Capital Market Expectations Flashcards

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1
Q

Discuss the framework for developing capital market expectations.

A
  1. Specify the final set of expectations that are needed, including the time horizon to which they apply.
  2. Research the historical record.
  3. Specify the method(s) and/or model(s) that will be used and their information requirements.
  4. Determine the best sources of information needs.
  5. Interpret the current investment environment using the selected data and methods, applying experience and judgement.
  6. Provide the set of expectations that are needed, documenting conclusions.
  7. Monitor actual outcomes and compare them to expectations, providing feedback to improve the expectations-setting process.
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2
Q

What are the three qualities of a good forecast?

A
  • unbiased, objective, and well researched
  • efficient, minimizes the magnitude of forecast errors
  • internaly consistent
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3
Q

Given n asset classes, quantify set of final expectations needed.

A
  • n exepcted returns
  • n standard deviations
  • (n2 - n)/2 distinct correlations
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4
Q

What are the limitations of Economic Data?

A
  • Time lag - The time lag in which economic data is collected, processes, and disseminated
  • Revisions to the initial values
  • Changes to the definition and/or calculation methonds.
  • Indices of economic and financial data are periodically re-based, meaning the specific time period used as the base of the index is changed.
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5
Q

What are the three Data Measurement Errors and Biases?

A
  • Transcript Errors
  • Survirorship bias
  • Appraisal (smoothed) data
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6
Q

What are transcription errors?

A

Errors in gathering and recording data.

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7
Q

What is Survivorship bias?

A

When data reflects only entities that have survived to the end of the period.

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8
Q

Contrast the results of appraisal (smoothed) data vs market-priced data and list the consequences of this difference.

A

Appraised values tend to be less volatile than market-determined valuese for the identical assets.

The consequences are:

  1. The calculated correlations with other assets tend to be smaller in absolute value than the true correlations
  2. The true standard deviation of the asset is baised downward.
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9
Q

What are the limitations of Histoircal data?

A
  • Changes in regime
  • Problems with long data series
    • The risk that the data cover multiple regimes increases.
    • Time series of the required length may not be available.
    • In order to get data series of the required length, the temptation is to use high frequency data. However high frequency data is more sensitve to asynchronism across variables. As a result, high frequency data tend to produce lower correlation estimates.
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10
Q

How can ex post risk be a biased measure of ex ante risk?

A

Looking backward, we are likely to underestimate ex ante risk and overestimate ex ante anticipated returns. We need to evaluate whether asset prices in the period reflected the posibility of a very negative event that did not materialize during the period.

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11
Q

What are the biases in analysts’ methods and how can they be avoided?

A
  • Data-mining bias
    • Scrutinize the variable selection process for data-mining bias and be able to provide an economic rationale for the variable’s usefulness in a forecasting mode.
  • Time-period bias
    • Examine the forecasting relationship out of sample.
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12
Q

Describe the theoretical advantage of a shrikage estimate of covariance compared to a raw historical estimate.

A

The shrinkage estimate should be more accurate, given that the weights are chosen appropriately.

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13
Q

What are the psychological traps that can undermine an analyst’s ability to make accurate and unbiased forecasts?

A
  • Anchoring trap
  • Status quo trap
  • Confirming evidence trap
  • Overconfidence trap
  • Prudence trap
  • Recallibility trap
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14
Q

What is the anchoring trap and how would you mitigate it?

A

The anchoring trap is the tendency of the mind to give disproportionate weight to the first information it recieves on a topic. Try to address this trap by consciously attempting to avoid premature conclusions.

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15
Q

What is the status quo trap and how would you mitigate it?

A

The status quo trap is the tendency for forecast to perpetuate recent observations-that is, to predict no change from the recent past. This trap may be overcome with rational analysis used within a decision-making process.

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16
Q

What is the confirming evidence trap and how would you mitigate it?

A

The confirming evidence trap is the bias that leads individuals to give greater weight to information that supports an existing or preferred point of view than to evidence that contradicts it. Several steps can be taken to help ensure objectivity:

  • Examine all evidence with equal rigor.
  • Enlist an independen-minded person to argue against your preferred conclusion or decision.
  • Be honest about your motives.
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17
Q

What is the overconfidence trap and how would you mitigate it?

