Cfa Level Iii - Study Session 6

Front 1

Capital Market Expectations in Portfolio Management
(SS6)

Capital Market Expectations (CME) in portfolio management process.

Back 1

Framework
1. Write the questions that need to be answered, most importantly the time horizon.
2. Research the historical period to find useful characteristics of the asset to predict a future range of future results. Find the factors that affect the asset class returns.
3. Specify model to be used and why they're using it. Different models need different input.
4. Find the best sources for this information
5. Interpret the data using known principles and figure out what conflicting info means in the data.
6. Reason and make assumptions based on the data
7. Monitor actual outcomes and compare them to expectations and feedback into the next process.

CME is called BETA RESEARCH (returns and risks to systematic risk)

ALPHA is capturing excess risk-adjusted returns

Front 2

Capital Market Expectations
(SS6)

Capital Market Expectation (CME) setting Information Requirements

Back 2

1. Expected return asset A (e.g. US broad market over 5 yr horizon)
2. Expected return asset B (e.g. US investment grade bond over 5 y horizon)
3. Standard deviation of Asset A (e.g. s.d. of US broad based market equities)
4. Standard deviation of Asset B (s.d. of US investment grade bonds)
5. Correlation of Asset A and B

Front 3

Capital Market Expectations
(SS6)

Challenges in Forecasting

Back 3

1. Faulty analysis and/or assumptions
2. Limitations of economic data like timeliness, construction, biases and accuracy.
3. Data measurement errors like transcription errors (when gathered), survivorship biases and appraisal (smoothed) data (where no markets exist to get asset information like house values). Appraisal data is less volatile, therefore smaller correlations and s.d. biased downward.
To correct this make variations larger and keep mean unchanged, like you might want to do with venture capital returns.
3. Historical estimates have limitations. You can't just extrapolate the past to get the future. Also problems of changes in regime (war, governments etc) which give nonstationary data where different parts existed under different rules.
4. Ex Post risk can be a biased measure of Ex Ante risk - only EX ANTE is important in decision making.
5. Bias in analyst's methods - data mining bias (drill until you find a relationship but no story no future, time period bias
6. Fail to account for conditioning information. Like when you know that the business cycle is different in the future than the cycle in your historical data.
7. Misinterpretations of correlations
8. Psychological Traps - anchoring, status quo, confirming evidence, overconfidence, prudence and recallability trap.

Front 4

Capital Market Expectations
(SS6)

CME and Psychological Traps

Back 4

i. Anchoring trap - where you pivot all others off the first presentation
ii. Status Quo trap - forecasts perpetuate recent observations, so no change from the recent past.
iii. Confirming Evidence - people listen more to things that support their convictions. To get over this hire someone independent and make yourself read things that are opposite to your beliefs.
iv. Overconfidence Trap - You think your forecasts are more accurate than they actually are. To narrow a range of forecast.
v. Prudence Trap - Temper forecasts so that they don't seem extreme, people are too cautious when they forecast.
vi. Recallability Trap - The stronger the even in peoples memory the more they are influenced from that.

Front 5

Capital Market Expectations
(SS6)

Tools for making CME - Formal Tools (4 types)

Back 5

Formal Tools = established methods
i. Statistical Methods - descriptive (getting the most important things out) and inferential statistics (guessing large sample on actuals from small sample)
ii. Discounted Cash Flow Models
iii. The Risk Premium Approach
iv. Financial Market Equilibrium Models

Front 6

Capital Market Expectations
(SS6)

Tools for making CME - Non Formal Tools

Back 6

1. Survey and Panel Methods - Ask a group of experts. If their opinions are consistent with each other then you have a "Panel".
2. Judgment - analyst should be able to factually explain basis of forecast.
Improve forecasts by using economic and psychological insight.

Front 7

Capital Market Expectations
(SS6)

Tools for making CME - (Formal) Statistical Methods

Back 7

i. Historical Statistical Approach - uses a sample of history to figure out arithmetic/geometric mean equity return
ii. Shrinkage Estimators - "Two estimates are better than one" Shrinkage is when the impact of extreme values in historical estimates are taken out (i.e. two estimates of the covariance matrix and a weighted average taken from the two)
iii. Time-series Estimators - forecasting based on laggard values. Good for short term forecasts because of "Volatility clustering" where high follows high and low follows low.
iv. Multifactor Models - explains total return on the values of a set of return drivers or risk factors. e.g. global equity sensitivity and global bond sensitivity of Market A, then Market B.
It uses the return on all assets based on a set of common drivers, which simplifies covariances because you can get these from asset factor sensitivities.
M = a + b1F1 + b2F2 + e
Mvar = b²Var (F1) + b²Var (F2) + 2b1b2 Cov(F1, F2) + Var (e)

