CFA 2018 r14 capital market expectations slides

Level III Capital Market Expectations www.ift.world Graphs, charts, tables, examples, and figures are copyright 2014, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Introduction • Capital Market Expectations: investor’s expectations concerning the risk and return prospects of asset classes • Investor can decide how he defines assets classes • Macro Expectations vs Micro Expectations Major Sections in this Reading: – – – Framework and Challenges Tools for Formulating Capital Market Expectations Economic Analysis www.ift.world 2 Organizing the Task: Framework and Challenges Specify final set of expectations that are needed Research the historical record Specify required models and information requirement Determine best sources for information needs Interpret current investment environment Provide set of expectations that are needed, documenting conclusions Monitor, feedback www.ift.world Step 1: Specify the final set of expectations that are needed, including the time horizon to which they apply • Understand specific objectives of analysis • Set boundaries  focus on what is relevant • Write the questions which need to be answered www.ift.world www.ift.world www.ift.world Step 2: Research Historical Trend • Most forecasts have connection to the past • Understand factors which drive returns • Can collect data based on geographic region, assets classes, sub-asset classes… www.ift.world Step 3: Specify methods and/or models that will be used and their information requirement • Consider time-horizon when selecting appropriate model • Long time horizon  DCF Model Step 4: Determine the best sources for information needs • Data quality, Cost, Frequency Step 5: Interpret the current investment environment using the selected data and methods, applying experience and judgment www.ift.world Step 6: Provide the set of expectations that are needed, documenting conclusions • Answer the questions which were formulated in Step • Read Example • Good forecasts are: – Unbiased, objective and well researched – Efficient  minimize forecast errors – Internally consistent (Example 5) Step 7: Monitor, feedback  improve forecasts www.ift.world 2.2 Challenges in Forecasting • Limitations in Economic Data – Definitions (GDP vs GNP, Example 6), construction, timeliness, accuracy, biases • Data Measurement Errors and Biases – Transcription Errors – Survivorship Bias – Appraisal (Smoothed) Data (Examples and 8) www.ift.world 10 Econometric Modeling Quantitative methods + economic theory  economic forecasts GDP Growth = f(Consumer Spending Growth, investment growth) • • • • • Model complexity depends on number of variables Requires good data Useful for simulating effect of changes in specific variables Require judgment Poor at forecasting recessions www.ift.world 51 Economic Indicators Early signs of probable events to come www.ift.world 52 Checklist Approach Consider range of economic data to assess future position of the economy www.ift.world 53 www.ift.world 54 Exhibit 25 Advantages and Disadvantages of Three Approaches www.ift.world 55 Example 30 Analyst Forecasts www.ift.world 56 4.6 Using Economic Information in Forecasting Asset Class Returns • Cash and equivalents – Make money through selection of maturity and by taking credit risk – If interest rates likely to fall go with higher maturity Example 31 www.ift.world 57 Nominal Default-Free Bonds Total yield = real yield + inflation Investors determine whether bonds are cheap or expensive Say 10-year bonds yield 5% and inflation = 2% Investor expects inflation to be 0.5% Should he invest? Investing in long term bonds over a short period… News of stronger economic growth  higher yields  low prices Defaultable Debt Spread over treasuries depends on: default risk of issuer and state of the economy www.ift.world 58 Emerging Market Bonds Sovereign debt of non-developed countries Inflation Indexed (Real) Bonds Economic growth rising  Yields rise Inflation expectations rise  Yields fall Investor demand rises  Yields fall www.ift.world 59 Common Shares Economic factors impacting earnings Also take a close look at Example 33/Exhibit 28 www.ift.world 60 P/E Ratio and the Business Cycle High in early stages of economic recovery High inflation rates depress P/E ratios Emerging Market Equities Equity risk premiums are higher and more volatile than developed market equities Real Estate Value determined by: growth in consumption, real interest rates, term structure and unexpected inflation www.ift.world 61 Example 34: Modifying Historical Capital Market Expectations (Extremely Important!) www.ift.world 62 Currencies Four broad approaches to exchange rate forecasting: Purchasing Power Parity: movements in exchange rate should offset difference in inflation rates Relative Economic Strength: focus on investment flows If investment opportunity is good capital flows in and currency strengthens Capital Flows: Focus on expected capital flows (FDI and Equity Investments) Savings-Investment Imbalances: Currency movement explained by domestic savingsinvestment imbalances Example 36 www.ift.world 63 4.7 Information Sources for Economic Data and Forecasts • Take a look at Exhibit 33 • Good for the real world • Not too useful for ‘exam-world’ www.ift.world 64 Conclusion www.ift.world 65 ...Introduction • Capital Market Expectations: investor’s expectations concerning the risk and return prospects of asset classes • Investor can decide how he defines assets classes • Macro Expectations. .. assets classes • Macro Expectations vs Micro Expectations Major Sections in this Reading: – – – Framework and Challenges Tools for Formulating Capital Market Expectations Economic Analysis www.ift.world... know how a market responds to factor movements If Market A moves 110 points in response to 100 point move of global equities… Factor sensitivity = 1.1 We can say Market A is a pure equity market