CFA 2018 level 3 schweser practice exam CFA 2018 level 3 question bank CFA 2018 r14 capital market expectations summary

Inventory and business cycles; consumer spending Inventory cycle reflects fluctuations in inventories Higher lower future sales Higher lower production Higher lower inventories Highe

Level III

Capital Market Expectations

Summary

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Framework for capital market expectations (CME) in the portfolio management process

1) Specify set of expectations that are

needed

Determine relevant asset classes; for n asset classes we need to estimate: n expected returns, n standard deviations and (n2 – n) / 2 distinct correlations

2) Research historical record Analyze each asset class’s historical performance by gathering relevant information

3) Specify methods and/or models and

their information requirement

Methods selected should be consistent with the objectives of the analysis and investment time horizon Example: Use DCF method for developing long-term equity market forecasts 4) Determine the best sources for the

information needed

Ensure data quality and select appropriate data frequency Example: Use quarterly or annual (daily) data series for long-term (short-term) CME

5) Interpret current investment

environment

Interpret information to make mutually consistent decisions

6) Provide the set of expectations that

are needed and document conclusions

Document answers (along with reasoning and assumptions) to the questions formulated in Step 1 to develop forward-looking forecasts on capital markets

7) Monitor actual outcomes to provide

feedback to improve CME process

Monitor and compare actual outcomes against expected outcomes to improve forecasts Good forecasts are 1) unbiased, objective and well researched, 2) efficient and 3)

internally consistent

Challenges in developing capital market forecasts

Limitations of economic data Change in definitions and calculation methods over time; errors in collection, measurements, and

formulas; lack of timeliness of data; re-basing of indices Data measurement errors and

biases

• Transcription errors

• Survivorship bias

• Appraisal (smoothed) data Limitations of historical

estimates

• Statistical problems associated with regime changes

• Using high-frequency data (weekly or even daily) results in underestimated correlations estimates

Ex post risk a biased measure of

ex ante risk

Ex-post risk estimates may be poor proxy of the ex ante risk estimate

Biases in analysts’ methods • Data mining bias

• Time-period bias Failure to account for

conditioning information

Expectations concerning systematic risk of an asset class should be conditioned upon on the state of the economy because systematic risk varies with business cycle

Misinterpretation of

correlations

High correlation between A and B could be because “A predicts B” or “B predicts A” or “C predicts A and B”

Psychological traps Anchoring trap, status quo trap, confirming evidence trap

Model and input uncertainty Uncertainty about whether selected model is correct; uncertainty about input data

Analyst only considered economies that achieved developed status

Application of formal tools for setting capital market expectations

Statistical Methods • Historical statistical approach (sample estimators): not appropriate for small samples

• Shrinkage estimators: [(weight × historical parameter estimate) + (weight × target parameter estimate)]

• Time-series estimators: forecasting based on lagged values of the variable being forecasted

Discounted Cash

Flow Models • Gordon growth model: E(Re) ≈ D0 (1+g)

P0 + g

• Grinold-Kroner model: E(Re) ≈ D

P - ∆S + i + g + ∆PE

• YTM represents expected rate of return on bonds Risk Premium

Approach

• Expected bond return = Real risk-free interest rate + inflation premium + default risk premium + illiquidity premium + maturity premium + tax premium

• Expected equity return = YTM on a long-term government bond + Equity risk premium Survey/Panel • Survey: inquire a group of experts for their expectations

• Panel: inquire a panel of experts for their expectations Financial Market

Equilibrium

Models

• International CAPM-based approach

• Singer-Terhaar approach

Singer-Terhaar approach:

Risk premium = (Degree of integration × risk premium under perfectly integrated markets)

+ ({1 - degree of integration} × risk premium under perfectly segmented markets)

With perfect integration: RPi = [(σi) x (ρi, M) x (Sharpe ratio of GIM)] + Illiquidity premium

With complete segmentation: RPi = [(σi) x Sharpe ratio of GIM)] + Illiquidity premium

Sharpe ratio = risk premium / standard deviation

ICAPM: E (Ri) = RF +βi [E (RM) – RF]

where E (RM) is the expected return on the world market portfolio

Global investable market (GIM) is a proxy for the world market portfolio

Refer to: 2014 Question 4

Inventory and business cycles; consumer spending Inventory cycle reflects fluctuations in inventories

