CFA Level III: Capital Market Expectations

Inflation Expectations and Asset Classes: Inflation Within Expectations

-Cash Equivalents: Earn the real rate of interest -Bonds: Shorter-term yields are MORE volatile than longer-term yields -Equity: No impact given predictable economic growth -Real Estate: Neutral impact with typical rates of return.

Inflation Expectations and Asset Classes: Inflation Above or (Below) Expectations

-Cash Equivalents: Positive (negative) impact with increasing (decreasing) yields. -Bonds: Longer-term yields MORE volatile than shorter-term yields. -Equity: Negative impact given the potential for central bank action or falling asset prices, though some companies may be able to pass rising costs on to customers. -Real Estate: Positive impact as real asset values increase with inflation.

Factors Associated with Increased Risk of Emerging Markets

1) Wealth concentration. 2) Income concentration and less diverse tax base. 3) Greater dominance of cyclical industries, including commodities and less pricing power. 4) Restrictions on capital flows and trade; Currency restrictions. 5) Inadequate fiscal and monetary policies. 6) Poor workforce education, infrastructure, and weak technological advancement. 7) Large amounts of foreign borrowing in foreign-currency denominated debt. 8) Less developed and smaller financial markets. 9) Exposure to volatile capital flows.

10 Problems in Forecasting Capital Market Expectations

1) Limitations to using economic data -->Data is available with time lags, and is subject to revision-->Be aware of LOOK AHEAD BIAS here. -->Inconsistency in data definitions and methodology calculations over time and among different sources. -->Indices are often rebased (i.e., the base upon which they are calculated can change) which can make comparisons over time more challenging. 2) Data measurement errors and biases -->Transcription errors (the misreporting or incorrect recording of information). -->Survivorship Bias (overstates returns and understates risk). -->Appraisal data for illiquid and infrequently priced assets (such as RE and PE) makes the path of returns seem smoother than they are. This imposes a DOWNWARD bias on calculated standard deviations and REDUCES correlations with more liquid priced assets (brings correlations closer to 0)-->A consequence of this could be a mistaken overallocation to RE or PE because it appears to lower risk and correlation to the rest of the portfolio. 3) Limitations of historical estimates -->Historical data is subject to "Regime Change" which is a structural change in the economic, political, regulatory, or technological environment. Because of these structural changes, values from historical data must often be adjusted significantly. -->NONSTATIONARITY of the data set (statistical characteristics differing by time period) is the result of Regime Change. -->Selecting the time period: a. Longer time periods or more frequent observations increase the quantity of data points, however, data may only exist for shorter time periods. b. Shorter time periods are LESS likely to include regime change. c. ***Remember: Use the LONGER periods unless: i. There is a reason to believe fundamentals have changed, or ii. Statistical analysis of subperiods reveals nonstationarity. 4) The use of Ex-Post risk and return measures -->Ex-post analysis may UNDERSTATE future (ex-ante) risks. -->Remember: The future can always be worse than the past (i.e. lower return and higher risk). -->The issue can also lead to an OVERESTIMATION of risk when sample data include rare negative events (using a subset of data that includes outliers will likely distort the estimation of VaR)-->Would suggest that rare negative events are expected with more frequency than would be observed in practice. 5) Non-repeating data patterns -->Using historical data, analysts can also uncover patterns in security returns that are unlikely to occur in the future and can produce biases in the data including: a. Data Mining Bias-->Occurs when an analyst continues to analyze data until a pattern emerges, even if it is not real/is spurious. b. Time Period Bias-->Results from the time span of data chosen, and is observed when a relationship holds in one period, but not another (ex. The outperformance of small cap stocks over large cap stocks disappears if you exclude data from the 1970s and 1980s). 6) Failing to account for "Conditioning Information"/Failure to Condition Data -->Remember: The relationship between security returns and economic variables is not constant over time. Historical data reflects performance over many different business cycles and economic conditions. -->Analysts must account for CURRENT conditions in their forecasts. 7) Misinterpretation of Correlations -->Mistaking correlation for causation. -->Overlooking the fact that the correlation between two variables could be spurious, or that a third unknown variable influences both other variables. -->Overlooking the fact that two variables may have a nonlinear relationship that is missed by the correlation statistic, which measures LINEAR relationships. 8) Psychological Bias -->Analysts are susceptible to: a) Anchoring Bias b) Status Quo Bias c) Confirmation Bias d) Overconfidence Bias e) Prudence/Conservatism Bias f) Availability Bias 9) Model uncertainty/Model Risk -->Model Uncertainty: Risk of selecting the wrong model to use. -->Parameter Uncertainty: Estimation errors in model parameters (i.e. assuming a normal distribution when the distribution of outcomes is actually skewed etc...) -->Input Uncertainty: Using the wrong inputs in the model.

Forecasting the Economic Growth Rate

A basic model for forecasting the economic growth rate focuses on the following: 1) Labor Input-->Based on the growth rate in the labor force (i.e. Number of workers) and labor participation. -->Growth rate in labor force depends on: Population growth and demographics. -->Labor participation refers to the % of the population working, and is affected by: Real wages, work/leisure decisions, and social factors. 2) Capital per Worker (CAPITAL DEEPENING)-->Increases labor productivity. 3) Total Factor Productivity (TFP)-->Reflected in technological progress and changes in governmental policies.

Uncovered Interest Rate Parity (UIP)

An economic theory which states that in the absence of transaction costs and risk, the expected difference in interest rates between two countries should be equal to the EXPECTED change in their EXCHANGE RATES. -->In other words, UIP suggests that when two countries have different interest rates, the currency of the country with the higher interest rate should depreciate in value relative to the currency of the country with the lower interest rate over time.

Cross-Sectional Consistency

Consistency across asset classes regarding portfolio risk and return characteristics. A feature of expectations setting which means that estimates for all classes reflect the same underlying assumptions, and are generated with methodologies that reflect or preserve important relationships among the asset classes, such as strong correlations. It is the INTERNAL CONSISTENCY across ASSET CLASSES.

