Reading 15 Capital Market Expectations Flashcards Preview

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Flashcards in Reading 15 Capital Market Expectations Deck (101):

How increase in short-term rates influences the value of domestic currency?

An increase in short-term interest rates may increase or decrease the value of the domestic currency.

Higher interest rates generally attract capital and increase the domestic currency value. At some level though, higher interest rates will result in lower currency values because the high rates may stifle an economy abd make it less attractive to invest there


During wich phase of the business cycle would TIPS be least useful to a portfolio manager?

U.S. TIPS are protected against increases in inflation. They would be needed the least when inflation is falling. During the initial recovery phase of the business cycle, the inflation is falling.


Limitations of Economic Data

  • The analyst needs to understand the definition, construction, timeliness, and accuracy of any data used, including any biases. The time lag with which economic data are collected, processed, and disseminated can be an impediment to their use.
  • Furthermore, one or more official revisions to the initial values are common.
  • Definitions and calculation methods change too.
  • Suppliers of indices of economic and financial data periodically re-base these indices, meaning that the specific time period used as the base of the index is changed.


Early Upswing stage of business cycle

After the initial recovery period, confidence is up and the economy is gaining some momentum. This is the healthiest period of the cycle, in a sense, because economic growth can be robust without any signs of overheating or sharply higher inflation. Typically, there is increasing confidence, with consumers prepared to borrow and spend more as unemployment starts to fall. Concurrently, businesses build inventories and step up investment in the face of strong sales and increased capacity use. Higher operating levels allow many businesses to enjoy lower unit costs, so that profits rise rapidly.

Capital market effects: A key question is how long it will take before inflation starts to become a problem. Short rates are moving up at this time as the central bank starts to withdraw the stimulus put in place during the recession. Longer bond yields are likely to be stable or rising slightly. Stocks are still trending up. This phase usually lasts at least a year and often several years if growth is not too strong and the output gap closes slowly.


Economy: Healthy economic growth; inflation remains low

Fiscal and Monetary Policy: -

Confidence: Increasing confidence

Capital Markets: Short rates moving up; bond yields (long-term interest rates) stable to up slightly; stock prices trending upward


Recession stage of business cycle

A recession is conventionally defined as two successive quarterly declines in GDP. There is often a large inventory pullback and sometimes a large decline in business investment. Consumer spending on big-ticket items such as cars usually declines (although the US 2001 recession was an exception). Once the recession is confirmed, central banks ease monetary policy, but only cautiously at first. Recessions typically last six months to a year. Both consumer and business confidence decline. Profits drop sharply. In a severe recession, the financial system may be stressed by bad debts, making lenders extremely cautious. Often, recessions are punctuated by major bankruptcies, incidents of uncovered fraud, or a financial crisis. Unemployment can rise quickly, putting downward pressure on inflation.

Capital market effects: Short-term interest rates drop during this phase, as do bond yields. The stock market usually starts to rise in the later stages of the recession, well before the recovery emerges.


Economy: Production declines; inflation peaks

Fiscal and Monetary Policy: -

Confidence: Confidence weak

Capital Markets: Short rates declining; bond yields (long-term interest rates) dropping; stocks bottoming and then starting to rise


Approaches to Forecasting Exchange Rates

There are four broad approaches to forecasting exchange rates, and most forecasters probably use a combination of them all:

  1. Purchasing Power Parity
  2. Relative Economic Strength
  3. Capital Flows
  4. Savings–Investment Imbalances



  • Quantitative models such as equilibrium models offer the prospect of providing a non-emotional, objective rationale for a forecast. The expectations-setting process nevertheless can give wide scope to applying judgment—in particular, economic and psychological insight—to improve forecasts. In forecasting, numbers, including those produced by elaborate quantitative models, must be evaluated.
  • Other investors who rely on judgment in setting capital market expectations may discipline the process by the use of devices such as checklists.


Using Economic Information in Forecasting Asset Class Returns: Nominal Default-Free Bonds

  • Nominal default-free bonds are conventional bonds that have no (or minimal) default risk.
  • For investors buying and selling long-term bonds over a shorter time period, the emphasis is on how bond yields will respond to developments in the business cycle and changes in short-term interest rates.
  • As bond investors look toward the long-term picture, they must carefully assess the future effects of inflation, which erodes the future purchasing power of the yields earned on their fixed-income investments.


The yield spread between the 10-year T-bond rate and the 3-month T-bill as a predictor of future growth in output

The yield spread between the 10-year T-bond rate and the 3-month T-bill rate has been found internationally to be a predictor of future growth in output. The observed tendency is for the yield spread to narrow or become negative prior to recessions. Another way of saying the same thing is that the yield curve tends to flatten or become inverted prior to a recession.

Effects that may explain a declining yield spread include the following:

1) Future short-term rates are expected to fall, and/or

2) investors’ required premium for holding long-term bonds rather than short-term bonds has fallen.


What Happens When Interest Rates Reach Zero?

Once interest rates are at zero, further monetary stimulus requires new types of measures.

  • First, the central bank can push cash (bank “reserves”) directly into the banking system.
  • A second possibility is to devalue the currency.
  • The third option is to promise to hold short-term interest rates low for an extended period.
  • The final option is for the central bank to buy assets directly from the private sector.


Influence of tighter monetary policy and stronger economic growth on currency levels

Countries with tighter monetary policy and stronger economic growth will see higher currency values. In fact, in the early 1980s, the U.S. had high real and nominal interest rates due to a tight monetary policym robust economy, and an increasing budget deficit. This resulted in a higher value of the dollar.


Illiquidity premium for an alternative investment

  • The illiquidity premium for an alternative investment should be positively related to the length of the investment’s lockup period or illiquidity horizon. How can the amount of the illiquidity premium be estimated? One estimation approach uses the investment’s multiperiod Sharpe ratio (MPSR), which is based on the investment’s multiperiod wealth in excess of the wealth generated by the risk-free investment (i.e., compounded return over compounded cash return).
  • There would be no incentive to invest in an illiquid alternative investment unless its MPSR—its risk-adjusted wealth—were at least as high as the MPSR of the market portfolio at the end of the lockup period.


The balance of payments

The balance of payments (an accounting of all cash flows between residents and nonresidents of a country) consists of:

  • the current account, dominated by the trade balance (reflecting exports and imports), and
  • the financial account, consisting of portfolio flows (from security purchases and sales—e.g., bonds and equities) and foreign direct investment (FDI) by companies (e.g., Toyota Motor Corporation building an automobile assembly plant in the United States), as well as flows such as borrowing from and deposits with foreign banks.

The sum of the current account and the financial account, or the overall trade balance, should be zero.


Grinold–Kroner model

Grinold–Kroner model, which is based on elaborating the expression for the expected single-period return on a share, is



E(Re) = the expected rate of return on equity

D/P = the expected dividend yield

ΔS = the expected percent change in number of shares outstanding

i = the expected inflation rate

g = the expected real total earnings growth rate (not identical to the EPS growth rate in general, with changes in shares outstanding)

ΔPE = the per period percent change in the P/E multiple

  • The term ΔS is negative in the case of net positive share repurchases, so −ΔS is a positive repurchase yield in such cases.
  • The Grinold–Kroner model can be used not only in expectations setting, but also as a tool to analyze the sources of historical returns.


Late Upswing  stage of business cycle

At this stage of the cycle, the output gap has closed and the economy is in danger of overheating. Confidence is high; unemployment is low. The economy may grow rapidly. Inflation starts to pick up, with wages accelerating as shortages of labor develop.

Capital market effects: Typically, interest rates are rising as the monetary authorities become restrictive. Any heavy borrowing puts pressure on the credit markets. Central banks may aim for a “soft landing,” meaning a period of slower growth to cool the economy but not a major downturn. Bond markets (long-term interest rates) anxiously watch this behavior, and bond yields will usually be rising as a result of changed expectations. Stock markets will often rise but may be nervous too, depending on the strength of the boom. Nervous investors mean that equities are volatile.


