Reading 2 - Attempt 2

Question 1

Central Tendency

Answer 1

Investment techniques assume that investments tend to return to their fundamental levels over time

Question 2

Shrinkage estimate

Answer 2

weighted average estimate based on history and some other projection

Question 3

How does investment horizon and Macaulay duration relate to each other?

Answer 3

1. If investment horizon is shorter than Macaulay duration, the capital gain/ loss impact will be more dominant that the reinvestment impact, meaning falling interest rates will result in higher realized return and rising interest rates result in lower realized return
2. If investment horizon is longer than Macaulay duration, reinvestment risk dominates, meaning that falling interest rates will result in lower realized return and rising interest rates will result in higher realized return

Question 4

What is the formula for Macaulay duration

Answer 4

Macaulay Duration = Modified duration x (1+YTM)

Question 5

Credit premium - downgrade bias

Answer 5

asymmetrical risk indicating that a downgrade is more likely than a credit improvement or an upgrade

Question 6

How do credit premiums relate to maturity?

Answer 6

credit premiums are not positively related to maturity. Credit premiums tend to be higher at shorter maturities, possibly due to event risk (defaults are large credit negative events, but a bond will not pay more than its face value) and iliquidity (bonds with short time left to maturity tend to be illiquid older bonds that are not actively traded).

Question 7

What is a barbell strategy?

Answer 7

Credit risk from shorter maturity bonds and duration risk from long maturity

Question 8

Expected total risk premium for 2 securities - one is a government bond, one a corporate

Answer 8

take the average of the risk premium (ex rf). So even if govt risk premium = 0, divide the other by 2 to get average.

Question 9

Emerging market bond risk indicators

Answer 9

1. Deficit to GDP: more than 4%

debt to GDP: 70-80%

expected real growth rate: atleast 4%

current account deficit: exceeding 4% of GDP

foreign debt levels greater than 50% of GDP. Higher than 200% - high risk

foreign exchange serves less than 100% of short term debt (greater than 200% is considered strong)

Question 10

Grinold-Kroner Model

Answer 10

expected return of s tock = dividend yield + inflationr ate + real earnings growth rate - change in stock outstanding + change in P/E

or Expected cash flow return (D/P - $ change in S) + expected nominal earnings growth ( inflaton + real growth rate) + expected repricing return (% change in P/E)

Question 11

Grinold-Kroner for extremely long term

Answer 11

% change in P/E = 0 (and also % change in S = 0)

Question 12

Singer-Terhaar Model

Answer 12

Step 1: expected equity risk premium of fully integrated market = correlation with global market * standard deviation of your market * sharpe ratio of global market

Step 2: expected equity risk premium = standard deviation of market i * sharpe ratio of market i (use global market sharpe ratio if no specific market ratio is given) + illiquidity premium (if given)

Step 3: take a weighted average given the degree of degmentation

Question 13

Real Estate Cycles

Answer 13

Boom: increased demand will drive up property values and lease rates, which induces construction activity. This higher activity translates to stronger economic activity.

Bust: falling demand leads to overcapacity and overbuilding, driving values and lease rates down. Because leases lock in tenants for longer terms and moving costs are high, excess supply can’t be quickly absorbed.

Question 14

Capitalization or Cap Rate

Answer 14

Commercial real estate property’s earnings yield = NOI / property value

For an infinite time period = expected return on real estate - NOI growth rate

During stable periods, NOI growth rate should be close to GDP growth rate

For infinite time horizon, expected return onr eal estate = cap rate + NOI growth rate - % change in cap rate

NOI growth rate is also a nominal measure, incorporating real growth plus inflation.

Question 15

Risk Premiums for Real Estate

Answer 15

TLCE

Term premium of holding long-term assets

Liquidity premium: 2-4% for commercial real estate

Credit premium: if tenant does not pay

Equity risk premium: above corporate bond returns for the fluctuation in real estate values, leases and vacancies

Question 16

Correlation of REITs with equity market

Answer 16

Generally strongly correlated with equities in the short term, while direct real estate shows low correlation.

