Book 2 Flashcards
What are the two methods of forecasting fixed income returns?
- Discounted Cash Flows
2. Building Block Approach
How do you project fixed income returns using the discounted cash flow method?
The YTM would be the expected return, assuming no interest rate changes
How does the MacDuration affect the composition of fixed income returns?
If your time horizon is smaller than the MacDuration, capital gains or losses will dominate your returns in the case of rate movements. If your horizon is longer, reinvestment dominates.
What are the components of the building block approach?
- Default Free Rate
- Term
- Credit
- Liquidity
What rate do you use to find the one period default free rate?
Roll over 30-day TBills
What are the four drivers of the term premium?
- Level-dependent inflation uncertainty - higher inflation expected means higher uncertainty (lognormal)
- Ability to hedge recession risk
- Supply and demand of bonds at various maturities
- Cyclical effects - shape of yield curve changes
What determines a fixed income’s ability to hedge against recession risk?
When AD drives growth and inflation, bond returns are generally negatively correlated to growth. When AS drives growth and inflation, bond returns are positively correlated with growth
What are the two components of the credit premium?
- Credit premium
2. Default rate
What is the relationship between the one period forward default rate and current conditions?
The forward default rate (and premium) will reflect previous defaults, stock market returns and volatility, and economic growth.
What are the primary drivers of credit spreads?
The primary drivers are the credit premium and financial market conditions, and only secondarily by default rates
What is the difference between the source of credit premiums in IG and HY?
IG bonds you are concerned about credit migration risk
HY are concerned about default risk, which is countercyclical
What are come current indicators of future credit premiums (and returns)?
- Corporate OAS
- Equity VIX
- Yield curve slope
When these move up, prices move down, implying higher future returns
What factors are good for liquidity?
- Priced near par
- Relatively new issues
- Large issuers
- Well known issuer
- Simple structures
- High quality
What are the economic reasons that EM may be less able to pay their bonds?
- Less diverse tax base
- Greater dependence on cyclical industries
- Restrictions on trade, capital flows, and currency conversion
- Poor fiscal and monetary controls
- Reliance on foreign borrowing
- Poor financial instructions
- Poor infrastructure
- Susceptibility to capital flight
- High Debt to GDP and lower growth?
What are the reasons why EM may be less willing to pay their bonds?
- Weak property rights
- Sovereign immunity
- Capital controls, restrictions on currency conversion
What are the specific economic metrics you should look at when evaluating EM debt?
- Fiscal Deficit is > 4% GDP
- Debt/GDP >70-80%
- rGDP growth <4%
- Current account deficit >4% GDP
- Foreign Debt > 50% GDP
- Forex reserves <100% of ST Debt
How can you use the discounted cash flow approach (GGM) to forecast equity returns?
r = For Div Yield + g (long term GDP growth)
What is the formula for the Grinold-Kroner Model?
R = D/P - %Change SO
+ % change in Earnings
+ % Change in P/E
When should you use the Grinold-Kroner Model?
This is suitable for short term estimates, but long term is simplifies to the GGM.
What is the equilibrium approach to projecting the ERP?
- Find the ERP for a full integrate market
ERP = Correl * Volatility (i) * SR(gm) - Find ERP for completely segmented market
ERP = Volatility(i) * SR(i) = ERP
Weight by degree of integration
What makes emerging market equities more risky?
- More fragile economies
- Less stable policy
- Value expropriated by gov, insiders, dominant shareholders
- Weaker legal protections
- Less globally integrated
Why is real estate so cyclical?
Supply is fixed in the short run, boom and bust
How does the quality of a property effect its cyclicality?
High quality (long leases, low turnover) will be more stable and less cyclical Low Quality is more sensitive, shorter leases allow more adjustment to real prices
What are the 5 steps in the real estate cycle?
- Perceptions of demand, higher prices, higher occupancy
- Causes people to develop (iterative process)
- Drives economic cycle
- Overbuilding
- Years for supply to be absorbed
What is the long run real estate expected return based on the cap rate model?
R = NOI/P + NOI growth rate (typically g from GGM)
G is long run GDP growth
What is the short run forecasted real estate return based on the cap rate model?
R = NOI/P + g - %change in cap rate
How are cap rates related to interest rates and credit spreads?
- Cap rates are correlated with interest rates (cyclical)
2. Cap rates are positively related to credit spreads which are countercyclical, which can offset the effect above
What are the risk premiums associated with real estate?
- Term premium - sensitive to long term rates, therefore higher term premium
- Credit risk of tenants (leases are bonds(ish))
- Equity Risk Premium
- Liquidity for commercial property
Total Premiums should be between bonds and equity
What are the steps in forecasting real estate using an equilibrium approach?
- Unsmooth data
- Add liquidity premium
- Low integration - very local
What is PPP a poor predictor of rates over the short-mid?
1) Not all goods are trades
2) Barriers
3) Ignores impact of capital flows
What factors influence exchange rates?
1) Net trade flows - generally pretty low
2) Relative PPP (long run) inflation differentials
3) Competitiveness & Sustainability of Current Account
How do varying levels of capital restrictions effect FX rate pressure?
1) No capital flows - FX must adjust a lot
2) Minimum restrictions - less pressure
If you have a trade deficit (downward FX pressure), it can be offset by higher investments by foreigners - if the trade deficit is financing spending, it is less sustainable
How does portfolio rebalancing affect FX rates?
Deficits must be financed for foreign borrowing. If foreign nations hold more FX exposure than they desire, they will sell off FX, driving prices down.
What is the issue with large, persistent current account deficits?
This will lead to major long term currency depreciation to ensure that the current account deficit stabilizes as exports become cheaper for foreign nations