Economy: Inflation gradually picks up

Fiscal and Monetary Policy: Policy becomes restrictive

Confidence: Boom mentality

Capital Markets: Short rates rising; bond yields (long-term interest rates) rising; stocks topping out, often volatile


Evaluating Factors that Affect the Business Cycle

For the purposes of setting capital market expectations, we need to focus business cycle analysis on four areas:

  • consumers;
  • business;
  • foreign trade; and
  • government activity, both monetary policy (concerning interest rates and the money supply) and fiscal policy (concerning taxation and governmental spending).
  1. Consumer spending amounts to 60–70 percent of GDP in most large developed economies and is therefore typically the most important business cycle factor.
  2. Business investment has a smaller weight in GDP than consumer spending but is more volatile.
  3. Foreign trade is an important component in many smaller economies, for which trade is often 30–50 percent of GDP. However, for the large economies, such as the United States and Japan, foreign trade is typically only around 10–15 percent of GDP and correspondingly less important.


Model Uncertainty

  • The analyst usually encounters at least two kinds of uncertainty in conducting an analysis: model uncertainty (uncertainty concerning whether a selected model is correct) and input uncertainty (uncertainty concerning whether the inputs are correct).
  • Input uncertainty and model uncertainty in particular often make it hard to confirm the existence of capital market anomalies (inefficiencies); some valuation model usually underlies the identification of an inefficiency. Behavioral finance (the theory that psychological variables affect and often distort individuals’ investment decision making) has offered explanations for many perceived capital market anomalies.


Economic Indicators

  • Economic indicators are economic statistics provided by government and established private organizations that contain information on an economy’s recent past activity or its current or future position in the business cycle. Lagging economic indicators and coincident indicators are indicators of recent past and current economic activity, respectively. A leading economic indicator (LEI) is a variable that varies with the business cycle but at a fairly consistent time interval before a turn in the business cycle. Most analysts’ greatest interest is leading indicators because they may provide information about upcoming changes in economic activity, inflation, interest rates, and security prices.
  • Composite LEIs combine these releases using weights based on an analysis of their forecasting usefulness in past cycles. They can also be combined in a so-called diffusion index, which measures how many indicators are pointing up and how many down. For example, if 7 out of 10 are pointing upward, then the odds are that the economy is accelerating.
  • In contrast with the release of some of its individual components, the release of the LEI index is rarely a market-moving event because some of its components are already public.
  • General rule was that three consecutive months of increases, or three consecutive months of decreases, signaled an upturn or downturn in the economy within three to six months.


The P/E Ratio and the Business Cycle

  • During the business cycle, the P/E ratio tends to be high and rising when earnings are expected to rise. For example, the P/E would be high in the early stages of an economic recovery, or when interest rates are low and the return on fixed-rate investments such as cash or bonds is less attractive. Conversely, P/Es are likely to be low and falling if the outlook for earnings worsens (e.g., in an economic slump).
  • P/E ratios vary over longer periods too. In general, they are lower for an economy stuck on a slower growth path.
  • High inflation rates tend to depress P/E ratios. Inflation can distort the economic meaning of reported earnings, leading investors to value a given amount of reported earnings less during inflationary periods, which tends to lower observed P/Es during those periods. Consequently, comparisons of current P/E with past average P/E that do not control for differences in inflation rates may be suspect.


Fixed-Income Premiums

The expected bond return, E(Rb), can be built up as the real rate of interest plus a set of premiums:

E(Rb) = Real risk-free interest rate + Inflation premium + Default risk premium + Illiquidity premium  + Maturity premium + Tax premium

  • The real risk-free interest rate is the single-period interest rate for a completely risk-free security if no inflation were expected.
  • The inflation premium compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt plus a premium (or discount) for the probability attached to higher inflation than expected (or greater disinflation). The sum of the real risk-free interest rate and the inflation premium is the nominal risk-free interest rate, often represented by a governmental Treasury bill YTM.
  • The default risk premium compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount.
  • The illiquidity premium compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly.
  • The maturity premium compensates investors for the increased sensitivity, in general, of the market value of debt to a change in market interest rates as maturity is extended, holding all else equal. The difference between the interest rate on longer-maturity, liquid Treasury debt and that on short-term Treasury debt reflects a positive maturity premium for the longer-term debt (and possibly different inflation premiums as well).
  • tax premium may also be applicable to certain classes of bonds in some tax jurisdictions


The Limitations of Historical Estimates

  • A historical estimate should be considered a starting point for analysis. The analysis should include a discussion of what may be different from past average results going forward. If we do not see any such differences, we may want to project the historical estimates into the future (perhaps after making certain technical adjustments).
  • Changes in the technological, political, legal, and regulatory environments, as well as disruptions such as wars and other calamities, can alter risk–return relationships. Such shifts are known as changes in regime (the governing set of relationships) and give rise to the statistical problem of nonstationarity (meaning, informally, that different parts of a data series reflect different underlying statistical properties).
  • Researchers have concluded that the underlying mean returns on volatile asset classes such as equities are particularly difficult to estimate from historical data.
  • A practical approach to deciding whether one should use the whole of a long data series is to answer two questions. The first question is: Is there is any fundamental reason to believe that the entirety of the series’ time period is no longer relevant? If there is, the next question to answer is: Do the data support that hypothesis?


Linkages between Fiscal and Monetary Policy

If fiscal and monetary policies are both tight, then the situation is unambiguous and the economy is certain to slow. Similarly, if both monetary policy and fiscal policy are expansionary, then the economy can be expected to grow.

Policy Mix and the Yield Curve:

Monetary&Fiscal/ Loose&Loose: Yield curve steep

Monetary&Fiscal/ Tight&Loose: Yield curve flat

Monetary&Fiscal/ Loose&Tight: Yield curve moderately steep

Monetary&Fiscal/ Tight&Tight: Yield curve inverted


Singer–Terhaar approach to ICAPM

  • The Singer–Terhaar approach recognizes the need to account for market imperfections that are not considered by the ICAPM. We will consider two market imperfections: illiquidity and market segmentation.
  • Illiquidity premium as compensation for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly. The ICAPM assumes perfect markets (markets without any frictional costs, where all assets trade in liquid markets). Thus, we need to add an estimated illiquidity premium to an ICAPM expected return estimate as appropriate.
  • Market integration means that there are no impediments or barriers to capital mobility across markets.
  • Market segmentation means that there are some meaningful impediments to capital movement across markets.
  • The more a market is segmented, the more it is dominated by local investors. When markets are segmented, two assets in different markets with identical risk characteristics may have different expected returns. If an asset in a segmented market appears undervalued to a nondomestic investor not considering barriers to capital mobility, after such barriers are considered, the investor may not actually be able to exploit the opportunity.
  • The risk premium for the completely segmented markets case is higher than that for the perfectly integrated markets case and equal to the amount shown below:


    This is the second key equation in the Singer–Terhaar approach.

To summarize, to arrive at an expected return estimate using the Singer–Terhaar approach, we take the following steps:

  1. Estimate the perfectly integrated and the completely segmented risk premiums for the asset class using the ICAPM.
  2. Add the applicable illiquidity premium, if any, to the estimates from the prior step.
  3. Estimate the degree to which the asset market is perfectly integrated.
  4. Take a weighted average of the perfectly integrated and the completely segmented risk premiums using the estimate of market integration from the prior step.


A Decomposition of GDP Growth and Its Use in Forecasting

The simplest way to analyze an economy’s aggregate trend growth is to split it into

  • growth from changes in employment (growth from labor inputs), and
  • growth from changes in labor productivity.

For longer-term analysis, growth from changes in employment is broken down further into growth in the size of the potential labor force and growth in the actual labor force participation rate (e.g., more or fewer women or older people working; “growth” can be positive or negative).

Productivity increases come from investment in equipment or new machines (growth from capital inputs) and from growth in total factor productivity (TFP growth), known also as technical progress and resulting from increased efficiency in using capital inputs.


Slowdown stage of business cycle

At this point, the economy is slowing, usually under the impact of rising interest rates. The economy is especially vulnerable at this juncture to a shock, which can turn a “soft landing” into a recession. Business confidence starts to waver. Despite the slowdown, inflation often continues to rise. The slowdown is exacerbated by the inventory correction as companies try to reduce their inventory levels. This phase may last just a few months, as in the United States in 2000, or it may last a year or more, as in the United States in 1989–1990 and 2009–2011.

Capital market effects: Short-term interest rates are high and rising at first but then may peak. Bonds top out at the first sign of a slowing economy and then rally sharply (yields fall). The yield curve often inverts. The stock market may fall, with interest-sensitive stocks such as utilities and financial services performing best.


