formulating capital market expectations, related to systematic risk
concerned with earning excess returns through the use of specific strategies within specific asset groups
7 step process to formulate capital market expectations
1. determine those needed
2. investigate historical performance
3. identify valuation model
4. collect good data
5. use judgment to interpret current investment conditions
6. formulate capital market expectations
7. monitor performance/refine process
Nine problems encountered in producing forecasts:
1. limitations to using economic data
2. data measurement error and bias
3. limitations of historical estimates
4. the use of ex post 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
too much weight on the first set of information received
status quo trap
analyst's predictions are highly influenced by the recent past
overly conservative in forecasts because you want to avoid the regret from making extreme forecasts that could end up being incorrect
let past disasters or dramatic events weigh too heavily on their forecasts
weighted averages of historical data and some other estimate, where the weights and other estimates are defined by the analyst
if the earnings yield is lower than the yield on the 10-year TSY, the investor would shift their money into the less risky TSY
often measured using the inventory to sales ratio
r_target = r_neutral + [0.5(GDP_exp - GDP_trend) + 0.5(i_exp - i_target)]
Six questions for emerging market investors:
1. Responsible fiscal and monetary policies?
2. What is the expected growth?
3. Does the country have reasonable currency values and current account deficits?
4. Is the country too highly levered?
5. What is the level of foreign exchange reserves relative to short-term debt?
6. What is the government's stance regarding structural reform?
savings-investment imbalances approach
Explains why currencies may diverge from equilibrium values for extended periods. If investment is greater than domestic savings, then capital must flow into the country from abroad to finance the investment. At the same time the country will have a current account deficit, which would normally indiciate that a currency will weaken, but not in this instance.