CFA III SS 6 Capital Market Expectations

  1. Seven steps to forming capital market expectations
    • 1. determine expectations needed given investor's tax status, time horizon, and allowable assets
    • 2. investigate assets' historical performance
    • 3. identify the valuation model used and its requirements
    • 4. collect the best possible data - ex. GDP vs GNP
    • 5. use experience and judgment to interpret current investment conditions
    • 6. formulate expectations - E(r), standard deviation, and correlations
    • 7. monitor actual performance and use it to refine the process
  2. Nine limitations to using economic data
    • 1. data issues: timeliness, revisions, rebasing
    • 2. measurement errors and biases: transcription errors, survivorship bias, use of appraisal data causes results to be smoothed and lowers standard deviation
    • 3. historical estimates: long time span helps precision of statistics, but nonstationarity from regime changes argues short time span
    • 4. using ex post data to estimate ex ante performance: analyst may be unaware of risk faced by investor at the time, especially if it never materialized
    • 5. data mining and time period: ensure have economic basis, scrutinize the modeling process, test with out of sample data
    • 6. conditioning: relationships can vary among variables, must account for current conditions
    • 7. correlations: association vs causation
    • 8. psychological traps: SS 3 + prudence and recallability traps 
    • 9. model uncertainty
  3. Five tools for setting CM expectations
    • 1. Statistical tools
    • 2. Discounted cash flows models
    • 3. Risk premium approach
    • 4. Financial equilibrium models
    • 5. Surveys, panels, judgment
  4. Four statistical tools
    • 1. projecting historic data
    • 2. shrinkage estimators - weighted average of historic data and another analyst determined estimate
    • 3. time series analysis - useful when assets exhibit positive serial correlation in volatility (high follows high)
    • 4. multifactor models
  5. DCF: Grinold-Kroner equation and component breakdown
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    Expected income = Image Upload 2

    Nominal earnings = Image Upload 3

    Repricing = Image Upload 4

    • Ri = expected return on equity
    • Div1 = dividend in time period 1
    • P0 = current price
    • i = expected inflation
    • g = real growth rate of earnings
    • change in S = % change in outstanding shares, or negative of the repurchase yield
    • change in P/E = change in the P/E ratio
  6. DCF: Bond segment expected return
    • Yield to maturity is the expected return
    • YTM assumes coupons reinvested at YTM, so use zero coupon bonds with maturity matching time horizon
  7. Risk premium approach for equities and bonds
    • E(r) equity: long-term government bond yield plus an equity risk premium
    • E(r) bond: real risk free rate plus premiums for inflation, default, liquidity, maturity, and taxes
  8. Financial equilibrium approach: expected return of a market
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    • ERPi = equity risk premium for market i
    • rho(i,m) = correlation market i and global market
    • standard devaition i = standard deviation for market i
    • ERPm/SIGm = sharpe ratio of global market

    • 1. calculate return of full integration using formula above, add liquidity premium
    • 2. calculate return if no integration, replacing rho in formula above with 1, add liquidity premium
    • 3. combine full integration and no integration using weighted average based on % of market integration, add risk free rate
  9. Calculate covariance between markets
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  10. Five business cycle phases and associated inflation, short term rates, bond yields, and stock prices
    • initial recovery: falling inflation, low or falling short term rates, low bond yields, rising stock prices
    • early expansion: rising short term rates, flat or rising bond yields, rising stock prices
    • late expansion: everything rising
    • slowdown: inflation rising, short term rates peak, bond yields peak and falling, stock pricing falling
    • recession: inflation peaks, short term rates fall, bond yields fall, stock pricing increase during later stages anticipating recovery
  11. Taylor rule
    Provides target short-term rate to balance inflation and recession risks

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    • rt = target short-term rate
    • rn = long-term neutral rate
    • GDPe = expected GDP
    • GDPt = trend or long-term GDP
    • ie = expected inflation
    • it = target inflation
  12. Yield curve shape when:
    • 1. fiscal policy and monetary policy are expansive
    • 2. fiscal and monetary are restrictive
    • 3. fiscal restrictive, monetary expansive
    • 4. fiscal expansive, monetary restrictive
    • 1. sharply upward sloping
    • 2. inverted
    • 3. slightly upward sloping
    • 4. flat
  13. Advantages and disadvantages of three economic forecasting methods
    • 1. Econometrics: adv - reusable, precise quantitative forecasts, complex; dis - difficult and time intensive, better at forecasting expansions, may not be applicable to future time periods
    • 2. Indicators: adv - available from outside parties, easy to understand; dis - inconsistent, may be misleading
    • 3. Checklist: analyst answers a series of questions, like central bank's next move, latest employment report, etc. adv - simple, easily changed; dis - subjective, open to interpretation, imprecise
  14. Four methods of forecasting exchange rates
    • Purchasing Power Parity (PPP): high inflation will see currency decline
    • Relative economic strength: favorable investment climate will attract investors, increase demand for currency, increase currency value
    • Capital flows: long-term capital will flow to the best investment opportunities
    • Savings-investment: savings deficit leads to a strong currency; savings deficits typically occur during expansion
Card Set
CFA III SS 6 Capital Market Expectations