Economy: Inflation continues to accelerate; inventory correction begins

Fiscal and Monetary Policy: -

Confidence: Confidence drops

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


Country Risk Analysis Techniques for Emerging Markets 

Following are six questions that country risk analysis seeks to answer, with suggestions for data to analyze and points to look for.

  1. How sound is fiscal and monetary policy? If there is one single ratio that is most watched in all emerging market analysis, it is the ratio of the fiscal deficit to GDP. Most emerging countries have deficits and are engaged in a perpetual struggle to reduce them. Deficits are a major cause of slow growth and frequently a factor in serious crises. A persistent ratio above 4 percent is regarded with concern. The range of 2–4 percent is acceptable but still damaging. Countries with ratios of 2 percent or less are doing well. If the fiscal deficit is large for a sustained period, the government is likely to build up significant debt. For a developing country, the level of debt that would be considered too high is generally lower than for developed countries. Countries with a ratio of debt of more than about 70–80 percent of GDP are extremely vulnerable.
  2. What are the economic growth prospects for the economy? Annual growth rates of less than 4 percent generally mean that the country is catching up with the industrial countries slowly, if at all. It also means that, given some population growth, per capita income is growing very slowly or even falling, which is likely to bring political stresses.
  3. Is the currency competitive, and are the external accounts under control? Managing the currency has proven to be one of the most difficult areas for governments. If the exchange rate swings from heavily undervalued to seriously overvalued, there are negative effects on business confidence and investment. Moreover, if the currency is overvalued for a prolonged period, the country is likely to be borrowing too much, creating a large current account deficit and a growing external debt. The size of the current account deficit is a key measure of competitiveness and the sustainability of the external accounts. Any country with a deficit persistently greater than 4 percent of GDP is probably uncompetitive to some degree. Current account deficits need to be financed. If the deficits are financed through debt, servicing the debt may become difficult. A combination of currency depreciation and economic slowdown will likely follow. The slowdown will also usually cut the current account deficit by reducing imports. Note, however, that a small current account deficit on the order of 1–3 percent of GDP is probably sustainable, provided that the economy is growing. A current account deficit is also more sustainable to the extent that it is financed through foreign direct investment rather than debt, because foreign direct investment creates productive assets.

  4. Is external debt under control? Analysts watch several measures of debt burden. The ratio of foreign debt to GDP is one of the best measures. Above 50 percent is dangerous territory, while 25–50 percent is the ambiguous area. Another important ratio is debt to current account receipts. A reading above 200 percent for this ratio puts the country into the danger zone, while a reading below 100 percent does not.

  5. Is liquidity plentiful? By liquidity, we mean foreign exchange reserves in relation to trade flows and short-term debt. Traditionally, reserves were judged adequate when they were equal in value to three months’ worth of imports. However, with the vastly greater importance of debt and capital flows, we now relate reserves to other measures. An important ratio is reserves divided by short-term debt (debt maturing in less than 12 months). A safe level is over 200 percent, while a risky level is under 100 percent.

  6. Is the political situation supportive of the required policies?


Savings–Investment Imbalances Approach to Forecasting Exchange Rates

  • The savings–investment imbalances forecasting approach explains currency movements in terms of the effects of domestic savings–investment imbalances on the exchange rate. Although it is not easy to use for forecasting, this approach can sometimes help with understanding why currencies depart from equilibrium for long periods.
  • If the private sector or government currency-related trends change, then the current account position must change too and the exchange rate moves to help achieve that. Suppose that an economy suddenly begins to expand rapidly, driven by a new government budget deficit or bullish entrepreneurs. If domestic savings do not change, there will be excess demand for capital as investment tries to exceed savings. The only way that investment can exceed savings in reality is for foreign savings to be used, since the accounts have to balance. But this solution requires a deficit on the current account of the balance of payments.
  • So, where does this deficit on the current account come from? Some of it may arise simply because imports are strong due to the buoyant economy or because exports are weak as companies focus on the domestic market. But if that is not enough, the exchange rate needs to rise. If capital flows are attracted to the country, either due to high interest rates or due to attractive expected returns on investments, then the exchange rate will indeed rise as needed.
  • !!! The savings-investment imbalances approach to forecasting currency values states that countries with savings deficit will have strong currency values to attract foreign capital


Inflation/Deflation Effects on Bonds

During a recession, with falling inflation and interest rates, bonds generally post capital gains.


Inflation at or below expectations: 

Yield levels maintained; market in equilibrium. [Neutral]

Inflation above expectations: 

Bias toward higher yields due to a higher inflation premium. [Negative]


Purchasing power increasing. Bias toward steady to lower rates (may be offset by increased risk of potential defaults due to falling asset prices). [Positive]


Correlation between two assets is?

According to elementary portfolio theory, the correlation between two assets is given by β1β2σ2M1σ2


Gordon (constant) growth model



D0 = the most recent annual dividend per share

g = the long-term growth rate in dividends, assumed equal to the long-term earnings growth rate

P0 = the current share price

The quantity g can be estimated most simply as the growth rate in nominal gross domestic product (nominal GDP).

more advanced analysis can take account of any perceived differences between the expected growth of the overall economy and that of the constituent companies of the particular equity index that the analyst has chosen to represent equities. The analyst can use

Earnings growth rate = GDP growth rate + Excess corporate growth (for the index companies)


Low/declining inflation - economic consquences

  • Low inflation can be benefitial for equities if there are prospects for economic growth free of central bank interference
  • Declining inflation ususally results in declining economic growth and asset pricies
  • The firms most affected are those that are highly leveraged because they are most sensetive to changing interest rates
  • Low inflation does not affect the return on cash instruments


Shrinkage Estimators for formulating CME

  • Shrinkage estimation involves taking a weighted average of a historical estimate of a parameter and some other parameter estimate, where the weights reflect the analyst’s relative belief in the estimates.
  • The term “shrinkage” refers to the approach’s ability to reduce the impact of extreme values in historical estimates. The procedure has been applied to covariances and mean returns.
  • A shrinkage estimator of the covariance matrix is a weighted average of the historical covariance matrix and another, alternative estimator of the covariance matrix, where the analyst places the larger weight on the covariance matrix he or she believes more strongly in.
  • A shrinkage estimator approach involves selecting an alternative estimator of the covariance matrix, called a target covariance matrix.


Statistical Methods for Formulating Capital Market Expectations

Statistical methods relevant to expectations setting include descriptive statistics (methods for effectively summarizing data to describe important aspects of a dataset) and inferential statistics (methods for making estimates or forecasts about a larger group from a smaller group actually observed).


The Risk Premium Approach

  • The risk premium approach expresses the expected return on a risky asset as the sum of the risk-free rate of interest and one or more risk premiums that compensate investors for the risky asset’s exposure to sources of priced risk (risk for which investors demand compensation).
  • The risk premium approach (sometimes called the build-up approach) is most often applied to estimating the required return in equity and bond markets.


Business and its influence on business cycle

Data on business investment and spending on inventories reveal recent business activity. As already mentioned, both tend to be relatively volatile so that it is not uncommon for business investment to fall by 10–20 percent or more during a recession and to increase by a similar amount during strong economic upswings.


Government Intervention in Currency Markets

Economists and the markets have been skeptical about whether governments really can control exchange rates with market intervention alone because of three factors.

  • First, the total value of foreign exchange trading, in excess of US$1 trilliondaily, is large relative to the total foreign exchange reserves of the major central banks combined.
  • Second, many people believe that market prices are determined by fundamentals and that government authorities are just another player.
  • Third, experience with trying to control foreign exchange trends is not encouraging in the absence of capital controls.


Time-Series Estimators for formulating CME

  • Time-series estimators involve forecasting a variable on the basis of lagged values of the variable being forecast and often lagged values of other selected variables.
  • Time-series methods have been found useful in developing particularly short-term forecasts for financial and economic variables. Time-series methods have been notably applied to estimating near-term volatility, given persuasive evidence of variance clustering (particularly at high frequencies, such as daily and weekly) in a number of different markets.
  • Volatility clustering is the tendency for large (small) swings in prices to be followed by large (small) swings of random direction. Volatility clustering captures the idea that some markets represent periods of notably high or low volatility.