Intertemporal Consistency

Consistency over various investment horizons regarding portfolio decisions over time. A feature of expectations setting which means that estimates for an asset class over different horizons reflect the same assumptions with respect to the potential paths of returns over time. It is the INTERNAL CONSISTENCY over various TIME HORIZONS.

Deflation and Impact on Economic Activity

Deflation: An environment of generally falling prices. Deflation is a severe threat to economic activity because: -It encourages default on debt obligations. -->Ex. A homeowner with a $100,000 home, and a $95,000 mortgage (i.e. homeowners has 5% equity in the home). A 5% decrease in home prices would result in NEGATIVE equity for the homeowner, and can trigger panic sales (which would further depress prices), defaulting on the loan, or both. -Negative inflation (deflation) can cause interest rates decline to near zero, which limits the ability of central banks to stimulate the economy via lowering interest rates. -->In this environment of low interest rate and negative inflation, governments have turned to "Quantitative Easing" (QE) to stimulate the economy.

Shrinkage Estimation

Estimation that 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. Shrinkage estimation can be applied when using statistical methods for forecasting capital market expectations. Shrinkage estimators are typically more reliable as predictors of equity returns than simply taking sample averages of mean equity returns over time (i.e. simply relying on past data to forecast future returns). Ex. 60% of historical return and 40% of a model-estimated return.

3 Approaches to Forecasting Capital Market Expectations

Forecasting returns requires not only assessing 1) Expected Returns, 2) Variances, and 3) Correlations, but also understanding that time horizons are important. The three approaches to forecasting CME include: 1) Formal Tools a. Statistical Methods -Statistical methods make use of: -->Sample statistics: Use well-known data, including means, variance, and correlation to forecast future data. This is the clearest approach in forecasting, but it can be imprecise. -->Shrinkage estimation: A weighted average estimate based on history and some other projection. Can be applied to the historical estimate if the analyst believes simple historical results do not fully reflect expected future conditions. -->Time-series estimation: Forecasts a variable using lagged values of the same variable combined with lagged values of other variables, which allows for incorporating dynamics (volatilities) into the forecasts. b. Discounted Cash Flow c. Buildup Model/Risk Premium Model 2) Surveys -->Can be the most useful way to gauge consensus. -->Ex. U.S. Federal Reserve Bank of Philadelphia conducts an ongoing survey regarding the U.S. consumer price index and GDP. 3) Judgment -->Adjustments to numerical forecasts from quantitative models of capital market expectations can be made by using qualitative information based on experience.

Characteristics of Appropriate Capital Market Expectations (CME) Forecasts

Forecasts of Capital Market Expectations (CME) should be: 1) (Internally) Consistent 2) Unbiased 3) Objective 4) Well Supported 5) Accurate, with minimal forecasting errors. *Remember: A general guideline is that AT LEAST 30 observations are needed to test a hypothesis.

Inflation vs. Disinflation vs. Deflation (and Relationship to the Business Cycle)

Inflation: An environment of generally rising prices. -->Results from too much money chasing too few goods. -->Typically accelerates LATE in the business cycle. Disinflation: A deceleration in the rate of inflation (i.e. inflation is still present, but is increasing at a decreasing rate). -->Frequently occurs as an economy enters a recession. Deflation: An environment of generally falling prices.

Inflation & The Business Cycle (Economic Policy Response and Market Environment): Slowdown

Inflation: Continues to accelerate Economic Policy Response: Becoming less restrictive Markets: -Short term rates: Peaking or beginning to decline -Long term rates: Peaking or beginning to decline (Bond prices starting to increase) -Stock prices: Declining

Inflation & The Business Cycle (Economic Policy Response and Market Environment): Early Expansion

Inflation: Low (good economic growth) Economic Policy Response: Becoming less stimulative Markets: -Short term rates: Increasing -Long term rates: Bottoming or beginning to increase (Bond prices beginning to decline) -Stock prices: Increasing

Inflation & The Business Cycle (Economic Policy Response and Market Environment): Contraction

Inflation: Peaking (Real economic activity is declining) Economic Policy Response: Easing Markets: -Short term rates: Declining -Long term rates: Declining (Bond prices increasing) -Stock prices: Begin to increase later in the recession

Leading Indicators: Composite vs. Diffusion Index

Leading indicators can be viewed individually, as a composite, or as a diffusion index. A composite is simply the combination of a number of different leading indicators into a single composite/index. A composite can also be interpreted as a "Diffusion Index" by observing the number of indicators pointing toward expansion versus contraction in the economy (i.e. how many indicators point to expansion vs. how many point to contraction).

Approaches to Economic Forecasting: Use of Economic Indicators

Leading indicators, which move ahead of the business cycle, are the most useful, as they can be used to predict where the economy is going. -->Leading indicators can be used individually or as a composite. -->Some leading indicators include: Stock prices; Manufacturing Indices; Initial unemployment claims Advantages of Economic Indicators: -Simple, intuitive, and easy to interpret. -Data are often readily available from third parties. -Indicator lists can be tailored to meet specific forecasting needs. -Supported by academic research. Disadvantages of Economic Indicators: -Poor record for predicting turning points in the economy. -Forecasting results have been inconsistent. -Economic indicators have given false signals. -Indicators are revised frequently, which can make them appear to fit past business cycles better than they did when the data were first released.

Macroeconomic Linkages

Macroeconomic linkages can produce convergence in business cycles among economies. These links are the result of: 1) International Trade -A recession in one country causes imports to decline, which reduces exports from its trading partners. -->i.e. A country's exports and economy will be depressed by a slowdown in a trading partner's economy and level of imports 2) International Capital Flows -A recession in one country causes cross-border capital investing with in trading partners to decline. *Remember: A country's current account and capital account are measures of macroeconomic linkages. -->The CURRENT Account largely consists of a country's net exports -->The CAPITAL Account reflects net investment flows -->(X - M) = (S - I) + (T - G) i.e. Net Exports = Net Private Savings + Government Surplus

Risk Premiums on Real Estate

Real estate assets require several risk premiums to compensate for their higher risk, which include: 1) Term Premium -->Compensation for holding long-term assets. 2) Credit Premium -->Compensation for the risk of tenant nonpayment. 3) Equity Risk Premium -->This premium will be higher than that of corporate bonds to compensate for the fluctuation in real estate values, leases and vacancies. 4) Liquidity Premium -->Compensation for the risk of being unable to sell the asset except for at periodic times (between 2%-4% for commercial real estate). *Overall, the COMBINED risk premium is higher than that of corporate bonds but lower than equities. It is important for an analyst to consider the LOCAL rather than the global nature of real estate when performing an analysis. *Once the appropriate risk premiums are calculated, real estate can be used in equilibrium models, including Singer-Terhaar. HOWEVER, analysts must make 2 adjustments: 1) The impact of smoothing must be removed from the data. 2) Adjust for illiquidty using a liquidity premium.

