Economics Flashcards
Alpha
earning excess returns with specific strategies within an asset class
Capital Market Expectation Process
- determine needs
- look at historical performance
- identify valuation model
- collect data
- interpret current conditions and assign values to inputs
- formulate expectations
- monitor/ repeat
Capital Market Forecasts
- consistent
- unbiased
- objective
- well supported
- accurate
Return Estimate Methods
- arithmetic average: single period
- geometric average (multiply): multiple periods; dec dramatic shifts
- weighted average (shrinkage estimate): historical estimates
Gordon Growth Model
E(r) = D1/ P0 + g
Grinold-Kroner Model
Ri = D1/ P0 + i + g - ΔS + Δ(P/ E)
return = div yeild + inflation + growth in earnings - % change in shares outstanding + change in P/ E ratio
Discounted Cash Flow Assumptions
reinvest cash flows at the realized rate of return
Time Series Model
forecasts generated using previous values of a variable and previous values of other variables
- volatility clustering: variance will persist for periods of time
Risk Premium Approach
YTM = rf + risk premiums(s)
rbond = rf + inflation + default risk + liquidity + taxes + maturity premiums
reqty = LT gov bond yield + eqty risk premium
Sharpe Ratio
excess return per unit of risk
( Rm - Rf )/ σm
ERPm / σm
β
systematic risk, used to value equity and fixed income sec
ρi,m σi / σm
Covariance
covi,j = βi,1βj,1σF12 + βj,1βj,2σF22 + ( βi,1βj,1 + βj,1βj,2 )cov(F1, F2)
covi,j = β1 β2 σm2
CAPM
r = rf + β( rm - rf )
Financial Equilibrium Approach
ERP = ρi,m σi ( ERPm/ σm )
segmented ERP = weighted avg of fully segmented and integrated ERP + additional risk premiums
E(r) = ERP + rf
Inventory Cycle
- 2-4 years
- inv/ sales
- inc I/S b/c inc I = positive
- inc I/S b/c dec S = negative
- LR lower inv b/c better inventory management
Business Cycle
- 9-11 years
- phases
- initial recovery
- early upswing
- late upswing
- slowdown
- recession
Initial Recovery
- ST and LT rates = low or declining
- inflation = dec
- confidence = inc
- gov = exp FP
- bond prices = peak
- stock prices = inc
Early Upswing
- ST and LT rates = inc
- inflation = low
- confidence = high
- gov = less exp FP
- bond prices = dec, flat yield curve
- stock prices = inc
Late Upswing
- ST and LT rates = inc
- inflation = inc
- confidence = peak
- gov = rest MP
- bond prices = dec
- stock prices = peak
Slowdown
- ST and LT rates = peak
- inflation = peak
- confidence = dec
- gov = less rest MP
- bond prices = inc
- stock prices = dec
Recession
- ST and LT rates = dec
- inflation = inc
- confidence = low
- gov = exp MP and FP
- bond prices = inc
- stock prices = inc
Monetary Policy
- stimulate econ = dec int rates
- upward sloping yield curve
- slow econ = inc int rates
- downward sloping yield curve
Deflation
BAD
defer spending now b/c cheaper in future, bad for econ
hard to use MP - can’t really dec rates more
Fiscal Policy
changes to budget deficit
stimulate econ = inc deficit
slow econ = dec deficit
Taylor Rule
r = policy neutral rate + 0.5(exp - trend GDP growth) + 0.5(exp - acceptable inflation)
used to anticipate changes in central bank policy/ int rates
Inflation on Asset Returns
- avg inf: cash, bonds, eqty, real estate = good
- high inf: cash, real estate = good; bonds, eqty = bad
- deflation: bonds = good; cash, eqty, real estate = bad
MP and FP
Impact on Yield Curve and Economy
- both stim: upward sloping yield curve, econ growth
- both rest: downward sloping yield curve, econ cont
- MP rest, FP stim: flatter yield curve, econ = ?
- MP stim, FP rest: slightly steep yield curve, econ = ?
Trend Rate of Economic Growth
- changes in employment
- changes in productivity and capital (TFP growth)
- consumer spending
- exogenous shocks
- gov interference/ support
Twin Deficit Problem
large gov deficit (G > T) and large capital acct deficit (M > X)
potential problems when dec deficits:
- gov spending inc int rates
- gov inc taxes
- inc foreign inv = dec currency value (inflation)
Pegged Currency
developing country pegs their currency FX rate to that of a developed country’s currency
- must follow econ policy of dev country
- pegged int rates > dev country’s int rates (riskier)
- interest rate differential changes based on confidence of peg
Emerging Markets Warning Signs
- gov debt/ GDP > 4%
- growth < 4% (insufficient to keep up w/ pop growth)
- current account deficit > 4% GDP
- foreign debt/ GDP > 50%
- foreign currency reserves < ST foreign currency debt
- gov policies not supportive of growth
Forecasting by Asset Class
- cash/ cash eq: MP and ST int rates
- default-free bonds: LT int rates, inflation, S/D
- credit risky bonds: credit spread
- inflation indexed bond: real yield, S/D
- common stock: earnings, P/E ratio
- emerging market stock: forecast of developed markets
- real estate: int rates, S/D
Forecasting Exchange Rates
- purchasing power pairity: higher relative inflation = curr dep
- relative econ strength: attracts capital = curr app
- capital flows: attracts capital = curr app
- savings-inv imbalances: savings/ inv = deficit, need curr app to attract inv
Expected Growth in GDP
%ΔY ≅ %ΔA + α(%ΔK) + (1 − α)(%ΔL)
ΔA = managerial and technological innovation
Gordon Growth Model
V0 = D1 / ( r - g )
H-Model
for emerging economies
Security Selection
top-down: macro analysis; identify sectors > markets > securities; manager focus on markets and industries
bottom-up: micro analysis; research firm, determine if it’s a good inv; manager focused on long-short, market neutral strategy
Fed Model
EY > treasury yield, ratio > 1 - undervalued
EY < treasury yield, ratio < 1 - overvalued
CONS: ignores ERP, ignores earnings growth, compares real variable (EY) to nominal value (treasury yield)
Yardeni Model
compares theoretical EY to acutal EY; variation of the constant growth DDM where earnings = div, yield on A-rated corp bonds = r and a 5 year growth forecast = g
actual EY < fair value yield - overvalued
actual EY > fair value yield - undervalued
CONS: assumed r, d varies over time, earnings estimates can be wrong
CAPE
cyclically adjusted P/E ratio
CAPE > historical avg - overvalued
CAPE < historical avg - undervalued
10 yr avg earnings captures effects of business cycle and inflation
Q Models
MV/ replacement cost
q > 1 - equity overvalued
q < 1 - equity undervalued