Inflation/Deflation Effects on Equity Asset Class

The impact of the inflation cycle on equities is more complex. In theory, as long as inflation stays near its expected or equilibrium level, the inflation rate is not very important. Higher inflation should be reflected in higher profits, so stocks will rise to compensate. However, signs that inflation is moving out of equilibrium indicate a potential threat because rising inflation could mean that the central banks need to act to slow the economy. Falling inflation, or possible deflation, is a problem because it threatens a recession and a decline in asset prices.


Inflation at or below expectations: 

Bullish while market in equilibrium state. [Positive]

Inflation above expectations: 

High inflation a negative for financial assets. Less negative for companies/industries able to pass on inflated costs. [Negative]


Negative wealth effect slows demand. Especially affects asset-intensive, commodity-producing (as opposed to commodity-using), and highly levered companies. [Negative]


If the number of asset classes is n, the analyst will need to estimate what number of distinct correlations?

If the number of asset classes is n, the analyst will need to estimate (n2 − n)/2 distinct correlations (or the same number of distinct covariances)


Consumer Impacts: Consumption and Demand

  • Consumers can be counted upon as the largest source of aggregate economic growth in both developed and developing economies.
  • Overall consumer consumption is quite stable over the business cycle. Milton Friedman developed an explanation for this stability in his permanent income hypothesis. The permanent income hypothesis asserts that consumers’ spending behavior is largely determined by their long-run income expectations.
  • Thus, consumer trends are usually stable or even countercyclical over a business cycle. When incomes rise the most (during the cyclical expansion phase), spending increases less than income rises. When incomes fall as an economy’s growth slows or declines, consumption falls only a fraction and usually only for a relatively short period of time.


Data Measurement Errors and Biases

Errors in data series include the following:

  • Transcription errors. These are errors in gathering and recording data. Such errors are most serious if they reflect a bias.
  • Survivorship bias. Survivorship bias arises when a data series reflects only entities that have survived to the end of the period. For example, a share index may be based on companies that trade on an exchange. Such companies are often delisted (removed from trading on the exchange) after events such as bankruptcy filings and mergers. Shares of bankrupt companies may trade elsewhere after delisting. Do reported returns on a share index reflect post-delisting returns? If not, the return series will probably convey an overly optimistic picture of the real-time investment returns from owning all listed shares. Without correction, statistics derived from series subject to survivorship bias can be misleading in the forward-looking context of expectations setting.
  • Appraisal (smoothed) data. For certain assets without liquid public markets, appraisal data are used in lieu of market price transaction data. Appraised values tend to be less volatile than market-determined values for the identical asset would be. The consequences are
    • 1) the calculated correlations with other assets tend to be smaller in absolute value than the true correlations, and
    • 2) the true standard deviation of the asset is biased downward. This concern has been raised particularly with respect to alternative investments such as real estate.

The analyst can attempt to correct for the biases in datasets (when a bias-free dataset is not available). For example, one heuristic approach to correcting for smoothed data is to rescale the data in such a way that their dispersion is increased but the mean of the data is unchanged.


Using Economic Information in Forecasting Asset Class Returns: Cash and Equivalents

  • Open market operations are the purchase or sale by a central bank of government securities, which are settled using reserves, to influence interest rates and the supply of credit by banks.
  • Money managers therefore spend a great deal of time in so-called “central bank watching.”


Capital Flows Approach to Forecasting Exchange Rates

  • The capital flows forecasting approach focuses on expected capital flows, particularly long-term flows such as equity investment and foreign direct investment (FDI). Inflows of FDI into a country increase the demand for the country’s currency, all else being equal.
  • Long-term capital flows may have the effect of reversing the usual relationship between short-term interest rates and the currency. This is explained by the fact that a cut in short-term rates would be expected to boost economic growth and the stock markets, thereby making long-term investments more attractive. In this environment, central banks face a dilemma. Whereas they might want to raise interest rates to respond to a weak currency that is threatening to stimulate the economy too much and boost inflation, the effect may actually be to push the currency lower. Hence, the effectiveness of monetary policy is much reduced.


Capital market expectations

  • Capital market expectations (CME): the investor’s expectations concerning the risk and return prospects of asset classes, however broadly or narrowly the investor defines those asset classes. Capital market expectations are an essential input to formulating a strategic asset allocation.
  • Capital market expectations are expectations about classes of assets, or macro expectations. By contrast, micro expectations are expectations concerning individual assets. Micro expectations are key ingredients in security selection and valuation.


Macroeconomic Linkages

Countries’ economies are directly affected by changes in the foreign demand for their exports. This is one way that the business cycle in one country can affect that in others. But there are other international linkages (other than trade) at work, such as those resulting from cross-border direct business investment.


The Failure to Account for Conditioning Information

  • We should not ignore any relevant information or analysis in formulating expectations. Indeed, the use of unconditional expectations can lead to misperceptions of risk, return, and risk-adjusted return.
  • The analyst would need to uncover through research that the asset class’s systematic risk varies with the business cycle. The analyst would then condition his or her forecasts on the state of the economy to formulate the most accurate expectations.


Historical Statistical Approach for formulating CME: Sample Estimators

  • Time series is stationary—that is, the parameters that describe the return-generating process are unchanged.
  • Arithmetic mean return (which is always used in the calculation of the sample standard deviation) best represents the mean return in a single period. The geometric mean return of a sample represents the compound rate of growth that equates the beginning value to the ending value of a data series. The geometric mean return represents multiperiod growth more accurately than the arithmetic mean return. The geometric mean return is always lower than the arithmetic mean return for a risky variable. The differences between the arithmetic mean and the geometric mean in historical estimates of the equity risk premium can be substantial.


Using Economic Information in Forecasting Asset Class Returns: Inflation-Indexed Bonds

The yield on indexed bonds still changes over time, and in practice it varies with three economic factors.

  • First, the yield goes up and down with the real economy and particularly with the level of short-term interest rates. If real yields generally are high because the economy is strong, then real yields on TIPS and ILGs will be higher.
  • Second, yields fall if inflation accelerates because these securities are more attractive when inflation is volatile. In other words, their value in hedging against inflation risk is higher.
  • Finally, as with all assets, the yield can vary according to institutional supply and demand. In practice, tax effects and the limited size of the market (particularly for TIPS in the United States) may also distort the real yield; thus, investors usually find it worthwhile to forecast all three components (real yield, inflation, and supply and demand).

The Macroeconomy and Real Yields:

Economic Observation                           Effect on Real Bond Yields

Economic growth rising (falling)             Rise (fall)

Inflation expectations rising (falling)      Fall (rise)

Investor demand rising (falling)              Fall (rise)


Discounted Cash Flow Models

DCF models are a basic tool for establishing the intrinsic value of an asset based on fundamentals (e.g., its projected cash flows) and its fair required rate of return. DCF models have the advantage of being forward-looking. They do not address short-run factors such as current supply-and-demand conditions, so practitioners view them as more appropriate for setting long-term rather than short-term expectations.


Purchasing Power Parity Approach to Forecasting Exchange Rates

  • Purchasing power parity (PPP) asserts that movements in an exchange rate should offset any difference in the inflation rates between two countries. PPP reflects the idea that exchange rates should find a level that keeps different countries broadly competitive with each other.
  • PPP in broad terms does seem to be useful in the long run—say, over periods of five years or longer. Furthermore, governments and central banks take PPP very seriously in their approach to exchange rates because periods of under- or overvaluation of a currency may lead to sudden exchange rate instability or be destabilizing for business.

  • However, with the huge rise in capital flows over the last three decades, exchange rates can depart from PPP levels for long periods of time. PPP is often not a useful guide to the direction of exchange rates in the short or even medium run (up to three years or so). There are also times when factors other than PPP dominate exchange rate movements. This usually happens when a large current account deficit is opening up and the markets question whether a growing deficit can be financed. Markets then focus on what level of the currency is needed to correct the deficit.


Level of integration of different markets

  • Research has suggested that developed market equities and bonds are approximately 80 percent integrated
  • Emerging market equities and bonds are about 65 percent integrated
  • Currency and cash markets are 100 percent integrated


The Inventory Cycle

  • The inventory cycle is a cycle measured in terms of fluctuations in inventories. The inventory cycle is caused by companies trying to keep inventories at desired levels as the expected level of sales changes.
  • In the up phase of the inventory cycle, businesses are confident about future sales and are increasing production. The increase in production generates more overtime pay and employment, which tends to boost the economy and bring further sales. At some point, there is a disappointment in sales or a change in expectations of future sales, so that businesses start to view inventories as too high. In the recent past, a tightening of monetary policy has often caused this inflection point. It could also be caused by a shock such as higher oil prices. Then, business cuts back production to try to reduce inventories and hires more slowly (or institutes layoffs). The result is a slowdown in growth.
  • The traditional interpretation is that a decreasing inventory-to sales ratio is a negative sign because business are preparing for a decrease in business. At the same time, there may exist an optimistic view about decreasing inventory-to-sales - that firms have been able to lower their levels of inventory with help of technology.


