CFA Level III Reading 15 Capital Market Expectations

Tool for formulating capital market expectations

Formal tools: - statistical methods - discounted cash flow methods - the risk premium approach - financial market equilibrium models

the global investable market (GIM)

a practical proxy for the world market portfolio consisting of traditional and alternative asset classes with sufficient capacity to absorb meaningful investment

challenges in forecasting

- limitations of economic data - data measurement errors and biases - limitations of historical estimates - ex post risk can be a biased measure of ex ante risk - biases in analyst methods - the failure to account for conditioning information - misinterpretations of correlations - psychological traps - model uncertainty

a framework to setting CME

- specify the final set of expectations that are needed, including the time horizon in which they apply -research the historical record - specify the methods that will be used and their information requirements - determine the best source for information needs - interpret the current investment environment using the selected data and methods - provide the set of expectations that are needed, documenting conclusions - monitor actual outcomes and compare them to expectations

The business cycle

1. Initial recovery 2. early upswing 3. Late Upswing 4. slowdown 5. recession

shrinkage estimator

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.

permanent income hypothesis

consumers' spending behavior is largely determined by their long-run income expectations.

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.

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.

diffusion index

measures how many indicators are pointing up and how many down

Time-period bias

results that are time period specific. Research findings are often found to be sensitive to the selection of starting and/or ending dates.

Data-mining bias

searching a dataset until the analyst finds some statistically significant pattern. Such patterns cannot be expected to be of predictive value

how is inflation affected by the business cycle

tends to rise in the late stages of a business cycle and to decline during recessions and the early stages of recovery

The confirming evidence trap

the bias that leads individuals to give greater weight to information that supports an existing or preferred point of view

Output gap

the difference between the value of GDP estimated as if the economy were on its trend growth path (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

Risk Premium Approach

the expected return of the asset equals the sum of the real risk free rate and one or more risk premiums - inflation premium - default risk premium - liquidity premium - maturity premium - tax premium

How can the amount of the illiquidity premium be estimated

the investment's multiperiod Sharpe ratio (MPSR)

capital market expectations

the investor's expectations concerning the risk and return prospects of asset classes

The status quo trap

the tendency for forecasts to perpetuate recent observations—that is, to predict no change from the recent past.

The recallability trap

the tendency of forecasts to be overly influenced by events that have left a strong impression on a person's memory.

The overconfidence trap

the tendency of individuals to overestimate the accuracy of their forecasts

The anchoring trap

the tendency of the mind to give disproportionate weight to the first information it receives on a topic.

The prudence trap

the tendency to temper forecasts so that they do not appear extreme, or the tendency to be overly cautious in forecasting.

Economic Forecasting 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

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

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

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).

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.

To summarize, with this approach, the trend growth in GDP is approximately the sum of the following:

•growth from labor inputs, comprising ◾growth in potential labor force size and ◾growth in actual labor force participation, plus •growth from labor productivity, comprising ◾growth from capital inputs and ◾TFP growth (i.e., growth from increase in the productivity in using capital inputs).

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.

micro expectations

Expectations concerning individual assets

Financial Market Equilibrium Models

- Black-Litterman approach - Singer and Terhaar (ICAPM)

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

- Fiscal policy is sound - The public sector intrudes minimally on the private sector - Competition within the private sector is encouraged - Infrastructure and human capital development are supported - Tax policies are sound

The chief measurements of economic activity are

- GDP - Output gap - Recession

Discounted Cash flow methods

- Gordon (constant) growth model - The Grinold-Kroner model

Statistical methods

- Historical Statistical Approach: Sample Estimators - Shrinkage estimators - Time series estimators - multi-factor models

Approaches to Forecasting Exchange Rates

- Purchasing Power Parity - relative economic strength forecasting approach. focuses on investment flows rather than trade flows - Capital Flows - Savings-Investment Imbalances

Errors in data series include the following

- Transcription errors - Survivorship bias - Appraisal (smoothed) data

Economic Forecasting Approaches

- econometric models approach - leading indicator - based approach - checklist approach

country risk analysis risk techniques

- how sound is fiscal and monetary policy - what are the economic growth prospects for the economy - is the currency competitive and are the external accounts under control - is external debt under control - is liquidity plentiful - is the political situation supportitive of the required policies

Central bank orthodoxy for dealing with inflation rests on three principles

- independent of political influence - should have an inflation target - should use monetary policy (primarily interest rates) to control the economy and prevent it from overheating

Deflation is a threat to the economy for two main reasons

- it tends to undermine debt-financed investments - undermines the power of central banks. In a deflation, interest rates fall to levels close to zero

macro expectations

Expectations concerning classes of assets.

Volatility clustering

The tendency for large (small) swings in prices to be followed by large (small) swings of random direction.