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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
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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
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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
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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
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DCF: Grinold-Kroner equation and component breakdown
Expected income = 
Nominal earnings = 
Repricing = 
- 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
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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
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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
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Financial equilibrium approach: expected return of a market
- 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
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Calculate covariance between markets
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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
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Taylor rule
Provides target short-term rate to balance inflation and recession risks
- 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
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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
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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
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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
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