship is 0.28, 28% of the variability in the returns on the Standard and Poor's 500, explains the returns in the share price of Kellogg's. Not a tight relationship, but a relationship nonetheless. So there we've seen a relationship between an individual share price and a market-wide index. But even markets are related to one another, not just individual corporations. So if we plot the relationship between the returns on the Standard and Poor's 500, for example, against the returns on the NASDAQ, we see an even tighter relationship than the one we just saw. Relationship between those two equity exchanges appears to be very close indeed, where we see that the R squared, the correlation, the relationship, the strength of the relationship between those two markets is 67%. 67% of the returns on NASDAQ can be explained by the returns on the Standard and Poor's 500. So how are markets connected? Well we've just seen that individual stock price movements are related. Individual stock price movements are related to market indices. And we've seen that different equity markets are in fact, very closely related. Similarly, bond market movements can be found to be closely related to money market movements. Short term money, long term money. Surely there's a relationship tied through, for example, inflation. And both of these debt markets are in fact related, sometimes in firstly, to our equity markets. And then there's the commodity markets. Surely commodity markets affect what happens with corporations using these commodities. So we expect commodity markets to also be related to equity markets. It truly is a complete market environment.
