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CFA Level 3 > Capital Market Expectations > Flashcards

Capital Market Expectations Flashcards

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1
Q

What are the common limitations of forecasting CME?

A
  1. Limitations of Economic Data
  2. Data measurement and biases (survivorship and smoothing)
  3. Limitations in historical estimates - caused by regime changes, nonstationary, asynchronous data
  4. Ex post risk can be a biased measure of ex ante risk
  5. Data mining and Time-period bias
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2
Q

What are some common exogenous shocks to growth?

A
  1. Policy changes
  2. New products and technologies
  3. Geopolitics
  4. Natural disasters
  5. Natural resources
  6. Financial crises
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3
Q

What are the two basic sources of trend growth?

A
  1. Growth from labour inputs (labour force, participation)

2. Labour productivity (TFP, capital)

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4
Q

What are the strengths of econometric models to forecast returns?

A
  1. Robust with many factors
  2. New data can be used in models easily
  3. Delivers quantitative impact of exogenous events
  4. Imposes consistency and discipline
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5
Q

What are the drawbacks in using econometric models to forecast returns?

A
  1. Complex and time consuming
  2. Inputs not easy to forecast
  3. Relationships are not static
  4. False sense of precision
  5. Rarely forecasts turning points
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6
Q

What are the benefits of using a leading indicator approach to forecasting returns?

A
  1. Intuitive
  2. Identifies turning points
  3. Easy to track
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7
Q

What are the drawbacks to using leading indicators to forecast returns?

A
  1. Current data may not be reliable
  2. Overfitted samples
  3. False signals
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8
Q

What are the strengths of using a checklist approach to forecasting returns?

A
  1. Limited Complexity
  2. Flexible
  3. Breadth of criteria
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9
Q

What are the drawbacks of using a checklist approach to forecast returns?

A
  1. Subjective
  2. Time consuming
  3. No consistency, very biased
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10
Q

What are the five steps in the business cycle?

A
  1. Initial recovery
  2. Early Expansion
  3. Late expansion
  4. Slowdown
  5. Contraction
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11
Q

What are the capital market effects of the “initial recovery” phase of the business cycle?

A
  1. Yields are low
  2. Yields may continue to decline in threat of disinflation
  3. Stock market rises briskly
  4. Cyclical, HY, EM, and riskier assets rise
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12
Q

What are the capital market effects of the “early expansion” phase of the business cycle?

A

Unemployment falls, people borrow, profits rise, demand for housing and durables is strong.

  1. Short rates may move up as stimulus stops
  2. Longer bonds yields may rise
  3. YC flattening
  4. Stocks up
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13
Q

What are the capital market effects of the “late expansion” phase of the business cycle?

A

Danger of overheating, wages and inflation rising

  1. Rates rise
  2. Private sector borrowing
  3. Rising but volatile markets
  4. Inflation hedges outperform, cyclical underperform
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14
Q

What are the capital market effects of the “slowdown” phase of the business cycle?

A
  1. Rising rates, but peaking
  2. Fewer viable projects
  3. Inflation rises
  4. Government yields lower
  5. Spreads widen
  6. Interest sensitive stocks drop
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15
Q

What are the capital market effects of the “contraction” phase of the business cycle?

A
  1. Rates drop
  2. Steepening curve
  3. Widening spreads
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16
Q

Why is deflation so harmful?

A
  1. Undermines debt-financed investments

2. Lower rates, therefore less power in central banks hands

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17
Q

How does cash react to inflation?

A

It is a zero duration, inflation protected asset that earns the floating rate. Cash is relatively attractive in rising rate environments.

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18
Q

How do bonds react to inflation?

A

Inflation is transmitted through the yield curve. Rises causes losses as the inflation component of yield increases. If inflation is within expectation, long term rates will move less than short term rates and have minor effects. If it is higher than expected, then long term yields may move.

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19
Q

How do stocks react to inflation?

A

If inflation is in line with expectations, typically a minimal effect. If there is high inflation, firms that can pass on inflation are fine.

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20
Q

How does real estate react to real estate?

A

Typically fine if inflation is in line with expectations. If it is higher than expected, will appreciate.

21
Q

What is the taylor rule?

A

Target rate = real policy target + expected inflation + (0.5)(Expected-Trend Real GDP) + 0.5(Expected - Target inflation)

22
Q

Why could negative rates be sustainable?

A

Because there is a convenience yield to holding money in deposit accounts to transact

23
Q

All else being equal, how does prolonged loose fiscal policy affect real rates?

A

Running large deficits must be offset by capital from abroad or domestic savings.

24
Q

How does the combination of loose monetary and fiscal policy play out?

A
  1. Higher Real Rates from fiscal
  2. High expected inflation
    Total = High Nominal Rates
25
Q

How does the combination of tight fiscal and monetary policy play out?

A
  1. Low real rates from fiscal
  2. Low expected inflation
    Total = Low nominal rates
26
Q

How does the yield curve change over the business cycle?

A

When recovering, long rates have bottomed and short rates rise first. The curve is steep. Progressively flattens. Yields begin to rise, curve flatteing from back to front. This may invert. Short rates dropping may steepen again when contraction hits.

27
Q

How does the relative supply of government bonds affect the yield curve?

