Reading 11: Capital Market Expectations: Part 2

Question 1

Emerging Market Current Account Deficit

Answer 1

When exports are less than imports, a current account deficit usually results. This can be problematic because the deficit must be financed through external borrowing. If the emerging country becomes overleveraged, it may not be able to pay back its foreign debt. A financial crisis may ensue where foreign investors quickly withdraw their capital. These financial crises are accompanied by currency devaluations and declines in emerging market asset values.

Question 2

Purchasing Power Parity

Answer 2

Countries with high inflation should see their currency depreciate. Expected change in exchange rate should follow expected inflation rate. Expected change in real exchange rates should be zero. Better explaining long term than short term. Actual exchange rates can differ due to things like trade barriers or capital restrictions.

Question 3

VCV Matrix

Answer 3

The manager can use the sample VCV matrix if the sample size exceeds the number of assets. However, this will be subject to large sample errors unless the number of observations is at least 10 times the number of assets. The factor matrix approach in this regard is superior because it can be used for any number of assets. However, the factor model is biased (inputs are estimated and not true indicator) and inconsistent (not more accurate with larger sample size). Can use shrinkage estimation of the weighted average of the sample and factor based VCV matrices to solve shortcomings.

Question 4

Credit Premiums

Answer 4

To increase exposure to credit risk, decrease the maturities of credit risky bonds. Essentially shortening maturity, as credit premiums are more generous at the short end of the curve.

Question 5

Emerging Market Signs

Answer 5

The debt-to-GDP ratio of 70% to 80% has been troublesome for emerging countries. A current account deficit exceeding 4% of GDP has been a warning sign of potential difficulty, however the length of deficit is a more important indicator of the future. Foreign exchange reserves less than 100% of short-term debt is a sign of trouble (greater than 200% is considered strong). Real growth rate should be assumed at 4%. Debt levels greater than 200% of current account receipts indicates high risk.

Question 6

Initial Recovery Phase

Answer 6

Inflation is falling so TIPS would be least useful here.

Question 7

Equity Vs Bonds Emerging Markets

Answer 7

Along with political, legal, and economic risk faced by both, equity holders also face corporate governance threats (dominant shareholder, insider revolt).

Question 8

Capitalisation Rate

Answer 8

Long term measure of risk discount rate for real estate property valuations. Positively related to interest rates and vacancy rates (decreases value of property if they go up) and inversely related to the availability of credit and debt financing.

Question 9

Real Estate Risk Premiums

Answer 9

Includes credit risk if tenants don’t pay, premium for fluctuation in real estate values, leases and vacancies (above equity premiums). Overall higher than bonds but lower than equity. Adjust for smoothed results, and the liquidity risk premium.

Question 10

Exchange Rates: Goods & Services

Answer 10

Trade flows: net trade flows (less exports) have little effect on FX if they can be financed.
PPP: prices reflect FX, if inflation is higher than another country the currency will depreciate.
Current account & FX: capital flow restrictions make FX more sensitive to the current account. Largest effect when persistent deficits and sustained (not the size). Structural imbalances: trade preferences, terms of trade, scarce resources.

Question 11

Exchange Rates: Capital Flows

Answer 11

Capital mobility: FX change can be difference between nominal short term rates and risk premiums of domestic portfolio vs foreign portfolio. Relative improvement in investment opportunities appreciates currency but it overshoots then declines.
UIP(uncovered interest rate parity): FX changes in relation to nominal interest rates. Carry trade assumes UIP doesn’t work. Hot money (inflows of capital) causes monetary policy issues, and overshooting FX rates.
Portfolio balance & composition: strong growth in country can cause increase in that country’s currency in global portfolio (decrease in their own currency unless capital stays or productivity gains are funded with foreign investment).

Question 12

Deficit / GDP

Answer 12

A number in excess of 4% is cause for concern.

Question 13

Cyclical Proxies

Answer 13

Cyclical proxies are indicators that influence the term premium and include the corporate profit-to-GDP ratio, business confidence, and the unemployment rate.