R10: CME Framework Flashcards
Is precision in forecasting realistic? If not, what’s the most important thing?
No. Consistency is key, both cross-sectional and intertemporal.
What’s the framework?
- Expectations needed and time horizon
- Historical record, identify factors that drive returns
- Economic and financial market data needed, model to be used
- Best source of info
- Apply model, use experience and judgement
- Conclusions
- Review, monitor and adjust expectations
What are the challenges to economic forecasting?
- Limitations of economic data (time lags, revisions, changes in definitions, rebasing)
- Errors and biases (transcription errors, survivorship bias, appraisal smoothing)
- Limitations of historical estimates (extrapolation, regime changes)
- Bias in analyst’s methods (data mining, time period)
Failure to account for conditional info
Misinterpretation of correlation (not causation, non-linear relationships)
Psychological (anchoring, status quo, confirming evidence, overconfidence, prudence, availability)
Model uncertainty (model, parameter, inputs)
What are the exogenous shocks?
Policy changes (unexpected, significant, persistent) New tech Natural disasters Natural resources Geopolitics Financial crisis
What’s the trend growth of GDP comprised of?
Change in labour inputs (labour force and labour participation rate)
+
Change in labour productivity (capital inputs and total factor productivity)
Anchoring asset returns to trend growth rate: risk free rate and long-run equity appreciation
Link between Rf and growth rate.
Vt=GDPt × Et/GDPt × P/Et
What are the three ways to forecast? What are the pros and cons for each?
Econometric models:
Reduced-form and Structural (econ theory)
+ many variables, can re-use once specified, output quantified and based on consistent relationships
- input error, time consuming, model mis-specified, relationships not static, rarely forecast turning points well
Economic indicators:
+ intuitive, sinple
- revised, look-ahead bias
Checking approach:
+ simple, flexible, can easily add/remove items
- subjective, time consuming, no consistency, manual
What are the different stages of the business cycle?
- Initial recovery (inflation still in decline, stimulators fiscal policies, confidence starts to rebound, short rates low/falling, bond yields bottoming but steep curve, stocks rising strongly)
- Early expansion (healthy growth, inflation low, withdrawing stimulus, increasing confidence, short rates moving up, bonds yields stable to up, yield curve becoming flatter as ST rates rise, stocks trending up)
- Late expansion (inflation picks up, policy becomes restrictive, boom mentality, short rates rising, bond yields rising but more slowly than ST rates, curve continues to flatten, stocks peaking and volatile)
- Slowdown (inflation accelerates, inventory correction, tight policy and tax revenues surge as accumulated capital gains are realised, confidence drops, short rates peaking, bond yields peaking, curve may invert, stocks declining)
- Contraction (output declines, inflation peaks then starts to fall, progressively more stimulative policy, confidence weak, short rate declining, bond yields falling, curve becoming steeper, stocks bottoming then rising)
What happens to cash, bonds, equity and RE/other when inflation is at or less than expected, more than expected or deflation?
At/less: Cash yields neutralor down Bond yields neutral Equity bullish RE CF neutral
More: Cash rates up Bond yields up Negative for financial assets RE prices, CFs and returns up
Deflation: Cash rates close to 0% Bond looser policy Equity low D RE CF neutral or negative, prices down
What’s the Taylor rule?
Roptimal= Rneutral + 0.5(INFLforecast-INFLtarget) + 0.5(◇GDPforecast-◇GDPtrend)
Where Rneutral is nominal.
Time lag and greatest risk of policy mistake at the top of cycle
Why do negative rates make setting CME more difficult?
- Appropriate non-negative Rf?
- Historical positive rates less relevant
- Policies like QE distorting yield curves
Impact of policies on interest rates?
FINS, real rates, expected inflation, nominal rates
- If both loose: all high
- if fiscal loose, monetary tight: high real, low inflation, mid nominal
- if monetary loose, fiscal tight: low real, high inflation, mid nominal
- if both tight: all lowq
What’s the Fundamental macro equation for international interactions?
(X-M)=(S-I)+(T-G)
When can two countries share a risk-free yield (have the same i/r)?
- Perfect capital mobility
- Exchange rate credibly fixed
- Independent MP
- If floating, i/r higher in currencies that are expected to depreciate to equalise risk-adjusted expected returns across markets.
What happens to ST yields vs LT if inflation as expected?
Will increase or decrease much more