Business Cycle Phases: Early Expansion

The "Early Expansion" is stage #2 of 5 of the business cycle. Early expansion occurs as the economy grows faster than trend. The Early Expansion period is characterized by: -Duration: 1 year to several years -Business confidence: Increasing -Inflation: Low -Economic Growth: Increasing -Short-term interest rates: Rising -Bond yields: Stable or rising (Bond prices begin declining) -Output Gap: Narrowing -Stock prices: Rising

Business Cycle Phases: Slowdown

The "Slowdown" is stage #4 of 5 of the business cycle. The slowdown stage occurs as GDP is above trend, but the growth rate is below trend and turning negative. The Slowdown period is characterized by: -Duration: A few months to a year or longer -Business Confidence: Declining -Inflation: Still rising -Monetary Policy: Turns neutral -Short-term interest rates: Peak -Bond yields: Peaking and possibly beginning to decline (Resulting in rising bond prices (i.e. bonds become favorable, especially compared to stocks/equities)) -Yield Curve: Possibly inverted -Stock prices: Falling (in anticipation of recession)

Forecasting Fixed Income Returns: Risk Premium (Building Block) Approach - The Short-Term Default-Free Rate

The building block approach starts with a risk-free rate and then adds compensation for additional risks. The Short-Term Default-Free Rate used should match the forecast horizon, and be calculated from the most LIQUID instrument -->The ST Default-Free Rate is closest to the government ZERO-COUPON yield, and is closely tied to the central bank policy rate. *Remember: If the investment horizon is much LARGER than the maturity of the short-term instrument, alternative approaches may be needed, including: 1) Using the yield of a longer maturity zero-coupon bond, or 2) Taking the return that could be realized by rolling over the short-term instrument over the investment horizon. -->Futures contract rates provide useful proxies for this expected path of ST interest rates.

Effect of Fiscal Policy on the Business Cycle

The use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth. To stimulate economic growth: -The government will increase spending or decrease taxes. To dampen economic growth: -The government will decrease spending or increase taxes. ***Two important aspects of Fiscal Policy: 1) It is not the LEVEL of the budget deficit that matters; It is the CHANGE in the deficit that catalyzes a stimulus or a dampening effect on the economy. -->Ex. A deficit by itself does not stimulate the economy; increases in the deficit are required to stimulate the economy. 2) Changes in the deficit that occur naturally over the course of the business cycle are NOT stimulative or restrictive. -->Ex. In an expanding economy, deficits will decline because tax receipts increase and disbursements to the unemployed decrease. The opposite occurs during a recession. -->Only changes in the deficit DIRECTED by government policy will influence growth.

Forecasting Exchange Rates: Effects of Trade in Goods and Services

Trade in goods and services affects exchange rates through: 1) Trade Flows -The impact of NET trade flows (i.e. Exports - Imports) tends to be relatively small on exchange rates (assuming they can be financed). -Large trade flows without large financing flows in FX markets likely indicates a crisis. 2) Purchasing Power Parity (PPP) -Implies that the prices of goods and services in different countries should reflect changes in exchange rates-->The expected exchange rate movement should follow the expected inflation rate differentials. -Implies the expected change in REAL exchange rates should be 0-->Real exchange rates may differ from those predicted by PPP, for example as a result of trade barriers. -PPP does NOT work well in explaining short-term exchange rates. -PPP works better in the long-term, and when inflation differences are large and are determined through money supply. -Remember: PPP does NOT account for capital flows (which may exert significant influence on exchange rates). 3) Competitiveness and Sustainability of the Current Account

Beta

β(i) = Cov(im)/σ^2(m) Covariance of Asset i's return with the Market Return/Variance of the Market ReturnBeta is the sensitivity of an asset's return to the return on the market index. Beta is a standardized measure of the covariance of the asset's return with the market return

Guidelines to Gauge Health of an Emerging Market

-A significant risk for a bond investor investing in Emerging Markets is credit risk, which encompasses: a) Ability to Pay and b) Willingness to Pay. -Factors a bond investor should consider before committing funds to Emerging Markets include: 1) Fiscal and Monetary Policies -Metric to analyze: Deficit-to-GDP ratio -Warning Sign: Government Deficit/GDP ratio > 40% -->Illustrates a perpetual struggle to reduce deficits, and substantial credit risk. -->Most EM countries borrow short-term and must refinance periodically. A buildup of debt increases the likelihood that the country will be unable to service its debt. 2) REAL Economic Growth -Metric to analyze: Real GDP growth rate -Warning Sign: Real Growth Rate < 4% -->Suggests the EM is slow to catch up with advanced economies, and that growth is insufficient to satisfy the expectations of the population. -->Suggests per capita income may be falling, which could be a source of political stress. 3) An OVERVALUED currency supporting a "Twin Deficit" problem financed by foreign borrowing -Twin Deficit = A Budget Deficit and a Current Account Deficit-->The country is importing more than it is exporting, and the country's government is spending more money than it is generating. -Warning Sign: Current Account Deficit > 4% of GDP -->Indicates a lack of competitiveness. 4) Excessive Foreign-Denominated Debt -Warning Sign: Foreign Debt/GDP Ratio > 50% -->Indicates the country may be overleveraged, which is exacerbated by an inability to print the foreign currency to pay the debt off. 5) Foreign Exchange Reserves -Metric to analyze: Foreign Currency Reserves/ST Foreign Currency Debt Ratio -Warning Sign: Foreign Currency Reserves/ST Foreign Currency Debt Ratio < 100% -->Inadequate short-term liquidity (i.e. foreign currency reserves) to service foreign debt is problematic because many EM loans must be paid back in a foreign currency (which the EM nation is unable to print). -->Ratio > 200% is considered strong. 6) Risky Political Situation -Related to a country's "Willingness to Pay" as opposed to its "Ability to Pay" -Policies NOT supportive of growth include: -->Weak property rights -->Weak enforcement of contract laws -->History of nationalization of property -->Sovereign Immunity Principle (provides a ruling government body with the option to choose immunity from civil lawsuits or criminal prosecution) -->Corruption -->Coalition governments (seen as riskier because of the inherent political, and therefore policy, instability)

