Capital Market Expectation Flashcards
Framework of developing capital market expectations
- Specify the set of expectations needed, including the time horizon(s) to which they apply.
- Research the historical record.
- Specify the method(s) and/or model(s) to be used and their information requirements.
- Determine the best sources for information needs.
- Interpret the current investment environment using the selected data and methods, applying experience and judgment.
- Provide the set of expectations needed, documenting conclusions.
- Monitor actual outcomes and compare them with expectations, providing feedback to improve the expectation-setting process.
Risks faced by investors in emerging market equities over and above those that are faced by fixed income investors in such markets
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 expropriated 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. Weak checks and balances on governmental actions may bring about regulatory uncertainty, seizure of property or nationalization.
Main issues arise whn conducting historical analysis of real estate returns
Properties trade infrequently so there is no data on simultaneous periodic transaction prices for a selection of properties. Analysis therefore relies on appraisals.
Secondly, each property is different, it is said to be heterogenous. The returns calculated from appraisals represent weighted averages of unobservable returns. Published return series is too smooth and the sample volatility understates the true volatility or returns.
It also distorts estimates of correlations.
Major Approaches to forecasting exchange rates
- Focus on flows of export and imports to establish what the net trade flows are and how large they are relative to the economy and other, potentially larger financing and investment flows. The approach also considers differences between domestic and foreign inflation rates that relate to the concept of purchasing power parity. Under PPP, the expected percentage change in the exchange rate should equal the difference between inflation rates. The approach also considers the sustainability of current account imbalances, reflecting the difference between national saving and investment.
- Focuses on capital flows and the degree of capital mobility. It assumes that capital seeks the highest risk-adjusted return. The expected changes in the exchange rate will reflect the differences in the respective countries’ assets’ characteristics such as relative short-term interest rates, term, credit, equity and liquidity premiums. The approach also considers hot money flows and the fact that exchange rates provide an across the board mechanism for adjusting the relative sizes of each country’s portfolio of assets.
Shrinkage Estimate
Shrinkage estimators can provide more reliable estimates by taking a weighted average of two estimates of the same parameter - one based on historical sample data and the other based on some other source or information.
Economic Forecasting Approaches: Strengths and Weaknesses
Econometric Modeling
- Strength
- Models can be quite robust, with many factors include to approximate reality
- New data may be collected and consistently used in the model to quickly generate output
- Delivery quantitative estimates of the 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 maybe mis-specified
- May give false sense of precision
- Rarely forecasts turning points well
Leading Indicator-Based Approach
- Strength
- Usually simple and intuitive in construction
- Focuses primarily on identifying turning points
- May be available from the 3rd party, easy to track
- Weakness
- History subject to frequent revision
- “current” data not reliable as input for historical analysis
- Overfitted in-sample. Likely overstates forecast accuracy
- Can provide false signals
- May provide little more than binary directional guidance
- History subject to frequent revision
Checklist Approach
- Strength
- Limited complexity
- Flexible
- Structural changes easily incorporated
- Items easily added/dropped
- Can draw on any information, from any source, as desired
- Breadth: Can include virtually any topics, perspectives, theories, and assumptions
- Weakness
- Subjective. Arbitrary. Judgmental
- Time-consuming
- Manual process limits depth of analysis. No clear mechanism for combining disparate information
- Imposes no consistency of analysis across items or at different points in time. May allow use of biased and/or inconsistent views, theories, assumptions
Appraisal Bias
Appraisal values tend to be less volatile than market-determined values for identical assets. Therefore measured volatilities are biased downward and correlations with other assets tend to be understated not exaggerated
Use of high-frequency (daily) data in developing capital market expectation
High-frequency data improves the precision of sample variances, covariances, and correlations but not the precision of the sample mean. High-frequency data are more sensitive to asynchronism across variables.
Anchoring Trap
Initial impressions, data, or estimates anchor subsequent judgments
Prudence trap
Tendency to temper forecasts so that they do not appear extreme
Availability bias
Tendency of forecasts to be overly influenced by events that have left a strong impression
Framework for Developing Capital Market Expectations
The process of setting capital market expectations (CMEs) involves the following seven steps:
- Specify the set of expectations needed, including the time horizon(s) to which they apply.
- Research the historical record.
- Specify the method(s) and/or model(s) to be used and their information requirements.
- Determine the best sources for information needs.
- Interpret the current investment environment using the selected data and methods, applying experience and judgment.
- Provide the set of expectations needed, documenting conclusions.
- Monitor actual outcomes and compare them with expectations, providing feedback to improve the expectation-setting process.
EM FI Risk vs. EM Equity Risk
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 expropriated 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.
- Weak checks and balances on governmental actions may bring about regulatory uncertainty, seizure of property or nationalization.
Main issues relating to historical analysis of real estate returns
Properties trade infrequently so there is no data on simultaneous periodic transaction prices for a selection of properties. Analysis therefore relies on appraisals. Secondly, each property is different, it is said to be heterogenous. The returns calculated from appraisals represent weighted averages of unobservable returns. Published return series is too smooth and the sample volatility understates the true volatility of returns. It also distorts estimates of correlations.
Exchange Rate Forecasting Approach
Focus on trade in goods and services: focus on flows of export and imports to establish what the net trade flows are and how large they are relative to the economy and other, potentially larger financing and investment flows. The approach also considers differences between domestic and foreign inflation rates that relate to the concept of purchasing power parity. Under PPP, the expected percentage change in the exchange rate should equal the difference between inflation rates. The approach also considers the sustainability of current account imbalances, reflecting the difference between national saving and investment.
Focus on capital flows: focuses on capital flows and the degree of capital mobility. It assumes that capital seeks the highest risk-adjusted return. The expected changes in the exchange rate will reflect the differences in the respective countries’ assets’ characteristics such as relative short-term interest rates, term, credit, equity and liquidity premiums. The approach also considers hot money flows and the fact that exchange rates provide an across the board mechanism for adjusting the relative sizes of each country’s portfolio of assets.
