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Formulate capital market expectations using the 7-step process

1. Determine the specific capital market expectations needed according to the investor's tax status, allowable asset classes, and time horizon.

2. Investigate assets' historical performance as well as the factors affecting their performance.

3. Identify the valuation model used and its requirements

4. Collect the best data possible.

5. Use experience and judment to interpret current investment conditions.

6. Formulate capital market expectations.

7. Monitor performance and use it to refine the process.


What are the problems encountered in producing forecasts?

1. Limitations to using economic data

2. Data measurement error and bias

3. Limitations of historical estimates

4. Use of expost risk and return measures

5. Non-repeating data patterns

6. Failing to account for conditioning information

7. Misinterpretation of correlations

8. Psychological traps

9. Model and input uncertainty


What are the 6 psychological traps analysts are susceptible to?

1. Anchoring trap.

2. Status quo trap.

3. Confirming evidence trap.

4. Overconfidence trap.

5. Prudence trap.

6. Recallability trap


What are the four statistical forecasting tools?

1. Projecting from historical data

2. Shrinkage Estimators

3. Time Series Analysis

4. Multifactor Models


Projecting historical data

Straight forward. Analyst projects the historical mean return, standard deviation, and correlations for a data set into the future


Shrinkage estimators

Used to reduce (shrink) the influence of historical outliers through a weighting process. Mean return and covariance are the paramters most often adjusted.


Most useful when the data set is so small that historical values are not reliable estimates of future parameters.


Time series analysis

Forecasts a variable using previous values of itself and sometimes previous values of other variables. Can be used to forecast means as well as variances.

In variance analysis, assets such as foreign exchange, stocks, and futures have been shown to exhibit volatility clustering. Volatility in the current period σt2, can be stated as a weighted average of the previous period volatility (σt-12) and a random error, Et2:




Multifactor Models

Multifactor models are used to forecast returns. They can also be used to forecast covariances. The advantage of using them to forecast covariances is that the model can simplify the forecasting procedure by reducing the forecast to a common set of factors. This modeling also eliminates the noise poresent in a sample of data and ensures consistent forecasts given a consistent covariance matrix.


Ri = ai + bi1F1 + bi2F2 + ... BixFx + Ei


5 Phases of the Business Cycle.


What is the formula for the Gordon Growth Model?

P0 = Div1/Ri-g => Ri = Div1/P0 + g


What is the Grinold + Kroner formula?

Ri = Div1/P0 + i + g - chg S + chg (P/E)

Expected income return = D/P - Chg S

Expected nominal earnings growth return = i + g

Expected repricing return = Chg (P/E)


Describe the risk premium approach, otherwise known as the bond yield risk premium approach.

To determine the expected return for bonds, Rb, using this approach, the analyst uses the real risk-free rate and risk premiums as follows:


Rb = real risk-free rate + inflation risk premium + default risk premium + liquidity risk premium + maturity risk premium + tax premium

  • Inflation risk premium
  • default risk premium
  • liquidity risk premium
  • maturity risk premium
  • tax premium

E(Re) = YTM on a LT Govt bond + Equity risk premium

  • equity risk premium


What is the equation for the ICAPM?

Ri = Rf + ßi(Rm-Rf)


Restate the equity risk premium by breaking down Beta, ERP, and the ICAPM.


What is the Singer and Terhaar Analysis?

It adjusts the ICAPM for market imperfections, such as illiquidity and market segmentation. The more illiquid an asset is, the greater the (liquidity) risk premium should be.

This is not a concern for developed world capital markets but is a concern for assets such as direct real etate and venture capital. In the case of private equity, an investment may not become liquid until the lock-up period expires.

To estimate the size, we use the multi-period Sharpe ratio for the investment and compare it to the estimated mpsr for the market. The Sharpe ratio must be at least as high as that for the market.

Capital does not flow in segmented markets - two assets with the same risk may be mispriced because capital cannot flow to the higher return asset - this increases the risk premium.


Describe the impact on the yield curve based on restrictive or expansive fiscal and monetary policies.


What 5 phases is the longer-term business cycle characterized by?

  1. Initial Recovery
  2. Early Expansion
  3. Late Expansion
  4. Slowdown
  5. Recession


Explain the relationship of inflation to the business cycle and the implications of inflation for cash, bonds, equity, and real estate returns


Explain the advantages and disadvantages of using econometrics, leading indicators, and a checklist approach in economic forecasting.