R15 - Application of Economic Analysis to Portfolio Management Flashcards
Steps to develop capital market expectations?
- determine relevant factors for investor: TH, allowable asset classes, other
- Determine historical perf and driving factors of asset classes
- Identify valuation model and methods to use
- Identify best sources of info
- Interpret current market conditions
- Document current capital market expectations
- Monitor results and refine
Capital market forecasts should be:
consistent unbiased objective well supported accurate (min forecasting errors)
What are some limitations in economic data?
- data available in time lag and subject to revision
- inconsistent definitions and calculation among sources
- indexed and rebased
What are some errors and biases that can exist in data?
- transcript error: numbers wrong
- survivorship bias: overstate return, understate risk
- smoothed data on illiquid assets
How smoothing works and consequences?
- illiquid assets infrequently traded/priced
- analysis implicitly assumes continuous price change between two points
- risk calculations unrelated and correlation closer to 0
What are some challenges to forecasting?
-Ex post understate ex ante risk: what actually happened may understate what can happen in future
- history-based estimates have limitations:
- –future diff from past
- –regime change may have happened b/c fundamental factors changed
When selecting time periods:
- longer time periods + more frequent observations increase data quality
- shorter periods less likely to include regime changes
- use longer periods unless:
- –reason to believe fundamentals have changed
- –stat analysis of sub-periods reveals nonstationarity
Analyst forecasting biases?
- data mining - keep analyzing until find pattern even if not real
- time period bias - relationship holds in one period but not another
- failure to condition data - e.g. using past nominal return without considering inflation
- mistaking correlation for causation
- psychological biases
- –anchoring trap
- –status quo
- –confirmation bias
- –overconfidence
- –prudence
- –availability
- model risk
- –selecting wrong model
- –input uncertainty
Using statistical tools for setting capital market expectations:
- If have stationary data, use historical return, variance, and correlations
- –use arithmetic avg for one period estimates of return
- –use geometric avg for multiperiod - Apply shrinkage estimate to historical data
- –i.e. use weighted avg of historical return and model estimated return - Apply time series analysis
- –sometimes see volatility clustering (shortrun volatility can persist) - Use multifactor models when have more than one driver of returns
Benefits of using multifactor models to unify statistical modeling?
- relates returns to common factors
- reduces noise
- factors can generate internally consistent covariance matrix
Gordon growth model:
E(R) = (Div1/P) + g_nominal
Grinold Kroner model:
Return = Div1/P + I + g - (% change in shares outstanding) + (% change in P/E ratio)
risk premium approach with bonds: what factors used?
risk free rate inflation premium default risk liquidity maturity taxes
risk premium approach for equity
long term bond yield + equity risk premium
Financial equilibrium formula for market ERP
ERPi = correlation with global portfolio x standard deviation of I x (ERP_m/std dev_m)
What is full integration of a market?
can fully diversify
What is full segmentation of market?
cannot diversify at all
Calculate ERP considering degree of integration/segmentation:
Steps:
1. Calculate ERP for the asset under full integration (corr x std dev x sharpe ratio of market) and full segmentation each (std dev x sharpe ratio of market)
- Weight ERP based on degree of integration and segmentation
- Add risk free rate to get expected return
- may have to add liquidity premium if in a problem
Beta formula:
beta = Covariance (ri,rm )/Variance of Market
Covariance formula:
Covariance.i,j = B.i x B.j x std dev ^ 2 of market
How inflation behaves at diff points in business cycle:
expansion phase - inflation increasing
declining phase - inflation decreasing
What happens during business cycle: Initial Recovery
Economic effects: exit recession -gov stimulates through policy -consumer confidence increasing -inflation declining initially
Capital market effects:
ST rates low or declining
LT rates bottoming and bond prices peaking
Stocks do well anticipating economic recovery
What happens during business cycle: Early Expansion
Economic effects:
- economy growing faster than trend
- output gap shrinks
- policy less stimulative
- increasing confidence
- inflation low
Capital market effects
- ST rates increasing
- LT rates bottoming/increasing, bond prices start declining
- Stocks improving
What happens during business cycle: Late Expansion
Economic effects:
- GDP growth above trend, but slowing
- policy becoming restrictive
- consumer confidence excessive
- inflation increasing
Capital market effects:
- ST rates increasing
- LT rates increasing with bond prices declining
- Stock prices volatile/topping out
What happens during business cycle: Slowdown
Economic effects:
- GDP still above trend but growth below trend and turning negative
- policy turning neutral
- consumer confidence peaking
- inflation still increasing
Capital market effects:
- ST rates peaking then declining
- LT rates high and the declining, bond returns favorable
- Stock prices declining in anticipation of recession
What happens during business cycle: Recession
Economic effects:
- 2 consecutive quarters of negative real growth
- output gap increasing
- policy easing
- consumer confidence weak
- inflation peaking
Capital market effects:
- ST/LT rates declining
- Bonds doing well
- Stock prices turn up later in recession
Is increasing Inv/S ratio due to Inv up or due to S down a positive or negative economic sign?
if Inv up = positive sign
if Sales down = negative sign
Components of GDP?
GDP = C + I + G + net exports
C = consumer spending
I = Investment (i.e. business capex and inv spending)
G = gov spending
Net exp = exports - imports
Monetary policy: how does gov affect ST rates?