A

The supply of bonds at each maturity is directly related to price, which is directly related to yield. At some point the central banks will want to unload government bonds from QE, and if bond tenure is concentrated there could be yield curve distortion.

28
Q

What are the different types of statistical models used to project CME?

A
  1. Basic sample statistics
  2. Shrinkage estimators
  3. Time series estimations - reduced form, lagged
29
Q

What is the difference between a structural and reduced form model?

A

Reduced form is when you have a system of equations and you solve for the endogenous variables. They are generally inductive in the sense that you do not need a general theory before solving. Structural models are the opposite, which are generally deductive.

30
Q

What are the arguments for a term premium on bonds?

A
  1. Level dependent inflation uncertainty
  2. Hedging recession risk - bond returns are correlated with growth when it is driven by supply, but negatively correlated when driven by demand
31
Q

Why do emerging markets bond carry additional risks?

A
  1. Greater concentration of wealth (tax base diversification)
  2. Industry concentration
  3. Restrictions on trade, flows
  4. Poor fiscal controls
  5. Less educated workforce, less infrastructure
  6. Reliance on foreign borrowing in other currencies
  7. Susceptibility to capital flight
32
Q

What are some general red flags for emerging market debts?

A
  1. Real growth rate less than 4%
  2. Debt to GDP greater than 70%
  3. Fiscal deficit greater than 4% GDP
  4. Current account deficit 4% GDP
  5. FX reserves 100% of short term debt
33
Q

How can we use the GGM to forecast equity returns?

A

return = CF (dividend yield - share buybacks) + Change in nomimal earnings + Repricing (P/E)
This is over an infinite time horizon

34
Q

How do you use the Singer Terhaar equilibrium approach?

A 
This is a two stage CAPM...
RP = w*RPgm + (1-w)*RPs
RPgm = corr with GM * Vol * GM sharpe
RPs = vol*segmented sharpe
Assumes perfect liquidity
35
Q

What is the general equation to project real estate returns over finite horizons?

A

R = Cap rates - change in cap rates + NOI growth

36
Q

How are cap rates affected by interest rates?

A

In general, cap rates are procyclical (in line with rates). However, cap rates are related to credit spreads, with are countercyclical, which mitigates this effect.

37
Q

What are the general risk premia associated with real estate?

A
  1. Credit risk of tenants
  2. Term premium for long duration
  3. Equity risk premium (procyclical)
  4. Liquidity premium
38
Q

How does the trade of goods and service affect exchange rates?

A
  1. Trade flows (net)
  2. PPP - not good
  3. Sustainability of the current account - current account is the difference between spending and saving
    A current account deficit that is related to profitable investment opportunities is more sustainable than current account deficits financing spending (low saving), low profits, or big deficits.
39
Q

How does capital mobility affect exchange rates?

A

Theoretically, money flows to the highest risk adjusted returns. It follows that FX rates will adjust as money flows to currencies. For example, if RaR in Canada are 8% and 9% in USA, flows from CAD to USD should eventually move down FX rates to equalize the return. This only happens after the USD would become very strong

40
Q

What is the process of using sample statistics to create VCV matrices and estimate volatility?

A

This is the process of using historical return data to estimate variances and covariances. The issue is that small samples sizes wont work. If the number of assets exceeds historical observation, some assets will appear to be riskfree.

41
Q

What is the process of using multi-factor models to forecast volatility?

A

You determine factors driving market returns, and use their Betas to reduce the amount of data you need. However, the matrix is incorrect no matter what. You are using this because you can be precise with data that is not perfect, rather than taking perfect data and introducing noise.

42
Q

What is the key idea of modelling an ARCH volatility model?

A

This model is a linear time series where current vol depends on past volatility and recent shocks.

43
Q

How should you adjust your asset allocation at the bottom of a cycle?

A
  1. Understand that term premiums are high (steep curve), credit premium is high (spreads are wide).
  2. Short term rates may rise, so reduce duration by selling intermediate bonds
  3. Increase exposure to credit
  4. Buy more equity
44
Q

How should you adjust your portfolio based on current account balances?

A
  1. Fluctuations are normal
  2. Prolonged deficits will put downward pressure on prices (require higher premium) in order to induce higher savings (if you can’t get capital elsewhere)
  3. In general, it could be advisable to shift from long term deficit accumulators to surplus accumulators
45
Q

How should you adjust your portfolio based on capital account balanced and currencies?

A
  1. If assets are attractive, it will cause short term FX increases, which will eventually form a level where currency will depreciate from
  2. This makes foreign assets less attractive as there is more currency downside
46
Q

What is the surplus optimization AA strategy?

A

This is when you use MVO with a utility function, but look to maximize surplus return (A-L/A) (subject to penalty). The benefit is that this incorporates natural hedging properties of assets and liabilities

47
Q

What are the drawbacks of the basic two portfolio liability hedging portfolio?

A
  1. Sometimes there is no surplus

2. Sometime a true hedge is not available

48
Q

What advantages does a dynamic asset-liability approach have over surplus optimization and two portfolio liability approaches?

A

Is it a multiperiod model so you can estimate the probability of meeting your objective

49
Q

Why would you prefer a liability based approach?

A

If you are more conservative

CFA Level 3 (28 decks)

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