Front 8

Capital Market Expectations
(SS6)

Tools for making CME - (Formal) Discounted Cash Flow Methods

Back 8

Asset's value is the PV of expected cash flows.(CF / discount rate)
Advantage is that they are forward looking
Disadvantage is that they are don't consider ST issues like supply-and-demand conditions, so they are bad for short-term expectations.
i. Equity Markets -
GGM Gordon Growth Model (assumes a long-term trend in dividends) = D1 / P0 + g
Grinold - Kroner Model (single period return on a share like GGM but it includes a repurchase yield where the company buys back stock)
Grinold Kroner Expected Return = Income/ Dividend return + Nominal earnings growth (real growth and inflation growth) + Repricing (repurchase and expansion of PE multiples
ii. Fixed- Income Markets - still use discount rate like the GGM, but for bonds know as YTM

Front 9

Capital Market Expectations
(SS6)

Tools for making CME - (Formal) The Risk Premium Approach

Back 9

i. Fixed-Income Premiums
Expected Bond Return is:
E (R) =
real risk free interest rate (when no inflation is expected) +
inflation premium (for expected inflation) +
default risk premium (for possibility that borrower will fail to make promised payments) +
illiquidity premium (relative loss if asset needs to be reverted to cash quickly) +
maturity premium (LT vs ST) +
tax premium (certain bonds in certain tax jurisdictions.
ii. Equity Risk Premium (for holding equity over debt)
E (R) =
YTM on a long-term gov. bond +
equity risk premium
Know as the 'bond-yield-plus-risk-premium' method

Front 10

Capital Market Expectations
Grinold-Kroner model

(SS6)

Back 10

Grinold-Kroner
= Income + nominal rate + repurchase yield

1. expected Income is dividend yield less % change in number of shares outstanding (repurchase yield)
DIVIDEND - REPURCHASE
2. Nominal is real + inflation
3. Repricing is: change in P/E multiple
14 - 14.5
-------------
14.5

Front 11

Capital Market Expectations
Fixed-Income Premiums

(SS6)

Back 11

Expected bond returns can be built up as the real rate of interest plus a SET of premiums
1. Real risk free ir
2. Inflation premium
3. Default risk premium
4. Illiquidity premium
5. Maturity premium
6. Tax premium

Front 12

Capital Market Expectations
Financial market equilibrium models

(SS6)

Back 12

Where supply and demand are in balance
1. Black-Litterman
2. Singer and Terhaar - based on ICAPM taking account of market imperfections that aren't considered in ICAPM.
If markets are fully integrated then you can use a correlation value.
If markets are segmented, then correlation = 1 because you can't move capital across markets so market pf is the local one
If 0.8 integrated then 20% not integrated.

Front 13

Capital Market Expectations
Singer and Terhaar

(SS6)

Back 13

Singer Terhaar is all about recognising the need to account for market imperfections that are not considered in ICAPM (illiquidity and segmentation)

risk premium

RPi = oi pim (RPm)
--------
om
1. Asset volatility
2. Correlation with global portfolio
3. Sharpe ratio global market pf

i. It's all about SYSTEMATIC risk
ii. It won't tell you much about valuation

Front 14

Capital Market Expectations
Market integration
Market segmentation

(SS6)

Back 14

Market integration
i. no impediments or barriers to capital mobility
ii. If integrated two assets in different markets with identical characteristics must have the same expected return

Market segmentation
i. some meaningful impediments to capital movement across markets.
ii. The more segmented it is, the more local investors there will be

Front 15

Capital Market Expectations

Example Setting CME using Singer-Tehaar

(SS6)

Back 15

To calculate the expected return for an asset class, we take the following steps.
1. Calculate risk premium of the asset class for full integration
Calculate risk premium of the asset class for complete segmentation
NB Add illiquidity premium
2, Average the two estimates of the risk premium for an asset class by WEIGHTING the full integration estimate by the assumed degree of integration and the complete segmentation estimate by (1 - degree of integration).
3. Add risk premium estimate to the risk free rate to get the expected return.

Front 16

Capital Market Expectations

Survey and Panel Methods

Judgement

(SS6)

Back 16

Ask a group of experts for their expectations
i. If their responses are stable the analyst has a panel of experts and the approach can be called a 'panel method'.

Judgement
i. Analyst should be able to factually explain the basis and rational for a forecast.
ii. Non-emotional, but models still need economic and psychological insight to improve forecasts.