Checklist Approach

  • Formally or informally, many forecasters consider a whole range of economic data to assess the future position of the economy. Checklist assessments are straightforward but time-consuming because they require looking at the widest possible range of data.
  • Such an approach involves a substantial amount of subjective judgment as to what is important in the economy.


Money Supply Trends

Over the long run, there is a reasonably stable relationship between the growth in money supply and the growth in nominal GDP (inflation plus real growth). If money growth is particularly strong in relation to nominal GDP, chances are that growth will accelerate in the near future and that inflation may eventually accelerate.


There is a factor analysis of two stocks, FGI and VCC

  • S - world equity index
  • B - world bond index

Estimations of returns of FGI and VCC:

  • RFGI = 1.4xFS,FGI - 0.2xFB,FGI + ΣFGI
  • RVCC = 0.8xFS,VCC + 0.1xFB,VCC + ΣVCC

The variance of the stock and bond factors are 0.04 and 0.007 respectively. The covariance of the factors is 0.01. 

What is the forecasted covariance of FGI and VCC?

Cov(i,j) = ßi,1ßj,1σ2F1 + ßi,2ßj,2σ2F2 + (ßi,1ßj,2i,2ßj,1) Cov (F1,F2)

Cov(i,j) = (1.4 x 0.8 x 0.04) - (0.2 x 0.01 x 0.007) + [(1.4 x 0.1) + (-0.2 x 0.8)] (0.01) = 0.04446


Business Cycle Analysis

In business cycle analysis, two cycles are generally recognized: a short-term inventory cycle, typically lasting 2–4 years, and a longer-term business cycle, usually lasting 9–11 years.

The chief measurements of economic activity are as follows:

  1. Gross domestic product (GDP): To focus on increases in the quantity (output) of goods and services produced—which are directly associated with increases in the standard of living—rather than on price-driven increases in the value of output, economists focus on real GDP (reflecting an adjustment for changes in prices during the period).
  2. Output gap: The output gap is the difference between the value of GDP estimated as if the economy were on its trend growth path (sometimes referred to as potential output) and the actual value of GDP. A positive output gap opens in times of recession or slow growth. When a positive output gap is open, inflation tends to decline. Once the gap closes, inflation tends to rise. When GDP is above its trend value, the economy is under inflationary pressure. Many macroeconomists consider the output gap as the key measure of real activity for policy making because it provides information about future inflationary pressures as well as an output objective. However, because changing demographics and technology affect the economy’s trend path, real-time estimates of the output gap can sometimes be quite inaccurate.
  3. Recession: In general terms, a recession is a broad-based economic downturn. More formally, a recession occurs when there are two successive quarterly declines in GDP.


Using Economic Information in Forecasting Asset Class Returns: Emerging Market Bonds

  • Emerging market debt refers here to the sovereign debt of nondeveloped countries.
  • Emerging market bonds, as an asset class, are different in that the country is borrowing in a foreign currency. The government therefore cannot simply inflate its way out of a problem in servicing the debt, and so the risk of default is correspondingly higher.


Biases in Analysts’ Methods


  • Data-mining bias. Data-mining bias is introduced by repeatedly “drilling” or searching a dataset until the analyst finds some statistically significant pattern. Such patterns cannot be expected to be of predictive value.The absence of an explicit economic rationale for a variable’s usefulness is one warning sign of a data-mining problem: no story, no future.
  • Time-period bias. Time-period bias relates to results that are time period specific. Research findings are often found to be sensitive to the selection of starting and/or ending dates.

The analyst should scrutinize the variable selection process for data-mining bias and be able to provide an economic rationale for the variable’s usefulness in a forecasting mode. A further practical check is to examine the forecasting relationship out of sample (i.e., on data other than those used to estimate the relationship). For example, the available data period could be split into two subperiods. If the forecasting relationship estimated from the first period does not hold similarly when tested using data from the second subperiod, the variable may not be useful as a forecaster.


Financial Market Equilibrium Models

  • Financial equilibrium models describe relationships between expected return and risk in which supply and demand are in balance. In that sense, equilibrium prices or equilibrium returns are fair if the equilibrium model is correct.
  • Equilibrium approaches to setting capital market expectations include the Black–Litterman approach and the international CAPM–based approach.


Economic Growth Trends

  • The economic growth trend is the long-term growth path of GDP.
  • The differences between economic trends and cycles need to be understood. Economic trends exist independently of the cycle but are related to it. Business cycles take the economy through an alternating sequence of slow and fast growth, often including recessions and economic booms.
  • Trends are more easily forecast than cycles, but there are always uncertainties. In practice, it is often difficult to know which trends are most important. Moreover, some trends or changes in trends are by definition not open to forecasting. These are often called “shocks.”
  • The expected trend rate of economic growth is a key input in discounted cash flow models of expected return. First, a country with a higher trend rate of growth may offer equity investors a particularly good return. Second, a higher trend rate of growth in the economy allows actual growth to be faster before there is a danger of inflation.


Perception of alternative investments is that they yield high returns with low risk. Explanation?

The perception of alternative investments is that they yield high returns with low risk and that they barely correlate with traditional asset classes. At least in some cases, this perception results from the uncritical use of flawed historical statistics because alternative assets are not traded on exchanges with continuously observable markets. 


Psychological Traps

1. The anchoring trap is the tendency of the mind to give disproportionate weight to the first information it receives on a topic. In other words, initial impressions, estimates, or data anchor subsequent thoughts and judgments.

2. The status quo trap is the tendency for forecasts to perpetuate recent observations—that is, to predict no change from the recent past.

3. The confirming evidence trap is the bias that leads individuals to give greater weight to information that supports an existing or preferred point of view than to evidence that contradicts it. The tendency to seek out information that supports an existing point of view also reflects this bias. Several steps may be taken to help ensure objectivity:

  • Examine all evidence with equal rigor.
  • Enlist an independent-minded person to argue against your preferred conclusion or decision.
  • Be honest about your motives.

4. The overconfidence trap is the tendency of individuals to overestimate the accuracy of their forecasts. The overconfidence trap would be reflected in admitting too narrow a range of possibilities or scenarios in forecasting. A good practice to prevent this trap from undermining the forecasting endeavor is to widen the range of possibilities around the primary target forecast.

5. The prudence trap is the tendency to temper forecasts so that they do not appear extreme, or the tendency to be overly cautious in forecasting. In a decision-making context, it is the tendency to be cautious when making decisions that could be potentially expensive or damaging to the decision maker’s career. To avoid the prudence trap, an analyst is again wise to widen the range of possibilities around the target forecast. In addition, the most sensitive estimates affecting a forecast should be carefully reviewed in light of the supporting analysis.

6. The recallability trap is the tendency of forecasts to be overly influenced by events that have left a strong impression on a person’s memory.


Market Expectations and the Business Cycle

Identifying the current phase of the cycle and correctly predicting when the next phase will begin is not that simple for several interrelated reasons:

  • First, the phases of the business cycle vary in length and amplitude.
  • Sometimes, the weak phase of the cycle does not even involve a recession but merely a period of slower economic growth or a “growth recession.”

A mild downturn, or growth recession, is most likely if the trend rate of growth of the economy is relatively rapid.

For the main industrial economies, with trend rates of annual growth of 2–4 percent, a mild downturn is more likely than a recession if some or all of the following conditions hold:

  • The upswing was relatively short or mild.
  • There was no bubble or severe overheating in the stock market or property market.
  • Inflation is relatively low, so the central bank is willing to cut interest rates quickly.
  • The world economic and political environments are positive.


Formal Tools

Formal tools are established research methods amenable to precise definition and independent replication of results. The information provided by well-chosen formal tools applied to sound data can help the analyst produce accurate forecasts.

