Flashcards in S6 Deck (49):

1

## Steps in formulation of capital market expectations

###
DETERMINE the specific capital market EXPECTATIONS NEEDED according to the investor's tax status, allowable asset classes, and time horizon.

INVESTIGATE assets' HISTORICAL PERFORMANCE to determine the drivers.

IDENTIFY the VALUATION MODEL used and its requirements.

COLLECT the BEST DATA possible.

Use experience and judgment to INTERPRET CURRENT MARKET CONDITIONS and decide what values to assign to the required inputs.

FORMULATE CAPITAL MARKET EXPECTATIONS.

MONITOR performance and use it to REFINE the process.

2

## Factors in evaluation of data

###
Calculation methodologies.

Data collection techniques.

Data definitions.

Error rates.

Investability and correction for free float.

Turnover in index components.

Potential biases.

3

## Nine problems encountered in producing forecasts

###
EE LL MM NN P

(2) Error and bias in data measurement,

(4) Ex post risk and return measures being used,

(1) Limitations to using economic data,

(3) Limitations of historical estimates,

(7) Misinterpretation of correlations,

(9) Model and input uncertainty.

(5) Non-repeating data patterns,

(6) Not accounting for conditioning information,

(8) psychological traps, and

4

## data measurement errors and biases

###
transcription errors (recording)

survivorship bias

appraisal (smoothed) data

5

## Benefits from using long term data

###
. It may be statistically required.

. provides more precise statistical estimates

. less sensitive to the starting and ending points selected for the time period.

6

## Problems from using long term data

###
. Regime changes

. relevant time period is too short to be statistically significant

. more frequent data points are often more likely to have missing or outdated values (asynchronism) and can result in lower, distorted correlation calculations.

7

## Gordon growth model or constant growth mode

### P0 (current) = D1 (next) /(R-g)

8

## Grinol Kroner model

###
Ri = exp ( income return) + exp (NOMINAL earnings growth ) + exp ( repricing return)

= ( D1/P0 - stock count growth) + (inflation + growth) + (p/e extension)

9

## Bond returns - risk premium approach

###
R = real risk-free rate + .......... In de li ma ta

+ inflation risk premium

+ default risk premium

+ liquidity risk premium

+ maturity risk premium

+ tax premium

10

## CAPM model - return =

### R=Rfr + asset beta x (market R - Rfr)

11

## Risk premium bonds & stocks =

### Standard deviation x correlation x Sharpe

12

## ERP - equity risk premium

###
ERP =

= Standard deviation

x Correlation with global market (1 if fully segmented)

x Sharpe ratio

+ Illiquidity premium for developing countries

13

## ERP including segmentation / integration =

###
Degree of segmentation x ERP segmentation +

+ Degree of integration x ERP integration +

14

##
Beta =

### Correlation A with market x Standdev asset A / Standdev market

15

## The longer-term business cycle - length and phases

###
9 to 11 years

the initial recovery,

early upswing,

late upswing,

slowdown,

recession.

16

## Initial Recovery • • •

###
Few months.

Rising stocks (esp risk assets), confidence.

Falling inflation, short term interest

Government stimulation: low rates and/or budget deficits.

Large output gap

Bond yields are bottoming out.

17

## Early Upswing • • • • • • • •

###
1+ years

Increasing growth with low inflation, confidence, inventories, stocks, short term interest, bond yields

Output gap is narrowing.

18

## Late Upswing • • • • • • •

###
Confidence and employment are high.

Output gap eliminated and economy at risk of overheating.

Central bank limits the growth of the money supply.

Rising inflation, short-term interest rates, bond yields, stock (increased risk and volatility)

19

## Slowdown

###
Few months - 1yr or longer.

Inflation is still rising.

Falling inventory levels, stocks, confidence.

Peaking Short-term interest rates and Bond yields.

Yield curve may invert.

20

## Recession

###
Duration of 6mo-1yr.

Large declines in inventory.

Declining confidence, profits, short-term interest rates, bond yields, rising bond prices

Increase in unemployment and bankruptcies.

Inflation tops out.

Stock prices increase during the latter stages anticipating the end of the recession.