Higher (lower) future sales

Higher (lower) production

Higher (lower) inventories

Higher

(lower)

employment

rate

Higher

(lower)

GDP

Falling inventory/sales

ratio indicates faster economic growth, as consumer spending increases at a faster rate than production

Sharply rising

inventory/sales ratio

indicates slower economic growth, as consumers spend less and inventories pile up

Business cycle represents short-run

fluctuations in GDP

Output gap = Trend GDP – Actual GDP Output gap is positive (negative) and inflation is low (high) during recession (expansion)

Wealth effect: consumers spend more in

response to perceived increase in wealth

Permanent income hypothesis: consumer

spending behavior is determined by long-term income expectations rather than temporary or unexpected (or one-time) change in

income/wealth

Impact of phases of the business cycle on short-term/long-term capital market returns

Fiscal and Monetary Policy Confidence Capital Markets

1 Initial recovery Inflation still

declining

Stimulatory fiscal and monetary policies

Confidence starts

to rebound

Short rates low or declining; bond yields bottoming; stock prices strongly rising

2 Early upswing Healthy economic

growth; inflation remains low

Withdrawal of stimulatory monetary & fiscal policies start

Confidence increasing

Short rates moving up; bond yields stable to up slightly; stock prices trending upward

3 Late upswing Inflation gradually

picks up

Restrictive monetary policy

Boom mentality Short rates rising; bond yields rising; stocks topping out,

often volatile

4 Slowdown Inflation continues to

accelerate; inventory correction begins

Withdrawal of restrictive monetary policy start

Confidence starts

to drop

Short-term interest rates peaking; bond yields topping out and starting to decline (inverted yield curve); stocks declining

5 Recession Production declines;

inflation peaks

Stimulatory monetary policy

Confidence weakens

Short rates declining; bond yields dropping; stocks bottoming and then starting to rise

Implications of inflation for cash, bonds, equity, and real estate returns

Inflation tends to

• rise in late phases of a business cycle

• decline during recession and early stages of recovery

Assets

Inflation at or

below

expectations

Short-term yields steady or declining

(Neutral)

Yield levels maintained;

Market is in equilibrium

(Neutral)

Bullish while market is in equilibrium state (Positive)

Cash flow steady to rising slightly; returns equate to long-term average; market in general equilibrium

(Neutral)

Inflation above

expectations

Bias toward rising rates (Positive)

Bias toward higher yields due

to a higher inflation premium

(Negative)

Negative for financial assets;

less negative for companies/

industries able to pass on inflated costs (Negative)

Asset values increase

(Positive)

Deflation Bias toward 0%

short-term rates (Negative)

Bias toward steady to lower rates (Positive)

Negative wealth effect slows demand; especially affects asset-intensive, commodity-producing and highly levered companies (Negative)

Cash flows steady to falling; asset prices fall (Negative)

Use of the Taylor rule to predict central bank behavior

Taylor rule equation:

R optimal = R neutral + [0.5 × (GDPg forecast – GDPg trend )] + [0.5 × (I forecast – I target )]

Interpretation: When forecast GDP growth rate and/or the forecast inflation rate > (<) trend or target

level, central bank must increase (reduce) the short term interest rates by half the difference between the forecast and the trend or target

Loose fiscal policy

Loose monetary policy

Steep yield curve

Tight fiscal policy

Tight monetary policy

Inverted yield curve

Tight fiscal policy

Loose monetary policy

Moderate

ly steep yield curve

Loose fiscal policy

Tight monetary policy

Flat yield curve

Evaluating shape of the yield curve as an

economic predictor and the relationship

between the yield curve and fiscal and

monetary policy

Steep yield curve indicates economic

upturn Investors demand more yield

as maturity increases because of the

associated risks of higher inflation

and higher interest rates in the

future In this case, invest in

shorter-duration bonds

Opposite is true when yield curve is

flat or inverted

Components of economic growth trends and their application in the formulation of

capital market expectations Economic growth trend: long-term, smooth growth path of GDP

Elements of pro-growth government structural policy

• Sound fiscal policy: e.g decrease in the long-term average budget deficit as % of GDP

• Minimal interference of public sector: e.g decline in the number of state-owned businesses

• Competition encouraged within the private sector: e.g declines in government tariff receipts

• Infrastructure and human capital development: e.g increases in the number of publicly funded schools

• Sound tax policies: e.g declines in government tax receipts

The higher the trend rate of economic growth of a country, the more attractive returns for equity investors

