Capital Expectation 10-11 Flashcards
fundamental law of investing is the uncertainty of the future.
Asset allocation is the primary determinant of long run portfolio performance
cross-sectional consistency
consistency across asset classes regarding portfolio risk and return characteristics.
Intertemporal consistency
consistency over various investment horizon regarding portfolio decision over time.
good forecast are unbiased, objective, well researched, efficient, and internally consistent.
at least 30 observations are needed to test a hypothesis.
transcription errors
errors in gathering and recording data
survivorship bias
biases arises when a data series reflects only entitles that survived to be end of the period.
appraisal (smoothed) data
appraisal values trend to be less volatile than market determined values. As a result, measure volatilities are biased downward and correlations with other assets tend to be understated.
limitation of historical estimates
- Regime changes cause non-stationary data
data may not be representative of futures period - analyst underestimating ex-ant risk and over-estimate ex-ante returns.
3.Time Period Bias – results that are period specific. The time period selected can alter results.
ex post risk vs. ex-ante risk (Peso prob)
analyst underestimating ex-ant risk and over-estimate ex-ante returns.
The high ex-post returns include risk premiums for adverse events (not materialized) provide a poor estimate of ex-ante expected return.
Biases in analysts’ method
- data mining arises from repeatedly searching a data set until a statistic significant pattern emerges
the statistical relationship cannot be expected to have predictive value. As a result, the modeling results are unreliable
use out-of-sample data to test and improve the reliability of model.
- time period bias relates to results that are period specific , research finding often turn out to be sensitive to the selection of specific starting/ending dates
to avoid:
test the discovered relationship with out-of-sample data to determine if the relationship is persistent.
failure to account for conditional information
a negligible measured correlation may reflect a strong but nonlinear relationship should explore the possibility if they have a solid reason for believing a relationship exist.
Psychological bias
modeling uncertainty
how exogeneous shocks may affect economic growth trend:
Economic growth trend is the LT average growth path of GDP around which the economic experiences semi-regular business cycles.
Trend changes that arises from significant exogeneous shocks to underlying economic and/or market relationships are not only impossible to foresee but also difficult to identify, assess, and quantify until the changes is well -established and retrospectively revealed in the data.
shocks arises from:
changes in gov’t policies that encourage LT growth fiscal policy, minimal gov’t interference with free market, facilitating competition in the private sector, development of infrastructure and human capital and sound tax policies.
new tech/products
geopolitics has potential to reduce growth by diverting resources to less economically productive uses
Natural disaster destroy productive capacity
natural resources/ critical inputs
financial crisis the financial system allow the economy to channel reserves to their most efficient use.
discuss the application of economic growth trend analysis to the formulation of capital market expectation:
trend rate of growth is an important input when setting capital asset expectation.
- forecasting returns with DCF models incorporate the trend rate of growth, the need to keep these forecast consistent with long-term economic growth imposes discipline on the models. the trend rate acts as an anchor for lt bond and equity returns.
- High trend growth rates may lead to higher stock returns assuming the growth is not already reflected in stock prices.
- a higher trend rate of growth in the economy allows actual growth to be faster before accelerating inflation becomes a significant concern.
- theory implies, and empirical evidence confirms, that the average level of real government bond yields is linked to the trend growth rate. Faster trend growth implies higher average real yields.
Solow growth model:
The theory states that economic growth is the result of three factors—labor, capital, and technology.
3 approaches to economic forecasting are
economic modeling
use of economic indicators
checklist approach
economic modeling use statistical model
Structural models - based on economic theory. The functional form and parameters of these models are derived from the underlying theory.
Reduced form models (losses to theory) can be models that are simply more-compact representations of underlying structural models or can be models that are essentially data driven, with only a heuristic rationale for selection of variables and/or functional forms.
structural models specifies functional relationship among variables based on economy theory
strength:
- model can be robust, with many factors included to approx. reality
- models can be revised by new info/input
- imposes consistency on analysis
weakness:
- complex and time-consuming
- requires adequate measure for real-world activities and relationships which maybe unavailable
- Model may be mis-specified, and relationships among variables may change over time.
economic leading indicator
Usually intuitive and simple in construction.
Focuses primarily on identifying turning points.
May be available from third parties. Easy to track.
- leading indicators that more ahead of the business cycle with a reasonable stable lead time
3 consecutive months of up/down for index are expect to signal the start of an economic expansion/contraction
strengths:
1. simple since it requires following a limited number of economic/financial variables.