21

## Taylor rule

### Rtarget = Rneutral + 0.5(GDPexpected-GDPtrend + InflationExpected-InflationTrend)

22

## If Monetary and Fiscal are stimulative, the yield curve is

### steep and the economy is likely to grow.

23

## If monetary and fical are restrictive, the yield curve is

### inverted and the economy is likely to contract.

24

## If monetary is restrictive and fiscal is stimulative, the yield curve is

### flat and the economy is unclear.

25

## If monetary is stimulative and fiscal is restrictive, the yield curve is

### moderately steep and the economy is unclear.

26

## country's long-term economic growth trend - 2 drivers

###
(1) changes in employment levels

... population growth

... rate of labor force participation

(2) changes in productivity.

... Spending on new capital inputs

... total factor productivity growth.

27

## Investing in emerging markets, key questions

###
RESPONSIBLE fiscal and monetary POLICIES?

.. Deficit to GDP ratio under 4%+

.. Debt levels under 70-80% of GDP

EXPECTED GROWTH rate of at least 4%?

STABLE CURRENCY values and CURRENT ACCOUNT deficits of less than 4% of GDP?

FOREIGN DEBT under 50% of GDP and under 200% of the current account receipts?

SUFFICIENT level of foreign exchange RESERVES relative to short-term debt

SUPPORTIVE GOV regarding structural reform

28

## Three approaches to used in determining capital market expectations

###
Econometrics

Economic indicators

Checklist

29

## Econometric analysis, adva and disadvantages

###
Advantages:

. once established, can be reused.

. quite complex and may accurately model real world conditions.

. precise quantitative forecasts of economic conditions.

Disadvantages: • • • •

. difficult and time intensive (expensive) to create.

. may not be applicable in future time periods.

. Better at forecasting expansions than recessions.

. Requires scrutiny of output to verify validity.

30

##
Economic indicators. Advantages and disadvantages.

###
Advantages:

. Available from outside parties.

. Easy to understand and interpret.

. Can be adapted for specific purposes.

. verified by academic research.

Disadvantages:

. economic relationships change through time.

. can be misleading by giving false signals.

31

## Checklist approach

###
Advantages: • •

. Simple.

. Allows changes in the model over time.

Disadvantages: • • •

. Requires subjective judgment .

. May be time intensive to create .

. May not be able to model complex relationships .

32

## 4 methods of forecasting exchange rates:

###
1. relative purchasing power parity:

higher inflation - lower future value of currency.

(2) relative economic strength:

Higher growth and interest rates - strengthen the currency value

(3) capital flows:

Capital flowing into a market (e.g. US stocks) lead to higher value of USD

(4) savings and investment imbalances:

When savings are insufficient to fund investments, foreign investment should be attracted by appreciation of local currency.

33

## Shorter historical sample may be unduly

### influenced by the time span chosen.

34

## A longer time span of historical data would increase the

### precision of population parameter estimates.

35

## In time series analysis, forecasts are generated using

### previous values of a variable and previous values of other variables.

36

## Beta i =

### Correl i,M x standdev i / standdev M

37

## Covariance =

### Cov i,j = beta i x beta j x standdevM ^2

38

## Who performs well during periods of falling inflation or deflation

### Bonds, as long as credit risk does not increase.

39

## Current account deficit - definition and risks

###
Imports minus exports

problematic because the deficit must be financed through external borrowing

40

## Econometric models

### system of equations that can capture the fact that GDP is a function of many variables, both current and lagged values

41

## Exception to the positive correlation between short term and long term rates

### If short-term rates increase enough such that a recession becomes more likely, the yields on bonds will fall as investors anticipate that the demand for loanable funds will fall.

42

## Exception to positive correlation between currency and interest rates

### if interest rates increase high enough to slow down the economy - investors shy away from the country because the country becomes a less attractive place to invest.

43

## Inventory to sales ratio can decline due to

###
Less optimistic businesses expecting a recession

Adoption of just-in-time inventory management approach.

44

## short-term interest rates and flat bond yields in what phase of economic cycle?

### Early upswing

45

## Oil shock stages

###
(1) a reduction in oil production as a result of turmoil in the Middle East,

(2) leading to higher oil prices and inflation,

(3) reduced consumer spending,

(4) increased unemployment, and

(5) a slowed economy.

(6) An oil shock could also be a reduction in oil prices resulting in the opposite effects.

46

## Financial crisis stages

###
(1) a country not being able to meet its debt payment,

(2) a currency devaluation, or

(3) a significant reduction in asset prices.

(4) Banks usually become vulnerable in a financial crisis.

47

## tools for formulating capital market expectations

###
formal tools:

. statistical tools,

. discounted cash flow models,

. risk premium approach,

. financial market equilibrium models

survey

panel methods

judgment - economic and psychological insight

48

## Nominal income =

### Real income + inflation

49