11-1 capital market expectations:
forecasting asset class returns
1 introduction
2 overview of
tools and
approaches
3 forecasting fixed-income returns
4 forecasting equity returns
5 forecasting real estate returns
heterogeneous indivisible and immobile
involves operating and maintenance costs
→ illiquid and costly to transfer
6 forecasting exchange rates
generally acknowledged to especially difficult
→ passively accept orr routinely hedge out
7 foracasting volatility
needs to forecast a variance-covariance (VCV) matrix
8 adjusting a global portfolio
the nature of the problem
approaches
to forecasting
applying DCF to fixed income
the building block approach
to fixed income returns
in terms of required compensation
for specific types of risk
risks in emerging market bonds
poses risks not entirely absent,
less significant in developed markets
time horizons matter
investment opportunities are not constant
central tendency - opportunities tend to revert over time
the whole probability distribution of the future returns
expected return / bariances and covariances
formal tools
surveys
judgment
statistical
methods
discounted cash flow models
basic method for establishing the intrinsic value
of an asset on the basis of fundamentals and
its fair required rate of return
risk premium models
risk-free rate of the
interest + risk premiums
sample statistics
to describe tthe distribution of the future returns
shrinkage estimation
weighted average of two estimates
of the same parameter
tiem - series estimation
on the basis of lagged values of the variable
an equilibrium model - CAPM
a factor model
building blocks
both equilibrium and factor impose structure on how returns generated
→ estimate expected returns and variances and covariances
have finite maturities and promised cash flows are known
yield to maturity YTM
the single discount rate equates PV of cash flows to market price
most commonly quoted metric and implicitly of expected returns
realized return may not equal
the initial yield to maturity
investment horizon shorter than the amount of time until maturity
the cash flow may reinvested at rates above or below initial YTM
two issues work in opposite directions
if investment horizon = macaulay duration → capital gain / loss and reinvestment effects roughly offset
if over horizon shorter than duration → capital gain/loss dominate
the timig of rate changes matters
tight connection between discount rates, valuations and returns
one-period default-free rate
compensation for interest rate risk
the term
premium
duration risk
the credit
premium
credit risk
the liquidity premium
illiquidity risk
the rate on the highest-quality, most liquid instrument with a maturity matches the forecast horizon
forecast horizon substantially
longer than standard shor-term
instrument call for adjustment
use the longer zero-coupon bond with maturity matches
replace with an estimate that take acount of the likely path of short-term rates → futures contracts for short-term instruments
positive and increase with maturity,
roughly proportional to duration and vary over time
four main drivers
level-dependent inflation uncertainty
nominal yields rise with inflation bacause of changes in both expected inflation and inflation risk component of term premium
ability to hedge recession risk
when growth and inflation primarily driven by aggregate demand → nominal bond returns negatively with growth
and low term premium is warranted
supply and demand
the ralatie outstanding supply influences the slope of yield curve
cyclical effects
steep around the through of the cycle
flat or even inverted around peak
both expected default losses and credit premium embedded in credit spreads
the previous year's default rate, stock market return, stock market volatility and GDP growth rate
were predictive of the subsequent year's default rate
credit spreads driven primarily by the credit risk premium and financial market conditions
three variables tended to
predict excess returns
bullish for investment-grade
corporate bond performance
high corporate option-adjusted spread
steep treasury curve
higher implied volatility in the equity market
event risk → tend to generous at the short end of curve
→ credit barbell - concentrate credit exposure at short maturities and take interest rate / duration risk via long-maturiyt government bonds
liquidity tends
to be better
priced near par / reflective of current market levels
relatively new
from a relatively large issue
from a well-known / frequent issuer
standard / simple in structue
high quality
baseline estimate of the pure liquidity premium:
the yield spread between fixed-rate, option-free bonds from the highest-quality issuer and the next highest-quality large issuer of similar bonds
economic risks / ability to pay
political and legal risks / willingness to pay
indicative guidelines watched:
the ratio of the fiscal deficit to GDP above 4%
a debt-to-GDP ratio exceeding 70%-80%
a persistent annual real growth rate less than 4%
persistent current account dificits greater than 4% of GDP
foreign echange reserves less than short-term debt
whether have access to support from
IMF, the world bank or other international agencies