Economic Analysis

Question 1

Inputs for Mean-Variance Optimization (MVO)

Answer 1

E(r), σ (std deviation), ρ (Correlation)

Framework for determining asset allocation in a portfolio max expected return for a level of risk

Question 2

Good forecast must be…

Answer 2

unbiased, well researched, with minimum errors and internally consistent (ie. correlations that make sense b/w assumptions)

Question 3

Challenges in Forecasting​

Time Lag Data Issues

Answer 3

1. Official revisions - initial estimates may be revised

2. Definitions & calculation methods change over time (GNP -> GDP)

3, Re-basing index values, cannot mix data w/o adj

Question 4

Challenges in Forecasting​

Data Measurement Error and Biases

Answer 4

4. Transcription errors - problems in gathering & recording data

5. Survivorship bias - data only maintain survivors (upward bias)

6. Appraisal/smoothed data - illiquid markets use appraisal values that do not represent mkt data (smaller correl w/ other assets). Should rescale, increasing dispersion and maintaining mean

Rescale data = multiply σ by the factor given to find new rescaled risk

Question 5

Challenges in Forecasting​

Limitations of Historical Data

Answer 5

7. Regime change - changes in political, regulatory or legal env., creates non-stationarity in data (diff parts have diff underlying assumptions)

8. Data set size - may require long data series, but raises problems (eg. large sets may lead to spurious correl)

9. Ex post (actual) risk can be a biased measure of ex ante (before) risk - evaluate if past asset prices reflect the possibility of a negative event that did not occur (and remove it if it was a mispricing event); only ex ante risk is what is important

Question 6

Challenges in Forecasting

Biases in Analyst Methods

Answer 6

10. Data mining - actively searching through data to identify a pattern

11. Time-period bias - selecting a specific time frame that explains a patter. Should scrutinize the variable selection process and provide the economic rationale for the variable’s usefulness

Question 7

Challenges in Forecasting

Failure to “condition information”

Answer 7

12. Failure to “condition information” - If a condition is present in the forecasting scenarion, then you should also condition your variables such as: E(r), σ & ρ in MVO

Question 8

Challenges in Forecasting

Misinterpretation of Correlations

Answer 8

13. Misinterpretation of Correlations - spurious correlation may exist, or even a third variable may link two variables that have high correlation, but low economic reasoning. Test for partial correlations b/w events using time-series analysis

Question 9

Challenges in Forecasting

Analyst Behaviour Traps in Forecasting [Solutio]

Answer 9

Question 10

Challenges in Forecasting

Model Uncertainty

Answer 10

15. Model Uncertainty - Is the model inputs correct? Especially difficult to use models during mkt anomalies. Sampling errors

Question 11

Statistical Methods of Forecasting

Answer 11

1. Historical Return - using historical means as expected return
2. Shrinkage Estimators - weighted avg of historical covariation and factor model covariation. Reflects belief and reduces the impact of extreme hist outliers. For return, wgt avg b/w sample avg and indv avg
3. Time Series Estimators - using lagged variables to forecast short-term vol

σ_t²= βσ_t-1² + (1 - β) ε _t²

REMEMBER: Std deviation_t = √σ_t²

ALL SQUARED. The greater the Beta, the greater the remembrance from the last period

Question 12

Covariance Matrix

Answer 12

σ_A * σ_B * Correl_(A,B)

σ_A * σ_A * Correl_{(A,A) =} σ_A² * 1

A | B

B

Question 13

Singer-Terhaar approach to ICAPM

Answer 13

1. Calculate expected risk premium for BOTH full integration market and complete segmentation market adding liquidity premium if necessary

ERP_i = σ _i * Correl_{(i, GIM)} * Sharpe_{GIM = (RPm/σm)} + illiquid premium

Remember that Correl_{(i, GIM)} in a completly segmented mkt is equal to 1 (local port is the same of the mkt port)

2. Calculate weighted risk premiums for full integration & segmentation
3. Calculate exp returns: E(R_i) = Rf + β_i [E(R_m) - Rf]
4. Calculate each market/asset’s beta: β_i = σ_i * Correl_{(i, GIM)} ​/ σ²_GIM
5. Calculate covariances: Cov_i,s = β_i β_s σ² and correlations: Correl_i,s = β_i β_s (σ² / σ_i σ_s)

Question 14

Output Gap

Answer 14

Output Gap = trend GDP - actual GDP

• Positive: Recession, no pressure on inflation (BAD THING, due to recessionary characteristic)
• Negative: Expansion, inflationary

Question 15

Business Cycle

5. Recession

Economy, Fiscal and Monetary Policy, Confidence, Capital Markets

Answer 15

5. Recession

Economy: Production declines; inflation peaks

Fiscal and Monetary Policy: n.a.

Confidence: Confidence weak

Capital Markets: Short rates declining; bond yields dropping; stocks bottoming and then starting to rise

Question 16

Business Cycle

4. Slowdown

Economy, Fiscal and Monetary Policy, Confidence, Capital Markets

Answer 16

4. Slowdown

Economy: Inflation continues to accelerate; inventory correction begins

Fiscal and Monetary Policy: n.a.

Confidence: Confidence drops

Capital Markets: Short-term interest rates peaking; bond yields topping out and starting to decline; stocks declining

Question 17

Business Cycle

3. Late upswing

Economy, Fiscal and Monetary Policy, Confidence, Capital Markets

Answer 17

3. Late upswing

Economy: Inflation gradually picks up

Fiscal and Monetary Policy: Policy becomes restrictive

Confidence: Boom mentality

Capital Markets: Short rates rising; bond yields rising; stocks topping out, often volatile

Question 18

Business Cycle

2. Early upswing

Economy, Fiscal and Monetary Policy, Confidence, Capital Markets

Answer 18

2. Early upswing

Economy: Healthy economic growth; inflation remains low

Fiscal and Monetary Policy: n.a.

