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

Level III Capital Market Expectations Summary Graphs, charts, tables, examples, and figures are copyright 2016, CFA Institute Reproduced and republished with permission from CFA Institute All rights reserved Framework for capital market expectations (CME) in the portfolio management process Steps Description 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) / distinct correlations 2) Research historical record Analyze each asset class’s historical performance by gathering relevant information 3) Specify methods and/or models and Methods selected should be consistent with the objectives of the analysis and investment their information requirement 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 to develop forward-looking forecasts on capital markets 7) Monitor actual outcomes to provide Monitor and compare actual outcomes against expected outcomes to improve forecasts feedback to improve CME process Good forecasts are 1) unbiased, objective and well researched, 2) efficient and 3) internally consistent www.ift.world Challenges in developing capital market forecasts Type Limitations of economic data Data measurement errors and biases Limitations of historical estimates Example Change in definitions and calculation methods over time; errors in collection, measurements, and formulas; lack of timeliness of data; re-basing of indices • Transcription errors Analyst only considered economies • Survivorship bias that achieved developed status • Appraisal (smoothed) data • • 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-post risk estimates may be poor proxy of the ex ante risk estimate ex ante risk • Data mining bias Biases in analysts’ methods • 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 www.ift.world Application of formal tools for setting capital market expectations Tool Comment 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) ≈ • Grinold-Kroner model: E(Re) ≈ • YTM represents expected rate of return on bonds • • 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 Risk Premium Approach D0 (1+g) +g P0 D - ∆S + i + g P + ∆PE www.ift.world 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 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 Singer-Terhaar approach: Risk premium = (Degree of integration × risk premium under perfectly integrated markets) + ({1 - degree of integration} × risk premium under perfectly segmented markets) Refer to: 2014 Question www.ift.world Inventory and business cycles; consumer spending Inventory cycle reflects fluctuations in inventories Higher (lower) future sales Higher (lower) GDP Higher (lower) employment rate Higher (lower) production Higher (lower) inventories 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 www.ift.world 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 Stimulatory fiscal and monetary policies Phase Initial recovery Economy Inflation still declining Confidence Capital Markets Confidence starts Short rates low or declining; bond yields bottoming; to rebound stock prices strongly rising 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 Late upswing Inflation gradually picks up Restrictive monetary policy Boom mentality Short rates rising; bond yields rising; stocks topping out, often volatile Slowdown Inflation continues to Withdrawal of accelerate; inventory restrictive correction begins monetary policy start Confidence starts Short-term interest rates peaking; bond yields topping to drop out and starting to decline (inverted yield curve); stocks declining Recession Production declines; Stimulatory inflation peaks monetary policy Confidence weakens www.ift.world 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 Cash Inflation at or below expectations Inflation above expectations Deflation Short-term yields steady or declining (Neutral) Bonds Yield levels maintained; Market is in equilibrium (Neutral) Equity Bullish while market is in equilibrium state (Positive) Negative for financial assets; Bias toward higher yields due Bias toward rising less negative for companies/ to a higher inflation premium rates (Positive) industries able to pass on (Negative) inflated costs (Negative) Negative wealth effect slows demand; especially affects Bias toward 0% short- Bias toward steady to lower asset-intensive, commodityterm rates (Negative) rates (Positive) producing and highly levered companies (Negative) www.ift.world Real Estate/Other Real Assets Cash flow steady to rising slightly; returns equate to long-term average; market in general equilibrium (Neutral) Asset values increase (Positive) Cash flows steady to falling; asset prices fall (Negative) Use of the Taylor rule to predict central bank behavior Taylor rule equation: Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)] + [0.5 × (Iforecast – Itarget)] Interpretation: When forecast GDP growth rate and/or the forecast inflation rate > ( 4%  risky Economic growth • • External account • • External debt Annual growth rates < 4%  risky 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 • Ratio of foreign debt to GDP > 50%  risky • Ratio of debt to current account receipts > 200% (