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Flashcards in Capital Market Expectations Deck (25)
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Discuss the role of, and a frameweek for, capital market expectations
in the portfolio management process.


Step 1. Determine the specific capital market expectations needed according to the
tax status, allowable asset dasses, andtime horizon. Time horizon is
particularly important in determining the set of capital market expectations that
arc needed.

Step 2. **Investigate assets’ historical performance to determine the drivers that have affected past performance and to establish some range for plausible future
performance. **

Step 3.**Identify the valuation model used and its requirements. **

Step 4. Cellect the best data possible. The usc of faulty data wi1llcad to faulty

Step 5. Usc experience and judgment to interpret current investment conditions and decide what values to assign to the required inputs. Verify that the inputs used
for the various asset classes arc consistent across classes.

Step 6 Formulate capital market expectations. Any assumptions and rationales used in the analysis should be recorded. Determine that what was specified in Step I has been provided.
Sup 7: Monitor performance and usc it to refine the proc:css_If actual performance
varies significantly from forecasts. the process and model should be refined.


Discuss challenges in developing capital market forecasts.


Nine problems encountered in producing for<easts></easts>(I) limitations to using economic data. (2) data measurement error and bias.
(3) limitations of historical estimates. (4) the use of ex POStrisk and return measures,
(5) non-repeating data patterns. (6) failing to ac:count for conditioning information.
(7) misinterpretation of correlations. (8) psychological traps. and (9) model and input


Limitation of using economic data


Limitiation to using economic data

TIme lag between collection and distributin is often quite long

Data are oftenr evised and revision are not made at the same time as publications


data measurement erros and biases


Formation of capital market expectation can also be adverely affected by several forms of data measurement erros and biases

Transcription error - recording infformation incorrectly and are more serious if tehy are biased in certain directrion

Survivorship bias -

Appraisal data - for assets with out liquid market assets, apprisal data are used in lieu of market price transaction data.

appraisal value tend to be less volatile than market determnied values.

T he reason is that acrual price fluctuations arc masked by the use of appraised data.


Limititation of histroical estimates


the values from historical data must often be adjusted going
forward as economic. political. regulatory. and technological environments change.

This is particularly true for volatile assets such as equity.


Demonstrate the application of formal tools for setting capital
market expectations, including statistical tools, discounted cash How models,the risk premium approach, and financial equilibrium models.


The formal
tools we examine arc statistical tools. discounted cash Bow models, the risk premium
approach. and financial equilibrium model s.


Statistical Tools


The various statistical tools for setting capital market expectations indude projecting
historical data .•shrinkage estimators. time series analysis. and multifactor models.

S.M projec:tS the historical mean return. standard deviation. and correlations for a data Set into the future.

The arithmetic mean is used in estimating standard deviation and is
also considered the best estimate of return in any single period.

However. the geometric mean is a more accurate projection of growth over multiple periods as it includes the eflicts of compounding.

Time series analysis forecaSts a variable using previous values of itself and sometimes previous values of other variables. These models can be used to forecast means as well …variances.


Discounted Cash Flow Models

Grinold and Kroner (2002)


The variables of the Grinold-Kroner model an be grouped into three components: the
expected income return. the expected nominal growth in earnings. and the expected
repricing return.


Risk Premium Approach


RB = real rlsk-free rate + inBation risk premium + default risk premium +
liquidity risk premium + maturity risk premium + taX premium

The inBation premium eompensates the bond investor for a loss in purchasing
power over time. It can be measured by comparing the yields for inBation-indexed
government bonds to non-inBation-indexed bonds of the same maturity.
• The default risk premium compensates the investor for the likelihood of nonpayment and can be estimated by examining the yields for bonds of differing credit
• The liquidity premium compensates the investor for holding illiquid bonds.
• The maturity risk premium rcAeca the yield differences of bonds of different
• The tax premium accounts for different tax treatments of bonds.


Financial Equilibrium Models


The final apression states that the risk premium for an asset is equal to its correlation
with the global market ponfolio multiplied by the standard deviation of the asset
multiplied by the Sharpe ratio for the global ponfolio (in parentheses).


LOS 17.d: Explain the use of survey and panel methods and judgment in
setting capital market expectations.


Discuss the inventory and business cycles, the impact of consumer
and business spending, and monetary and fiscal policy on the business cycle.


I) cyclical - Short term
(2) trend-growth components - Long term

Within cyclical analysis, there arc two components: (J) the inventory cycle and (2) the business cycle.

The measures of economic activity are GOP. the output gap, and a recession.

Within cyclical analysis, there arc two components: (J) the inventory cycle and (2) the business cycle.


Inventory Cycle & Business cycle


The inventory cycle is thought to be 2 to 4” years in length. It is often measured using
the inventory to sales ratio.

The longer-term business cycle is thought to be 9 to II years in length. It is
characterized by five phases: (1) the initial recovery. (2) early upswing. (3) late upswing.
(4) slowdown. and (5) recession.


LOS 17_f: Discuss the impact that the phases of the business cycle have on
short-term/long-term capital market returns.


Initia! Recovery
• Duration of a few months.
• Business confidence is rising.
• Government stimulation is provided by low interest rates and/or budg

Falling inflation.
• Large output gap
• Low or falling short-term interest rates,
• Bond yields are bottoming out.
• Rising stock prices.
• Cydiw, riskier assets su~ as small-cap stocks and high yield bonds do well


Duration of a year to several years.
Increasing growth with low inllation.
Increasing confidence.
Increasing inventcrie s,
Rising short-term interest rates.
Output gap is narrowing.
Flat or rising bond yields.
Rising stock prices.