Front 17

Economic Analysis
Output gap

(SS6)

Back 17

Output gap
i. Difference between the value of GDP estimated as if the economy were on its trend path and the actual value of GDP
ii. Positive gap output gap when slow growth or times of recession
iii. Positive gap is when inflation tends to decline

Front 18

Capital Market Expectations
Central bank deals with inflation 3 ways

(SS6)

Back 18

1. Central banks' policy-making decisions must be independent of political influence. If politics comes in they always want monetary policy to be loose and that lets inflation gradually accelerate.
2. Central banks should have an inflation target, to discipline themselves and as an indicator to the market
3. Central banks should use first and foremost monetary policy (interest rates) to control the economy and prevent overheating or languishing.
3.

Front 19

Capital Market Expectations
Inflation's impact on:
Cash

(SS6)

Back 19

i. Inflation at or below:
Short-term yields steady
(neutral)
ii. Inflation above expectations
Bias toward rising rates
(positive)
iii. Deflation
0% short term rates
(negative - like now)

Front 20

Capital Market Expectations
Inflation's impact on:
Bonds

(SS6)

Back 20

BONDS:
i. Inflation at or below:
yield levels maintained, market equilibrium
(neutral)
ii. Inflation above expectations
Bias towards higher yields to compensate for higher inflation premium
(negative)
iii. Deflation
purchasing power increasing
(positive)
Although more people might be defaulting due to falling asset prices.....

Front 21

Capital Market Expectations
Inflation's impact on:
Equity

(SS6)

Back 21

EQUITY:
i. Inflation at or below:
Bullish equity because market is in equilibrium
ii. Inflation above expectations
Can you pass on inflated costs? Yes, then you are OK
Otherwise inflation is a (negative)
iii. Deflation
negative wealth effect, especially bad for highly levered and commodity producing companies

Front 22

Capital Market Expectations
Inflation's impact on:
Real Estate/Other real assets

(SS6)

Back 22

Real Estate
i. Inflation at or below:
cash flow steady
(neutral)
ii. Inflation above expectations
Asset values increasing
(positive)
iii. Deflation
Cash flows steady to falling
Asset values decreasing
(negative)

Front 23

Capital Market Expectations
Business Cycle Factors:
Inventory up/down
What does it mean?

(SS6)

Back 23

Rising inventory
i. could mean businesses are confident of sales and are spending ahead of expected sales
ii. if a rising inventory level is at the end of the business cycle, then it could signal an involuntary rise in inventory because sales are lower than expected. NEGATIVE

Front 24

Capital Market Expectations
Business Cycle Factors:
Monetary Policy expansionary/contract
What does it mean?

(SS6)

Back 24

Expansionary Monetary Policy (M2 up)
i. M2 up when economy is weak
Contract M2
i. when economy is strong and in danger of overheating
ii. use it to slow growth. if they are wrong and a recession happens then they cut rates to restore growth.

Front 25

Capital Market Expectations
Taylor Rule
(for central bank interest rate target)


(SS6)

Back 25

TAYLOR RULE gives the optimal short-term interest rate as a neutral rate plus an amount that is positively related to excess of forecast of GDP and inflation
i. Take short term interest rate
ii. Add half GDP above trend
iii. Add half INFLATION above target/trend

1. If GDP is below forecast then it will reduce optimal ir to stimulate growth
2. If inflation is below forecast then it will reduce optimal ir then it will stimulate money supply and get inf back to target.

Front 26

Capital Market Expectations
Policy Mix and the Yield curve

(SS6)

Back 26

Steep Yield curve IF:
i. Loose fiscal, loose monetary
Inverted yield curve IF:
ii. Tight fiscal, tight monetary

Front 27

Capital Market Expectations
TFP
Total Factor Productivity

(SS6)

Back 27

Growth from labour INPUTS
i. growth in potential labour force size
ii. growth in actual labour force participation
Growth from labor PRODUCTIVITY
i. Capital inputs
ii. TFP total factor productivity growth (technical progress from increased productivity from investment in new machines)

Front 28

Capital Market Expectations
Example - Forecasting GDP Trend Growth

(SS6)

Back 28

Canadian GDP will grow at a long-term 3.5% annual rate. According to Casey's own research, a 3.2% growth rate is more realistic. Assumptions are
i. Labour force will grow at 1% per year
ii. Labour force participation will grow at 0.25% per year
iii. Growth from capital inputs will be 1.5% per year.