However, the low correlation is partly due to smoothing of return data.

Over long time horizons, REITs have a relatively high correlation with direct real estate

Question 17

What adjustments must an analyst make while adjusting risk premiums using equilibrium models?

Answer 17

1. remove the effect of smoothing from the data
2. adjust for illiquidity using liquidity premium

Question 18

How are cap rates related to vacancy rates and availability of debt financing?

Answer 18

Cap rates are positively related to changes in interest rates and vacancy rates. They are inversely related to availability of credit and availability of debt financing

Question 19

How does trade in goods and services impact exchange rates?

Answer 19

PTT

1. Trade Flows: Impact of net trade flows is small on exchange rates assuming they can be financed
2. PPP: real exchange rate changes are zero, but in reality doesnt work in short term. Also PPP does not account for trade barriers and capital flows. Exchange rates may also be influenced by economic development independent of PPP.
3. Current account and exchange rates: Current account balances will have the largest influence on exchange rates when they are persistent and sustained. However it is not the size of the current account balance that matters as much as the length of the imbalance.

Question 20

How does capital mobility impact exchange rates?

Answer 20

1. Capital mobility: when there is relative improvement in investment opportunities in a country, the currency initially tends to see significant appreciation, but overshoots and eventually depreciates. There are 3 phases of the response to stronger investment opportunities: exchange rate will initially appreciate, following an extended level of stronger exchange rates in the intermediate term, investors will start to expect a reversal and the exchange rate in the long run will tend to start reverting (Depreciate) once the investment opportunities have been realized.

UIP: UIP states that exchange rates should equal differences in nominal interest rates. However carry trades prove it wrong (borrow in low yielding currency and lend in high rate currency).

3. Portfolio balance and composition: home country bias, if growth due to productivity gains investors may fund it with financial flows and FDI, higher trend growth rates are usually smaller EM, etc.

Question 21

Hot Money

Answer 21

Related to capital mobility

when capital flows into a country given exchange rate differentials. Hot money creates monetary policy issues.

1. central banks ability to use monetary policy effectively is limited.
2. firms use short-term financing to fund long-term investments, which increases financial market risk.
3. exchange rates tend to overshoot, creating business disruption. Central banks may try to counter the effects of hot money flows through intervention in the currency markets, including selling government securities or maintaining interest rate targets.

Question 22

Volatility forecasting: Sample VCV Matrix

Answer 22

no. of observations should be at least 10 time slarger than the number of portfolio assets

Question 23

Advantage of factor based VCV Matrices over same based

Answer 23

significantly reduces the number of required observations. correlations can be estimated using a few common factors, while variances require factors related to specific assets.

VCV needs [(N(N-e)/2] covariances; factor model needs only N*K factor sensitivities and [K(K+1)/2] factor elements.

Question 24

Shortcomings of factor based VCV Matrices

Answer 24

1. the matrix is biased: matrix inputs need to be estimated and will be misspecified. as a result, the matrix will be biased, meaning it will not be a good predictor of the true returns, not even on average
2. the matrix is inconsistent: As the sample size increases in the factor-based VCV matrix, the model does not converge to the true matrix. In contrast, the sample VCV matrix will both be consistent and unbiased.

Question 25

Shrinkage estimates to measure volatility

Answer 25

weighted average estimate of sample and target (ie factor based) matrix, with the same weights used for all elements of the matrix, including the variance and covariance factors. Even though shrinkage estimates may be biased, more precise (less biased) matrices will result in greater improvement.

Question 26

Smoothed Returns to Estimate Volatility

Answer 26

Rt = ( 1- lambda) r1 + lamba rt-1

variance = [(1+ lambda)/ (1 - lambda)] * Variance of R

Question 27

Volatility clustering

Answer 27

asset returns generally show periods of high and low volatilitie,s leading to volatility clustering. These volatilities can be addressed through autoregressive conditional heteroskedasticity (ARCH) models.