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CFA Level 3 > REVISED Capital Market Expectations > Flashcards

REVISED Capital Market Expectations Flashcards

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1
Q

What is the basic framework/steps for determining asset class expectations?

A
  1. Specify the set of expectations needed including time horizon - generate a list of asset classes
  2. Research the historical record - understand the factors that matter
  3. Specify the methods and models to use
  4. Determine the best sources of information
  5. interpretation of current investment environment
  6. Provide the set of expectations
  7. Monitor actual vs expectations
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2
Q

What are the characteristics of a quality forecast?

A

consistent, unbiased, objective, well supported

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3
Q

What are the limitations of the quality of our forecasts?

A
  1. Limitations on data - there may be time lag
  2. Data measurement errors and biases. This includes transcription errors, survivorship bias, appraisal indices
  3. Limitations of historical estimates
    Things change - technology, regime changes, regulatory changes
    Data will not all have the same number of observations
  4. Ex post risk is a biased measure of ex ante risk - fears that never came to fruition will not show in economic data but could have reflected in volatility in the past
  5. Biases in methods - data mining and time period biases (time specific results)
  6. Failure to account for conditioning information
  7. Misinterpretation of correlation - absence of correlation does not mean no relationship
  8. Psychological traps
  9. Model uncertainty
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4
Q

What are psychological traps when forecasting returns?

A
  1. Anchoring
  2. Status quo
  3. Confirming evidence - confirmation bias
  4. Overconfidence
  5. Prudence trap - don’t want extreme forecasts
  6. Availability bias
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5
Q

What is the difference between cycles and trends?

A

Trends show long term activity while cycles happen in the short to mid term. Trend is driven by slowly changing factors or exogenous shocks.

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6
Q

What are examples of types of exogenous shocks?

A
  1. Policy changes -
  2. New products and technology
  3. Geo-politics
  4. Natural disasters
  5. Natural resources and critical inputs
  6. Financial crises, although this is also endogenous in theory
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7
Q

How do we form long term expectations of the average growth rate?

A
  1. Growth from labour inputs

2. Growth from labour productivity

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8
Q

what causes growth from labour inputs?

A
  1. Potential potential labour size

2. Growth in participation

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9
Q

What causes growth from labour productivity?

A
  1. Growth from capital inputs

2. Growth from total factor productivity

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10
Q

How do we estimate the total value of market equity?

A

MV = GDP * Share of GDP in profit * PE (stable in long run)

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11
Q

What are the three main approaches to economic forecasting?

A
  1. Econometric - system of equations
  2. Economic indicators - lagging, coincident, leading indicators, although revision in indicators will cause hindsight issues
  3. Checklist approach
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12
Q

What are the pros and cons of econometric forecasting models?

A

Pros:
1. Robust and examine the effect of many variables
2. Quick output using new data
3. Delivers estimates of impact due to changes
4. Imposes consistency
5. Simulate the effect of exogenous variables
Cons:
1. Complex and time consuming
2. Misspecified models and nonstationarity
3. False sense of precision
4. Doesn’t forecast turning points
5. Requires forecasts for exogenous variables which increases error

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13
Q

What are the pros and cons of economic indisctors for forecasting models?

A 
Pros:
1. Intuitative and easy to construct
2. Limited number of variables
3. Focuses on identifying turning points
4. Easy to track
Cons:
1. Overfitting in sample data
2. False signals
3. Binary direction but no magnitude
4. Look ahead bias due to indicator revisions over time
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14
Q

What are the pros and cons of checklists for forecasting models?

A 
Pros:
1. Flexible
2. Can incorporate structural changes easily
3. Breadth
Cons:
1. Subjective, arbitrary, judgemental
2. Time consuming
3. No level of consistency
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15
Q

What are the phases of the typical business cycle?

A
  1. Initial recovery
  2. Early Upswing
  3. Late Upswing
  4. Slowdown
  5. REcession
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16
Q

Describe the initial recovery phase of the business cycle?

A
  1. Picks up from recession
  2. Business confidence rises
  3. Fiscal and monetary stimulus still exists
  4. Typically investories are growing
  5. Yields start to bottom
  6. Stocks rally, specifically HY bonds and cyclical stocks
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17
Q

Describe the early upswing phase of the business cycle?

