Capital Market Expectations Flashcards
(38 cards)
Discuss the role of, capital market expectations in the portfolio management process.
- Capital market expectations help in formulating the strategic asset allocation.
- They can also assist in detecting short-term asset mispricings exploitable through tactical asset allocation.
- Asset allocations should display both cross-sectional and intertemporal consistency.
What are the 7-Steps in developing the framework for, capital market expectations.
The following approach helps add discipline to setting CME:
1. Specify the expectations set: asset classes and time horizons.
2. Research the historical records: to develop some possible ranges for future results.
3. Specify the methods/models: and their required inputs.
4. Determine the best information sources.
5. Implement the research and investment process: Apply experience and judgment to interpret the current investment environment.
6. Provide the necessary expectations: set along with documented conclusions.
7. Use actual outcomes: as feedback to the expectations setting process
Discuss challenges in developing capital market forecasts.
Limitations in the use of economic data for forecasting include the following:
* Data are reported with a lag, subject to revision, and defined inconsistently
* Data are subject to biases and errors: transcription errors, survivorship bias, and smoothed data estimates.
* Using historical data is less appropriate when economic conditions change
* Ex-post risk generally understates ex-ante risk, (past does not guarantee the future)
* Data mining or selection of time periods
* Models should be conditioned for the likely state of the economy.
* Correlation does not imply causation.
* Psychological biases and cognitive errors may affect an analysis.
* Models, parameters, and inputs are subject to uncertainty.
Explain how exogenous shocks may affect economic growth trends.
Exogenous shocks are unanticipated events that occur outside the normal course of an economy and may have either a positive or negative impact on growth.
They can be caused by different factors, such as changes in government policies, political events, technological progress, natural disasters, discovery of natural resources, and financial crises.
Discuss the application of economic growth trend analysis to the formulation of capital market expectations.
Ther are 2 main components:
* Changes in employment levels: which are related to population growth and labor force participation.
* Changes in productivity: which are related to capital inputs and technological advancement.
Compare major approaches to economic forecasting.
Econometric analysis: uses statistical methods to formulate forecasting models. These models lags to predict the future.
Economic indicators: attempt to characterize an economy’s phase in the business cycle and are separated into
* lagging indicators
* coincident indicators
* leading indicators
Checklist approach: the analyst checks off a list of questions that should indicate the future growth of the economy. Given the answers and judgment an analyst forecast their expecations.
What are the 5 Business Cycle Phases
- initial recovery
- early expansion
- late expansion
- slowdown
- contraction
Explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns.
Real Estate (Leverage Investments):
* Inflation varies over the business cycle, rising in the latter stages of an expansion and falling during a recession and the initial recovery.
* Deflation reduces the value of investments financed with debt because leverage magnifies losses.
Bond prices:
* Will rise during a recession when inflation and interest rates are declining.
* In a strong expansion, bonds tend to decline in price as inflation expectations and interest rates rise.
Equities:
* Provide an inflation hedge when inflation is moderate.
* High inflation can be problematic because slow growth may result from central bank action to combat inflation.
* Deflation is harmful because it encourages defaults and limits the scope for monetary policy.
Discuss the effects of monetary and fiscal policy on business cycles.
Monetary Policy: Central banks often use as a countercyclical force. The goal is to keep growth near its long-run sustainable rate, (increased inflation). To spur growth, a central bank can take actions to reduce short-term interest rates.
The Taylor rule: determines the target interest rate using the neutral rate, expected GDP relative to its long-term trend, and expected inflation relative to its targeted level.
Fiscal Policy: If the government wants to stimulate the economy, it can implement loose fiscal policy by decreasing taxes or increasing spending, thereby increasing the budget deficit. If they want to rein in growth, the government does the opposite (fiscal tightening).
Interpret the shape of the yield curve as an economic predictor and discuss the relationship between the yield curve and fiscal and monetary policy.
The yield curve: demonstrates the relationship between interest rates and the maturity of debt securities (sensitive to government actions).
When fiscal and monetary policies are expansive, the yield curve is sharply upward sloping (expansion)
When fiscal and monetary policies are restrictive, the yield curve is downward sloping (contracting)
If monetary policy is expansive while fiscal policy is restrictive: the yield curve tends to be upward sloping.
If monetary policy is restrictive while fiscal policy is expansive, the yield curve tends to be flatter.
Identify and interpret macroeconomic, interest rate, and exchange rate linkages between economies.
Macroeconomic links: refer to similarities in business cycles across countries. Economies are linked by both international trade and capital flows so that a recession in one country dampens exports and investment in a second.
Exchange rate: links are found when countries peg their currency to others. The benefit of a peg is that currency volatility is reduced and inflation can be brought under control. Interest rates in the pegging country often reflect a risk premium relative to the country to which it pegs.
Interest rate differentials: between countries can also reflect differences in economic growth, monetary policy, and fiscal policy.
