Section 1 - R3 - Capital Markets Expectations

Question 1

Subject of the CME Topic (Explain)

Answer 1

Discuss the impact of expectations in building a portfolio

Question 2

CME Framework (List)

Answer 2

1. Specify the set of expectations needed (time horizon, historical records)
2. Search the historical record
3. Specify methods to be used
4. Determine the best sources of information
5. Interpretation of current investment environment
6. Monitor outcomes and compare with the expectations

Question 3

Describe good forecasts

Answer 3

They are (i) consistent, (ii) unbiased, (iii) objective, (iv) well supported, (iv) minimum forecast errors

Question 4

Forecasts Limitations (List)

Answer 4

1. Eco data limitations
2. Data measurement error and biases (transcription, survivorship bias, smoothed data)
3. Limitations of Historical Estimates (past is a starting point but does not dictate future)
4. Risk Ex-Post =/= Risk Ex-Ante
5. Analyst Bias (data mining, time period bias)
6. Failure to account for conditioning information
7. Misinterpretate correlation

Question 5

Psychological Traps (List)

Answer 5

1. Anchoring Trap
2. Status Quo Trap
3. Confirming Evidence Trap
4. Overconfidence
5. Prudence
6. Availability
7. Model Uncertainty

Question 6

Exogenous Shocks (List of Impacts)

Answer 6

• Positive or negative
• New Products and Technology (iPhone)
• Geopolitics (Ucrânia)
• Natural Disasters (Terremoto)
• Financial crises

Question 7

Economic Growth Factors (List)

Answer 7

1. Labor Inputs: ↑ Size and ↑ Participation
2. Labor Productivity: ↑ Capital and ↑ TFP

Question 8

Market Value of Equity (Formula)

Answer 8

Vet = GDPt * Skt * PEt, where

Vet = Value of Equities in t
GDPt = Nominal GDP in t
Skt = Share % of Profits in Economy
PEt = Pricing Adjustment

Question 9

Economic Forecast Types (List)

Answer 9

1. Econometric Modelling
2. Economic Indicators (leading, lagging)
3. Checklist items (Moody’s Country Report)

Question 10

Business Cycle (List of Moments)

Answer 10

1. Initial Recovery: Govt YTM at bottom, stocks rally, riskier assets outperform
2. Early Upswing: ↑ Confidence, ↑ Momentum, no π, ↓ Unemployment
3. Late Upswing: Output gap closes, π ↑, Unemployment @ bottom, ↑ Wages
4. Slowdown: ↓ Confidence, Bonds rally, π strong

Question 11

Inflation Impacts per Asset Class

Answer 11

1. Cash: zero duration, π protected
2. Bonds: hurt with ↑ rates because ↓ prices fall
3. Stocks: π in line with expectations already priced in. Little effect.
4. Real Estate: π already in expectations. Increasing inflation benefits asset class.

Question 12

Taylor Rule (Formula)

Answer 12

Rtarget = Rneutral + π expected + 0.5(GDPe - GDPtrend) + 0.5(πe - π target)

Question 13

International Interactions in Economics (List of Channels)

Answer 13

1. Trade
2. Foreign Direct Investment
3. Capital Flows
4. Interest Rate / FX Linkages

Question 14

Fixed Income Returns

Answer 14

IH < MacDur: Price (Capital Gain) dominates Reinvestment

IH > MacDur: Reinvestment dominates Price

Question 15

Asset Return: Building Blocks Approach (Formula & Concept)

Answer 15

Return = Rf + Term Premium + Credit Premium + Liquidity Premium

Question 16

Emerging Markets Risks

Answer 16

1. Economic: Ability to pay
2. Dependancy: on few industries
3. Trade Restrictions
4. Poor fiscal controls
5. Political risks: regime change
6. Legal risks: weak laws, enforcement of contracts

Question 17

Forecast of Equities (List of Methods)

Answer 17

1. Historical Statistics Approach: samples imprecise
2. DCFs: Sensible to rates, CFs uncertain, terminal value
3. Risk Premium Approach:
   3.a. Risk Premium Approach
   3.b. Equilibrium Approach

Question 18

DCF Model: Grinold-Kroner (Formula)

Answer 18

E(Rp) = (D/P - Δ%S) + %E + %ΔP/E, onde

Δ%S: Shares in the Mkt (IPO = negative)

Δ%P/E: Ajuste de Preço

%ΔE: Earnings

Question 19

Equilibrium Approach Formula

Answer 19

a. Global Markets: RPi GM = ρi,GM * σi*Sharpe GM

b. Segregated: RPi = σi*Sharpe market

c. Attribute weights

Question 20

Forecast of Real Estate (List of Issues)

Answer 20

1. Physical asset
2. Heterogeneous
3. Imóvel
4. Trade infrequently

Question 21

Boom-Bust Cycle in Real Estate (Describe)

Answer 21

1. Perceptions of Rising
2. Development of New Property
3. Overbuild
4. Takes years for market to absorb excess

Question 22

Real Estate Valuation (Formulas)

Answer 22

Formula 1: k = NOI / P
Formula 2: E(Re) = NOI / P + g - Δ%(NOI / P)

Question 23

Forecast of FX rates (Formulas)

Answer 23

1. Trade Flows Impacts: explains little
2. Relative PPP: only holds in LT ΔSf/d = πf - πd
3. Competitiveness & Sustainability of the Current Account

Question 24

FX Impact of Portfolio Balance (Concept)

Answer 24

Countries with trade deficits finance their trades with increased borrowing

Question 25

FX Impact of Portfolio Composition given Time Horizon

Answer 25

Short Term: ~Fixed
Long Term: May change (CNY v. USD)

Question 26

Forecast Volatility Estimators (List of Methods and Formulas)

Answer 26

1. Sample Statistics:
   - Use VCV matrix
   - For small samples, can not estimate VCV (estimation errors)
   - Many inputs
2. VCV Matrix from Factors
   - Many assets, few risk factors
   - Less estimation error
   - Improve cross-sectional consistency
   - May handle large # of assets
   - May be biased and unconsistent
3. Shrinkage Estimation of VCV Matrix
   VCV = (wSample) +[ (1-w)Target]
4. Unsmooth Returns:
   var (R) = [(1+λ)/(1-λ) *var(R)] > original
5. Time-Varying Volatility: ARCH models (dependent of last output)