Capital Market Expectations 2 Flashcards
Jesper Bloch works for Discrete Asset Management (DAM) in Zurich. Many of the firm’s more risk-averse clients invest in a currency-hedged global government bond strategy that uses cash flows to purchase new issues and seasoned bonds all along the yield curve to maintain a roughly constant maturity and duration profile. The yield to maturity of the portfolio is 1% (compounded annually), and the modified duration is 4.84. DAM’s chief investment officer believes global government yields are likely to rise by 200 bps over the next two years as central banks remove extraordinarily accommodative policies and inflation surges. Bloch has been asked to project approximate returns for this strategy over horizons of two, five, and seven years. What conclusions is Bloch likely to draw?
If yields were not expected to change, the return would be very close to the yield to maturity (1%) over each horizon. The Macaulay duration is 4.89 (= 4.84 × 1.01), so if the yield change occurred immediately, the capital gain/loss and reinvestment impacts on return would roughly balance over five years. Ignoring convexity (which is not given), the capital loss at the end of two years will be approximately 9.68% (= 4.84 × 2%). Assuming yields rise linearly over the initial two-year period, the higher reinvestment rates will boost the cumulative return by approximately 1.0% over two years, so the annual return over two years will be approximately −3.3% [= 1 + (−9.68 + 1.0)/2]. Reinvesting for three more years at the 2.0% higher rate adds another 6.0% to the cumulative return, so the five-year annual return would be approximately 0.46% [= 3.25 + (1 + 1.0 + 6.0)/5]. With an additional two years of reinvestment income, the seven-year annual return would be about 1.99% [= 1 + (−9.68 + 1.0 + 6.0 + 4.0)/7]. As expected, the capital loss dominated the return over two years, and higher reinvestment rates dominated over seven years. The gradual nature of the yield increase extended the horizon over which the capital gain/loss and reinvestment effects would balance beyond the initial five-year Macaulay duration.
The Building Block Approach to Fixed-Income Returns
Required comp for types of risk
The Short-term Default-free Rate
The Term Premium
The Credit Premium
The Liquidity Premium
- Default free rate is self explanatory but for longer periods maybe look at using rolled over short term rates since a long term may contain some term premium.
- Term premium: Cant get this directly from curve. We could derive the forward rates and deduct what we think will be short term rate at that perod.
- Credit premium: The premium earned for this is mostly for downgrade risk. Steep treasury curve is good because it means we are in trough so times are getting better.
- liquidity premium: In general, liquidity tends to be better for bonds that are (a) priced near par/reflective of current market levels, (b) relatively new, (c) from a relatively large issue, (d) from a well-known/frequent issuer, (e) standard/simple in structure, and (f) high quality. These factors tend to reduce the dealer’s risk in holding the bond and increase the likelihood of finding a buyer quickly.
What metrics to look for when looking at emerging market bonds?
- fiscal deficit to GDP, keep it to under 4%
- Debt-to-GDP should not exceed 70-80%
- Real growth below 4%
- Current account deficit should be under 4% of GDP (lack of competitiveness)
- Foreign debt should be less than 50%
- Foreign exchange reserves should not be less than 100% of short term debt, should be over 200%
What’s the Grinold Kroner Model?
E(Re) ≈ D/P + (%ΔE−%ΔS) + %ΔP/E
The term in parentheses, (%ΔE − %ΔS), is the growth rate of earnings per share
Cashflow return is D/P minus %ΔS
Nominal earnings growth is %ΔE
Expected repricing return is %ΔP/E
Must tailor the growth rates to the horizon, can’t say that P/E increases or Buy backs persist forever. GDP growth is also a lot less volatile, we use E (earnings) = Nominal GDP growth.
Formula for Beta (both methods)
Cov (Ri, Rm) / Var (Rm)
ρi,m (σi/σm)
Singer–Terhaar
Full integration:
Corr of i,gm x σi x (RPgm / σGM)
Full segmentation:
σi x (RPi / σi)
We then weight by degree of integration
What’s the problem with working with Real Estate returns?
RE Investors rely heavily on appraisals since properties trade infrequently. We don’t get a sequence of simultaneous, periodic transaction prices for a cross section of properties.
Appraisals reflect slowly moving averages. Returns being calculated from this represent weighted averages of unobservable true returns - returns that would be observed if there were transactions. The averaging doesn’t bias the mean return but it does distort correlations and volatility. The published returns are too smooth and understates volatility. It is now standard to unsmooth data using a time series model.
Adding a liquidity premium may also be necessary.
What drives the risk premium for RE?
- Sensitive to long term IR therefore high duration
- Therefore it earns a term premium
- Most properties exposed to credit risk of tenants, a lease is like a bond issued where rent is interest.
- ERP since owner bears brunt of value fluctuations but also rent growth, lease rollover and vacancies.
- These values are pro-cyclical
- Bond like components and stock like components puts it somewhere between bonds and stocks.