Inflation Expectations and Asset Classes: Deflation

-Cash Equivalents: Positive impact if nominal interest rates are bound on the downside by 0%. -Bonds: Positive impact as fixed future cash flows (i.e. coupons) have GREATER purchasing power (assuming no default on the bonds). -->In addition, deflation leads to lower interest rates, which increases the price of bonds. -Equity: Negative impact as economic activity and business declines. -Real Estate: Negative impact as property values generally decline.

Emerging Market Bond Risk

-Emerging market debt offers investors higher expected returns, but at the expense of higher risk. -Many emerging countries are dependent on foreign borrowing, which can later create crisis situations in their economy, currency, and financial markets. -->Borrowing via foreign-currency denominated debt (and thus being unable to print the currency in which it has to pay its debt obligations back in) can create many problems for the EM nation in question. -Many emerging countries also have unstable political and social systems. -->The rights of foreign investors are not as well protected in less stable, more authoritarian political regimes. -EM countries tend to have less diversified economies than larger, more developed nations/economies. The relatively undiversified nature of smaller EM economies makes them susceptible to volatile capital flows and economic crises.

Key Considerations/Factors of Economic Growth Trend Analysis

-Forecasting returns with DCF models incorporates the trend rate of growth and acts as an anchor for long-term bond and equity returns. -HIGHER trend growth rates may lead to HIGHER stock returns (assuming the growth is not already reflected in stock prices). -Higher trend growth means that the economy can grow at a fast pace BEFORE inflation becomes a major concern. -->This consideration influences monetary policy and the level of bond yields. -Higher trend growth rates tend to generate HIGHER bond yields. **Overall, the trend rate of growth is relatively stable in developed economies. In emerging economies, that growth rate can be less predictable and include longer periods of rapid growth as those economies catch up with developed economies.

Modified Duration

-Modified Duration = (Macaulay Duration)/(1 + YTM of Bond) -Modified Duration is a LINEAR approximation of the relationship between yield and price. For this reason, duration-based estimates of a bond's full price become increasingly POOR for larger changes in YTM. *Remember: The only time that an investor will actually receive the initial YTM of a bond/bond portfolio is if the modified duration of the bond/bond portfolio matches the maturity of the bond/bond portfolio.

Macaulay Duration

-The investment horizon at which reinvestment risk and market price risk offset. In fixed income, a change in interest rates presents two risks: 1) Price Risk -->Risk that price will decrease if interest rates rise. 2) Reinvestment Risk -->Risk that the rate at which you can reinvest fixed income cash flows will decrease if interest rates fall. MacDur = (Mod. Dur)(1 + YTM) *For the exam, remember that the Macaulay Duration can be calculate by multiplying Modified Duration by the bond's YTM. If: -Investment Horizon < Macaulay Duration -->Price Risk is more impactful than reinvesment risk -Investment Horizon > Macaulay Duration-->Reinvestment Risk is more impactful than Price Risk

Steps to Formulate Capital Market Expectations (CME)

7-Step Process for formulating capital market expectations: 1) Determine the specific capital market expectations needed given the investor's: allowable asset classes and investment/time horizon(s), and other relevant factors. -->Time horizon is particularly important in determining the set of capital market expectations that are needed. 2) Determine the historical performance and driving factors of the asset classes. -->Investigate assets' historical performance to determine drivers of past performance and to establish some range of plausible future performance. -->Analyst can use drivers of past performance to forecast expected future performance AND to compare the forecast to past results to see if the forecast appears reasonable. 3) Identify the valuation models and methods to be used and their requirements. -->Ex. A comparables-based, relative value approach used in the U.S. would not be appropriate to apply to an EM analysis. 4) Collect the best data possible. -->Bad data will produce poor conclusions. Financial publications and commercial databases are usually the best source of reliable info. 5) Use experience and judgment to interpret investment conditions and decide what values to assign to required inputs. -->Verify that the inputs used for the various asset classes are consistent across classes. 6) Formulate capital market expectations and record any assumptions and rationales used in the analysis. 7) Monitor performance and use it to refine the process for setting expectations. -->Refine the process and model is actual performance varies significantly from forecasts. *The focus is MACROECONOMICS and "Beta Research" to determine asset class expectations. *"Alpha Research" is used to ADD value within an asset class.

The Singer-Terhaar Model

A financial equilibrium approach/model, based on two versions of the international CAPM, which is used to calculate an Equity Risk Premium. The two versions of the international CAPM include: -->A version in which global asset markets are FULLY INTEGRATED and -->A version in which global asset markets are FULLY SEGMENTED. -The model then takes the weighted average of these two measures based on the market's degree of integration with the global market. 1) The Singer-Terhaar Model begins with the CAPM: Ri = Rf + βi,m (Rm - Rf) OR RPi = βi,m × RPm Where: Ri = Expected return on asset i Rf = Risk-free rate of return βi,m = Sensitivity (systematic risk) of asset i returns to the global investable market Rm = Expected return on the global investable market RPi = Asset i's risk premium RPm = The market's risk premium ***The "Global Investable Market" should be thought of as consisting of all investible assets (traditional and alternative) 2) Break Beta down into component parts: βi,m = [(Cov(Ri,Rm)/Var(Rm)] = ρ(i,m)(σi/σm) Where: ρ(i,M) = correlation between the returns on asset i and the global market portfolio σi = standard deviation of the returns on asset i σm = standard deviation of the returns on the global market portfolio Cov(Ri, Rm) = covariance of asset i return with the global market portfolio return 3) Rearrange CAPM to arrive at expression for risk premium for asset "i"--RPi: RPi = (βi,m)(RPm) = (ρi,m)(σi)(RPm/σm) -->REMEMBER: (RPm/σm) is the SHARPE RATIO for the global market portfolio 4) Calculate the Risk Premium assuming FULLY INTEGRATED markets: RPi= (ρi,m)(σi)(RPm/σm) -In this step, we use the Sharpe Ratio of the GLOBAL market rather than the market-specific Sharpe Ratio. *Remember to add on ILLIQUIDITY PREMIUM at the end, if applicable (more common in EM). 5) Calculate the Risk Premium assuming FULLY SEGMENTED markets: RPi= (σi)(RPm/σm) -In this step, we use the Sharpe Ratio of the LOCAL market rather than the global market Sharpe Ratio. -->This will cause ρ(i,M) = 1 because the market we are analyzing is the local market, so the correlation of the local market to itself is 1. *Remember to add on ILLIQUIDITY PREMIUM at the end, if applicable (more common in EM). *When markets are

