TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS 3.1 Formal Tools 3.1.1 Statistical Methods 3.1.1.2 Shrinkage Estimators Analyst use historical data for forecasting.. Discounted CF Mod
Trang 1“ CAPITAL MARKET EXPECTATIONS ”
2 ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES
CMEs ⇒ β research (related to systematic risk)
CMEs:
Macro expectations ⇒ regarding asset classes
Micro expectations ⇒regarding individual assets
Process to formulate CMEs:
Specify CMEs needed according to investor’s tax status, allowable asset classes & time horizon
Research the historical record
Identify the valuation model & its requirements
Collect the best data possible
Use experience & judgment to interpret current investment conditions
Formulate CMEs & document conclusions
Monitor actual outcomes & compare them to expectations & refined the process if needed
Good forecasts are unbiased, objective, well researched & efficient
2.1 A Framework for Developing Capital Market Expectations CMEs = Capital Market Expectations
Poor forecasts can result in inappropriate asset allocation
Some problems in the use of data & analysts mistakes & biases are as follows
2.2 Challenges in Forecasting
Time log b/w collection & distribution of data
Revisions are not made at the time of publication
Data definitions & methodology ∆ over time
Data indices are often rebased over time
2.2.1 Limitations of Economic Data
2.2.2 Data Measurement Errors and Biases
Survivorship Bias
Errors in gathering & recording data
More problematic if biased in a certain direction
Data of surviving entities only
Return series convey an overly optimistic picture
Appraisal data are used in lieu of market price data for illiquid assets
Correlation & SD of the asset
Potential solution ⇒ rescale the data without effecting mean return
Trang 2Past simply can’t be simply extrapolated to produce future results
Regime changes ⇒ ∆ in the technological, political legal & regulatory environment (on stationary data)
Statistical tools should be used to indentify regime
∆ or turning points
Long Data Series
Precisions with population parameters are estimated
Parameters (e.g return, SD etc) are less sensitive to time span
Data may no longer be relevant
Time series of required length may not be available
Asynchronous data if frequency is
Test shorter time series of data should be used
If data is non-stationary
Regime ∆ deleted statistically
Export data ⇒ after the fact, ex ante data ⇒ before the fact
Looking backward, analysts are likely to underestimate
ex ante risk & overestimate ex ant anticipated returns
2.2.4 Ex Post Risk Can Be a Biased Measure of Ex Ante Risk
2.2.5 Biases in Analysts' Methods
Repeatedly searching a dataset until the analyst finds some statistically significant pattern
To avoid the bias:
Find economic basis for the variable
Test the discovered relationship with out-of-sample data
Results from the time span of the data chosen
Relationship b/w security returns & economic variables
is not constant overtime
2.2.6 The Failure to Account for Conditioning Information
Trang 3The analyst should take care in interpreting correlations because:
Correlation may be spurious
Endogenous variable may be unable to explain exogenous variable
Correlation statistic missed the nonlinear relationship b/w two variables
Multiple regressions (alternative to correlation) are used to uncover predictive relationship
Partial correlation is used for desired analysis
2.2.7 Misinterpretation of Correlations
2.2.8 Psychological Traps
Disproportionate weight to the 1st information
Solution ⇒ avoid premature conclusion
Predict no change from the recent past
To avoid cognitive cost or regret
Solution ⇒ rational analysis within a decision-making process
Greater weight to information that supports
an existing or preferred view
To ensure objectivity:
Give all evidence equal scrutiny
Seek out opposing opinions
Be honest about your motives
Overestimate the accuracy of forecasts
Too narrow a range of scenarios in forecasting
Solution ⇒ wider the range of possibilities
Overly conservative forecasts
Stay close to the crowed (herding behavior)
Solution ⇒ wider the range of forecasted values
Too many weights to the events that left a storing impression on a person’s memory
Solution ⇒ conclusions on objective data
Model uncertainty ⇒ uncertainty concerning whether a selected model is correct
Input uncertainty ⇒ uncertainty concerning whether the inputs are correct
Some analysts believe that market anomalies are results of different valuation models
2.2.9 Model Uncertainty
Trang 4Tools that are accepted within the investment community
3 TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS
3.1 Formal Tools
3.1.1 Statistical Methods
3.1.1.2 Shrinkage Estimators
Analyst use historical data for forecasting
Project the historical mean, SD & correlations for a data set into the