Confidence: Increasing confidence

Capital Markets: Short rates moving up; bond yields stable to up slightly; stock prices trending upward

Question 19

Business Cycle

1. Initial Recovery

Economy, Fiscal and Monetary Policy, Confidence, Capital Markets

Answer 19

1. Initial Recovery

Economy: Inflation still declining

Fiscal and Monetary Policy: Stimulatory fiscal policies

Confidence: starts to rebound

Capital Markets: Short rates low or declining; bond yields bottoming; stock prices strongly rising

Question 20

Inflation at or below exp / Inflation above exp / Deflation

vs.

Cash / Bonds / Equity / Real Estate

Answer 20

Question 21

Taylor Rule

Answer 21

Used to predict Central Banks moves

R_optimal = R_neutral + ½ (GDPg_forecast - GDPg_trend) + ½ (Inflation_forecast - Inflation_target)

If GDP & Inflation are above trend and target, raise interest

If GDP & Inflation are below trend and target, lower interest

Question 22

Growth trends vs. cycles

Answer 22

Growth trends (long-term) are impacted by population growth, changing demographics, business inventory, gov. structural policies & banking/lending practices. Trends are a key input in DCF.

Cycles (short-term) are alternate sequences of slow and fast growth.

Trends are easier to forecast than cycles, but exogenous shocks can make forecast unpredictable (such as wars, currency, regulation, etc).

Question 23

Permanent income hypothesis

Answer 23

Consumption is influenced by long-run earnings expectations (somewhat countercyclical even)

Question 24

GDP trend growth (Cobb Douglas)

Answer 24

GDP trend growth = Δ labor productivity (size and participation) + Δ capital + Δ total factor productivity (TFP)

TFP not observable, residual (ie. you will find it after doing the math)

Question 25

**Emerging Markets** - Country Risk Analysis Techniques (for bonds downside risk protection)

Answer 25

1. How sound is Fiscal & Monetary policy? 2. Economic prospects for the economy 3. Is the currency and external accounts under control? 4. Is external debt under control? 5. Is liquidity plentiful? 6. Is the political situation supportive of the required policies?

Question 26

Leading x Coincident x Lagging Indexes for economy

Answer 26

Question 27

* *Advantages and Disadvantages of the three approaches to economic forecasting** 1. Econometric Models 2. Leading Indicator-Based Approach 3. Checklist Approach

Answer 27

Question 28

Forecasting Currencies

Answer 28

1. Purchasing Power Parity (PPP) - Movements in FX is offset by inflation. Currency depreciates w/ higher inflation. [FUNDAMENTAL INDICATOR] 2. Relative Strenght (Psych) - Economic growth appreciates FX. Focus on investment flows rather than trade flows. Represents response to news on economy, but nothing about the level of FX. Best used w/ PPP. [TECHNINCAL INDICATOR] 3. Capital Flows - Growth and low valuation appreciates FX. This could lead to inflation and at some point, FX depreciation. 4. Savings-Investment Imbalances - When savings drop, there is a tendency for a current account deficit which may encourage capital inflow that will depreciate FX

Question 29

Cobb-Douglas Production Function

Answer 29

Real Output Y = TFP + α \* (Capital Growth K) + β \* (Labor Growth) *β = 1 - α* L & K are observable. Technical progress or TFP is not and is the residual, that may include innovation, change in tariffs/policies & other. MUST identify the difference b/w one-time impact vs. structural change for steady-state level forecast.

Question 30

DDM H-model

Answer 30

High growth that linearly decays to a perpetual growth state

Question 31

Justified P/E₁

Answer 31

Estimated intrinsic value (DDM) divided by year-ahead expected earnings. Used to compare with market P/E

Question 32

Solve for the perpetual discount rate (r) with Gordon Growth DDM model

Answer 32

r = D₁/P₀ + g

Question 33

Problems with Top-Down vs. Bottom-up approach

Answer 33

Bottom-up approach may be too optimistic, being influenced by company mgt Top-down is based on past trends to forecast data (historical estimates) and the econometric model may be slow capturing inflection points

Question 34

Relative Valuation Models

Answer 34

_Used for tactical allocation decision. All mean-reverting._ **1. Fed Model** - E₁/P S&P vs 10-yr T-note. Best used when prices are at extreme values. Problems: Ignores equity risk premium, ignores inflation and long-term growth **2. Yardeni Model** - E₁/P = y_B - d x g. d is a weighting factor and y_B is the yield on corp bonds. Problems: Better than yield on gvt bond, but still not the equity risk premium. Assumption used for g (or LTEG) may not be sustainable for perpetuity. d varies over time. **3. CAPE** - Cyclically adjusted P/E. Real term Price / 10-yr avg real term earnings. Smooth business cycle, normalizes. Problems: Change in accounting and low R² **4. Asset-Based Models** - Tobin's q = (MV_Equity + MV_Debt) / Replacement cost of assets. If q \> 1, then the mkt places company`s assets at a higher value than replacement and injecting capital would be profitable. If q \< 1, inj K is unprofitable and the company is undervalued Problems: Change in accounting and low R² Equity q = MV_Equity / Net Worth (NW = replacement cost - liabilities). Different from P/B, since it is not based on historical book value. Problem: Difficult to get replacement cost estimates, intangible is difficult to value. Low q may persist for long periods of time.