2. focuses on identifying turning points
3. may be available from 3rd party easy to track
weakness:
1. Can provide false signals on the economic outlook.
2 Data subject to frequent revisions resulting in “look-ahead” bias.
3. “Current” data not reliable as input for historical analysis.
History subject to frequent revision.
Overfitted in-sample.
Likely overstates forecast accuracy.
Can provide false signals.
checklist approach
most subjective, straightforward but time consuming
strength:
1. limited complexity
2. flexible
weakness:
no consistency of analysis across items or at different points in time.
1. subjective, judgmental
2. time-consuming
3. manual process limits depth of analysis
how business cycle affect short/long term expectations
turning point for business cycle/capital market expectation is not straight:
turning point are difficult to predict
also depends on investor’s behavior
difficult to distinguish effects result from LT and those result from ST
BUSINES CYCLES ARISES IN RESPONSE TO THE
interaction of uncertainty
expectation errors
rigidity
reflect decisions that
- made based on imperfect info
- require significant current resources and/or time to implement
- costly/difficult to reverse
monitor business cycle
gdp growth
industrial production
unemployment rate
output gap=
Actual GDP - potential GDP
>0 expansion
<0 recession
business cycle
initial recovery
Duration of a few months.
Business confidence rising.
Government stimulus provided by low interest rates and/or budget deficits.
Falling inflation.
Large output gap.
Low or falling short-term interest rates.
Bond yields bottoming out.
Rising stock prices.
Cyclical, riskier assets such as small-cap stocks and high yield bonds doing well.
business cycle
early expansion
Duration of a year to several years. Increasing growth with low inflation. Increasing confidence. Rising short-term interest rates. Output gap is narrowing. Stable or rising bond yields. Rising stock prices. yld increase, front ylf steeping back half flattening
business cycle
late expansion
restrictive
output gap closed
inflation rise
stock market peak
volatile stock market
Bond yld/yld curve
st/lt rates increase, curve flattening
maturiesi inward
business cycle
slowdown
less restrictive
accelerate inflation
bond prices increases
stock fall
Bond yld/yld curve
curve flat and invert
business cycle
contraction
simulative
peaking inflation
stock rise
Bond yld/yld curve
curve steeping, steepest
Falling short-term interest rates.
Falling bond yields, rising prices.
deflation
encourage default on debt
interest rate decline to near zero and limit central banks to lower interest rate and stimulate the economy
Within the equity market, higher inflation benefits firms with the ability to pass along rising costs. In contrast, falling inflation or deflation is especially detrimental for asset-intensive and commodity-producing firms unable to pass along the price increases.
QE
use open market to increase money supply and decrease short term rates
buying high quality fixed income instrument
Effect of monetary and fiscal policy on business cycles
monetary policy to stimulate growth
mechanism for intervention in the business cycle
fiscal policy
gove’t spending and taxation
Taylor rule:
ntarget = rneutral + iexpected
+ [0.5(GDPexpected − GDPtrend)
+ 0.5(iexpected − itarget)]
negative interest rate complicate the process of forming capital market expectation:
- policy neutral rate in the Taylor rule can be used a discount rate in DCF models
- multiple path projection is essential to allow for uncertainty regarding convergence.
- Negative I/R are consistent with the business cycle expectations
loose monetary policy
ST rate decrease
spending increase
value of equity fi, inflation increase
tight monetary policy
st rate increase , expected inflation decline
loose fiscal policy
decrease tax increase spending
budget deficit = tax - spending
in an expanding economy, deficits will decrease
tax receipt increase
large government budget deficits forecasted by are unlikely to have much of a lasting impact on the yield curve, especially given that private sector borrowing will be falling during the contraction, somewhat offsetting the increase in the supply of government securities.
disbursement to unemployed decrease
tight fiscal policy
int rate interest
increasing the rate of tax
both policies are simulative (loose)
yld curve steep, encourage spending/growth
both policies are restrictive
yld curve inverted, contract conomy
money policy is restrictive (mp domintes)
fiscal policy is simulative
yield curve is flat, less clear
money policy is stimulative (MP dominate)
fiscal policy is restrictive
yld curve moderately steep
the implications for the economy are less clear.
Globalization increase linkage between macroeconomic, int rates, and exchange rate between economies
capital account = net export = export- import
x-m = (S-I) + (T-G) increase implies slowdown
Pegged currency
A currency peg is a policy in which a national government sets a specific fixed exchange rate for its currency with a foreign currency or a basket of currencies.