Taylor Rule

A monetary rule that stipulates exactly how much a central bank should change real interest rates by in response to divergences of real GDP from potential GDP, and divergences of actual rates of inflation from a target rate of inflation. -->The Taylor Rule is used by central banks to estimate a short-term interest rate target. The Taylor Rule can be used by central banks to implement countercyclical monetary policy. In NOMINAL terms: n(target) = r(neutral) + i(expected) + [0.5(GDP(expected) − GDP(trend)) + 0.5(i(expected) − i(target))] In REAL terms: Where: -n(target) = target nominal short-term interest rate -r(neutral) = neutral real short-term interest rate -GDP(expected) = expected GDP growth rate -GDP(trend) = long-term trend in the GDP growth rate -i(expected) = expected inflation rate -i(target) = target inflation rate The Taylor Rule can be used as an active management tool to anticipate changes in central bank policy and interest rates. Remember: The two competing problems in the economy are 1) Inflation--usually problematic when too HIGH and 2) GDP--usually problematic when too LOW. -->Determining which of these two factors is the bigger problem determines how short-term rates should be adjusted. -->i.e. If the divergence between expected and target inflation is significantly greater than that between expected and trend GDP, then short-term rates should be INCREASED to counteract inflation which is too high. -->Conversely, If the divergence between expected and trend GDP is significantly greater than that between expected and actual inflation, then short-term rates should be DECREASED to counteract lagging GDP (which is too low).

Approaches to Economic Forecasting: Econometrics

An approach to economic forecasting which uses statistical methods to explain economic relationships and formulate forecasting models. -->Ordinary least squares regression is most often used, but other statistical methods are also available. 2 other main types of models: 1) Structural Models -Have a direct link to economic variables (are based on economic theory). 2) Reduced Form Models -Much more data-driven. Advantages of Econometrics: -Modeling can incorporate many variables. -Once the model is specified, it can be reused. -Output is quantified and based on a consistent set of relationships. -Can model complexities of reality using both current and lagged values. Disadvantages of Econometrics: -Models are complex and time-consuming to construct. -The data may be difficult to forecast and the relationships can change. -Output may require interpretation or be unrealistic. -Poor record of forecasting recessions.

Quantitative Easing (QE)

An expansionary monetary policy program orchestrated by central banks around the world during the 2007-2009 Financial Crisis. Typical Open Market Operations vs. QE: -A typical expansionary monetary policy would traditionally include be comprised of open market operations (to increase the money supply and decrease short-term interest rates) on a temporary basis by buying HIGH QUALITY fixed-income instruments. -Quantitative Easing (QE) differed from traditional Open Market Operations because it was: -->Much larger in scale -->Purchases included other security types such as mortgage-backed securities (MBS) and corporate bonds, even those of lower quality. -->Intent was a LONG-TERM increase in bank reserves rather than a temporary increase

Capitalization Rate ("Cap Rate")

Cap Rate = Discount Rate - Growth Rate The Cap Rate can also be defined as the CURRENT YIELD on a real estate investment: Cap Rate = NOI1/Value When an infinite time period is assumed, the cap rate can be calculated as: Cap Rate = E(Rre) - NOI Growth Rate -->During stable periods, the long-run NOI growth rate should be close to GDP growth. -->The Cap Rate is similar to the denominator of the Gordon Growth Model (i.e. r-g) If an investors has a finite time period, the formula changes to the following: E(Rre) = Cap Rate + NOI Growth Rate - %ΔCap Rate -->This formula has similarities to the Grinold-Kroner model, noting that NOI growth is also a nominal measure, incorporating real growth plus inflation. Because of the difficulties in determining the appropriate Discount Rate (r) and the appropriate Growth Rate in NOI (g), we determine Cap Rate by evaluation of comparisons to Cap Rates of comparable properties. Cap Rates are used in the Income Based Approach to real estate valuation (i.e. Direct Capitalization Method and Discounted Cash Flow Method) to discount Year 1 NOI. Because the cap rate is based on Year 1 NOI, it is sometimes called the "Going-In Cap Rate" (R0) ***Remember: -Cap rates are POSITIVELY correlated with changes in interest rates and vacancy rates. -->i.e. As interest rates and vacancy rates increase, cap rates increase. -Cap rates are NEGATIVELY correlated to the availability of credit and the availability of debt financing. -->i.e. As the availability of credit and debt financing increases, cap rates decrease.

Capital Market Expectations

Capital market expectations are the risk and return expectations regarding classes of assets. Investors should establish long-term expectations for each allowable asset class specified in the Investment Policy Statement (IPS). -->They can also create short-term expectations for making ACTIVE investment decisions. *Remember: Using a disciplined approach to set short- and long-term expectations leads to more effective: -Security Selection -Asset Allocation -Risk Management

Hot Money

Capital which flows into a country given exchange rate differentials. Hot money creates monetary policy issues: 1) Limits the ability of the central bank to use MP 2) Firms use short-term financing to fund long-term investments-->Increases financial market risk. 3) Exchange rates tend to overshoot, creating business disruptions. Eventually, currency values will decline. Central banks may try to counter the effects of hot money flows through interventions in currency markets, including selling government securities (reducing the degree of currency appreciation) or maintaining interest rate targets.

