Capital Markets Flashcards
T-Bill Rates, Inflation Rates, and Real Rates over time (Chart)
Investments in the U.S. Capital Markets
1926- 2016
Return Decomposition: Large Cap & Long Term Bonds
1927- 2016
Exam notes on Capital Markets
You may be tested on long term returns, risk measures or correlations.
You probably will not be tested on specific periods of time unless they are considered meaningful (e.g., financial crises).
Has the U.S. ever defaulted on its debt?
Many times: 1779, 1790, 1798, 1862, 1933, 1971, and 1979
Remember: the term default does not solely mean that a debtor did not pay, it more broadly
means that a debtor did not pay per the debt’s original terms (i.e., as was promised).
The Gold Standard
Monetary system where the economic unit of trade (e.g., local currency) is based on or linked to gold.
Three types of gold standard systems:
1. Exchange
fixed exchange rate to currency backed by gold
2. Bullion
bullion is traded on demand in exchange at fixed price for currency
3. Specie standard
gold coins are the primary unit of trade
No government today is actually on the gold standard. The U.S. stopped
following a strict form of the gold standard in 1933 and abandoned the entire concept in 1971.
Bretton Woods Agreement 1944: The U.S. dollar essentially becomes the worlds primary reserve currency (near the conclusion of World War II), but the dollar was still tied to gold at a new fixed rate.
The U.S. moves completely away from any gold standard in 1971.
Pros and cons of gold standard
Ramifications: Requiring gold reserves to back up or guarantee paper currency should, in theory, help manage inflation. Assuming that the amount of gold available is fixed, this can actually have a deflationary effect.
Potential Benefits:Stabilizes prices; can reduce uncertainty in trade; acts as a check and balance in keeping governments from creating units of their own currency at will; a system such as the gold standard can help prevent dishonest governments from manipulating economies and financially systems.
Potential Drawbacks: Applying a gold standard system is not convenient, is not very flexible and may not be sufficiently scalable; can create large short term swings in value and price; such a standard can also be manipulated or controlled through war and other means.
Correlation: the value of gold and the U.S. dollar typically have an inverse relationship (e.g., if the U.S. dollar rises then the price of gold falls in dollar terms).
Equity Premium
The excess returns of stocks over the risk-free rate over a time period
[(1 + equity return)/(1 + risk free return)] - 1 = (1+.107)/(1+0.048)-1= 5.6%
using treasury bill return. Sometimes equity premium is defined using long term bonds, for a premium of 4.4
S&P Composite Regression to Trend Chart
PE10 Ratio (Shiller’s PE)
Also known as the “cyclically adjusted PE” (CAPE);
smoothes out fluctuations in earnings due to the business cycle; uses earnings per share figures adjusted for inflation and averaged over 10 years as the denominator
Graph looks like SPX regression to trend graph
Q Ratio
developed by James Tobin (Yale); a valuation model that says the actual value of all companies should be equal to the replacement cost of their assets
Q Ratio = Total Market Value of Firm/Total Asset Value
Value < 1 implies the stock or market is undervalued
Value > 1 implies the stock or market is overvalued
Global Markets Valuation Comparison
Developed vs Developing Equities P/E Ratios
Reducing Portfolio Risk
While standard deviation is a measure of total (or overall) risk and a helpful metric to be sure; we’re actually looking for low correlations to lower the overall “portfolio risk” when considering adding any new asset or investment to a portfolio.
Benefits of Intl Diversification?
Correlations between countries suggest international
diversification is beneficial, especially for active
investors.
•Sharpe ratio of internationally diversified portfolio is
higher than the U.S. alone.
•M 2 shows advantage of the world countries portfolio is
284 basis points.
BUT: Correlations between countries may increase in a crisis.
Increases in correlations
Reasons
Since the 1990’s there has been an increase in correlation in equity prices of many international developed markets.
Possible reasons for increased correlations:
– Globalization (advances in technology, communication, etc.)
– Increased volatility and crises lead to higher correlations
– Increase in emerging market capitalization
Correlations of Asset Classes with S&P
Which have the lowest correlation?
Which have the highest?