Peg is likely to create a more stable currency that provides confidence for investors and business, both of which promote economic stability.
the country must largely follow the economic policies of the currency to which it’s pegged.
pegging country int rate S > those of the country to which they peg USD
interest rates must generally be higher (lower) in the country whose currency is expected to depreciate (appreciate)
3 approaches to forecast exp. return
- formal tools
- survey - consensus view
- judgement
formal tools -
statistical method (Quant models, time series ARCH)
discounted CF
risk premium models capm, factor model, building block
why realized return deviate from initial YTM?
TD reinvestment risk dominates, i increase return increase
- Investment horizon T < Maturity D
change in int. rate generate a capital gain/loss at the horizon - CF maybe reinvested at rates above/below the initial YTD
rates increase, price fall - capital loss
reinvestment income increase
building block approach
set of exp(r) in terms of required compensate for specific types of risks 1-period default free \+ term premium (increase with maturity) \+ credit premium \+liquidite premium
4 drivers of term premium for nominal bonds
- high inflation and inflation uncertainty coincide
nominal old increase with inflation because change in both exp inflation and inflation risk of the term premium. - hedge recession risk
when inflation is driving by aggregated demand, low term premium is wanted.
when inflation is driving by aggregated supply, a higher term premium is required.
- supply & demand, influence low of yield curve
- cyclical effect change in business cycle and old curve
health of EM 4%
fiscal policy
deficit/gdp rate >=4 % credit risk, warning sign of difficulty
debt/gdp 70-80%, troublesome
expect real growth at least 4%
Grinold & Kroner model
expectation of valuation levels through the familiar P/E ratio
expected capital gain = exp nominal earning + exp. repricing return
E(re) = D/P
+ (%E-%shares)
+%P/E (repricing)
- ignore that PE reverse to LT average
- failure to tailor growth rates to the horizon can easily lead to impossible results
- assumptions of the Grinold-Kroner model may lead to irrational results. Because the model assumes an infinite time horizon, it ignores an investor’s time horizon.
equity vs. bond premium reflects an incrementl/bulding block approach to develop expected return
equity vs. bills premium reflect a single composite premium for the risk of equity inestment
CAPM = RP= beta(ERP) = E(R) -rf
correlation (stdi / stem)
singer-terhaar model (combination of 2 underlying CAPM)
adj. CAPM for market imperfection
when a market becomes more globally integrated, its required return should decline
allocation to markets that are moving toward integration should be increased.
- all global market and asset classes are fully integrated
- assume complete segmentation of markets such that each asset class in each country is priced without regard to any other country/asset class.
RPis = std asset * (rips/std i ) —sharpe ratio
RPi = degree to asset globally integrated RPIg
+(1-degree to asset globally integrated) * RpiS (segmented)
highly integrated markets are likely to be relatively liquid, and liquid is one reason that a market may remain segmented.
Risk in EM
more fragile economics
less stable political and policy framework
weaker legal protection
generally less fully integrated into the global economy and the global market.
local economic and market factors exert greater influence on risk and R.
Explain how economic and competitive factors can affect expectations for real estate economic market and sector returns:
immobile and liquid
heterogeneous with unique characteristics
require maintenance/operating cost can be significant
appraisal - return subjective to time lags and data smoothing given that they are done infrequently
require use of equilibrium framework
- impact of smoothing must have been remove to avoid distorting prices
- fully liquid assets in equilibrium models
- real estate is location specific and may therefore be more closely related to local as opposed to global economic/market factors that are financial claims
high quality property tend to fluctuate less with business cycles
low quality properties will show more cyclicality
Boom: increase, drive up property value and lease rate, stronger economic activity
Bust: falling demand, over capacity and over building
lease locks in tenants for longer terms and money cost are high
excess supply can’t be quickly absorbed
CAP rate=
real estate
NOI/Property value
=E(r) - NOI growth rate
E(R) = cap rate + NOI growth + (cap rate 2/cap rate 1)
increase with vacancy rate
inversely related to the availability of credit
Public/private real estate analysis
- transaction based return of unlettered direct real estate holdings
- firm-by-firm deleveraging of REIT returns based on their individual B/S over time
forecasting exchange rate:
either fully hedge or accept the risk
Goods and Services, Trade and the Current Account
- impact of net trade flows
- Purchasing power parity (PPP)
- Current account and exchange rates
Capital Flows/Capital mobility
- Uncovered interest rate parity (UIRP)
- Portfolio balance and composition
structural imbalance (like to press) arises from
- persistent fiscal imbalance
- perferenes demographics and institutional characteristics affect savings decisions.