Effect of Monetary Policy on the Business Cycle

Central banks often use monetary policy as a countercyclical force, attempting to optimize the economy's performance by balancing PRICE STABILITY and ECONOMIC GROWTH. -->Ultimate goal: Keep growth near long-term sustainable rate. To stimulate economic growth: -Central bank will increase the money supply to reduce short-term rates-->Results in greater consumer spending, greater business spending, higher stock prices, and higher bond prices. To dampen economic growth: -Central bank will decrease the money supply to increase short-term rates-->Results in lower consumer spending, lower business spending, lower stock prices, and lower bond prices.

Forecasting Equity Returns: Discounted Cash Flow (DCF) Approach

DCF is a commonly-used tool for setting capital market expectations. DCF models calculate the intrinsic value of an asset as the PV of future cash flows. The most common application of DCF models are: 1) The Gordon Growth Model (or constant growth model) 2) Grinold-Kroner Model

Time-Series Estimation

Estimation that is based on lagged values of the variable being forecast and selected other lagged variables. Estimation technique that forecasts a variable using lagged values of the variable combined with lagged values of other variables. -->Time-series estimation allows for incorporating dynamics (volatilities) into forecasts. Time-series estimation can be applied when using statistical methods for forecasting capital market expectations.

Exogenous Shocks: Effects on the Long-Term Trend Rate of Economic Growth

Exogenous shocks are unanticipated events outside the normal course of the economy; these events are NOT predicted or built into current market prices. Exogenous shocks can be caused by: 1) Changes in Government Policy -Government policy can INCREASE long-term growth by way of: -->Sound economic policy -->Minimal government interference with free markets -->Sound tax policy (i.e. lower and predictable) -->Facilitating competition in the private sector -->Promote competition, free trade, and capital flows -->Sound fiscal policy (i.e. countercyclical, but balance over the economic cycle) -->Development of infrastructure and human capital 2) Political Events -Geopolitical tensions divert resources to LESS productive uses, which may decrease growth. -Conversely, cuts in defense spending due to higher levels of world peace may lead to increases in growth. 3) Technological Progress -The creation of new and innovative technology/markets has the potential to INCREASE growth. 4) Natural Disasters -Likely REDUCE short-term growth but could encourage long-term growth if more efficient capacity replaces previous capital. 5) Discovery of Natural Resources -New supply of natural resources or more efficient production (ex. fracking) can increase growth. 6) Financial Crises -Shocks to the financial system can lead to a decrease in consumer confidence. -Can also lead to reduction in economic output in the short term and decrease the long-term trend rate of growth.

The Yield Curve as an Economic Predictor and Relationship with Fiscal and Monetary Policy

Expansionary Monetary & Fiscal Policy: -Yield Curve is sharply upward sloping. -The economy is likely to expand. Restrictive Monetary & Fiscal Policy: -Yield Curve is downward sloping. -The economy is likely to contract. Expansionary Monetary Policy; Restrictive Fiscal Policy: -Yield Curve mildly upward sloping. -Implication for the economy are less clear. Restrictive Monetary Policy; Expansionary Fiscal Policy: -Yield Curve is more or less flat. -Implication for the economy are less clear. *In terms of business cycles, the Yield Curve is typically STEEP at the BOTTOM of the cycle. As the cycle moves towards expansion, the curve tends to flatten.

Inflation & The Business Cycle (Economic Policy Response and Market Environment): Late Expansion

Inflation: Increasing Economic Policy Response: Becoming restrictive Markets: -Short term rates: Increasing -Long term rates: Increasing (Bond prices falling) -Stock prices: Peaking and volatile

Inflation & The Business Cycle (Economic Policy Response and Market Environment): Initial Recovery

Inflation: Initially declining Economic Policy Response: Stimulative Markets: -Short term rates: Low or declining -Long term rates: Bottoming (Bond prices peaking) -Stock prices: Increasing

Net Operating Income (NOI)

NOI is the amount of income remaining after subtracting vacancy and collection losses and operating expenses (e.g. insurance, property taxes, utilities, maintenance, repairs etc...) from potential gross income. NOI is very similar to EBIT! *NOI is calculated BEFORE subtracting financing costs and income taxes! NOI = Rental Income (if fully occupied) + Other Income - Vacancy and Collection Loss - Operating Expenses With the Direct Capitalization method of real estate valuation, value is based on capitalizing the Year 1 NOI of the property using a Capitalization Rate ("Cap Rate").

Negative Interest Rates and Complications for forming Capital Market Expectations

Negative interest rates complicate the process of forming capital market expectations (CME) as a result of the following: 1) The risk-free rate is the starting point for buildup models used to estimate long-run returns for asset classes. Negative rates throw off normal valuation models. 2) Forming CME over shorter time horizons is complicated by a need to forecast the time path over which negative rates will converge to a long-run sustainable risk-free rate. -->i.e. When forming CME for the long-run in the presence of negative rates, the text suggests analysts should use a long-run sustainable risk-free rate. The issue is the analyst must determine what this rate should be. 3) Some forecasting method interpret negative risk-free rates as being consistent with contraction or early recovery stages of the business cycle. 4) It is not generally possible to use historical data, as few comparable periods exist (and the negative rates suggest significant structural economic changes are occurring).

Real Estate Cycles

Real Estate values are BOTH subject to business cycle movements, but they also drive business cycles as well. Because supply is fixed at any given point in time, property values exhibit CYCLICALITY. Demand for real estate is strongly influenced by the quality and type of property available. -->High quality properties tend to fluctuate LESS with business cycles, and vice versa for lower-quality properties (which will show more cyclicality). When looking at real estate and business cycles, we observe the following characteristics: -Boom: Increased demand will drive up property values and leaser rates-->Induces construction activity-->Translates to stronger economic activity. -Bust: Falling demand leads to overcapacity and overbuilding which drives property values and lease rates down-->Because leases lock in tenants for longer terms and moving costs are high, excess supply can't be quickly absorbed.