Late Upswing
• Confidence and employment are high.
• Output gap eliminated and economy at risk of overheating.
• Inflation increases.
• Central bank limits the growth of the money supply.
• Rising short-term interest rates.
• Rising bond yields.
• Rising stock prices, but increased risk and volatility




Aggregate inflation is measured most frequendy by consumer price indices.

Inflation rises in the latter stages of economic expansion and falls during a recession and the initial recovery


17.g: Explain the relationship of inflation to the business cycle and the
implications of inflation for cash, bonds, equity, and real estate returns.


asset prices and inflation is tied to business cylce

Real estate provides good inflation hedge

consumer confidence increases as
the economy begins to recover from a recession,
Consumers continue spending until the economy shows signs that it has peaked (i.e., top o the business cycle) and reversed. At this point, consumers begin saving more and more until the economy “turns the corner,” and the cycle starts over.

Most central banks strive to balance price stability against
economic growth. THe ultimate goal is to keep GDP at long term stability growth and growth higher than that results in inflation

To spur growth, a central bank can take actions to reduce short-term interest rates. This results in greater consumer spending, greater business spending, higher stock prices and higher bond prices.


I7.h: Demonstrate the use of the Taylor rule to predict central bank


R target = R netural + (0.5( GDP expected - GDP Trend ) + 0.5 (Iexpected -Itarget)

Fisical Policy - SImulate the economy - Governament can decrease taxes or increase spedning. Not the size of the budget deficit but change in the budget defict.


Evaluate 1) the shape of the yield curve as an economic predictor
and 2) the relationship between the yield curve and fiscal and monetary policy.


Both monetery and fisical policy are expanisve yield curve is sharply upward sloping (i.e., short-term ratesarc lower than long-tcrm rates),

When fiscal and monetary policics arc restrictive, the yield CUrve is downward sloping (i.e. as short-term rates are higher than long-term rates), and the economy is likely to contract in the future. the shape of the curve is inverted.

If monetary is restrictive and fiscal is stimulative, the yield curve i. Bat and the
economy is unclear.
• If monetary is stimulative and fiscal is restrictive, the yield curve is moderately steep
and the economy is unclear.


Identifx and interpt the components of economic growth trends
and demonstrare the application of economic growth trend analysis to the
formulation of capital market expectations.


(I) changes in employment levels and
(2) changes in productivity.

Changes in employment :- Populatin growth and the rate of labor participation

The productivity component can be broken down into - spending on new capital inputs and total factor productivity growth.

individuals tend to consume an amount that is fairly constant over time and related to their expected long-run income. This is the essence of **Milton Friedman’s permanent income hypothesis. **

Governament strutual policies - are more important component of long term growth.

1) government should provide the infrastructure needed for growth.
2. a government sbould bave a responsible jiselll pDlicy.
3. a government should have tax policies that are transparent,
4. the governmcnt should promote compctition in the marketplace,


17.k: Explain how exogenous shocks may affect economic growth trends.


Exogenous shocks are unanticipated events that occur outside the normal course of
an economy. events are unanticipated, they are not built into current
market prices. usually negative impact - contagin ( spread to other countries)

endogenous,- normal trends in an economy -are built into market prices.


Identify and interpret macroeconomic, interest rate, and exchange
rate linkages between economies


Macroeconomic links refer to similarities in business cycles across countries.

Another link between economics are exchange rates,

Interest rare differcntials between countries can also reflect differences in economic growth. monetary policy and fiscal policy

Countries with high real interest rate should see the value of their
currency increase. page 91 study note


17.m: Djscuss the risks faced by investors in emerging-market securities
and the country risk analysis techniques used to evaluate emerging market


Does the country have responsible fiscal and monetary policies?

Ratios greater than 4% indicate substantial credit risk. Debt levels of 70 to 80% of GDP have been troublesome for developing countries.

What u the expected growth?

**Does the country have reasonable currency values and current account delicits? **

Is the country too highly levered?

What is the level of foreign exchange reserves relative to short-term debt?

**What is the government’s stance regarding structural reform? **


17.n, Compare the major approaches to economic forecasting.


(I) econometrics, (2) economic indicators, and (3) a checklist approach.

Econometric analysis uses economic theory to formulate the forecasting model. The models can be quite simple to very complex, involving several data items of various time period lags to predict the future.

Once established, can be reused.
Can be quite complex and may accuratdy modd real world conditi
Can provide precise quantitative forecasts of economic conditions.

Disadvantages -

May be difficult and time intensive (expensive) to create.
Proposed model may not be applicable in future time periods, better for expansion than recessions.

Economic indicators are available from goverrnments, Internarional organiz.ations
. They attempt to characterize an economy’s phase in the business cycle and are separated into lagging indicators, coincident indicators. and leading indicators.

• Not consistently accurate as economic relationships change through time.
• Forecasts from leading indicators can be misleading by giving false signals.

In a checklist approach, the analyst checks off a Ii.. of questions that should indicate the future growth of the economy.

Disadvantages -
• Requires subjective judgment.
• May be time intensive to create,
• May not be able to model complex relationships.