A
  1. Confidence grows
  2. no inflation yet
  3. Unemployment falls
  4. Business investment grows
  5. Short rates move up, long rates stable
  6. Stocks go up
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18
Q

Describe the late upswing phase of the business cycle?

A
  1. Output gap closed
  2. Wages growing
  3. Wages grow
  4. increased equity vol
  5. Hawkish monetary policy
  6. unemployment is low
  7. Short rates rising
  8. Inflation hedges perform, cyclicals do not
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19
Q

Describe the slowdown phase of the business cycle?

A
  1. Slowing economy
  2. Confidence dropping
  3. Inflation is strong
  4. Less inventory
  5. Short rates top out
  6. Long rates go lower (invert)
  7. Stocks become soft
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20
Q

Describe the recession phase of the business cycle?

A
  1. Rates drop
  2. Large inventory pullback
  3. Durable good sales drop
  4. Stocks drop, but bottom out before the end
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21
Q

How is inflation related to the business cycle?

A

It is procyclical, where the term structure is upward sloping during recoveries and downward sloping during peaks

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22
Q

How does inflation effect bonds?

A

Rising inflation means a higher discount rate = lower prices

Inflation expectations also increase the discount rate.

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23
Q

How does inflation effect stocks?

A

If inflation is at expectation, there is little effect. Higher than expected inflation may slow down the economy, but lower rates could result in a decline in asset.

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24
Q

What effects should monetary and fiscal policy have on capital market expectations?

A

Monetary policy will effect cycles, but fiscal policy will effect trend growth

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25
Q

What is the Taylor rule?

A

Nominal Rate target = Neutral Target Rate + Inflation expectations + 0.5(Expected GDP - Trend GDP) + 0.5(Expected Inflation - Target inflation)

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26
Q

What would you expect from rates when fiscal and monetary policy are both loose?

A

You’d expect higher real rates and higher expected inflation, resulting in higher nominal rates

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27
Q

What would you expect from rates when fiscal policy is loose and monetary policy is tight?

A

You’d expect high real rates and low expected inflation, resulting in mid nominal rates

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28
Q

What would you expect from rates when fiscal policy is tight and monetary policy is tight?

A

You’d expect low real rates and low expected inflation, resulting in low nominal rates

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29
Q

What would you expect from rates when fiscal policy is tight and monetary policy is loose?

A

You’d expect low real rates and high expected inflation, resulting in mid nominal rates

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30
Q

How does the shape of the yield curve change over the business cycle?

A
  1. Initial recovery - steep curve
  2. Early expansion - front steepening but back half is flattening as mid rates increase
  3. late expansion - flattening from long inwards
  4. Slowdown - flat to inverted
  5. Recession - steepening
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31
Q

What are the important international interactions we need to consider when forecasting asset returns?

A
  1. Macro linkages - trade, FDI, capital flows - if you have government deficits and net imports you must fund using savings, likely another countries savings
  2. Interest rate and FX rate linkages
    You cannot simultaneously
    a) Allow unrestricted flows
    b) Maintain a fixed rate
    c) Pursue independent monetary policy
32
Q

Under what situation would you expect permanent convergence between two country yield curves?

A
  1. Unrestricted capital flows

2. FX rate is credibly linked forever

33
Q

How do we forecast fixed income returns using DCF principles?

A

We compare MacDuration to investment horizon and expected changes in yield. When Duration is higher than the horizon, capital gains dominate reinvestment.

34
Q

How do we forecast fixed income returns using the building block method?

A

We add up…

  1. One period default free rate (real rate + expected inflation) - typically rolling over 30day TBills
  2. Term premium
  3. Credit Premium
  4. Liquidity premium
35
Q

What are the four main drivers of the term premium?

A
  1. Inflation uncertainty compounded over time
  2. Ability to hedge recession risk
    If the bonds are a good equity hedge it means they are negatively correlated. This typically happens in an economy where demand drives up growth and inflation. Bonds are a bad equity hedge when the supply drives growth as this supply shifting outward would not increase prices and inflation. Good hedges have lower premiums.
  3. Supply and demand of bonds across maturities
  4. Cyclical effects - bond returns are often countercyclical with growth, as good economic data will often cause negative bond returns in the next period.
36
Q

How does the spread on HY bonds change with the business cycle?

