1. Economic Analysis
1.1. Cycles
1.1.1. Business Cycle Analysis
1.1.1.1. Business Cyle
1.1.1.1.1. Lasts 9-11 years
1.1.1.1.2. A typical business cycle has 5 phases
1.1.1.1.3. Quantatative Easing
1.1.1.1.4. Gold Standard System
1.1.1.2. Monetary and Fiscal Policy decisions impacts on yld curve.
1.1.1.3. Evaluating Factors that affect the Business Cycle
1.1.1.3.1. The Taylor Rule
1.1.2. Inventory Cycle
1.1.2.1. Last 2-4 years
1.1.2.2. Inventory/Sales ratio
1.1.3. The Chief measurements of economic activity are:
1.1.3.1. GDP
1.1.3.1.1. GDP refers to "real GDP"
1.1.3.2. Output Gap
1.1.3.2.1. Positive Output Gap
1.1.3.2.2. Negative Output Gap
1.1.3.2.3. Trend "real" GDP = POTENTIAL OUTPUT
1.1.3.2.4. A decline in INFLATION is associated with the economy experiencing the opening of a POSITIVE "output gap"
1.1.3.3. Recession
1.1.3.4. EOC problems
1.1.3.4.1. Comparing countries economic activity and forecast side by side to see which country is better situated for economic growth
1.1.3.4.2. EOC 11 Comparing short term trends to long term trends
1.2. Using economic information for forecasting asset class returns
1.2.1. 4 Approaches to forecasting Foreign Exchange rates
1.2.1.1. Concise explanation
1.2.1.1.1. Relative Economic Strength
1.2.1.1.2. Capital Flows
1.2.1.1.3. Savings-Investment Imbalances
1.2.1.1.4. Purchasing Power Parity
1.2.2. Comparing two countries side by side each row with a check mark would indicate a variable that would cause the currency to appreciate relative to the other. EOC 18
1.2.2.1. Notice that a current account SURPLUS will cause that countries currency to APPRECIATE. The higher the more attractive.
1.2.2.2. Current account DEFICITS will cause the countries currency to decline.
1.3. 3 Economic Forecasting Methods (Strengths & Weaknesses)
1.3.1. Econometric Method
1.3.1.1. Uses Optimization like least squares or regression analysis using historical data to create parameters of the quantitative equation.
1.3.1.2. A simple example of an Econometric Model
1.3.1.2.1. GDP growth = Consumer Spending & Investment Growth
1.3.1.3. Pro
1.3.1.4. Con
1.3.2. Economic Indicators
1.3.2.1. Pro
1.3.2.2. Con
1.3.2.3. Leading, Coincedental, Lagging Indicators
1.3.2.3.1. Favorite Leading
1.3.2.3.2. Favorite Coincident
1.3.2.3.3. Favorite Lagging
1.3.3. Checklist Approach
1.3.3.1. Allows an analyst to assess whether the output measures are in an equilibrium state or nearer to an extreme reading.
1.3.3.1.1. An Example of a Checklist for evaluating economic growth.
1.3.3.2. Sample of a Checklist Approach problem
1.4. Exogenous Shocks
1.4.1. Oil Crises
1.4.2. Financial Crises
1.5. Economic Growth Trends
1.5.1. Consumer impacts on growth trends
1.5.1.1. Permanent Income Hypothesis
1.5.1.1.1. Spending behvavior
1.5.1.1.2. An analyst forecasting a decline in GDP but an increase in consumer spending would be consistent with the Permanent Income Hypothesis.
1.5.2. Decomposing GDP growth & its use in forecasting
1.5.2.1. To analyze an economy's aggregate growth trend, split it into 2 parts
1.5.2.1.1. Growth from changes in employment (growth from labor inputs)
1.5.2.1.2. Growth from changes in Labor Productivity
1.5.3. Government structural policies
1.5.3.1. The Following are 5 elements of a PRO-GROWTH government structural policy.
1.5.3.1.1. Fiscal Policy is SOUND
1.5.3.1.2. The PUBLIC Sector intrudes minimally on the PRIVATE sector
1.5.3.1.3. Competition within the private sector is encouraged
1.5.3.1.4. Tax Policies are SOUND
1.5.3.1.5. Infrastructure and human capital development are supported.
1.6. International Interactions
1.6.1. Macroeconomic Linkages
1.6.2. Linking Interest rates & Foreign Exchange rates
1.6.3. Emerging Markets
1.6.3.1. Essential Differences between Emerging and Major Economies
1.6.3.1.1. They need higher rates of investment than developed countries. Due to lower savings rates of locals to invest in local economy to drive growth.