A

The overcondifence trap is the tendency of individuals to overestimate the accuracy of their forecast. A good practice to prevent this trap is to widen the range of possibilities around the target forecast.

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18
Q

What is the prudence trap and how would you mitigate it?

A

The prudence trap is the tendency to temper forecast so that they do not appear extreme, or the tendency to be overly cautious in forecasting. A good practice to prevent this trap is to widen the range of possibilities around the target forecast.In addition, the most sensitive estimates affecting a forecast should ne carefully review in light of the supporting analysis.

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19
Q

What is the recallability trap and how would you mitigate it?

A

The recallability trap is the tendency of foecast to be overly influed by events that have left a strong impression on a person’s memory. To minimize the distortions fo the recallability trap, analysts shuold ground their conclusions on objective data and procedures rather than on personal memories and emotions.

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20
Q

What are the nine problems encountered in producing forecast?

A
  1. Limitation to economic data
  2. Data measurement error and bias
  3. Limitations of historical estimates
  4. The use of ex post risk and returns
  5. Non-repeating data patterns
  6. Failing to account for conditioning information
  7. Misinterpretation of correlations
  8. Physciological traps
  9. Model input and uncertainty
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21
Q

What are regime changes in historical data?

A

Shifts in the underlying fundametals.

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22
Q

What is the equation for the Gordon Growth Model? How do we use the model to find expected return?

A
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23
Q

What is the equation for the Grinold & Kroner model?

A
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24
Q

What is the equation for the expected return for bonds using the risk premium approach?

A
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25
Q

What is the equation for the ICAPM?

A
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26
Q

What is the equation for the correlation coefficient?

A
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27
Q

What is the equation for beta (ß)?

A
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28
Q

Using the correlation coefficient equation, what is the equation for beta (ß)?

A
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29
Q

What is the risk premium for asset i in a perfectly integrated market?

A
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30
Q

What is the risk premium for asset i in a fully segmented market?

A
31
Q

Explain what model the Singer and Terhaar analysis uses, and how it adjust to market imperfections, such as liquidity and segmentations?

A

To estimate the size of the liquitity premium, one could estimate the multi-period Sharpe ratio for the investment over the time until it is liquid and compare it to the estimated multi-period Sharpe ratio for the market. The sharpe ratio must be at least as high as that for the market. The difference of the market multi-period Sharpe ratio and the asset multi-period Sharpe ratio to the asset’s risk premium.

To estimate the asset’s risk premium in a partially segemented/integrated market, take the weighted average of the risk premium for the perfectly integrated market and the fully segemented market. The weight would be an estimate of integration.

32
Q

What are the two components of economic growth?

A
  1. Cyclical-growth component
  2. Trend-growth component
33
Q

What are the two components of cyclical analysis?

A
  1. Inventory cycle
  2. Business cycle
34
Q

How is the inventory cycle measured?

A

Inventory to sales ratio

35
Q

What are the phases of the business cycle?

A
  1. Initial recovery
  2. Early upswing/expansion
  3. Late upswing/expansion
  4. Slowdown
  5. Recession
36
Q

What are the characteristics of the Initial Recovery phase? (DGIOSBS)

A
  • Duration of a few months
  • Government stimulation
  • Low interest rates
  • Falling inflation
  • Large output gap
  • Low or falling short-term interest rates
  • Bond yields are bottoming out
37
Q

What are the characteristics of the early upswing/expansion? (DGIOSBS)

A
  • Duration of a year to several years
  • Government cut stimulus
  • Increasing growth with low inflation
  • Output gap is narrowing
  • Rising short-term interest rates
  • Flat or rising bond yields
  • Rising stock prices
38
Q

What are the characteristics of the late swing/expansion? (DGIOSBS)

A
  • Duration - not discussed
  • Central bank limits the growth of the money supply
  • Inflation increases
  • Output gap eliminated and economy at risk of overheating
  • Rising short-term interest rates
  • Rising bond yields
  • Rising stock prices, but increased risk and volatility
39
Q

What are the characteristics of the slowdown? (DGIOSBS)

A
  • Duration a few months
  • Government intervention - not discussed in text
  • Inflation is still rising
  • Still an output gap
  • Short-term interest rates are at a peak
  • Bond yields have peaked and may be falling, resulting in rising bond prices
    • Yield curve may invert
  • Falling stock prices
40
Q

Define a recession and list its characteristics. (DGIOSBS)

A

A recession is to sucessive characters of negative GDP growth.