A

HY spreads are countercyclical, so increases in rates have less of an effect. The interest rate risk is a minor component. Increases in interest rates coincide with good economic results, which reduces HY spreads.

37
Q

What are the components of a credit spread? What are they driven by?

A

Two components are the default rate and the credit premium. Credit premium in IG bonds reflects migration risk, whereas in HY bonds it reflects default risk.

38
Q

What features drive increased liquidity in bonds?

A
  1. Priced near par
  2. New
  3. Large issuer
  4. Well known issuer
  5. Simple
  6. High Quality
39
Q

Why are EM bonds more risky?

A
  1. More concentrated tax base
  2. Less diversification across industries
  3. Restriction on capital flows
  4. Poor fiscal controls
  5. Reliance on foreign borrowing
  6. Less sophisticated financial markets
  7. Susceptible to capital flight
40
Q

What are some red flags when investing in EM bonds?

A
  1. Fiscal deficit > 4% GDP
  2. Debt/GDP > 70-80%
  3. GDP growth < 4%
  4. Current account deficit > 4% GDP
  5. Foreign debt > 50% GDP
  6. FX reserves < 100% of ST debt
41
Q

How do you calculate expected equity returns using the GGM?

A

r = D1/P + g

G can be simplified to long term trend growth (real GDP and expected inflation)

42
Q

How do you calculate expected equity returns using the Grinold-Kroner Model?

A

Expected Return = (D/P - Change in Shares) + Nominal earnings growth + Multiple Expansion

43
Q

What is the basic premise of the Singer & Terhaar equilibrium ERP approach?

A

It is a combination of two CAPM models that integrates how segmented a market is from the rest of the world.

44
Q

How do you calculate the Singer Terharr ERP?

A

R for global market = Correlation * SD of country *(RP GM / SD GM) OR
Correlation * SD of country * SR of GM
Correlation * SD of country/SD of GM is the covariance/beta

R for country market = SD of asset * Sharpe Ratio
Weight total return by level of integration

45
Q

What are the additional risks to EM equities?

A
  1. Corporate governance risks as ownership claims may be expropriated by insiders or dominant shareholders
  2. Interested parties may misuse company assets
  3. Weak disclosures and accounting rules mean less transparency
  4. Weak checks and balanced on government actions creates regulatory uncertainty on whether companies could have property seized or be nationalized.
46
Q

What is unique about real estate cycles?

A

Supply is typically fixed in the short run, so it is very cyclical.
Higher quality properties are less cyclical as leases are long term in nature and there is low turnover
Lower quality properties are more sensitive to the overall economy as they have shorter leases and higher turnover

47
Q

Draw and explain the boom or bust real estate cycles

A
  1. Perceptions of rising demand, values, occupancy
  2. Development of new properties
  3. Second reinforces the first
  4. Overbuilding
  5. Years for excess supply to be absorbed
48
Q

How do we use cap rate to project real estate returns?

A

Expected return = NOI/Price + g
In the short run we can subtract multiple expansions.
It is negative because we assume that NOI and property values grow at a certain rate. If cap rates increase, this means price is not going up as fast as the cap rate, which means returns will be lower than expected

49
Q

Explain how cap rates are both procyclical and countercyclical with interest rates and the economy

A

They are procyclical with interest rates - higher rates means lower prices which increases cap rate
They are countercyclical as they are related to credit spreads. When rates rise the economy is good, so spreads often tighten.

50
Q

What are the risk premiums use to calculate expected real estate returns?

A
  1. Term premium - sensitive to long rates
  2. Credit premium - tenants
  3. Equity risk premium - owner bears full risk of fluctuations
  4. Liquidity premium
51
Q

How do you calculate real estate projected returns using an equilibrium model?

A

Yes:

1) Unsmooth data
2) Add liquidity premium as equilibrium models assume full liquidity
3) Show low integration due to local effects

52
Q

What are the main factors to consider in an FX forecasting model that considers trade in goods and services

A
  1. Trade flows - how large are net trade flows relative to economies.
  2. PPP - not good though as it ignores that not all goods are freely traded
  3. Sustainaiblity of current account position
53
Q

How are current account balanced related to FX?