future
Decision point relates to the choice b/w AM & GM
AM best represents the mean return in a single period
GM repents the multi period growth
For a risky variable GM<AM
Weighted avg of a historical estimate of a parameter & some other parameters estimate
Impact of historical extreme values
Applied to mean return & covariance
Efficiency of covariance if plausible target is selected
= + 1 −
Forecasting a variable using previous values of itself or other variables
Variance clustering ⇒ high (low) volatility tend to follow high (low)
volatility
J.P Morgan an model to measure current period volatility:
where
= rate of decay (between 0-1)
Explains the return to an asset in terms of the values of a set of risk factors
Useful for molding asset return & covariance’s
Models usefulness:
When factors are well chosen, the model may filter out noise
Common set of factors simplify the task of estimating covariance
Verify covariance consistency
3.1.2 Discounted Cash Row Models
DCF model ⇒ asset’s values is the present value of future CF
Advantage⇒ forward looking
Disadvantages ⇒ don’t address current supply &
demand condition so not suitable for short-term expectations
Trang 5Discounted CF Models
Gordon Growth Model
YTM of a reference bond in a segment
is used as expected return for the segment
Problem ⇒ YTM assumes reinvestment at YTM
Solution ⇒ use YTM of a zero coupon bond
= భ
బ+ where భ
బ = Dividend yield
g = growth (capital gains)
When applied at entire market level
g = nominal GDP growth + excess corporate growth
Grin old & Kroner Model
≈ భ
బ− where
-∆S = repurchase yield
i = expected inflation rate
g = expected real total earning growth
∆P/E = par period change in P/E multiple
Three components:
Expected income return: D/P -∆S
Expected nominal earning growth = i+g expected capital gains
Expected reprising return ∆ P/E expected capital gains
Fed Model
Stock market is overvalued (undervalued) is market’s E/P <(>) 10 year treasury bond yield
3.1.3 The Risk Premium Approach
= Real Rf rate + inflation premium + default risk premium + illiquidity premium + maturity premium + tax premium
3.1.3.2 Fixed-Income Premiums
Equity risk premium ⇒ compensation required for the additional risk of equity
Bond yield plus risk premium approach ⇒ = YTM on longer term govt bond + equity risk premium
3.1.3.3 The Equity Risk Premium
Describe relationship b/w E(R) & risk in which supply & demand are in balance
3.1.4 Financial Market Equilibrium Models
Trang 6Equilibrium Models
If PPP holds then:
= + − where
= return on global investable market
= asset’s sensitivity to the return on the world market portfolio
Asset class’s risk premium
= ,
The ICAPM Approach
Account for two market imperfections
Illiquidity
Market segmentation
Illiquidity premiums can be estimated through investment’s multi period sharpe ratio(MPSR)
Investment’s MPSR should at least be as high as MPSR
Steps of singer-Tehaar approach:
Estimate perfectly integrated &
segmented risk premiums
Add the illiquidity premiums
Estimate the degree of market integration
Weighted avg of completely integrated &
segmented market
Calculate the expected returns ⇒ +
Singer-Terhaar Approach
Survey method ⇒ asking a group of experts for their expectations & using the responses in CME
Pane method ⇒ group pooled is fairly constant over time
Equity risk premium expectations of practitioners are consistently more optimistic than that of academies
3.2 Survey and Panel Methods
Economic & psychological insights to improve forecasts
Investors may use checklists
3.3 Judgment
Assets with lower (higher) expected payoffs during business cycle ⇒ higher (lower) risk premiums
Points of inflection in economic activity provide unique investment opportunities
Economic growth has two components:
Trend growth (use in longer tem CME)
Cyclical growth (important for short-term CME)
4 ECONOMIC ANALYSIS
Trang 7Two cycles:
Inventory cycle (2-4 years)
Business cycle (9-11 years)
Chief measures of economic activity:
Output Gap ⇒ difference b/w actual GDP & trend
Recession ⇒ two successive quarterly in GDP
4.1 Business Cycle Analysis
Usually judged through inventory/sales ratio:
When this ratio has moved down (up) ⇒ economy is likely to be strong (weak) in next few months
Overall this indicator has been trending down ⇒ improved techniques
4.1.1 The Inventory Cycle
4.1.2 The Business Cycle
Economy picks up form recession
Business confidence
Inflation
Bond yield
Stock prices
Economy gains momentum
Consumer confidence
Short term rates & longer term bond yield are
Stocks are trending
Economy is in the danger of overheating
Confidence, unemployment
Interest rates & bond yields are
Equities are volatile
Confidence start wavers
Inflation continues to rise
Short term IR are high & bond yield curve inverts
Stock market may
Recession
Inventories pull back
