Capital Market Expectations Flashcards
A framework for developing capital market expectations
- Specify the final set of expectations that are needed, including the time horizon to which they apply
- Research the historical record
- Specify the method(s) and/or model(s) that will 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 that are needed, documenting conclusions
- Monitor actual outcomes and compare them to expectations
Alpha research
Research related to capturing excess risk-adjusted returns by a particular strategy
Beta research
Research related to systematic (market) risk and return
Expected return models
- Historical mean return with adjustment
- Risk premium approach
- Discounted cash flow
- Implied market estimates of expected return with adjustment (Black-Litterman model)
Gross National Product (GNP)
Is the market value of all the products and services produced in one year by labour and property supplied by the citizens of a country. Unlike gross domestic product (GDP), which defines production based on the geographical location of production, GNP indicates allocated production based on location of ownership
Data measurement errors and biases
- Transcription errors
- Survivorship bias
- Appraisal (smoothed) data
Psychological traps
- Anchoring
- Status quo
- Confirming evidence
- Overconfidence
- Prudence
- Recallability
- Descriptive statistics
- Inferential statistics
- Methods for effectively summarizing data to describe important aspects of a dataset
- Methods for making estimates or forecasts about a larger group from a smaller group actually observed
Shrinkage estimation
Involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, where the weights reflect the analyst’s relative belief in the estimates
Volatility clustering
The tendency for large (small) swings in prices to be followed by large (small) swings of random direction
Volatility in period t (as per RiskMetrics Group)
- β measures the rate of decay of the influence of the value of volatility in one period on future volatility - the rate of decay is exponential
Multifactor models
- Ri = the return to asset i
- ai = an intercept term in the equation for asset i
- Fk = the return to factor k, k = 1, 2, …, K
- bik = the sensitivity of the return to asset i to the return to factor k, k = 1, 2, …, K
- εi = an error term
Multifactor models variance and covariance
Gordon growth model
Growth rate g for the Gordon growth model (market growth rate)
Earnings growth rate = GDP growth rate + Excess corporate growth (for the index companies)
Grinold-Kroner model
The term ΔS is negative in the case of net positive share repurchases, so −ΔS is a positive repurchase yield in such cases
Grinold-Kroner model notation
- E(Re) = the expected rate of return on equity
- D/P = the expected dividend yield
- ΔS = the expected percent change in number of shares outstanding (is negative in the case of net positive share repurchases)
- i = the expected inflation rate
- g = the expected real total earnings growth rate (not identical to the EPS growth rate in general, with changes in shares outstanding)
- ΔPE = the per period percent change in the P/E multiple
Grinold-Kroner model
- Expected income return
- Expected nominal earnings growth return
- Expected repricing return
- D/P − ΔS
- i + g
- ΔPE
Risk premium approach (build-up approach)
Fixed-income premium approach
The Equity Risk Premium (also called the bond-yield-plus-risk-premium method)
E(Re) = YTM on a long-term government bond + Equity risk premium
International CAPM (ICAPM) E(Ri)
- βi = the asset’s sensitivity to returns on the world market portfolio, equal to Cov(Ri,RM)/Var(RM)
ICAPM Asset class i risk premium for fully integrated markets
- RPi = E(Ri) − RF
- RPi = Bi * (RPM)
- (RPM / σM) = GIM Sharpe ratio
ICAPM Asset class i risk premium for fully segregated markets
Global investable market (GIM)
A practical proxy for the world market portfolio consisting of traditional and alternative asset classes with sufficient capacity to absorb meaningful investment
Singer-Terhaar fully integrated risk premium
= (Sharpe ratio fo the GIM) * standard deviation of the asset class * correlation with the GIM
Singer-Terhaar approach 4 steps
- Estimate the perfectly integrated and the completely segmented risk premiums for the asset class using the ICAPM
- Add the applicable illiquidity premium, if any, to the estimates from the prior step
- Estimate the degree to which the asset market is perfectly integrated
- Take a weighted average of the perfectly integrated and the completely segmented risk premiums using the estimate of market integration from the prior step
- Market integration
- Market segmentation
- No impediments or barriers to capital mobility across markets
- Some meaningful impediments or barriers to capital mobility across markets
Covariance between two asset classes in a one-beta model
= β1m * β2m * σ2m
Correlation between two asset classes in a one-beta model