A

If you have a current account deficit (X-M) but your investment is high it is pretty sustainable. However, a trade deficit combined with low savings and government deficits it means that the deficits are being used for consumption.

54
Q

If one country has higher risk adjusted returns than another, what should happen to the exchange rate?

A

The higher country would actually decrease based on the overshooting argument - people must hold the currency until returns are realized then people will sell.

55
Q

What is the theory of portfolio balance suggest about the fx rates of countrys?

A

Countrys with trade deficits must finance their spending with increased foreign borrowing. Surplus nations will receive wealth in that currency, but may own too much. They may want to rebalance their portfolio which will crush the deficit country.

56
Q

Why does it make sense that a country with a prolonged deficit will experience currency depreciation?

A

The deficit country financed will experience major depreciation as they will need to rebalance the current account - depreciation will encourage exports.

57
Q

What does the theory of portfolio composition suggest about FX rates?

A

Investors may allocate their investments to countries who are in the beginning of a business cycle, which drives up currency. In the long term, relative trend growth and current account balances will drive currency.

58
Q

How do we forecast volatility using a multi-factor model?

A

We use common risk factors among assets to avoid needed to have massive amounts of data for normal VCV matrices.
The way to do this is to measure the factor Beta for the portfolio and construct a VCV of those factors.
This will contain less estimation error compared to using small samples.
It will improve cross sectional consistency and handle a larger number of assets. However, it will be biased and inconsisteny

59
Q

What is the primary difference in accuracy of normal VCV matrix models and VCV multi factor models for forecasting volatility?

A

Normal VCV models are unbiased and consistent in that they are estimating the right thing but there is a lot of error due to sample size. Multifactor VCV are not directly measuring variance of assets and therefore are biased and inconsistent. However, they are relatively precise.

60
Q

Explain what the shrinkage estimation of VCV matrices means

A

This is a case where you take the sample VCV matrix (normal) with a specific weighting and another VCV matrix weighted.

61
Q

How do we estimate unsmoothed returns?

A

You will unsmooth current returns by conceiving true returns as some weighting between past observed returns and true returns that are unobservable. For example, if you are appraising monthly, you will take last months appraisal weighted plus some current true return by a proxy.

62
Q

What model would you use to measure time varying volatilities?

A

An ARCH model

63
Q

How does trend growth affect where our assets should be allocated?

A

If trend growth is up, you want equities and don’t want bonds as real rates will go up.

64
Q

How does the level of global integration affect required return rates?

A

As country’s become more integrated, required returns should go down due to lower risk.

65
Q

How do current account balances affect how we should allocate portfolio assets?

A

Rising deficits creates upward pressure on real required returns, causing asset prices to drop.

66
Q

What does the trades in goods and services approach to forecasting exchange rates consider?

A
  1. Exports and imports relative to economy size
  2. Inflation differentials and the concept of PPP
  3. Sustainability of current account
67
Q

What does the capital flows approach to forecasting exchange rates consider?

A
  1. Capital seeks the highest risk adjusted returns

2. Portfolio assets of currencies affect the desire to hold FX

68
Q

What indicates an efficient active approach?

A
  1. Lower active risk
  2. Fewer securities
  3. Higher active share
69
Q

How does unexpected inflation affect stock returns?

A

Negatively

70
Q

How do you calculate growth from labour productivity?

A

= Growth in capital inputs + TFP growth

71
Q

How do you calculate GDP trend growth?

A

= Growth in productivity + Growth in labour force size + Growth in actual participation

72
Q

Uncertainty around maintaining a currency peg typically leads to…

A

Higher rates

73
Q

What do intertemporal and cross sectional consistency mean and why are they relevant?

A

Intertemporal = across time
Cross Sectional = across asset classes
This is important as assumptions for asset classes must reflect the high degrees or correlation within asset classes.

74
Q

Which economic research method is a small firm with limited resources likely going to use?

A

A leading indicators approach as it may be available by third parties.

75
Q

What is the trade flows approach to forecasting FX rates?

A

This is the general belief that trade flows do not have a significant impact on exchange movements, provided they can be financed. The only concern is if trade flows are very high relative to the size of an economy.

76
Q

What are the three stages of the overshoot mechanism?

A
  1. FX appreciate due to attractive returns
  2. Consolidation
  3. Retraction

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