  • Statistical Methods
    • Historical Statistical Approach: Sample Estimators
    • Shrinkage Estimators
    • Time-Series Estimators
    • Multifactor Models
  • Discounted Cash Flow Models
  • The Risk Premium Approach
  • Financial Market Equilibrium Models


Economic Forecasting

There may be distinguished at least three distinct approaches:

  • Econometric models, the most formal and mathematical approach to economic forecasting.
  • Leading indicators: variables that have been found to lead (precede) turns in the economy.
  • Checklists, requiring the subjective integration of the answers to a set of relevant questions.


Using Economic Information in Forecasting Asset Class Returns: Currencies

  • The exchange rate between two countries reflects the balance of buyers and sellers. One major reason for buying and selling foreign currencies is to facilitate trade in goods and services (exports and imports).
  • The other motive is international flows of capital. Companies wishing to invest in a country are likely to be buyers of the currency as they bring in capital to build assets. Strong domestic economic growth and an opening of new industries to foreign ownership are two possible drivers of a rise in foreign direct investment that will likely push up a currency too.
  • Portfolio flows may be influenced by the growth of the economy or by domestic interest rates. When interest rates are high, inflows are likely to be higher and the currency value rises. Conversely, falling interest rates often weaken a currency. However, the link between interest rates and the currency sometimes works the other way. This is because investors may see higher interest rates as slowing the economy.


Inflation/Deflation Effects on Cash Asset Class

Inflation at or below expectations: 

Short-term yields steady or declining. [Neutral]

Inflation above expectations: 

Bias toward rising rates. [Positive]


Bias toward 0% short-term rates. [Negative]


Conditional return correlations are?

The correlations that depend upon market volatility.


Advantages and limitations of the Cyclical Indicator Approach


  • Available from outside parties
  • Easy to interpret and understand
  • Can be adapted for specific purposes
  • Effectiveness has been verified by academic research


  • False signals - this occurs when a series that is moving in one direction suddenly reverses and nullifies a prior signal, or hesitates, which is difficult to interpret.
  • Currency of the Data and Revisions - some data series are reported with a lag. Also, revisions in data can change the magnitude of the signal, and even change the direction implied by the original data.
  • Economic sectors not reported - examples inlude service sector, import-export, and many international series.
  • Changes in relationships among economic variables - unstable relationships might invalidate assumptions about the effects of changes in a variable (not consistently accurate as economic relationships change through time).


Multifactor Models for formulating CME

multifactor model is a model that explains the returns to an asset in terms of the values of a set of return drivers or risk factors.

The structure of a multifactor model, if the analyst believes that K factors drive asset returns, is as follows:



Ri = the return to asset i

ai = an intercept term in the equation for asset i

Fk = the return to factor k, k = 1, 2, …, K

bik = the sensitivity of the return to asset i to the return to factor k, k = 1, 2, …, K

εi = an error term with a zero mean that represents the portion of the return to asset i not explained by the factor model. The error term is assumed to be uncorrelated with each of the K factors and to be uncorrelated with the error terms in the equations for other assets.

Multifactor models are useful for estimating covariances for the following reasons:

  1. By relating the returns on all assets to a common set of return drivers, a multifactor model simplifies the task of estimating covariances: estimates of covariances between asset returns can be derived using the assets’ factor sensitivities.
  2. When the factors are well chosen, a multifactor model approach may filter out noise (i.e., random variation in the data specific to the sample period).
  3. Such models make it relatively easy to verify the consistency of the covariance matrix, because if the smaller factor covariance matrix is consistent, so are any covariances computed on the basis of it.

Factor covariance matrix, as it contains the covariances for the factors assumed to drive returns. In order to derive the asset covariance matrix (the covariance matrix for the asset classes or markets under consideration), we need to know how each of the markets responds to factor movements. We measure the responsiveness of markets to factor movements by the markets’ factor sensitivities (also known as factor betas or factor loadings), represented by the quantities bik.

Every market has some risk that is not explained by the factors. This is called the market’s idiosyncratic or residual risk and is represented by the residual variance, Var(εi) for market i. It is assumed that the residuals are uncorrelated.

We compute the markets’ variances and covariance using equations, respectively (for 5 assets):

Mii=b2i1Var(F1)+b2i2Var(F2)+2bi1bi2Cov(F1,F2)+Var(εi),                  for i=1 to 5

Mij=bi1bj1Var(F1)+bi2bj2Var(F2)+(bi1bj2+bi2bj1)Cov(F1,F2)             for i=1 to 5, j=1 to 5 , andi≠j


Resampled efficient frontier

Monte Carlo simulation is used to create an efficient frontier at each return level and run thousands of times resulting in an efficient frontier that is the result if an averaging process. The efficient frontier becomes a blur rather than a single sharp curve. At each level of return, the most efficient of the simulated efficient portfolios is at the center of the distrbution.


Relative Economic Strength Approach to Forecasting Exchange Rates

  • The relative economic strength forecasting approach focuses on investment flows rather than trade flows. It suggests that a strong pace of economic growth in a country creates attractive investment opportunities, increasing the demand for the country’s currency and causing it to appreciate. Sometimes, demand comes from a higher short-term deposit rate in that country combined with an expectation that the currency will stay the same or appreciate. More recently, the focus has been on the pace of economic growth and the existence of attractive investment opportunities in general.
  • It can be helpful to combine the PPP and relative strength approaches. The relative strength approach indicates the response to news on the economy but does not tell us anything about the level of exchange rates. The PPP approach indicates what level of the exchange rate can be regarded as a long-term equilibrium. By combining the two, we can generate a more complete theory.


Inflation/Deflation Effects on Real Estate/Other Real Asset

Inflation at or below expectations: 

Cash flow steady to rising slightly. Returns equate to long-term average. Market in general equilibrium. [Neutral]

Inflation above expectations: 

Asset values increasing; increased cash flows and higher expected returns.[Positive]


Cash flows steady to falling. Asset prices face downward pressure. [Negative]



Assuming that the risk premium on any currency equals zero—as it would be if purchasing power parity relationships hold—the ICAPM gives the expected return on any asset as the sum of:

  • the (domestic) risk-free rate, and
  • a risk premium based on the asset’s sensitivity to the world market portfolio and expected return on the world market portfolio in excess of the risk-free rate.

E(Ri) = RF + βi[E(RM) – RF]


E(Ri) = the expected return on asset i given its beta

RF = the risk-free rate of return

E(RM) = the expected return on the world market portfolio

βi = the asset’s sensitivity to returns on the world market portfolio, equal to Cov(Ri, RM)/Var(RM)

An important question concerns the identification of an appropriate proxy for the world market portfolio. The GIM (global investable market) is a practical proxy for the world market portfolio consisting of traditional and alternative asset classes with sufficient capacity to absorb meaningful investment.

Asset class’s risk premium equals the product of the Sharpe ratio (RPMM) of the world market portfolio, the asset’s own volatility, and the asset class’s correlation with the world market portfolio (assuming full integration):



Equation above is one of two key equations in the Singer–Terhaar approach.


Initial Recovery stage of business cycle

This is usually a short phase of a few months in which the economy picks up from its slowdown or recession. Generally, confidence is rising among businesses, although consumer confidence may still be at low levels since unemployment is still high. In the initial recovery phase, there are often stimulatory economic policies from the government in the form of lower interest rates or a budgetary deficit. The business cycle recovery is usually supported by a simultaneous upswing in the inventory cycle, which is sometimes the main cause of the recovery. Inflation will still be falling in the initial recovery phase. The output gap is still large.

Capital market effects: Government bond yields (long-term interest rates) may continue to come down through this phase in anticipation of a further decline in inflation but are likely to be bottoming. Stock markets may rise strongly at this point because fears of a longer recession (or even a depression) dissipate. Cyclical assets—and riskier assets, such as small stocks, higher-yield corporate bonds, and emerging market equities and bonds—attract investors and perform well.


Economy: Inflation still declining

Fiscal and Monetary Policy: Stimulatory fiscal policies

Confidence: Confidence starts to rebound

Capital Markets: Short rates low or declining; bond yields (long-term interest rates) bottoming; stock prices strongly rising


The Business Cycle

In addition to the inventory cycle, there is evidence of a longer cycle, often lasting 9–11 years, called the business cycle. The business cycle represents fluctuations in GDP in relation to long-term trend growth. A typical business cycle has five phases:

  1. initial recovery,
  2. early upswing,
  3. late upswing,
  4. slowdown, and
  5. recession.