1.6.3.1.2. EM's have volatile political and social environments
1.6.3.1.3. Structural Reform is needed to unlock their potential.
1.6.3.1.4. EM's economies are often concentrated in a few areas such as particular commodities or in a narrow range of manufactured goods.
1.6.3.2. Country Risk Analysis Techniques
1.6.3.2.1. 6 Questions that country risk analysis seeks to answer. Ratios that tell a story of a countries healthiness.
2. Tools for Formulating/Making CME forecasts
2.1. Formal Tools
2.1.1. 2 Financial Equilibrium Models
2.1.1.1. Black Litterman
2.1.1.2. Singer Terharr
2.1.1.2.1. ICAPM
2.1.1.3. Illiquidity premium applicability
2.1.2. 4 Statistical Tools
2.1.2.1. Historical Samples
2.1.2.2. Shrinkage Estimators
2.1.2.2.1. Adjusting Historical Covariance
2.1.2.3. Time Series
2.1.2.3.1. Volatility Clustering
2.1.2.4. Multifactor Models
2.1.3. 3 DCF Models
2.1.3.1. GGM
2.1.3.2. Grinold Kroner
2.1.3.2.1. example using the repurchase yield
2.1.3.2.2. Explanations of each component in the equation.
2.1.3.3. Yld to maturity
2.1.4. Risk Premium Approach
2.1.4.1. For stocks
2.1.4.2. For Bonds
2.1.4.2.1. Notice that when computing the Expected return for each bond the real rf & expected inflation are included but when asked what the "total risk premium" of all 3 bonds is we ignore Expected inflation and real rf.
2.1.4.3. Equity Risk Premium
2.1.4.3.1. CFAI states that for the time horizon of the LT govt. bond, 10 to 20 yrs is appropriate.
2.2. Non-Formal Tools
2.2.1. Survey Method
2.2.2. Panel Method
2.2.3. Judgement
3. Framework and Challenges of Setting Capital Market Expectations
3.1. The Framework to use for developing Capital Market Expectations (for making forecasts) 7 Steps.
3.1.1. 1) Specify the final set of expectations that are needed, including the time horizon to which they apply.
3.1.2. 2) Research the historical record.
3.1.2.1. Most forecasts have some connetion to the past.
3.1.3. 3) Specify the methods and or models that will be used and their information requirements
3.1.4. 4) Determine the best sources of information needs.
3.1.5. 5) Interpret the current investment environment using the selected data and methods, applying experience and judgement.
3.1.6. 6) Provide the set of expectations that are needed, documenting conclusions.
3.1.7. 7 Monitor actual outcomes and compare them to expectations, providing feedback to improve the expectations-setting process.
3.2. Challenges in Forecasting
3.2.1. 9 Challenges Analysts face in setting Capital Market Expectations
3.2.1.1. Limitations of Economic Data
3.2.1.2. Data Measurement Errors and Biases
3.2.1.2.1. Transcript Errors
3.2.1.2.2. Survivorship bias
3.2.1.2.3. Appraisal (smoothed) data.
3.2.1.3. Limitations of Historical Estimates
3.2.1.3.1. Regime Changes
3.2.1.4. Ex Post Risk can be biased measure of Ex Ante Risk
3.2.1.5. Biases in Analysts Methods
3.2.1.5.1. 2 such biases
3.2.1.6. Failure to account for Conditioning Information
3.2.1.6.1. Looking at this chart we can see that just going off of unadjusted (unconditioned) CAPM that the expected return would be 8%. But when we probability weight or "condition" in some other manner that reflects today's and forecasted market we can get a "True unconditioned" expected return that is 7.2%. It is a return that has been conditioned.
3.2.1.7. Misinterpretation of Correlations
3.2.1.7.1. Exogenous variable
3.2.1.7.2. Endogenous variable
3.2.1.7.3. Partial Correlation
3.2.1.8. Psychological Traps (COPRAS)
3.2.1.8.1. Anchoring Trap
3.2.1.8.2. Status Quo Trap
3.2.1.8.3. Confirming Evidence Trap
3.2.1.8.4. Overconfidence Trap
3.2.1.8.5. Prudence Trap
3.2.1.8.6. Recallability Trap
3.2.1.9. Model Uncertainty.