Unemployment, inflation & confidence
Short term IR & bond yields
Stock markets start to rise in the later stage
Trang 8Inflation tend to rise in later stages of cycle & to during recession &
early stages of recovery
Three principles of central banks to deal with inflation:
Decision making must be independent of political influence
Inflation target
Use monetary policy to control economic growth (inflation)
Deflation is a threat:
It tends to undermine debt-financed investments
Central bank is unable to stimulate economy by further IR (already in bottom)
Bonds outperform during recession
Rising inflation is good for equities unless the central bank tends to IR
4.1.3 Inflation and Deflation in the Business Cycle
Business cycle phases are difficult to identify & predict (CME difficult to form)
4.1.4 Market Expectations and the Business Cycle
Business cycle analysis should be focused on:
Consumer spending (major part of GDP)
Business (small part of GDP out volatile)
Foreign trade
Govt activity (monetary policy & fiscal policy)
4.1.5 Evaluating Factors that Affect the Business Cycle
Links b/w target short-term IR to the rate of economic growth & inflation
Prescriptive tool & fairly accurate at predicting central bank action
=
+ 0.5 − +
5
When IR are at zero, further monetary stimulus requires new type of measures:
More cash into the banking system
Currency devaluations
Low short term IR for an extended period
Buy asset directly from the private sector
The Taylor Rule
Govt () spending or () taxes to stimulate (slow) the economy
Two $ points should be kept in mind:
It is ∆ in deficit that matter not the level of deficit
Only deliberate changes in fiscal policy matters
4.1.5.4 Fiscal Policy
Trang 9Expansionary fiscal & monetary policy ⇒ steeply upward sloping Y.C
Restrictive monetary & fiscal policy ⇒ inverted Y.C
Expansionary monetary & restrictive fiscal policy ⇒ moderately upward sloping Y.C
Expansionary fiscal & restrictive monetary policy⇒ flat Y.C
The Yield Curve
Long term growth path GDP
Shocks in trends are difficult to forecast
Trend rate, equity returns
4.2 Economic Growth Trends
Consumer spending is quite stable over business cycle
Permanent income hypothesis ⇒ consumer spending behavior is largely determined by long run income expectations
4.2.1 Consumer Impacts: Consumption and Demand
Aggregate trend growth is the sum of the following:
Changes in employment
Growth in potential labour force size
Growth in actual labour force participation rate
Changes in labour productivity:
Growth from capital inputs
Growth in total factor productivity
If investment is growing faster than returns, returns on invested capital are driven down
4.2.2 A Decomposition of GDP Growth and Its Use in Forecasting
Policies that affect the limits of economic growth & incentives with in a private sector
Elements of structural policy:
Sound fiscal policy ⇒ stimulate economy through budget deficits three problems:
It brings current A/C deficit
Inflation
Take resources from private sector
Low government intervention
Competition within the private sector is encouraged
Sound tax policies
4.2.3 Government Structural Policies
Trang 10Unanticipated events that occur outside the normal course of
an economy
These shocks usually produce a negative impact on the economy & not built into prices
4.3 Exogenous Shocks
Types of Economic Shocks
Oil prices, inflation, growth
Oil prices, inflation, growth
Significant oil prices, overheated economy, inflation
4.3.1 Oil Shocks
Affect growth through bank leading
or investor confidence
More dangerous in low IR environment
4.3.2 Financial Crises
4.4 International Interactions
Business cycle in one country can affect that
in others
Even economies of developed countries are not perfectly integrated
4.4.1 Macroeconomic Linkages
Some countries unilaterally peg their currencies to one of the major currencies
Pegging strategy has two benefits:
Currency volatility is reduced
Inflation can be brought under control
4.4.2 Interest Rate/Exchange Rate Linkages
4.4.3 Emerging Markets
Emerging countries:
Rely heavily on foreign capital
Have volatile political & social environment
Need major structural reform
Rely on commodities
4.4.3.1 Essential Differences between Emerging and Major Economies
Emerging bond investors ⇒ focus on default risk
Emerging stock investors ⇒ evaluate growth prospects
Investors should ask the following question before investing in EM:
How sound is fiscal & monetary policy?
< 4% )
What are the economic growth prospects of the economy (growth rate > 4% is
appropriate)
Is the currency competitive, & are external accounts under control? (deficit > 4% of GDP is uncompetitive)
It external debt under control? (ratio of foreign debt GDP A/C receipts > 200% is dangerous)
Is liquidity plentiful?
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4.4.3.2 Country Risk Analysis