Econometric
Strengths:
* Many factors help represent reality; valid statistical relationship
* Quickly updated using new data
* Provides quantitative estimates
* Imposes analytical discipline/consistency
Weaknesses:
* Complex, time-consuming to formulate
* Forecasting inputs difficult
* Model may be misspecified due to changing relationships
* False precision impression
* Turning points hard to forecast
Leading indicators
Strengths:
* Intuitive and simple
* Focuses on turning points
* Available from third parties
* Easy to track
Weaknesses:
* Can provide false signals
* Binary (yes/no) directional guidance
* Subject to frequent revision
* Current data might not be relevant to historical returns
* Overstates accuracy due to overfitting in sample
Checklist approach
Strengths:
* Not overly complex
* Can include a wide variety of check points (breadth)
* Flexible
* Easily incorporates structural changes
* Items easily added/dropped
Weaknesses:
* Arbitrary, judgmental, and subjective
* Manual process that limits ability to combine different types of information
* Time consuming
Initial recovery
Economic Features:
* After the low point, the output gap is large, inflation is decelerating, stimulative policies remain in place, and the economy starts to grow.
Capital Market Features:
* S-T and L-T government bond yields are likely to be bottoming but may still decrease.
* Stock markets may begin to rise quickly as recession fears subside.
* Riskier small-cap stocks, high-yield bonds, and emerging market securities start to do well.
Early expansion
Economic Features:
* Output gap remains negative, but unemployment starts to fall.
* Consumers start to borrow to spend; housing and consumer durable demand increases.
* Businesses step up production; profits begin to expand rapidly.
* Central bank begins to remove stimulus.
Capital Market Features:
* Short rates begin to increase; long rates remain stable or increase slightly.
* Flattening yield curve.
* Stock prices trend upward.
Late expansion
Economic Features:
* Positive output gap and danger of inflation; capacity pressures boost investment spending.
* Low unemployment, strong profits, rising wages and prices (inflation).
* Debt coverage ratios may deteriorate as business borrows to fund growth.
* Monetary policy becomes more restrictive.
Capital Market Features:
* Private sector borrowing causes rates to rise.
* Yield curve continues to flatten as short rates rise faster than long rates.
* Stocks are volatile as investors watch for deceleration.
* Inflation hedges (commodities) may begin to outperform other cyclical assets.
Slowdown
Economic Features:
* Fewer viable investment projects and overleveraging cause slowing growth; business confidence wavers.
* Inflation continues to rise as business pricing attempts to outpace rising input costs.
* The economy is vulnerable to shocks.
Capital Market Features:
* L-T bonds may top but S-T rates continue to rise or may peak; yield curve may invert.
* Credit spread widens, depressing bond prices for lower credit issues.
* Stocks may fall; utilities and quality stocks are likely to outperform.
Contraction (12 to 18 months)
Economic Features:
* Firms cut investment spending, then decrease production; unemployment can rise quickly (which hinders household formation).
* Profits drop sharply; credit markets tighten, accounting transgressions are uncovered, and bankruptcies can result.
Capital Market Features:
* S-T and L-T rates begin to fall; yield curve steepens
* Credits spread widens; remains wide until trough.
* Stock market:
* Early phase—Declining
* Late phase—Begins to rise
What are the 3-types of Exogenous shocks.
Type 1: A permanent, one-time decline with resumption of the trend rate after the initial shock.
Type 2: No persistent one-time decline, but continuation at a lower trend rate.
Type 3: Both a permanent, one-time decline and continuation at a lower trend rate.
What are the 3 approaches to setting expectations for fixed-income and equity returns?
The three approaches to forecast fixed income returns are:
1. The DCF method
2. the risk premium approach
3. the equilibrium model.
What 6 factors of liquidity tends to be highest for bonds
Liquidity tends to be highest for bonds that are
1. issued at close to par or market rates
2. new
3. large in size
4. issued by a frequent and well-known issuer
5. simple in structure
6. of high credit quality
What is Macaulay Duration
The Macaulay duration will determine whether an expected yield change will generate positive or negative returns (by looking at its impact on prices vs. return from reinvestment of cash flow).
The YTM is only actually earned if these 3 conditions are met:
- The cash flows of the bond are received in full and on time.
- The bond is held to maturity. If the bond is sold prior to maturity, the investor will underperform the YTM if interest rates have risen over the investment horizon, causing bond prices to fall.
- Cash flows are reinvested at the YTM. The investor will underperform the YTM If interest rates fall causing early cash flows received on the bond to be reinvested at a rate lower than that of the original YTM of the bond.
If the investment horizon is less than the duration of the portfolio, then condition 2 will dominate and the investor underperforms the YTM when interest rates rise.
If the investment horizon is greater than the portfolio’s duration, condition 3 will dominate and the investor will underperform the YTM when interest rates fall.
