Forecast Asset classes Returns Flashcards
What are the 2 main approaches to forecasting ?
- Formal tools
- Survey (Judgement)
Elaborate on Formal tools
Statistical methods
Discounted CF method
Risk premium models
Elaborate on Statistical methods
Statistical sampling (mean-variance and correlation) Shrinkage estimation method Time series using independent variable
Elaborate on Risk premium models
Equilibrium model (CAPM) Factor model Building blocks
Applying DCF to CF
Over horizon shorter than the duration, the capital market gain/loss impact will tend to dominate such that rising rates imply lower return whereas over horizon longer than the duration, the capital gain/losses impact will tend to dominate such that rising rates imply higher returns.
Elaborate on Building blocks approach to FI return
Default risk premium
Term premium
Credit premium
Liquidity premium
Elaborate on on risk in EM
In addition to the common risks, EM face economical (ability to pay) and political risks (willingness to pay). A persistent ratio above 4% is a likely cause for concern, a debt to GDP ratio exceeding 70-80%, is a sign of vulnerability. persistent deficit above 4% indicate lack of competitiveness. Weak property right and legal environment are areas of concerns.
Elaborate on Grinold-Kroner model
E(r) = D/P + (% Δ Earning - %Δ share outs.) + % ΔP/E
than total earnings.
With a minor rearrangement of the equation, the expected return can be divided into three components:
■ Expected cash flow (“income”) return: D/P – %ΔS
■ Expected nominal earnings growth return: %ΔE
■ Expected repricing return: %ΔP/E
Define Term premium
Term prem = Rf bond - Rf bill
Elaborate Equity Premium
Equity Return vs Rf bill (old fashion)
Equity Return vs Rf bond (current trend)
Because of their volatility, these premium are not very useful for predicting.
Compute Singer - Terhaar model
We divide the market into 2
Fully integrated model
Fully segmented model
Bi,M = corr i,M (stdi/sdtM)
If the market is global,
RPi = Corr i,GM * std i (RPGM/ std GM)
If the market is segmented,
RPi = 1* RPi = 1*std i (RPS/std S)
We combine both now:
RP = wRPG + (1-w) RPS
Always add back the Rf rate to arrive at the final Expected return.
Summary of the Singer - Terhaar model
1) compute the integrated approach
corr * vola * share ratio
2) compute the segmented approach
vola * sharpe ratio
3) multiply the approaches with the respective weights
Equity risk in EM
The main risk beside liquidity constraints reside in expropriation, insider dealings, dominant shareholders.
Elaborate on RE return
Historical return in RE tend to suffer from lag reporting, smooth averages and distorted volatility and correlation with the market.
Elaborate on RE cycles
RE are very cyclical, with fixed supply at any point in time. High quality properties have little turnover. Lower quality properties are more subject to the whim of the economy.
Elaborate Cap in RE
Cap rate is a standard metric for commercial RE
Cap rate = NOI / Property value
Elaborate Expected return in RE
Expected return = Cap rate + NOI growth rate.
In the short run
Expected return = Cap rate + NOI growth rate - %Δ Cap rate
In the long run, the NOI growth rate = GDP growth rate
Cap rate will diverge based on the usage, the quality and geography of the RE. Higher vacancy should induce higher cap rate.
Elaborate on the Risk premium perspective on RE
Effective duration is a key characteristic in broad assessment of the likely performance of RE. RE expected returns fall between those of bond and equities. Indeed they are a combination of (term prem) + (credit prem) + (stock like prem). Liquidity prem should be taken into account. RE are still geographically very segmented.
Public RE vs Private RE
Deleverage REIT have much more similar return to direct RE than leverage REIT. Deleverage reduces by half the vola while marginally reducing the return.
Public and private RE are very different. Private RE are less correlated with capital markets.
REIT act like stock in the short run and like RE in the long run.
Forecasting FX
Trade flow (very limited impact)
- PPP (hold over long term + inflation is determined by money supply)
- Competitiveness and sustainability of the current account.
Adjustment will tend to be gradual and depend on the initial situation and its sources.
Forecasting FX and implication of capital mobility
The expected changes in the FX will reflect the =/= in nominal short term interest rates (r), term premium , credit premium, Equity premium and liquidity premium . The currency with the higher risk premium is expected to depreciate to the other
Uncovered interest rate parity
Δ E(ΔSd/f) = Rf - Rd
Uncovered interest rate parity does not hold well, this allows carry trade.
Higher interest rate and ERP will make the currency appreciate in the short run. This will eventually reverse to LT PPP.