Interest Rate/Exchange Rate Linkages

  • One of the linkages of most concern to investors involves interest rates and exchange rates. Sometimes, short-term interest rates are affected by developments in other countries because one central bank pursues a formal or informal exchange rate link with another currency. Some governments unilaterally peg their currencies firmly or loosely to one of the major currencies.
  • The countries that follow this strategy find two benefits. First, domestic business has some reassurance that exchange rates are not going to fluctuate wildly. Second, by pegging the exchange rate, a “pegged” country often hopes to control inflation.
  • If a country is following such an exchange rate policy, then the level of interest rates will depend on overall market confidence in the peg. A high degree of confidence in the exchange rate peg means the interest rate differential can converge to near zero.
  • If a country is known to be linking its currency to another, then bond yields of the weaker currency are nearly always higher.
  • Obviously, nominal bond yields vary between countries according to those countries’ different inflation outlooks and other factors. It is sometimes thought that real bond yields ought to be similar in different countries because international capital flows will equalize them. However, movements in exchange rates to under- or overvalued levels can compensate for different real bond yields. Although real yields can and often do vary among countries, they tend to move together.
  • The key factor linking bond yields (especially real bond yields) is world supply and demand for capital or the perceptions of supply and demand.


Calculation of beta, formula

ßi=(σi x Correlation with GIM)/σM


Essential Differences between Emerging and Major Economies

  • Emerging markets need higher rates of investment than developed countries in physical capital and infrastructure and in human capital. But many emerging countries have inadequate domestic savings and therefore rely heavily on foreign capital.
  • Emerging countries have a more volatile political and social environment than developed countries.
  • Most emerging countries need major structural reform to unlock their potential, which can be difficult to achieve in a volatile political environment. The potential for growth is often blocked by governments protecting vested interests.
  • Even the largest emerging countries are relatively small in world terms, and their economies are often concentrated in a few areas such as particular commodities or in a narrow range of manufactured goods. Others rely heavily on oil imports and are thus vulnerable to fluctuation in oil prices or are dependent on continuing capital inflows.


Econometric Modeling

  • Econometric models have several limitations.
    • First, econometric models require the user to find adequate measures for the real-world activities and relationships to be modeled, and these measures may not be available.
    • Variables may also be measured with error.
    • Relationships among the variables may change over time because of changes in the structure of the economy; as a result, the econometric model of the economy may be misspecified.
  • In practice, therefore, skillful econometric modelers use a great deal of personal judgment in arriving at forecasts. Very often, the first run of the model will generate a forecast that the modelers do not believe. So, they will go back and change some of the exogenous variables to arrive at a forecast they do believe.
  • The great merit of the econometric approach, however, is that it constrains the forecaster to a certain degree of consistency and also challenges the modeler to reassess prior views based on what the model concludes.
  • In practice, model-based forecasts rarely forecast recessions well, although they have a better record in anticipating upturns.


Oil Shocks

A sudden rise in prices affects consumers’ income and reduces spending. Inflation rates also rise, though here the effect is ambiguous. Although inflation moves up initially, the contractionary effect of higher oil prices restricts employment and opens up an output gap so that, after a period, inflation slows to below the level where it otherwise might have been.


A Framework for Developing Capital Market Expectations

Framework for a disciplined approach to setting CME.

  1. Specify the final set of expectations that are needed, including the time horizon to which they apply.
  2. Research the historical record. Beyond the raw historical facts, the analyst should seek to identify the factors that affect asset class returns and to understand the what, when, where, why, and how of these return drivers. The analyst will then have a better sense of the information mosaic that he or she will need to piece together to arrive at well-informed conclusions.
  3. Specify the method(s) and/or model(s) that will be used and their information requirements. In Step 3, the analyst also needs to be sensitive to the fact that the effectiveness of forecasting approaches and relationships among variables may be related to the investor’s time horizon

  4. Determine the best sources for information needs. The cost of data may also be relevant. In short, analysts must understand everything they can about the data they will use for analysis. Using flawed or misunderstood data is a recipe for faulty analysis. Furthermore, analysts should constantly be alert to new, superior sources for their data needs.

  5. Interpret the current investment environment using the selected data and methods, applying experience and judgment. The analyst should be sure that he or she is working from a common set of assumptions in interpreting different elements of the investment and economic scene so that the analyst’s conclusions are mutually consistent. The analyst often needs to apply judgment and experience to interpret apparently conflicting signals within the data.

  6. Provide the set of expectations that are needed, documenting conclusions. These are the analyst’s answers to the questions set out in Step 1. The answers should be accompanied by the reasoning and assumptions behind them.

  7. Monitor actual outcomes and compare them to expectations, providing feedback to improve the expectations-setting process. Finally, we want to use experience to improve the expectations-setting process. We measure our previously formed expectations against actual results to assess the level of accuracy that the expectations-setting process is delivering. Generally, good forecasts are:
  • unbiased, objective, and well researched;
  • efficient, in the sense of reducing the magnitude of forecast errors to a minimum; and
  • internally consistent.


Central bank orthodoxy for dealing with inflation rests on three principles

Central bank orthodoxy for dealing with inflation rests on three principles:

  • Central banks’ policy-making decisions must be independent of political influence. If political pressure is brought to bear on central banks, they may be too loose in their monetary policy and allow inflation to gradually accelerate.
  • Central banks should have an inflation target, both as a discipline for themselves and as a signal to the markets of their intentions. An inflation target also serves to anchor market expectations.
  • Central banks should use monetary policy (primarily interest rates) to control the economy and prevent it from either overheating or languishing in a recession for too long.


Consumers and its influence on business cycle

  • By far the most important factor affecting consumption is consumer income after tax, which depends on wage settlements, inflation, tax changes, and employment growth.
  • If the household savings rate remained constant, then changes in income would exactly predict changes in spending. But the savings rate does change over time.


If inflation rises, the yields for TIPS will?

If inflation rises, the yields for TIPS will actually fall and their prices rise because the demand for them increases as investors seek out their inflation protection.


The Taylor Rule



Roptimal = the target for the short-term interest rate

Rneutral = the short-term interest rate that would be targeted if GDP growth were on trend and inflation on target

GDPgforecast = the GDP forecast growth rate

GDPgtrend = the observed GDP trend growth rate

Iforecast = the forecast inflation rate

Itarget = the target inflation rate

The federal funds rate, or fed funds rate for short, is the interest rate on overnight loans of reserves [deposits] at the Fed between Federal Reserve System member banks.


Survey and Panel Methods

The survey method of expectations setting involves asking a group of experts for their expectations and using the responses in capital market formulation. If the group queried and providing responses is fairly stable, the analyst in effect has a panel of experts and the approach can be called a panel method. These approaches are based on the straightforward idea that a direct way to uncover a person’s expectations is to ask the person what they are.


Examples of economic indicators

Leading Index Factor
1. Average weekly hours, manufacturing 
2. Average weekly initial claims for unemployment insurance 
3. Manufacturers’ new orders, consumer goods and materials 
4. Vendor performance, slower deliveries diffusion index 
5. Manufacturers’ new orders, non-defense capital goods 
6. Building permits, new private housing units
7. Stock prices, 500 common stocks 
8. Money supply, M2
9. Interest rate spread, 10-year Treasury bonds less federal funds 
10. Index of consumer expectations 

Coincident Index
1. Employees on nonagricultural payrolls 
2. Personal income less transfer payments 
3. Industrial production 
4. Manufacturing and trade sales

Lagging Index
1. Average duration of unemployment 
2. Inventory/sales ratio, manufacturing and trade 
3. Labor cost per unit of output, manufacturing 
4. Average prime rate 
5. Commercial and industrial loans 
6. Consumer installment credit to personal income ratio 
7. Consumer price index for services 


Misinterpretation of Correlations

1. In financial and economic research, the analyst should take care in interpreting correlations. When a variable A is found to be significantly correlated with a variable B, there are at least three possible explanations:

  • A predicts B;
  • B predicts A;
  • a third variable C predicts A and B.

Without the investigation and modeling of underlying linkages, relationships of correlation cannot be used in a predictive model.

2. An exogenous variable is determined outside the system, in contrast to an endogenous variable, which is determined within the system.

3. Another surprise that might be in store: A and B could have a strong but nonlinear relationship but have a low or zero correlation.

