CME Flashcards
Econometric analysis
Uses statistical methods to explain economic relationships and formulate forecasting models
Checklist approach
An analyst considers a series of questions
Then he uses judgement and perhaps statistical modeling to interpret answers
What’s shrinkage estimation
Shrinkage estimation involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, in which the weights reflect the analyst’s relative belief in the estimates.
Deficit to GDP ratio
Shouldn’t be more than 4%
Debt to GDP ratio
Not more than 70-80%
Real growth rate
More than 4%
Current account deficit
Not more than 4%
Foreign debt levels
Not more than 50% of GDP
Not more than 200% of current account receipts
Appraisal data bias
Appraisal data bias occurs when asset valuations are based on subjective appraisals rather than market prices, leading to smoothed or understated volatility and risk in reported data. This can cause an overestimation of portfolio stability, as the appraised values may not reflect true market fluctuations. correlations are understated
prudence bias
The prudence bias is the tendency to temper forecasts so that they do not appear extreme or the tendency to be overly cautious in forecasting.
Econometric model advantages
Advantages
- Models can be quite robust, with
many factors included to approximate
reality.
■ New data may be collected and
consistently used within models to quickly generate output.
■ Delivers quantitative estimates of
impact of changes in exogenous
variables.
■ Imposes discipline/consistency on
analysis.
econometric model disadvantages
■ Complex and time-consuming to formulate.
■ Data inputs not easy to forecast.
■ Relationships not static. Model may be mis-specified.
■ May give false sense of precision.
■ Rarely forecasts turning points well.
Leading indicator advantages
■ Usually intuitive and simple in
construction.
■ Focuses primarily on identifying
turning points.
■ May be available from third parties.
Easy to track
Leading indicator disadvantages
■ History subject to frequent revision.
- look ahead bias
● “Current” data not reliable as input for historical analysis.
● Overfitted in-sample. Likely overstates forecast accuracy.
■ Can provide false signals.
■ May provide little more than binary (no/yes) directional guidance.
Checklist approach advantages
■ Limited complexity.
■ Flexible.
● Structural changes easily
incorporated.
● Items easily added/dropped.
● Can draw on any information, from
any source, as desired.
■ Breadth: Can include virtually any
topics, perspectives, theories, and
assumptions.
Checklist approach disadvantages
■ Subjective. Arbitrary. Judgmental.
■ Time-consuming.
■ Manual process limits depth of analysis. No clear mechanism for combining
disparate information.
■ Imposes no consistency of analysis across items or at different points in time. May allow use of biased and/or inconsistent views, theories, assumptions.
Challenges in setting CME
- Limitations of economic data
- data measurement errors and biases
- model uncertainity
Asset class charachteristics
Assets within an asset class should be relatively homogeneous; asset classes should be mutually exclusive; asset classes should be diversifying; asset classes as a group should make up a preponderance of the world’s investable wealth; asset classes selected for investment should have the capacity to absorb a meaningful proportion of an investor’s portfolio.
usually equity increases with trend, not always though. why?
- Growth already priced in
- Diminishing return on capital
- Valuation multiples
structural models (in econometric models)
specify functional relationships among variables based on economic theory. The functional form and parameters of these models are derived from the underlying theory.
short term interest rate movements
Initial recovery - Short-term rates and government bond yields are low. (probably because monetary policies are still based on contraction)
Early expansion - Short rates are moving up as the central bank starts
to withdraw stimulus put in place during the recession.
Late expansion - Interest rates are typically rising as monetary policy becomes restrictive, soft landing is aimed by monetary policy
Slowdown - Short-term interest rates are high, perhaps still rising, but likely to peak.
Contraction - Short-term interest rates drop during this phase
Bond yields and yield curve in different situations
Initial recovery - Bond yields may continue to decline in anticipation of further disinflation but are likely to be bottoming. High yield bonds doing well
Early expansion - Longer-maturity bond yields are likely to be stable or rising slightly. The yield curve is flattening.
Late expansion - Bond yields are usually rising, more slowly than short
rates, so the yield curve continues to flatten.
Slowdown - Government bond yields top out at the first clear sign of a slowing economy and may then decline sharply. The yield curve may invert, especially if the central bank continues to exert upward pressure on short rates.
Contraction - Yields drop and The yield curve steepens substantially
Stock performance during different times
Initial recovery - Stock markets may rise briskly as fears of a longer recession (or even a depression) dissipate. Cyclical and risky assets doing well
Early expansion - Stocks trend upward.
