CFA III SS 6 Capital Market Expectations
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Seven steps to forming capital market expectations
 1. determine expectations needed given investor's tax status, time horizon, and allowable assets
 2. investigate assets' historical performance
 3. identify the valuation model used and its requirements
 4. collect the best possible data  ex. GDP vs GNP
 5. use experience and judgment to interpret current investment conditions
 6. formulate expectations  E(r), standard deviation, and correlations
 7. monitor actual performance and use it to refine the process

Nine limitations to using economic data
 1. data issues: timeliness, revisions, rebasing
 2. measurement errors and biases: transcription errors, survivorship bias, use of appraisal data causes results to be smoothed and lowers standard deviation
 3. historical estimates: long time span helps precision of statistics, but nonstationarity from regime changes argues short time span
 4. using ex post data to estimate ex ante performance: analyst may be unaware of risk faced by investor at the time, especially if it never materialized
 5. data mining and time period: ensure have economic basis, scrutinize the modeling process, test with out of sample data
 6. conditioning: relationships can vary among variables, must account for current conditions
 7. correlations: association vs causation
 8. psychological traps: SS 3 + prudence and recallability traps
 9. model uncertainty

Five tools for setting CM expectations
 1. Statistical tools
 2. Discounted cash flows models
 3. Risk premium approach
 4. Financial equilibrium models
 5. Surveys, panels, judgment

Four statistical tools
 1. projecting historic data
 2. shrinkage estimators  weighted average of historic data and another analyst determined estimate
 3. time series analysis  useful when assets exhibit positive serial correlation in volatility (high follows high)
 4. multifactor models

DCF: GrinoldKroner equation and component breakdown
Expected income =
Nominal earnings =
Repricing =
 Ri = expected return on equity
 Div1 = dividend in time period 1
 P0 = current price
 i = expected inflation
 g = real growth rate of earnings
 change in S = % change in outstanding shares, or negative of the repurchase yield
 change in P/E = change in the P/E ratio

DCF: Bond segment expected return
 Yield to maturity is the expected return
 YTM assumes coupons reinvested at YTM, so use zero coupon bonds with maturity matching time horizon

Risk premium approach for equities and bonds
 E(r) equity: longterm government bond yield plus an equity risk premium
 E(r) bond: real risk free rate plus premiums for inflation, default, liquidity, maturity, and taxes

Financial equilibrium approach: expected return of a market
 ERPi = equity risk premium for market i
 rho(i,m) = correlation market i and global market
 standard devaition i = standard deviation for market i
 ERPm/SIGm = sharpe ratio of global market
 1. calculate return of full integration using formula above, add liquidity premium
 2. calculate return if no integration, replacing rho in formula above with 1, add liquidity premium
 3. combine full integration and no integration using weighted average based on % of market integration, add risk free rate

Calculate covariance between markets

Five business cycle phases and associated inflation, short term rates, bond yields, and stock prices
 initial recovery: falling inflation, low or falling short term rates, low bond yields, rising stock prices
 early expansion: rising short term rates, flat or rising bond yields, rising stock prices
 late expansion: everything rising
 slowdown: inflation rising, short term rates peak, bond yields peak and falling, stock pricing falling
 recession: inflation peaks, short term rates fall, bond yields fall, stock pricing increase during later stages anticipating recovery

Taylor rule
Provides target shortterm rate to balance inflation and recession risks
 rt = target shortterm rate
 rn = longterm neutral rate
 GDPe = expected GDP
 GDPt = trend or longterm GDP
 ie = expected inflation
 it = target inflation

Yield curve shape when:
1. fiscal policy and monetary policy are expansive
2. fiscal and monetary are restrictive
3. fiscal restrictive, monetary expansive
4. fiscal expansive, monetary restrictive
 1. sharply upward sloping
 2. inverted
 3. slightly upward sloping
 4. flat

Advantages and disadvantages of three economic forecasting methods
 1. Econometrics: adv  reusable, precise quantitative forecasts, complex; dis  difficult and time intensive, better at forecasting expansions, may not be applicable to future time periods
 2. Indicators: adv  available from outside parties, easy to understand; dis  inconsistent, may be misleading
 3. Checklist: analyst answers a series of questions, like central bank's next move, latest employment report, etc. adv  simple, easily changed; dis  subjective, open to interpretation, imprecise

Four methods of forecasting exchange rates
 Purchasing Power Parity (PPP): high inflation will see currency decline
 Relative economic strength: favorable investment climate will attract investors, increase demand for currency, increase currency value
 Capital flows: longterm capital will flow to the best investment opportunities
 Savingsinvestment: savings deficit leads to a strong currency; savings deficits typically occur during expansion