Why are their forecasts so different?
1. They only agree on 3 out of 4 GDP growth components
2. The must have a different view on TFP total factor productivity growth.
3. Casey must assume that TFP is 3.2 - (1+0.25 + 1.5%) = 0.45%
4. In contrast the consultant is predicting that TFP growth is
3.5 - (1 + 0.35 + 1.5%) = 0.75%

Therefore the consultant is more optimistic than Casey about GDP growth from increases in the productivity in using capital inputs.

Front 29

Capital Market Expectations
List five general elements of a pro-growth government structural policy

(SS6)

Back 29

1. Fiscal policy is sound. Fiscal policy is sometimes used to control the business cycle.
Ideal is budget deficit close to zero over the long term.
2. The public sector intrudes minimally on the private sector.
Worst interferences are labour market rules.
3. Competition within the private sector is encouraged.
4. Infrastructure and human capital development are supported.
5. Tax policies are sound. Taxes distort economic activity and the ideal is a low marginal tax rate with a very broad base.

Front 30

Capital Market Expectations

Emerging Markets
Name the four key differences
(SS6)

Back 30

Emerging markets
1. Need high rates of investment, which is always in short supply, therefore they rely on foreign capital.
Physical infrastructure needs to be built as well as human capital.
2. Volatile political and social situations.
3. World Bank, IMF etc try and push for structural reforms - political social and pro-growth
4. Emerging countries have economies that are relatively small and undiversified. Those emerging economies that are dependent on oil imports are especially vulnerable in periods of rising energy prices and can be dependent on ongoing capital inflows.

Front 31

Capital Market Expectations

Leading Index Indicators

(SS6)

Back 31

1. Average weekly hours, manufacturing
2. Initial claims for unemployment
3. Manufacturing new orders - consumer goods and materials
4. Delivery index
5. Manufacturing new orders - capital goods
6. Building permits
7. Stock prices
8. Money Supply, M2
9. Interest rate spread, 10y treasury bonds
10. Consumer expectations

Front 32

Capital Market Expectations

Coincident Indicators

(SS6)

Back 32

1. Payroll employees
2. Personal income less transfer payments
3. Industrial production
4. Manufacturing and trade sales

Front 33

Capital Market Expectations

Three approaches to Economic Forecasting

(SS6)

Back 33

1. Econometric Modeling
2. Leading Indicator-Based Approach
3. Checklist Approach

Front 34

Capital Market Expectations
Economic Forecasting:
Econometric Modeling Advantages/Disadvantages

(SS6)

Back 34

Econometric Modeling
Advantages
1. Robust model
2. Once model is built all you need to do it put each new year of data in
3. Gives quantitative estimates based on changes in exogenous variables.

Disadvantages
1. Time-consuming
2. Complex
3. Data inputs are not easy to forecast and are not static
4. Rarely forecasts recessions well

Front 35

Capital Market Expectations
Economic Forecasting:
Leading Indicator-Based Approach Advantages/Disadvantages

(SS6)

Back 35

Leading Indicator-Based economic forecasting approach:
Advantages
1. Intuitive and simple construction
2. Can buy it from third parties
3. Can be tailored to an individual need
4. Based in theory

Disadvantages
1. Can provide false signals, up one period then down the next
2. Historically hasn't worked

Front 36

Capital Market Expectations
Economic Forecasting:
Checklist Approach Advantages/Disadvantages

(SS6)

Back 36

Checklist Approach
Advantages
1. Limited complexity
2. Flexible: allows structural changes to be easily incorporated

Disadvantages
1. Subjective
2. Time consuming
3. Manual process, so of course the complexity has to be limited.

Front 37

Capital Market Expectations
Inflation-Indexed Bonds

(SS6)

Back 37

Inflation Indexed bonds are the perfect risk free assets, because they have no risk from unexpected inflation.

BUT the yield still changes over time
1. Economic growth going up = real bond yields also go up
2. Inflation expectations rising = real bond yields go DOWN (prices rise because people want more of these
3. Investor demand rising = real bond yields FALL (more people want them, so the price goes up)

Front 38

Capital Market Expectations
Approaches to forecasting Exchange Rates

(SS6)

Back 38

1. PPP - Purchasing Power Parity
i. movements in the exchange rate shoulds offset the difference in the inflation rates between two countries
ii. good over the long run (5 years plus), not a good predictor in the short run.
iii. ERs can depart from PPP for a long period of time. PPP is not really a useful guide for short term
2. Relative economic strength
3. Capital flows (capital forecasting approach)
i. allowing foreign direct investment into a country increase the demand for the country's currency
ii. raising ir to boost weak currency may deter foreign investment in business because it is more expensive to finance and this might push ER in the unintended direction
4. Savings-Investment imbalances