REIT

Tax-advantaged companies (trusts) that are (for the most part) exempt from corporate income tax. Actively managed; own income-producing real estate; seek to profit by growing cash flows, improving existing properties, and purchasing additional properties. Advantages: 1. Superior liquidity 2. Transparency 3. Exemption from taxation 4. Predictable earnings 5. Access to premium properties 6. Active professional management 7. Greater potential for diversification Disadvantages: 1. Limited potential for income growth-->REITs' high rates of income payout limit REITs' ability to generate future growth through reinvestment, which limits income growth and may dampen the share price. 2. Forced equity issuance-->A REIT may be forced to issue equity at a disadvantageous price to finance growth, as availability of retained earnings is limited. 3. Lack of flexibility-->The rules that quality REITs for favorable taxation also imposes some restrictions in the investment choices for REITs. REITs are generally strongly correlated with equities in the short term, while direct real estate shows low correlation. -->The low short-term correlation between direct real estate and equities is partly due to the smoothing of return data. -->Over long time-horizons, REITs have a relatively high correlation with direct real estate.

Business Cycle Phases: Contraction

The "Contraction" is stage #5 of 5 of the business cycle. Some define "Recession/Contraction" as 2 consecutive quarters of negative REAL growth. The Contraction period is characterized by: -Duration: 12-18 months -Business confidence: Declining -Unemployment: Increasing (as well as increasing number of bankruptcies) -Output Gap: Negative output gap widens (producing below potential output) -Inflation: Peaking/topping out -Short-term interest rates: Falling -Bond yields: Falling (Bond prices rise and outperform stocks) -Stock prices: Increasing during the latter stages, anticipating the end of the recession

Business Cycle Phases: Initial Recovery

The "Initial Recovery" is stage #1 of 5 of the business cycle. Initial Recovery takes place as the economy is exiting recession. The Initial Recovery period is characterized by: -Duration: A few months -Business confidence: Rising -Monetary/Fiscal Policy: Government stimulus is provided via low interest rates and/or budget deficits -Inflation: Decelerating -Output Gap: Large -Short-term interest rates: Low or falling -Bond Yields: Bottoming out -Stock prices: Rising (in anticipation of economic recovery) -Cyclical and riskier assets (such as small-cap stocks and high-yield bonds) outperform

Business Cycle Phases: Late Expansion

The "Late Expansion" is stage #3 of 5 of the business cycle. Late expansion occurs as GDP is above trend, but growth is slowing. The Late Expansion period is characterized by: -Business confidence: High -Unemployment: Low -Output Gap: Eliminated (the economy is at risk of overheating) -Inflation: Increasing -Monetary Policy: Central bank limits the growth of the money supply -Short-term interest rates: Rising -Bond yields: Rising (and declining bond prices) -Stock prices: Rising and/or peaking with increased risk and volatility

Approaches to Economic Forecasting: Checklist Approach

The Checklist Approach to economic forecasting is highly subjective. In the Checklist Approach, the forecaster considers a list of factors--essentially a series of questions to consider in forming conclusions. -Ex. In forecasting GDP: -->What was the latest employment report? -->What is the central bank's next move, given the latest information released? -->What is the latest report on business investment? The forecaster must then use judgment and perhaps some statistical modeling to interpret the answers and formulate a forecast. Judgment is required both in determining WHICH factors to consider and HOW to interpret them. Advantages: -Less complex than econometrics. -Flexible in mixing objective statistical analysis with judgment to incorporate changing relationships. Disadvantages: -Subjective. -Time-consuming. -Complexity must be limited due to manual process. Relies on manual interpretation of the information.

Forecasting Fixed Income Returns: Risk Premium (Building Block) Approach - Credit Premium

The Credit Premium is a component of the building block approach. Compensates for the expected level of losses and for the risk of default losses, both of which are components of the credit spread. Yield spread is typically not a good predictor of future default rates because premiums earned tend to be uneven and subject to significant clustering of persistent high and low spreads. -->Spreads are affected primarily by financial market conditions and the credit premium, but only to a lesser extent by expected default losses. Downgrade Risk vs. Default Risk: -Downgrade Bias: An asymmetrical risk indicating that a downgrade is more likely than a credit improvement or an upgrade. -->Very high credit quality (i.e. IG Debt) have extremely low default rates, and their Credit Premium and spreads are mainly driven by downgrade bias. -Default Risk: The risk that a borrower will be unable to make the required payments on their debt obligation. -->The credit premium and spreads of low(er) rated bonds, especially non-investment grade bonds (i.e. High Yield Debt), reflect much higher compensation for credit risk.

Grinold-Kroner Model

The Grinold-Kroner Model is an adaptation of the Gordon Growth DCF Model (or the Constant Growth Model) E(Re) ≈ (D/P) + (%ΔE - %ΔS) + %Δ(P/E) OR E(Re) ≈ ((D/P) − %ΔS) + %ΔE + %Δ(P/E) i.e. The expected return of a stock is the sum of: Expected Cash Flow Return + Expected Nominal Earnings Growth + Expected Repricing Return Where: E(Re) = Expected Equity Return (D/P) = Dividend Yield %ΔE = Expected % change in total earnings %ΔS = Expected % change in shares outstanding %Δ(P/E) = Expected % change in the P/E ratio The variables of the GK model can be regrouped into three components: 1) Expected Cash Flow Return (Income Return) Income Return = ((D/P) - %ΔS) -->Remember: A share repurchase is a REDUCTION in shares outstanding, which means the company buys back shares and pays cash to investors. This cash payment is a form of positive return and INCREASES cash flow to investors, EPS, and expected return. -->A share repurchase is a NEGATIVE %ΔS term, so subtracting a negative term becomes a POSITIVE (i.e. increases the "Income Return" metric). 2) Expected Nominal Earnings Growth %ΔE = Expected Nominal Earnings Growth Return 3) Expected Repricing Return Expected Repricing Return = %Δ(P/E) Remember: The assumptions of the GK model may lead to irrational results because the model assumes an infinite time horizon (it ignores an investor's time horizon). -->Ex. By selecting any positive growth rate for the P/E ratio, the model assumes an infinitely rising P/E ratio, which is obviously implausible. For VERY long-term horizons, the theoretically appropriate %ΔP/E = 0 (and also %ΔS = 0) -By rearranging the GK model into the three components as shown below, we can think of the model as the sum of: 1) Expected Cash Flow Return; 2) Expected Nominal Earnings Growth Rate; and 3) Expected Pricing Return. E(Re) ≈ ((D/P) − %ΔS) + %ΔE + %Δ(P/E) ***This is a key model on the exam!!!