Increase money supply -> lowers ST rates -> stimulates economy
decrease supply -> raises rates -> slows economy
Deflation effect on interest rates?
can have zero interest rates
What is fiscal policy?
managing the budget deficit
deficit = G - T
increase deficit to stimulate economy and vise versa
Taylor Rule formula:
expected ST rate = policy neutral rate + .5(exp - trend GDP growth) + .5(exp - acceptable inflation)
Asset returns when inflation is at or below expectations?
- cash/bonds do well with stable/declining yields
- equity favorable with predictable economic growth
- real estate neutral, with typical returns
Asset returns when inflation is above expectations?
- cash does well with increasing yield
- bonds bad as prices fall
- equity bad, unless company can pass through inflation with price increases
- real estate does well as asset values increase with inflation
Asset returns with deflation?
- cash: low return with ~0% interest rate (gains real purchasing power)
- bonds: attractive; future cash flows greater purchasing power
- equity: bad; economic activity falls and asset values fall
- real estate: bad with declining property values
What happens to yield curve when fiscal + monetary policy expansive?
sharp upward slope
economy likely to expand
What happens to yield curve when fiscal + monetary policy restrictive?
yield curve downward sloping
economy likely to contract
What affects changes in employment levels?
population growth
labor force participation
What affects productivity and capital?
spending on capex
total factor productivity growth
sound banking system + reasonable gov policies
Two factors that affect economic growth?
changes in employment levels
changes in productivity and capital
What is consumer spending driven by and what does it tend to do for economic growth?
permanent income
stabilizes economic growth
What can capex in excess of economic growth do to returns on capital and equity returns?
may limit them
Pro growth governmental policies:
- don’t interfere with free markets
- support infrastructure and human capital development
- competition, free trade, capital flows
- sound tax policy: lower and predictable
- sound fiscal policy: counter cyclical, but balanced over economic cycle
- –avoid twin deficit problem
Describe twin deficit problem:
large budge deficit G>T associated with large acct deficits (exports < imports)
what happens?
If gov spending financed domestically
- –increases interest rates
- –crowds out business borrowing and capex spending
If financed from foreign investors
- –inflation devalues debt
- –lower G and higher Taxes to repay debt, but slows growth
Macroeconomic linkage means two economies are linked by what?
International trade
Capital flows
When two economies are linked by macroeconomic links, what does a recession in one country do?
Imports decline, trading partner exports decline
Investment spending in trading partner declines
When a country pegs their currency to another, what does that mean? What are some impacts on interest rates?
Peg at certain rate of other currency. Must follow other country’s economic policies
Pegging country int rates typically higher than pegged country
Interest rate differential fluctuates with market’s confidence in the peg
If there is no currency peg, and currency perceived as overvalued + expected to fall, interest rates will be what?
Higher? Or lower?
Higher to compensate investors for the expected decline.
Do relative nominal/real bond yields increase or decrease with a strong economy?
They increase.
What is a key warning sign of irresponsible fiscal and monetary policies?
Gov deficit/GDP ratio > 4%
What is a key warning sign of insufficient real economic growth to satisfy expectations of the population in an emerging economy?
Growth < 4%
What is a key warning sign of overvalued currency supporting a twin deficit problem financed by foreign borrowing (budget and current account deficit) in an emerging economy?
Current account deficit > 4% of GDP
What is a key warning sign of excessive foreign denominated debt in an emerging economy?
Foreign debt/GDP ratio > 50%
What is a key warning sign of inadequate short term liquidity to service foreign debt in an emerging economy?
Foreign currency reserves/ST foreign currency debt ratio < 100%
What is a key warning sign of a risky political situation in an emerging economy?
Policies not supportive of growth.
How to forecast asset class: cash equivalents?
Increase maturity if ST rates expected to decrease
Decrease maturity if ST rates increase
Adjust credit quality based on perception of credit risk
How to forecast asset class: default free bonds?
Forecast changes in LT rates:
Increase/decrease maturity if LT rates exp to decrease/increase
Long focused investors should forecast changes in inflation
Short focused investors should forecast business cycle and changes in demand for funds
How to forecast asset class: credit risky bonds?
Forecast changes in credit spread:
Avoid widening spread
-spreads widen in recession as defaults increase
How to forecast asset class: foreign denominated emerging market debt?
Forecast country’s economic and political policies:
- avoid widening spread
- the bonds cannot be paid by printing money or inflating away the debt
- politics must support sound economic policies to service debt
How to forecast asset class: inflation indexed bonds?
Forecast changes in real yield and demand for inflation protection:
- coupon payment based on real rate applied to principal that adjusts with inflation
- if real rates increase/dec the bond prices will dec/inc
- if desire for inflation protection increases/dec the bond prices will inc/dec
How to forecast asset class: common stocks?
Forecast changes in earnings and multiples:
- earnings growth is trend of economic growth
- earnings grow faster/slower in Econ expansion/contraction
- P/E tends to increase/decrease in anticipation of economic expansion/contraction
How to forecast asset class: emerging market stock?
Forecast G-7 business cycle:
-returns inc/dec when developed market economies expand/slow
How to forecast asset class: real estate?
Lower int rates decrease cap rates and increase prices
Increasing demand for property increases prices
Describe purchasing power parity.
Higher relative inflation associated with currency depreciation.
High economic strength does what for capital flows and currency?
Attracts capital
Raises currency
Capital flows: Best investment opps do what for capital flows and currency?
Attracts capital
Appreciates currency
Describe the Savings-Investments Imbalances approach to forecasting exchange rates.
If have inadequate domestic savings, the country requires foreign savings
So
It raises rates to attract capital and thus currency value