Trend growth in GDP = Growth from labor inputs + Growth from changes in labor productivity

Growth from labor inputs = Growth in potential labor force size + Growth in actual labor force participation

Growth from changes in labor productivity = Growth from capital inputs + Total factor productivity growth

Higher savings  higher capital 

higher growth in GDP

Effects of exogenous shocks on economic growth trends

Exogenous shock examples: short-lived political events, wars, abrupt changes in government tax or trade policies, sudden collapse in an asset market or in an exchange rate, natural disasters etc

Major types of economic shocks with contagion effects:

1) Oil shocks (sharp increase in the price of oil):

Implications:

• lower consumer purchasing power

• higher inflation

• lower employment rate and slowdown in economy

2) Financial shocks (countries inability to meet debt payments, currency devaluation, decline in asset prices):

Implications:

• decreases bank lending

• decreases investor confidence

• reduces economic growth

Macroeconomic, interest rate, and exchange rate linkages between economies

Macroeconomic

linkages

Trade in goods and services: As foreign demand increases  exports increase  aggregate demand increases  economic growth increases

As foreign investment increases  economy improves

Interest rate/exchange

rate linkages

Interest rate/exchange rate linkages affect countries that unilaterally peg their currencies firmly

or loosely to major currencies (e.g USD)

• Level of domestic interest rates depends on overall market confidence in the peg i.e the higher the confidence in the exchange rate peg, the lower the interest rate differential

• Bond yields of the country with undervalued (overvalued) exchange rate tend to be lower (higher)

Risks faced by investors in emerging-market securities

Country Risk Analysis

Fiscal and

monetary policy

• Fiscal deficit to GDP between 2-4%  acceptable but still risky

• Fiscal deficit to GDP < 2%  safe

• Fiscal deficit to GDP > 4%  risky Economic growth • Annual growth rates < 4%  risky

External account

• Ratio of current account deficit to GDP > 4%  risky

• Ratio of current account deficit to GDP < 3%  safe

• Current account deficit should be financed through FDI External debt

• Ratio of foreign debt to GDP > 50%  risky

• Ratio of debt to current account receipts > 200% (<100%)  risky (safe)

Liquidity • Ratio of foreign reserves to short-term debt <100% (>200%) risky

(safe) Political situation • Strong and less volatile political environment  safe

Risks of emerging countries:

• High debt (especially short-term)

• Volatile political and social environment

• Large % of people with low income

• Small and undiversified economies

Investors demand high return to compensate for high risk

Major approaches to economic forecasting

Econometric

modeling

• Robust

• Consolidates existing empirical and theoretical knowledge

• Provides quantitative estimates

• Imposes a consistency constraint

• Useful to forecast economic upturns

• Easily modifiable

• Complex and time-consuming

• Difficult to implement

• Not useful to forecast recessions

• Requires good data, which may not always be available

• Assumes constant relationships among variables

• Requires careful analysis of output

Economic

indicators

(leading,

coincident and

lagging)

• Intuitive and simple to construct

• Easily available

• Easily tailored

• Effective in assessing outlook of an economy

• May provide false signals

• Some data series are reported with a lag and are subject to revisions

• May not be effective on consistent basis

Checklists

• Simple and straightforward method

• Provides flexibility

• Time-consuming

• Involves subjective judgment

• Difficult to use for complex modeling

Use of economic information in forecasting asset class returns

Cash & cash

equivalents

• Invest in shorter maturity papers when the yield curve is upward sloping

• Invest in longer maturity papers when the yield curve is flat or inverted

Nominal default-free

bonds

• Avoid nominal default-free bonds if inflation is expected to increase because when inflation rises  market yields rise / prices fall

• Avoid nominal default-free bonds during economic upswings because of expectations of higher inflation

Risky corporate debt • Avoid risky bonds during recession because  credit spreads widen  bond yields increase /

prices fall

Emerging market

debt

• Avoid emerging market debt when the spread between emerging market government bonds and the US Treasury yield curve widens due to any adverse policy changes

Inflation-indexed

bonds

• Avoid inflation-indexed bonds during rising economy because when the economy is strong  real yields on inflation-indexed bonds will be higher  prices will fall

• Invest in inflation-indexed bonds during times of high inflation expectations

• Invest in inflation-indexed bonds when investors’ demand for indexed bonds is greater