Forecasting Fixed Income Returns: Risk Premium (Building Block) Approach - Liquidity Premium

The Liquidity Premium is a component of the building block approach. Generally, liquidity is higher for bonds that are: 1) Issued at close-to-par or market rates 2) Newly issued 3) Large in size 4) Issued by a frequent and well-known issuer 5) Simple in structure 6) High credit quality Securities with the highest liquidity are the newest sovereign bond issues, current coupon MBS, and some high quality corporate bonds.

Neutral Rate

The Neutral Rate is the theoretical federal funds rate (i.e. "short-term" rate) at which the stance of central bank monetary policy is neither accommodative nor restrictive. It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability.

Forecasting Fixed Income Returns: Risk Premium (Building Block) Approach - Term Premium

The Term Premium is a component of the building block approach. -Rates implied from the SPOT yield curve give us useful information about the term premium. -The real term premium cannot be derived from the yield curve alone, however. 4 primary drivers of the Term Premium: 1) Inflation Uncertainty -->HIGHER inflation levels typically correspond to HIGHER inflation uncertainty-->Causes nominal yields to RISE and the Term Premium to INCREASE 2) Recession Hedge -->When inflation is caused by strong aggregate demand: Nominal bond returns are NEGATIVELY correlated with growth-->LOW Term Premiums. -->When inflation is caused by aggregate supply: Nominal bond returns are POSITIVELY correlated with growth-->HIGHER Term Premiums. 3) Supply and Demand -->The relative supply of short- and long-term default-free bonds determines the slope of the yield curve, which influences the level of Term Premiums. 4) Business Cycles -->The slope of the yield curve and level of Term Premiums are influenced by current phase of the business cycle.

Forecasting Fixed Income Returns: Risk Premium (Building Block) Approach

The building block approach starts with a risk-free rate and then adds compensation for additional risks. The required return will include: 1) The Short-Term Default-Free Rate -Matches the forecast horizon and is calculated from the most LIQUID instrument-->it is closest to the government zero-coupon yield and is closely tied to the central bank policy rate. -If the investment horizon is much larger than the short-term instrument, alternative approaches may be needed, either by using the yield of a longer maturity zero-coupon bond, or taking the return that could be realized by rolling over the short-term instrument over the investment horizon. 2) Term Premium -Rates implied from the spot yield curve give us useful information about the term premium. -The real term premium cannot be derived from the yield curve alone. It is driven by: a) Inflation Uncertainty b) Recession Hedge; c) Supply and Demand; d) Business Cycles 3) Credit Premium -Compensates for the expected level of losses and for the risk of default losses, both of which are components of the credit spread. -Yield spread is typically not a good predictor of future default rates because premiums earned tend to be uneven and subject to significant clustering of persistent high and low spreads. 4) Liquidity Premium -Generally, liquidity is higher for bonds that are: -->Newly issued at close-to-par or market rates. -->Large in size and issued by a well-known issuer. -->Simple in structure and of high credit quality.

Duration Gap

The difference between a bond's Macaulay Duration and the bondholder's investment horizon. -Duration Gap = MacDur - Investment Horizon -Positive Duration Gap (Macaulay Duration > Investment Horizon): Exposes the investor to Market Price Risk from increasing interest rates. -Negative Duration Gap (Macaulay Duration < Investment Horizon): Exposes the investor to Reinvestment Risk from decreasing interest rates.

Output Gap

The difference between the ACTUAL output of an economy and the maximum POTENTIAL output of an economy expressed as a percentage of GDP. A country's output gap may be either positive OR negative: -NEGATIVE output gap: -->Suggests that actual economic output is BELOW the economy's full capacity for output. -->Associated with decelerating and/or low inflation. -POSITIVE output gap: -->Suggests that actual output is HIGHER than the economy's recognized maximum capacity output. -->Associated with increasing inflation.

The Business Cycle and Its Effects on Short- and Long-Term Expectations

The trend rate of growth provides guidance on setting long-term CME. Deviations from this trend tend to cancel out over the long-run. -->Identifying deviations, however, can be very useful when making shorter-term projections. Difficulties associated with using the business cycle to form CME: 1) Business cycles vary in duration and intensity, and their turning points are difficult to predict. 2) It is difficult to identify out shorter-term factors that will affect the longer-term trend rate of economic growth. 3) Returns in capital markets are strongly related to activity in the real economy, but they are also affected by investors' attitudes toward risk and return.

Factor-Based Variance-Covariance Matrices

Using multifactor models for VCV matrices significantly reduces the number of needed observations to arrive at a meaningful output. Correlations can be estimated from a few common factors, while variances require factors related to specific assets. -->A VCV matrix needs (N(N - 1)/2) covariances. -->A factor model would only need (N x K) factor sensitivities and (K(K+1)/2) factor elements. Ex. For N = 50 and K = 6 (where N = # of Assets in a portfolio; K = # of Factors being considered) -->VCV matrix would need 1,225 sensitivities. -->Factor model would need only 300 sensitivities and 21 elements.

Forecasting Fixed Income Returns: DCF Analysis

When valuing bonds with a DCF analysis, the YTM is used as the discount rate that makes the present value of future bond cash flows equal to the bond's price. YTM is an IRR calculation. -REMEMBER: Assumes that the reinvestment rate on all cash flows is as the INITIAL IRR. -->If cash flows are reinvested at a HIGHER rate than the initial YTM, the return on the bond will be HIGHER than the initial YTM. -->If cash flows are reinvested at a LOWER rate than the initial YTM, the return on the bond will be LOWER than the initial YTM. *For the exam, remember that the Macaulay Duration can be calculate by multiplying Modified Duration by the bond's YTM.