  • Duration of six months to a year
  • Government stimulus
  • Inflation tops out
  • Still an output gap.
  • Falling short-term interest rates
  • Falling bond yields, rising prices
  • Stock prices increases during the latter stages anticipating the end of the recession
41
Q

When does inflation rise and fall?

A

Inflation rises during the late upswing/expansion when the output gap widens and fall during the recession and into the intial recovery as the output gap peaks and starts to narrow and eventually close.

42
Q

What is the link between inflation and bonds?

A

When inflation is expected to rise bonds yields rise (prices fall), to compensate for the inflation risk. When inflation is expected to fall bond yields fall (prices rise).

43
Q

What is the link between equities and inflation?

A

Low inflation is positive for equities, given there are prosepects for economic growth without government intervention. Equities provide a hedge when inflation is moderate and when the prices increases can be passed onto the consumer. High inflation (above 3%) is problematic due to the likelihood that the central bank will restrict economic growth. Declining inflation and or deflation is problematic because this usally results in declining economic growth and asset prices.

44
Q

How does inflation affect cash instruments?

A

Low inflation does not affect cash instruments. High inflation is a postive for cash because the return on cash instruments increase as inflation rises. Deflation is a negative for cash because returns fall to almost zero.

45
Q

How does inflation affect the real estate market?

A

When inflation is at or below expectations, the cash flows for real estate and other real assets rise slowly, and returns are near their long-term average. When inflation is high the cash flows and returns for real assets are higher. In the case of many properties rents often increase as inflation increases. Thus, real estate provides a good inflation hedge.

46
Q

What is the Taylor rule used for?

A

To predict central bank behavior inregards to rate increases and decreases.

47
Q

What is the neutral rate when discussing the Taylor rule and monetary policy.

A

The neutral rate is composed of an inflation component and a real growth component.

48
Q

What is the equation for the Taylor rule?

A
49
Q

Decribe the yield curve in relation to expansive and restrictive, monetary and fiscal policy.

A
  • Monetary policy & Fiscal policy are expansionsive - Yield curve is upward sloping - Economy is likely to grow.
  • Monetary policy & Fiscal policy are restrictive - Yield curve is downward sloping (inverted) - Headed to a recession.
  • Monetary is restrictive & Fiscal is expansive (stimulative) - Yield curve is flat and the economy is unclear.
  • Monetary is expansive & Fiscal is restrictive - Yield curve is moderately steep and the economy is unclear.
50
Q

What is the economic growth trend?

A

The long-term growth path of GDP. The long-term growth path reflects the average growth rate around with the economy cycles. Economic trends exist independently of cycles but are related to it.

51
Q

What are the main components of a country’s long-term economic growth trend?

A
  1. Growth from changes in employment.
  2. Growth from changes in labor productivity.
52
Q

What are the components of growth from changes in employment?

A
  1. Growth in the potential size of the labor force.
  2. Growth in the labor force participation rate.
53
Q

What are the components of growth in labor productivity?

A
  1. Growth from capital inputs.
  2. Growth in Total Factor Productivity (TFP).
54
Q

What is the permanent income hypothesis?

A

Consumer spending is the largest component of GDP and is fairly stable over the business cycle. The permanent income hypothesis states that the reason is that individuals tend to consume an amount that is fairly constant over time and related to their expected long-run income. Due to this consumer spending is not the most important compent to changes in economic growth.

55
Q

List the criteria for a pro-growth government structural policy?

A
  1. Fiscal policy is sound.
  2. The public sector intrudes minimally on the private sector.
  3. Competition withn the private sector is encouraged.
  4. Infrastructure and human capital dvevelopment are supported.
  5. Tax policies are sound.
56
Q

What are two common exogenous shocks and how may they affect economic growth trends?

A

Exogenous shocks are unanticipated events that occur outside of the normal course of an economy. Since the events are unanticipated, they are not already built into current market prices.