4. Are there any more powerful tools to apply to establish the variable’s usefulness than simple correlation? Multiple-regression analysis may be one such tool. For example, suppose we have a model that suggests B predicts A but we need to eliminate C as mediating the relationship between A and B (as in the third bullet point above). We can estimate the following regression:

A = β0 + β1B + β2C + ε

The variable C in this regression is a control variable. The coefficient β1 represents the effect of B on A after accounting for the effect of the control variable C on A. The coefficient β1 reflects the partial correlation between A and B. If the estimated value of β1 is significantly different from 0 but β2 is not significantly different from 0 (based on t-tests), we have a piece of evidence in support of the proposition that B predicts A.


Government Structural Policies

Government structural policies refer to government policies that affect the limits of economic growth and incentives within the private sector.

The following are elements of a pro-growth government structural policy:

  1. Fiscal policy is sound. Fiscal policy is sometimes used to influence the business cycle and can play a useful role. For example, decreasing a budget surplus (or increasing a budget deficit) may be a justifiable economic stimulus during a recession. Countries that regularly run large deficits tend to have one or more of three potential problems. First, a government budget deficit often brings a current account deficit (the so-called “twin deficits” problem), which means that the country must borrow abroad. Eventually, when the level of foreign debt becomes too high, that borrowing must be scaled back. This usually requires a large and potentially destabilizing devaluation of the currency. Second, if the deficit is not financed by borrowing, it will ultimately be financed by printing money, which means higher inflation. Third, the financing of the deficit takes resources away from private sector investment, and private sector investment is usually more productive for the country as a whole. It is for all these reasons that investors prefer to see governments hold the budget deficit close to zero over the long term.
  2. The public sector intrudes minimally on the private sector. According to economic theory, a completely unfettered competitive market would probably supply too little in the way of public goods, such as national defense, and too much in the way of goods with negative externalities, such as goods whose manufacture pollutes the environment. However, the thrust of economic theory is that the marketplace usually provides the right incentives to individuals and businesses and leads to an efficient allocation of scarce resources. The most damaging regulations for business tend to be labor market rules (e.g., restricting hiring and firing) because such regulations tend to raise the structural level of unemployment (the level of unemployment resulting from scarcity of a factor of production); however, such regulations are also the most difficult to lift.
  3. Competition within the private sector is encouraged. Competition is important for trend growth because it drives companies to be more efficient and therefore boosts productivity growth. Another positive government policy is openness to foreign investment. However, note that competition makes it more difficult for companies to earn high returns on capital and thus can work against high stock market valuations.
  4. Infrastructure and human capital development are supported. Projects supporting these goals may be in partnership with the private sector. Building health and education infrastructure has important economic benefits.

  5. Tax policies are sound. Sound tax policy involves simple, transparent, and rarely altered tax rates; low marginal tax rates; and a very broad tax base.


Fiscal Policy

Fiscal policy means manipulating the budget deficit to influence the economy. Governments increase spending or cut taxes to stimulate the economy and cut spending or raise taxes to slow the economy.

It is crucial to remember two points.

  • First, an analyst should focus on the changes in the government budgetary deficit, not its level.
  • Second, it is only changes in the deficit due to deliberate changes in government fiscal policy that matter. The budget deficit will constantly change in response to the economy without any change in fiscal policy.


beta and beta research

The development of capital market expectations is beta research (research related to systematic risk and returns to systematic risk). As such, it is usually centralized so that the CME inputs used across all equity and fixed-income products are consistent. On the other hand, alpha research (research related to capturing excess risk-adjusted returns by a particular strategy) is typically conducted within particular product groups with the requisite investment-specific expertise.


Advantages and Disadvantages of Three Approaches to Economic Forecasting

Econometric Models Approach


  • Models can be quite robust with many factors used that can approximate reality.
  • Once models are built, new data may be collected and consistently used within models to quickly generate output.
  • Provides quantitative estimates of the effects on the economy of changes in exogenous variables.


  • Most complex and time-consuming to formulate.
  • Data inputs and relationships not easy to forecast and not static.
  • Requires careful analysis of output.
  • Rarely forecasts recessions well.

Leading Indicator–Based Approach


  • Usually intuitive and simple in construction.
  • May be available from third parties.
  • May be tailored for individual needs.
  • A literature exists on the effective use of various third-party indicators.


  • Historically, has not consistently worked, as relationships between inputs are not static.
  • Can provide false signals.

Checklist Approach


  • Limited complexity.
  • Flexible: allows structural changes to be easily incorporated.


  • Subjective.
  • Time-consuming.
  • Complexity has to be limited due to the manual nature of the process.


Using Economic Information in Forecasting Asset Class Returns: Defaultable Debt

Defaultable debt is debt with some meaningful amount of credit risk—in particular, most corporate debt.


Using Economic Information in Forecasting Asset Class Returns: Common Shares

Some companies, generally the ones with large fixed costs and a pronounced sales cycle, are more sensitive to the business cycle than others. These are called cyclical stocks. Examples include car manufacturers and chemical producers.


Threats of deflation?

Deflation is a threat to the economy for two main reasons.

  • First, it tends to undermine debt-financed investments. If the price of a debt-financed asset (e.g., new equipment or a house) declines in value, the value of the “equity” in the asset (i.e., the difference between the asset’s value and the loan balance) declines at a leveraged rate.
  • Second, deflation undermines the power of central banks. In a deflation, interest rates fall to levels close to zero. When interest rates are already very low, the central bank has less leeway to stimulate the economy by lowering interest rates.
  • Quantitative easing: central bank buys financial assets to inject a predetermined quantity of money in the financial system.
  • In today’s economies, prolonged deflation is not really likely. In the now distant past, prolonged deflation was caused by the limited money supply provided by the gold standard currency system. (In the gold standard currency system, currency could be freely converted into gold at established rates, so that the money supply was constrained by the size of a government’s gold reserves.) With governments able to expand the money supply to any desired degree, there is really no reason for deflation to last long.
  • Resistance to reduction in wages is a counterweight to deflationary pressures.





GNP makes an adjustment to GDP equal to the receipts of factor income from the rest of the world to the country, less the payments of factor income from a country to the rest of the world.


Monetary Policy

The key variables watched by monetary authorities are as follows:

  • the pace of economic growth;
  • the amount of excess capacity still available (if any);
  • the level of unemployment; and
  • the rate of inflation.
  1. In recent times, the common means for the largest central banks to effect monetary policy has been setting short-term interest rates to levels that are meant to control inflation without inhibiting economic growth.
  2. Lower rates encourage more borrowing by consumers and businesses. Lower interest rates also usually result in higher bond and stock prices. These in turn encourage consumers to spend more and encourage businesses to invest more. From an international trade perspective, lower interest rates usually lower the exchange rate and therefore stimulate exports.
  3. Conceptually, the argument is that a neutral level of short-term interest rates should include a component to cover inflation and a real rate of return component. For example, in the United States, if inflation is targeted at 2 percent and the economy is growing at 2 percent, many economists argue that the neutral level of interest rates is about 4 percent.


The Equity Risk Premium

E(Re) = YTM on a long-term government bond + Equity risk premium

  • “long-term” has usually been interpreted as 10 or 20 years
  • Equation above has been called the bond-yield-plus-risk-premium method of estimating the expected return on equity
  • Equity risk premium in practice is specifically defined as the expected excess return over and above a long-term government bond yield.


Financial Crises

  • Periodic financial crises affect growth rates either directly through bank lending or indirectly through their effect on investor confidence.
  • Financial crises are therefore potentially more dangerous in a low interest rate environment.


Exogenous Shocks

  • Exogenous shocks are events from outside the economic system (not literally) that affect its course - outside the normal course of an economy.
  • Shocks may have short-lived effects or drive changes in trends.
  • Most shifts in trends are likely to come from shifts in government policies, which is why investors closely watch both specific measures and the overall direction of government policy.
  • Some shocks do not affect trends but are felt in a more immediate or short-term manner.
  • Shocks cannot be forecast in general. But there are two types of economic shock that periodically affect the world economy and often involve a degree of contagion, as problems in one country spread to another. Oil shocks are important because a sharp rise in the price of oil reduces consumer purchasing power and also threatens higher inflation. Financial shocks, which can arise for a variety of reasons, threaten bank lending and therefore economic growth.

Decks in Lucy's CFA Level 3 Notes Class (31):