Reading 2 Flashcards
Central Tendency
At their core, investment techniques assume that investments tend to return to their fundamental value over time.
Approaches to forecasting capital market expectations
- formal tool
- surveys
- judgements
Shrinkage estimate
weighted average estimate based on history and some other projections
Time series estimate
forecasts a variable using lagged values of the same variable and combines it with lagged values of other variables, which allows for incorporating dynamics (volatilities) into the forecasts
Modified Duration
Macaulay Duration / (1+YTM)
Decline in bond yields given modified duration and YTM
If Macaulay duration (modified duration * YTM) is longer than the investment horizon, decline in bond yields will result in realized return higher than YTM because gain on the bond price will outweigh the decline in reinvestment yield
Drivers of term premium
- inflation uncertainty
- recession hedge
- supply and demand
- business cycles
Recession hedge as driver of term premium
When inflation is caused by strong AD, nominal bond returns are negatively correlated with growth, corresponding to low term premiums. When inflation is caused by aggregate supply, nominal bond returns are positively correlated with growth, corresponding to higher term premiums.
Barbell strategy
take credit risk from shorter maturity bonds and duration risk from long maturities
Fiscal policy guage
Deficit to GDP ratio
If more than 4%, indicates substantial credit risk
Emerging market debt guage
Debt to GDP ratio of 70% to 80% - troublesome
Current account deficit gauge
If current account deficit excees 4% of GDP - has been a warning sign of potential difficulty
Foreign debt levels for judging EM
if more than 50% of GDP - overleveraged country; debt levels greater than 200% in general of the current account receipts also indicate high risk
What are the 2 adjustments that analysts must make to the risk premiums calculated using equilibrium models?
once an analyst estimates the risk premiums using equilibrium models, the analyst should:
1. remove the impact of smoothing from the data
- adjust for illiquidity using a liquidity premium
Foreign exchange reserves for judging EM
If less than 100% of short term debt - sign of trouble; greater than 200% in general: strong
Grinold-Kroner Model
Expected return of a stock is its dividend yield, plus inflation rate, plus real earnings growth rate, minus change in stock outstanding, plus change in PE ratio; also expected cash flow return + expected nominal earnings growth + expected repricing return
Grinold-Kroner model: expected cash flow return
Dividend yield D/P (using expected dividend) minus % of share repurchases
Grinold Kroner - expected nominal earnings growth
real growth in earnings + expected inflation (% change in E)
Grinold-Kroner: expected repricing return
expected change in P/E ratio
Equity risk premium
amount by which the equity return exceeds risk free rate
List 2 adjustments that analysts must make to the risk premiums calculated using equity models
once an analyst estimates the risk premiums using equilibrium models, the analyst should
1. remove the impact of smoothing from the data
2. adjust for illiquidity using a liquidity premium
What are the 3 methods of forecasting fixed income returns?
- DCF
- risk premium approach
- Equilibrium model
How does Macaulay duration and investment horizon work?
- If investment horizon is shorter than Macaulay duration, the capital gain/ loss impact will be more dominant than the reinvestment impact eg falling interest rates will result in higher realized return, rising interest rate will result in lower realized return
- if Investment horizon is longer than Macaulay duration, the reinvestment risk dominates, meaning that falling interest rates will result in lower realized return, while rising interest rates will result in higher realized return
Downgrade Bias in Credit Premium
asymmetrical risk indicating that a downgrade is more likely than a credit improvement or an upgrade
Risk premium approach
rf + term premium + liquidity premium + credi tpremium
Discuss how cap rates are related to changes in interest rates and vacancy rates?
cap rates are inversely related to the availability of credit and the availability of debt financing
What happens if Macaulay duration = investment horizon?
capital loss created by an increase in yields and the reinvestment effects (gains) will roughly offset, leaving the realized return approximately equal to the original yield to maturity. This relationship is exact if:
1. yield curve is flat
2. change in rates occurs immediately in a single step.
Grinold Kroner Model