Late expansion - Stock markets often rise but may be volatile as nervous investors endeavor to detect signs of looming deceleration. Cyclical most hit
Slowdown - The stock market may fall, with interest-sensitive stocks such as utilities and
“quality” stocks with stable earnings performing best.
contraction - The stock market declines in the earlier stages of the contraction but usually starts to rise in the later stages, well before the recovery emerges.
A monetary policy cannot simulataneously…
Allow unrestricted capital flows.
Maintain a fixed exchange rate.
Pursue an independent monetary policy.
Think of it like this
America and UK - unrestricted cash flows and floating currency, therefore they have an independent monetary policy, once its fixed… then the trouble begins
Quantitative bottom up
Quantitative bottom-up investors rely on models applied to quantifiable, company-level data.
Performance of real estate
Retail and Office REITs: Higher returns and lower volatility than direct real estate.
Industrial Properties: Similar returns with higher volatility in REITs.
Apartments: Direct investments outperformed REITs with higher returns and lower volatility.
Strenghts of vcv matrix using sample statistics
Simple and intuitive.
Unbiased estimator.
No assumptions about structure.
Easy to compute.
Weaknesses of VCV Matrix Using Sample Statistics
Limited by sample size.
High variance/estimation error with small samples.
Inability to handle many assets.
No cross-sectional consistency.
Strenghts of Factor-Based VCV Matrix
Reduces complexity.
Handles many assets.
Improves estimation precision.
Ensures cross-sectional consistency.
Weaknesses of Factor-Based VCV Matrix
Risk of model mis-specification.
Reduced flexibility.
Dependent on factor selection.
Factor identification challenges.
Key reporting elements include
- Performance evaluation
- Compliance with investment guidelines
- Progress toward stated goals and objectives
Governance reporting in investment governance
addresses the strengths and weaknesses in program execution, enabling efficient committee meetings.
2 types of benchmarks used in investment governance
Investment manager performance relative to the purpose for which they were hired.
Policy portfolio performance compared to the actual portfolio.
how to tackle key person risk
Good governance reduces this risk by diversifying responsibilities and ensuring that no single person is indispensable to the operation of the investment program.
Economy during initial recovery
- Economy starts to pick up.
- Business confidence improves.
- Policies still stimulative (government/central bank support in place).
- Negative output gap (unused capacity in the economy).
- Inflation decelerates (prices stabilize or rise slowly).
- Boost in housing and consumer durable spending.
Economy during an early expansion
- Unemployment falls, but output gap is still negative.
- Consumers borrow and spend.
- Businesses increase production and investment.
- Profits rise quickly.
Strong demand for housing and durables.
Economy in late expansion
Output gap closes (no slack left in the economy).
Boom mentality sets in.
Unemployment very low.
Profits are strong, but wages and inflation rise.
Businesses face capacity pressures, so they invest more.
Central bank may raise interest rates (soft landing goal).
Fiscal balances improve as the government collects more revenue.
Economy in slowdown
Interest rates rise, making borrowing expensive.
Debt accumulates, investment projects decline.
Economy is vulnerable to shocks.
Business confidence weakens.
Inflation still rising as firms raise prices to cover costs.
Economy during contraction
Investment spending drops sharply (first sign).
Firms cut production and jobs.
Central bank eases policy (lowers rates to help recovery).
Profits drop; bankruptcies rise.
Unemployment spikes, hurting households.
May reveal fraud or financial crises.
Process of setting up CME
- Specify the set of expectations needed, including the time horizon(s) to which they apply.
- Research the historical record.
- Specify the method(s) and/or model(s) to 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 needed, documenting conclusions.
- Monitor actual outcomes and compare them with expectations, providing feedback to improve the expectation-setting process.
Which REITS, hightest returns and lowest volatility
Retail reit - highest return and second lowest volatility
Industrial REIT - Lowest return and highest volatility
Foreign exchange reserves
Less than 100% of short term debt is risky
More than 200% is ample
Correlation of REITs with other asset classes
Short term - REITs high correlation with Equity and equity low correlation with Direct real estate
Long tem - REITs high correlation with direct real estate
Inflation during initial recover
Declining inflatoin
Inflation - early expansion
Low inflation and good economic growth
Inflation - Late expansion
Inflation rate increasing
Inflation - slowdown
Inflation continues to accelerate
Inflation - contraction
real economic activity declining and inflation peaking