= β1m * β2m * σ2m / σ1 * σ2
Output gap
The difference between the value of GDP estimated as if the economy were on its trend growth path (sometimes referred to as potential output) and the actual value of GDP
- Inventory Cycle
- Business Cycle
- Cycle measured in terms of fluctuations in inventories. Lasts for 2 - 4 years
- Cycle represented by fluctuations in GDP in relation to long-term trend growth. Lasts for 9 - 11 years
The five phases of the business cycle
- Initial recovery
- Early upswing
- Late upswing
- Slowdown
- Recession
Stagflation
Persistent high inflation combined with high unemployment and stagnant demand
- Recession
- Depression
- Occurs when there are two successive quarterly declines in GDP
- Occurs when a recession lasts two or more years
Consumer spending and foreign trade % of GDP
- Consumer spending amounts to 60–70 percent of GDP in most large developed economies and is therefore typically the most important business cycle factor
- Foreign trade is an important component in many smaller economies, for which trade is often 30–50 percent of GDP. However, for the large economies, foreign trade is typically only around 10–15 percent of GDP and correspondingly less important
Taylor rule
Taylor rule notation
- Roptimal = the target for the short-term interest rate
- Rneutral = the short-term interest rate that would be targeted if GDP growth were on trend and inflation on target
- GDPgforecast = the GDP forecast growth rate
- GDPgtrend = the observed GDP trend growth rate
- Iforecast = the forecast inflation rate
- Itarget = the target inflation rate
Fiscal and monetary policy impact on the yield curve
Permanent income hypothesis
Asserts that consumers’ spending behavior is largely determined by their long-run income expectations
Growth in total factor productivity (TFP growth)
Technical progress and increased efficiency from capital inputs
Government structural policies
Refer to government policies that affect the limits of economic growth and incentives within the private sector
Structural level of unemployment
The level of unemployment resulting from scarcity of a factor of production
Diffusion index
Measures how many indicators are pointing up and how many are pointing down
Economic observations and their effect on real bond yields
Approaches to Forecasting Exchange Rates
- Purchasing power parity (PPP)
- Relative economic strength forecasting approach
- Capital flows forecasting approach
- Savings–investment imbalances forecasting approach
A data-mining bias
Occurs when variables are added to an analysis without any predictive merit (i.e., there is no causal relationship for adding the variables).
Time-period bias
Time-period bias relates to results that are time-period specific. Research findings are often found to be sensitive to the selection of starting and/or ending dates
Deflation impact on real estate, bonds and equities
- Real estate experiences downward pricing pressure (negative)
- Bonds benefit from improving purchasing power (positive)
- Inflation at or below expectations is a positive for equities
Leading indicators vs econometric approach
A disadvantage of the leading indicators–based approach is that historically, it has not consistently worked because relationships between inputs are not static. An advantage to the econometric approach is that it provides quantitative estimates of the effects on the economy of changes in exogenous variables
Market oriented
An investment strategy that cannot be clearly categorized as value or growth
High frequency data
Data of high frequency (weekly or daily) are more sensitive to asynchronism across variables. As a result, high-frequency data tend to produce lower correlation estimates
Cyclical turns - bottom-up versus top-down analysis
Most top-down models are of the econometric type and rely on historical relationships to be the basis for assumptions about the future. Thus, they can be slow in detecting cyclical turns
Long-term GDP growth based on labor
- = growth from labor inputs (changes in employment) + growth from changes in labor productivity
- Growth from labor inputs (changes in employment) = growth in potential labor force + growth in labor force participation
- Growth from changes in labor productivity = growth from capital input + growth in total factor productivity
The five elements of a pro-growth government structural policy
- Fiscal policy is sound and sometimes used to control the business cycle
- Tax policies are sound
- The public sector intrudes minimally on the private sector
- Competition within the private sector is encouraged
- Infrastructure and human capital development are supported
Currency PPP using inflation differential
- Inflation differential = inflation % of country A - inflation % of country B
- PPP prediction = CurrencyA / CurrencyB * (1 + inflation differential)
Advantages and disadvantages of the econometric, economic indicators and checklist approaches