- how large must the liquidity premium be to entice investors? In RE the illiquidity means they may not find any buyer at all. Commercial property has 2-4% premium.
Assessing Real Estate Investments
Tammi Sinclair, an analyst at a large retirement fund, recently attended investor presentations by three private real estate firms looking to fund new projects. Office Growth Partners specializes in building and owning low-cost, standardized office space for firms seeking to place sales representatives in the most rapidly growing small population areas across the region. Mega-Box Properties builds and owns large, custom-designed distribution facilities for multinational makers of brand-name products. The facilities are strategically located near major global transportation hubs. Exclusive Elegance Inc. develops and then manages some of the world’s most luxurious, sought-after residential buildings in prime locations. It never breaks ground on a new property until at least 85% of the units have been sold and, to date, has never failed to sell out before construction is complete.
Identify important characteristics of each business that Sinclair will need to consider in establishing a required rate of return for each potential investment.
Guideline answer:
Office Growth Partners (OGP) is likely to be a very high-risk investment. It essentially chases hot markets, it builds generic office space, and its typical tenants (opportunistic sales forces) are apt to opt out as soon as the market cools. All these aspects suggest that its business is very exposed to a boom-and-bust cycle. It is likely to end up owning properties with persistently high vacancy rates and high turnover. Hence, Sinclair will likely require a rather high expected return on an investment in OGP.
Mega-Box’s business should be fairly stable. The distribution centers are strategically located and designed to meet the needs of the tenant, which suggests long-term leases and low turnover will benefit both Mega-Box and the tenant firms. The average credit quality of the tenants—multinational makers of brand-name products—is likely to be solid and disciplined by the public bond and loan markets. All things considered, Sinclair should probably require a significantly lower expected return on an investment in Mega-Box than in OGP.
Exclusive Elegance appears to be even lower risk. First, it deals only in the very highest-quality, most sought-after properties in prime locations. These should be relatively immune to cyclical fluctuations. Second, it does not retain ownership of the properties, so it does not bear the equity/ownership risks. Third, it is fairly conservative in the riskiest portion of its business—developing new properties. However, Sinclair will need to investigate its record with respect to completing development projects within budget, maintaining properties, and delivering top-quality service to residents.
What are the ways in which trade in G&S can influence XR?
- Trade flows: Relatively small, trade flows are small compared to financial flow and overall economy.
- PPP: Free trade forces the real XR to be constant - changes in the nominal rate are from differences in inflation expectations.
Deviations can happen though due to nontraded goods, PPP does not hold in the short term but holds better in the long term and when inflation diff are large and determined by money supply.
- Current account: Sensitivity will increase if there are restrictions on capital flows - the prices / production / spending decisions are pretty stable. Current account balances will have the largest influence when persistent and sustained.
Adjustments to capital flows will place pressure on XR.
3 important considerations are:
- Capital mobility: In a world with no restrictions on capital flows, investors will pursue the highest risk-adjusted returns. If the risk-free rate is 2.8% in Country A and 2.5% in Country B, capital will flow into Country A. Overall, investment would flow into Country A at the prospect of earning a 1.3% higher return for the same level of risk. The implication for exchange rates is that Country A’s currency will be so strong due to high demand among investors before weakening. Specifically, Country A’s currency is expected to depreciate by 1.3% relative to Country B’s. Essentially, the exchange rate will adjust to eliminate the possibility of earning excess risk-adjusted returns.
- UIP: UIP states that exchange rate changes should
equal differences in nominal interest rates. Says differences in premiums for term, credit etc like the above risk adjusted returns, dont make a diff. UIP means borrowing in low yield and investing in high yield should fail but we see carry trades work often. - 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.
In the long run, a currency portfolio’s share of the global market portfolio will be primarily influenced by the country’s trend growth rate and current account balance. A large, persistent current account balance must be financed by foreign capital, which will put downward pressure on the domestic currency as foreign investors allocate more resources to the country. While the impact may be lessened if the current account deficit is due to productivity-driven economic growth, deficits caused by low domestic savings rates and undisciplined fiscal policy will weaken the domestic currency.
Whats the most basic approach to volatility forecasting and whats the main issue with it?
VCV Variance Covariance Matrix is a chart with each assets covariance with each other, and itself (variance). It is based on historic data. You need 10 times more obs than assets. There is a risk of sampling error.
What are multi-factor VCVs?
This method lets us focus on exposures to a small amount of common factors. Like using GDP and inflation as factors:
Ra = a + Bg Fg + Bi Fi + e
a is constant intercept, Bg is asset sensitivity to GDP, Fg is input for GDP growth factor and e is a stochastic term unique to asset. This method uses a lot less estimations and has better cross sectional structure. However it is biased, inconsistent and doesnt converge to true matrix with bigger samples. Therefore shrinkage involving this and sample VCV is common.
