Capital Market Expectations - R18

Question 1

Formulate capital market expectations using the 7-step process

Answer 1

1. Determine the specific capital market expectations needed according to the investor’s tax status, allowable asset classes, and time horizon.
2. Investigate assets’ historical performance as well as the factors affecting their performance.
3. Identify the valuation model used and its requirements
4. Collect the best data possible.
5. Use experience and judment to interpret current investment conditions.
6. Formulate capital market expectations.
7. Monitor performance and use it to refine the process.

Question 2

What are the problems encountered in producing forecasts?

Answer 2

1. Limitations to using economic data
2. Data measurement error and bias
3. Limitations of historical estimates
4. Use of expost risk and return measures
5. Non-repeating data patterns
6. Failing to account for conditioning information
7. Misinterpretation of correlations
8. Psychological traps
9. Model and input uncertainty

Question 3

What are the 6 psychological traps analysts are susceptible to?

Answer 3

1. Anchoring trap.
2. Status quo trap.
3. Confirming evidence trap.
4. Overconfidence trap.
5. Prudence trap.
6. Recallability trap

Question 4

What are the four statistical forecasting tools?

Answer 4

1. Projecting from historical data
2. Shrinkage Estimators
3. Time Series Analysis
4. Multifactor Models

Question 5

Projecting historical data

Answer 5

Straight forward. Analyst projects the historical mean return, standard deviation, and correlations for a data set into the future

Question 6

Shrinkage estimators

Answer 6

Used to reduce (shrink) the influence of historical outliers through a weighting process. Mean return and covariance are the paramters most often adjusted.

Most useful when the data set is so small that historical values are not reliable estimates of future parameters.

Question 7

Time series analysis

Answer 7

Forecasts a variable using previous values of itself and sometimes previous values of other variables. Can be used to forecast means as well as variances.

In variance analysis, assets such as foreign exchange, stocks, and futures have been shown to exhibit volatility clustering. Volatility in the current period σ_t², can be stated as a weighted average of the previous period volatility (σ_t-1²) and a random error, E_t²:

Question 8

Multifactor Models

Answer 8

Multifactor models are used to forecast returns. They can also be used to forecast covariances. The advantage of using them to forecast covariances is that the model can simplify the forecasting procedure by reducing the forecast to a common set of factors. This modeling also eliminates the noise poresent in a sample of data and ensures consistent forecasts given a consistent covariance matrix.

R_i = a_i + b_i1F₁ + b_i2F₂ + … B_ixF_x + E_i

Question 9

5 Phases of the Business Cycle.

Answer 9

Question 10

What is the formula for the Gordon Growth Model?

Answer 10

P0 = Div1/Ri-g => Ri = Div₁/P₀ + g

Question 11

What is the Grinold + Kroner formula?

Answer 11

R_i = Div₁/P₀ + i + g - chg S + chg (P/E)

Expected income return = D/P - Chg S

Expected nominal earnings growth return = i + g

Expected repricing return = Chg (P/E)

Question 12

Describe the risk premium approach, otherwise known as the bond yield risk premium approach.

Answer 12

To determine the expected return for bonds, Rb, using this approach, the analyst uses the real risk-free rate and risk premiums as follows:

Rb = real risk-free rate + inflation risk premium + default risk premium + liquidity risk premium + maturity risk premium + tax premium

• Inflation risk premium
• default risk premium
• liquidity risk premium
• maturity risk premium
• tax premium

E(Re) = YTM on a LT Govt bond + Equity risk premium

• equity risk premium

Question 13

What is the equation for the ICAPM?

Answer 13

R_i = Rf + ß_i(Rm-Rf)

Question 14

Restate the equity risk premium by breaking down Beta, ERP, and the ICAPM.

Answer 14

Question 15

What is the Singer and Terhaar Analysis?

Answer 15

It adjusts the ICAPM for market imperfections, such as illiquidity and market segmentation. The more illiquid an asset is, the greater the (liquidity) risk premium should be.

This is not a concern for developed world capital markets but is a concern for assets such as direct real etate and venture capital. In the case of private equity, an investment may not become liquid until the lock-up period expires.

To estimate the size, we use the multi-period Sharpe ratio for the investment and compare it to the estimated mpsr for the market. The Sharpe ratio must be at least as high as that for the market.

Capital does not flow in segmented markets - two assets with the same risk may be mispriced because capital cannot flow to the higher return asset - this increases the risk premium.

Question 16

Describe the impact on the yield curve based on restrictive or expansive fiscal and monetary policies.

Answer 16

Question 17

What 5 phases is the longer-term business cycle characterized by?

Answer 17

1. Initial Recovery
2. Early Expansion
3. Late Expansion
4. Slowdown
5. Recession

Question 18

Explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns

Answer 18

Question 19

Explain the advantages and disadvantages of using econometrics, leading indicators, and a checklist approach in economic forecasting.

Answer 19