- abundance or lack or important resources
overshooting mechanism Dornbusch
the foreign exchange rate will temporarily overreact to changes in monetary policy to compensate for sticky prices of goods in the economy.
In the short run, the equilibrium level will be reached through shifts in financial market prices, rather than through shifts in the prices of goods themselves.
Gradually, as the prices of goods unstick and adjust to the reality of these financial market prices, the financial market, including the foreign exchange market, also adjusts to this financial reality.
portfolio balance, composition/sustainability issues
factors to mitigate
investors tends to have a strong home country bias, which leads them to absorb a larger share of the new assets.
if growth is due to productivity gains, investors may fund it with financial flows and foreign direct investment.
country that experience high trend rates tend to be smaller, emerging markets. Increasing the weight in these countries generally does not weaken their currency.
Large CA deficit also weaken exchange rates but several mitigate factor exist:
- current account deficit due to large investment spending are easier to finance if they are expected to be profitable
- small current account deficits in global reserve currencies, including USD, help provide global liquidity and are beneficial to the financial system.
forecasting volatility
sample statistics var & covariance
it is unbiased and consistent.
- cannot be used to estimate large number of assets
2. given typical sample sizes, this method is subject to substantial sampling error
multi-factor model
volatility forecasting
The main advantage of using multifactor models for VCV matrices is that it significantly reduces the number of required observations.
handling large number of assets, imposition of cross sectional structure
imposting structure with a factor model makes the VCV matrix much simpler
a well-diversified factor model can also be improve cross sectional consistency.
shortcoming:
1. The matrix is biased: Matrix inputs need to be estimated and will be misspecified. As a result, the matrix will be biased, meaning it will not be a predictor of the true returns, not even on average.
- The matrix is inconsistent: As the sample size increases in the factor-based VCV matrix, the model does not converge to the true matrix. In contrast, the sample VCV matrix will be both consistent and unbiased.
shrinkage estimate
volatility forecasting
can be applied to the historical estimate if the analyst believes simple historical results do not fully reflect expected future conditions.
The shrinkage estimate is a weighted average estimate of the sample and target (e.g., factor-based) matrix, with the same weights used for all elements of the matrix, including the variance and covariance factors. The resulting figures will be more efficient because they will have smaller error terms.
estimating volatility from smoothed return
soothing of unobservable underlying true returns, is underweight the volatility of observed data and distorts correlations with other asset.
timing-varying volatility: ARCH model
allows for incorporating dynamics (volatilities) into the forecasts.
Asset returns generally show periods of high and low volatilities, leading to volatility clustering. These volatilities can be addressed through autoregressive conditional heteroskedasticity (ARCH) models.
unexpected component of return in period t
variance in period t depends in variance in period (t-1)+a shock
high (a+b) implies higher emphasis on past info, leading to volatility clustering.
Regime risk
extend the data series back increases the risk of the data representing more than one regime.
A change in regime is a shift in the technological, political, legal, economic, or regulatory environments.
Regime change alters the risk–return relationship since the asset’s risk and return characteristics vary with economic and market environments.
Analysts can apply statistical techniques that account for the regime change or simply use only part of the whole data series.
Misinterpretation of correlation
states that the high correlation between nominal GDP and equity returns implies nominal GDP predicts equity returns.
This statement is incorrect since high correlation does not imply causation. 因果关系
In this case, nominal GDP could predict equity returns, equity returns could predict nominal GDP, a third variable could predict both.
Correlation does not allow the analyst to distinguish between these cases. As a result, correlation relationships should not be used in a predictive model without understanding the underlying linkages between the variables.
Cash
The fund benefits from its cyclically low holdings of cash. With the economy contracting and inflation falling, short-term rates will likely be in a sharp decline. Cash, or short-term interest-bearing instruments, is unattractive in such an environment. However, deflation may make cash particularly attractive if a “zero lower bound” is binding on the nominal interest rate. Otherwise, deflation is simply a component of the required short-term real rate.
Bonds
The fund’s holdings of high-quality bonds will benefit from falling inflation or deflation. Falling inflation results in capital gains as the expected inflation component of bond yields falls. Persistent deflation benefits the highest-quality bonds because it increases the purchasing power of their cash flows. It will, however, impair the creditworthiness of lower-quality debt.
Equities
The fund’s holdings of asset-intensive and commodity-producing firms will be negatively affected by falling inflation or deflation. Within the equity market, higher inflation benefits firms with the ability to pass along rising costs. In contrast, falling inflation or deflation is especially detrimental for asset-intensive and commodity-producing firms unable to pass along the price increases.