  1. Oil shocks are usually characterized as (1) a reduction in oil production as a result of turmoil in the Middle East, (2) leading to higher oil prices and inflation, (3) reduced consumer spending, (4) increased unemployement, and (5) a slowed economy. (6) An oil shock could also be a reduction in prces resulting in the opposite effects.
  2. A financial crisi is usually characterized by (1) a country not being able to meet its debt payment, (2) a currency devaluation, or (3) a significant reduction in asset prices. (4) Banks usually become vulnerable in a financial crisis. To stabilize the economy, the central bank intervenes to increase liquidity by reducing or maintaining low rates.
57
Q

What are the macroeconomic linkages between economies?

A

Macroeconomic links refer to similarities in business cycles across countries. Economies are linked by both international trade and capital flows.

58
Q

What are the exchange rate linkages between economies?

A

Countries may peg their currency to other currenies. This reduces currency volatiltiy and helps bring inflation under control. Since countries are not always successful and maintaining the peg (the weaker country usually abandons it and devalues their currency), interest rates between the two countries often reflect a risk premium, with the weaker country having higher interest rates.

59
Q

What are the interest rate linkages between economies

A

Interest rate differentials can reflect differences in economic growth, monetary policy, and fiscal policy. In theory real interest rates should be the same, the exchage rates will equalize them. Countries with high real interest rates should see the value of their currency increase.

60
Q

What are the risks of emerging markets?

A
  • An unstable political and social system.
  • Heavy infrastructure investments financed by foreign borrowing
61
Q

What are the questions investors should answer before investing in emerging markets and how would you find the answer?

A
  1. Does the country have responsibile fiscal and monetary policies? Examine the deficit to GDP ratio.
  2. Does the country have reasonable currency values and current account deficits? A volatile currency discourages needed foregin investments, and an overvalued currency encourages excessive government borrowing.
62
Q

Why are analyst often not satified with using the historical sample covariance matrix?

A

Because investment data series are relatively short and samples often reflect the nonrecurring peculiarites of a historical period. The sampe covariance matrix is perfectly well suited for summarizing an observed datasetand has the desirable (large-sample) property of unbiasedness. The shrinkage estimator is a superior approach for estimting the population covariance matrix for the medium- and lsmaller-size datasets that are typical in finance.

63
Q

What are the four axioms of Utility theory?

A
  1. Completeness
  2. Transititvity
  3. Independence
  4. Continuity
64
Q

What is the Completeness axiom?

A

Assumes individuals know their preferences and uses them to choose between any two mutually exclusive alternatives. Given a choice between D or E, they could prefer D, E, or be indifferent.

65
Q

What is the Transitivity axiom?

A

Transitivity assumes individuals consistenlty apply their completeness rankings. If F is preferred to E and F is preferred to D, then F must be prederred to E.

66
Q

What is the Independence axiom?

A

Independence assumes rankis are also additive and proportional. If D and F are mutually exclusice choices where D is preferred and J is an additional choice that adds positive utility, then D + x(J) will be preferred to F + x(J). In this case, x is some portion of J.

67
Q

What is the Continuity axiom?

A

Continuity assumes utility indifference curves as continuous, meaning that unlimited combinations of weightings are possible. If F is preferred to D, which is preferred to E, then there will be some ocmbination of F and E for which the individual will be indifferent.

68
Q

What is the equation for Bayes formula?

A
69
Q

Explain a risk-averse person

A

The risk-averse person suffers a greater loss of utility for a given loss of wealth than they gain in utility for the same rise in wealth.

70
Q

Explain a risk-neutral person

A

The risk-neutral person gains or loses the same utility for a given gain or loss of wealth.

71
Q

Explain a risk-seeker

A

The risk-seeking person gains more in utility for a rise in wealth than they lose in utility for an equivalent fall in wealth.

72
Q

Traditional finance is based in utility theory with an assumption of diminishing marigal return. What are the two consequences?

A
  1. The risk-averse utility function is concave. As more and more wealth is added, utility (satisfication) increases at a diminishing rate.
  2. It leads to downward sloping convex indifference curves due to a dimishing marginal rate of substitution.
73
Q

What is the shape of the utility function of wealth for a risk-averse, risk-neutral, and risk-seeking person?

A
  • Risk-averse - concave
  • Risk-neutral - linear upward-sloping
  • Risk-seeking - upward-sloping convex