FinQuiz smart summary, study session 6, reading 18

1 2013, Study Session # 6, Reading # 18 “CAPITAL MARKET EXPECTATIONS” CMEs = Capital Market Expectations ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES 2.1 A Framework for Developing Capital Market Expectations
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 2.2 Challenges in Forecasting
Poor forecasts can result in inappropriate asset allocation
Some problems in the use of data & analysts mistakes & biases are as follows 2.2.1 Limitations of Economic Data



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 2.2.2 Data Measurement Errors and Biases Transcription Errors 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 (Smoothed/Data)
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 Copyright © FinQuiz.com All rights reserved 2 2013, Study Session # 6, Reading # 18 2.2.3 The Limitations of Historical Estimates
Past 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 Statistical Necessity (Advantages)
 Precisions with population parameters are estimated
Parameters (e.g return, SD etc) are less sensitive to time span Problems
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 2.2.4 Ex Post Risk Can Be a Biased Measure of Ex Ante Risk
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 2.2.5 Biases in Analysts' Methods Data-Mining Bias
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 Time-Period Bias
Results from the time span of the data chosen 2.2.6 The Failure to Account for Conditioning Information
Relationship b/w security returns & economic variables is not constant overtime
Analyst should account for expected market condition in their forecasts Copyright © FinQuiz.com All rights reserved 3 2013, Study Session # 6, Reading # 18 2.2.7 Misinterpretation of Correlations
The 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 2.2.8 Psychological Traps Anchoring Trap Status Quo Trap
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 decisionmaking process Confirming Evidence Trap Overconfidence Trap
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 Prudence Trap Recallability Trap
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 2.2.9 Model Uncertainty
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 Copyright © FinQuiz.com All rights reserved 4 2013, Study Session # 6, Reading # 18 TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS 3.1 Formal Tools Tools that are accepted within the investment community 3.1.1 Statistical Methods 3.1.1.1 Historical Statistical Approach: Sample Estimators20
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 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?   

 
< 100 %  ! 
Is the political situation supportive of the required policies? Copyright © FinQuiz.com All rights reserved 11 2013, Study Session # 6, Reading # 18 4.5 Economic Forecasting Approach of Economic Forecasting Econometric Models Leading Indicators Formals & mathematical approach to forecasting Variable found to lead turns in the economy Checklists Subjective integration of the answers to a set of questions 4.5.1 Econometric Modeling Definition Benefit Application of quantitative molding & analysis
Can be reused
Prices quantitative forecasts Limitations
Complex & time taking
Variables may also be measured with error 4.5.2 Economic Indicators Definition Advantages Contain information on an economy’s recent past activity or its current or future positions in business cycle



Available from outside parties Easy to understand & interpret Adapted for specific purposes Verified by academic research Disadvantages
Not consistently accurate
Forecasts can be misleading 4.5.3 Checklist Approach Definition Advantages Check off a list of questions that should indicate the future growth of the economy
Flexible
Simple Disadvantages
Require subjective judgment
Time intensive to create 4.6 Using Economic Information in Forecasting Asset Class Returns 4.6.1 Cash and Equivalents
Short term debt with maturity of a year or less
Longer maturity & less credit worthy instruments have  expected return & risk
In order to outperform, manager must be able to forecast future rates better than other managers Copyright © FinQuiz.com All rights reserved 12 2013, Study Session # 6, Reading # 18 4.6.2 Nominal Default-Free Bonds
Default free bonds issued by govt in developed countries
Yield on these bonds:
Real yield
Expected inflation
Stronger eco growth ⇒ bond yields (demand for capital &  inflation)
Changes in short term IR have less predictable effects on bond yield
 in short term rates ⇒  longer term bond’s yield (but if economy slows as result of  in IR then yield
) 4.6.3 Defaultable Debt
Debt with credit risk (particularly corporal debt)
During recession (expansion) spread tend to widen (narrow) 4.6.4 Emerging Market Bonds
Debt of non-developed countries
Emerging countries usually borrow in foreign currency, so the risk of default is higher 4.6.5 Inflation-Indexed Bunds
Yield on inflation indexed bonds changes over time with three economic factors:
Strong economy ( real yields), real yields on TIPS will be higher
Supply & demand may also effect yields on TIPS
Yields fall if inflation accelerates 4.6.6 Common Shares 4.6.6.1 Economic Factors Affecting Earnings 4.6.6.2 The PIE Ratio and the Business Cycle 4.6.6.3 Emerging Market Equities
The trend growth rate,  the avg earnings growth
Defensive stocks receive  market valuation while cyclical stocks receive
valuation during recession
A P/E rate tends to be  during early stages of a recovery
Molodovsky effect ⇒ P/Es of cyclical companies may be  than their own historical means during downturns (investors anticipates a sharp future earnings)
 Inflation rates tend to depress P/E ratios Equity risk premiums for emerging markets are on average higher & more volatile than developed markets 4.6.7 Real Estate
Determinates of real estate returns ⇒ consumption growth, real IR, term structure of IR & unexpected inflation
Low IR are positive for real estate valuation Copyright © FinQuiz.com All rights reserved 2013, Study Session # 6, Reading # 18 4.6.8 Currencies  Imports,
economic growth &
IR, currency will depreciates 4.6.9 Approaches to Forecasting Exchange Rates 4.6.9.1 Purchasing Power Parity 4.6.9.2 Relative Economic Strength
Exchange rate differential = inflation differential
Does not hold in short or medium term
Focus on investment flows rather than trade flows
Strong economic growth,  currency demand, currency appreciation
 Short-term deposit rates,  capital moves in to the country, currency appreciation
This approach tells nothing about level of exchange rates 4.6.9.3 Capital Flows 4.6.9.4 Savings-Investment Imbalances
Particularly equity investment & foreign direct investment (FDI)
 FDI inflows, currency tends to appreciates
Capital flows may reverse the usual relationship b/w IR & currency
During expansion, if domestic savings are < investments then foreign borrowings (appreciate domestic currency to attract foreign capital)
If investments < savings then currency will deprecates 4.6.10 Government Intervention
Govt face three challenges when try to influence exchange rates:
Foreign exchange trading value > foreign exchange reserves
Exchange rates are determined by fundamentals (govt is just another player)
Foreign exchange trends control is not encouraging in the absence of capital control Copyright © FinQuiz.com All rights reserved 13 ... for expected market condition in their forecasts Copyright © FinQuiz. com All rights reserved 3 2013, Study Session # 6, Reading # 18 2.2.7 Misinterpretation of Correlations
The analyst should... anomalies are results of different valuation models Copyright © FinQuiz. com All rights reserved 4 2013, Study Session # 6, Reading # 18 TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS 3.1 Formal... condition so not suitable for short-term expectations Copyright © FinQuiz. com All rights reserved 5 2013, Study Session # 6, Reading # 18 Discounted CF Models 3.1.2.1 Equity Markets Fixed-Income Markets