Real Estate
The fund’s real estate holdings will be negatively affected by falling inflation or deflation. Falling inflation or deflation will put downward pressure on expected rental income and property values. Especially negatively affected will be sub-prime properties that may have to cut rents sharply to avoid rising vacancies.
Hot money is flowing out:
central bank is the most likely to sell foreign currency (thereby draining domestic liquidity)
to avoid depreciation of the domestic currency
and buy government securities (thereby providing liquidity) to sterilize the impact on bank reserves and interest rates.
Unsmoothed std=
sqr [ (1+ro)/(1-ro)*variance]
singer-terhaar model
ERPfull integrated= stdi * p*sharpe ratio + illiquidity premium
ERPsegmented = std * Sharpe ratio + illiquidity
ERP=%integrated * ERPfull integral
+ (1-%integrated ( ERPsegmented)
If no local market Sharpe ratio is given, then use the global market Sharpe ratio.
An econometric model approach
may give a false sense of precision, and a leading indicator-based approach can provide false signals.
strength:
Models can be quite robust, with many factors included to approximate reality.
New data may be collected and consistently used within models to quickly generate output.
Delivers quantitative estimates of impact of changes in exogenous variables.
Imposes discipline/consistency on analysis.
weakness:
Complex and time-consuming to formulate.
Data inputs not easy to forecast.
Relationships not static.
Model may be mis-specified.
May give false sense of precision.
Rarely forecasts turning points well.
Less-developed markets are likely to be undergoing more rapid structural changes,
which may require the analyst to make more significant adjustments relative to past trends.
In the late upswing phase,
interest rates are typically rising as monetary policy becomes more restrictive.
Cyclical assets may underperform, whereas the yield curve is expected to continue to flatten.
tools to close output gap:
expansionary monetary & fiscal policy
monetary: increase money supply to drive down short-term rates, simulate economy
fiscal: increase government spending to simulate the economy
yield curve is upward sloping, steep
in inflationary environment
Cash equivalent and real estate doing well
in deflationary environment
bond does well
Equity investor in EM face more risk than fixed income
(1) economic
(2) political and legal.
3. corporate governance risks.
In addition to the economic, political and legal risks faced by fixed income investors, equity investors in emerging markets face
corporate governance risks.
Their ownership claims may be taken away by corporate insiders, dominant shareholders or the government. Interested parties may misuse the companies’ assets. Weak disclosure and accounting standards may result in limited transparency that favors insiders.
Challenges in Data Forecasting
(1) limitations to using economic data
(2) data measurement error and bias
(3) limitations of historical estimates
Challenges in Data Forecasting
Data time lags –
Data Revisions –
Changes in Data Definitions and Methodology Over time –
The time lag with which economic data are collected, processed, and disseminated can impede their use because data that are not timely may be of little value in assessing current conditions.
Sometimes these revisions are substantial, which may give rise to significantly different inferences.
suppliers of economic and financial indexes periodically re-base these indexes, meaning that the specific period used as the base of the index is changed
Measurement Errors and Biases:
Transcription Errors
Survivorship Bias
Appraisal Bias
– errors in gathering and recording data.
– This bias arises when a data series reflects only entities that survived to the end of the period.
– appraisal values trend to be less volatile than market determined values. As a result, measure volatilities are biased downward and correlations with other assets tend to be understated.
Inflation within expectations
Cash equivalents: Earn the real rate of interest
Bonds: Shorter-term yields more volatile than longer-term yields
Equity: No impact given predictable economic growth
Real estate: Neutral impact with typical rates of return
Inflation above or below expectations
Cash equivalents: Positive (negative) impact with increasing (decreasing) yields
Bonds: Longer-term yields more volatile than shorter-term yields
Equity: Negative impact given the potential for central bank action or falling asset prices, though some companies may be able to pass rising costs on to customers
Real estate: Positive impact as real asset values increase with inflation
Deflation
Cash equivalents: Positive impact if nominal interest rates are bound by 0%
Bonds: Positive impact as fixed future cash flows have greater purchasing power (assuming no default on the bonds)
Equity: Negative impact as economic activity and business declines
Real estate: Negative impact as property values generally decline
EM Bond risk Economic Risks (Ability to Pay)
- Greater concentration of wealth and income; less diverse tax base
- Greater dependence on specific industries, especially cyclical industries, such as commodities and agriculture;
- low potential for pricing power in world markets
- Restrictions on trade, capital flows, and currency conversion
- Poor fiscal controls and monetary discipline
- Less educated and less skilled work force; poor or limited physical infrastructure; lower level of industrialization and technological sophistication
- Reliance on foreign borrowing, often in hard currencies not their own
- Small/less sophisticated financial markets and institutions
- Susceptibility to capital flight; perceived vulnerability contributing to actual vulnerability
EM Bond risk
Political/Legal Risks (Willingness to Pay)
Investors in emerging market debt may be unable to enforce their claims or recover their investments due to:
- Weak property rights laws and weak enforcement of contract laws are clearly of concern in this regard.
- An inability to enforce seniority structures within private sector claims is one important example.
- The principle of sovereign immunity which makes it very difficult to force a sovereign borrower to pay its debts.
- Confiscation of property, nationalization of companies, and corruption are also relevant hazards.
- Coalition governments which could also pose political instability problems.
- The imposition of capital controls or restrictions on currency conversion may make it difficult, or even impossible, to repatriate capital.
forecast equity return
- dcf
Grinold and Kroner - Risk Premium Approach
3.Equilibrium Approach
The Singer–Terhaar
4.Emerging Market Equity Risk
forecast fi
- DCF Models
- Risk Premium Models
Term premium, credit liquidity
Exchange Rates Forecasting
- focus on goods & services, trade and current account
if trade lows through the fx market become large relative to investment flow, it’s likely that a crisis is emerging
the impact of net trade flows (gross trade flows less exports) tends to be relatively small on exchange rates assuming they can be financed.
Exchange Rates Forecasting
current account
When restrictions are placed on capital flows, exchange rate sensitivity tends to increase relative to the current account (trade) balance. Current account balances will have the largest influence on exchange rates when they are persistent and sustained. However, it is not the size of the current account balance that matters as much as the length of the imbalance.
small CA balance ~2% of GDP are likely to sustainable
=national savings - investment >0 surplus
<0 deficit reflect strong profitable investment spending
Exchange Rates Forecasting
Purchasing power parity (PPP):
PPP implies that the prices of goods and services in different countries should reflect changes in exchange rates. As a result, the expected exchange rate movement should follow the expected inflation rate differentials.
ppp ignores impact of capital flow
law of one price change in fx = exp (inflation a)- exp (inflation b)
impact or relative ppp on fx trend to be most evident when inflation diffitial are large, persistent, and driven primarily by monetary conditions.
inflation is determined by money supply
Exchange Rates Forecasting
2. capital flow/mobility
Adjustments to capital flows will place substantial pressure on exchange rates. Three important considerations to look at are the implications on capital mobility, uncovered interest rate parity, and portfolio balances and compositions.
The expected percentage change in the exchange rate can be computed as the difference between nominal short-term interest rates and the risk premiums of the domestic portfolio over the foreign portfolio:
building block approach E(%ΔSd/f) = (rd – rf ) + (Termd – Termf ) \+ (Creditd – Creditf ) + (Equityd – Equityf ) \+ (Liquidd – Liquidf )
=money market + gov’t bond + corp bond
three phases of the response to stronger investment opportunities:
(1) the exchange rate will initially significantly appreciate, (2) following an extended level of stronger exchange rates in the intermediate term, investors will start to expect a reversal, and
(3) the exchange rate in the long run will tend to start reverting (depreciate) once the investment opportunities have been realized.
Exchange Rates Forecasting
Uncovered interest rate parity (UIRP)
In UIRP, the currency with the higher interest rate is expected to depreciate to balance out the rate premium.
When capital flows into a country given exchange rate differentials, this is referred to as hot money. Hot money creates monetary policy issues.
First, central banks’ ability to use monetary policy effectively is limited.
Second, firms use short-term financing to fund long-term investments, which increases financial market risk.
Third, exchange rates tend to overshoot, creating business disruption. Central banks may try to counter the effects of hot money flows through intervention in the currency markets, including selling government securities or maintaining interest rate targets.
Exchange Rates Forecasting
Portfolio balance and composition:
Strong economic growth in a country tends to correspond to an increasing share of that country’s currency in the global market portfolio. Investors need to be induced to increase their allocations to that country and currency, which weakens the currency and increases the risk premiums. However, a few factors could mitigate this impact:
Investors tend to have a strong home country bias, which leads them to absorb a larger share of the new assets.
If growth is due to productivity gains, investors may fund it with financial flows and foreign direct investment.
