2019 CFA level 3 finquiz curriculum note, study session 8, reading 16

Capital Market Expectations

1.

INTRODUCTION

Capital market expectations (CME) (also known as
macro expectations) represent the investors’
expectations regarding the risk and return prospects of
broad asset classes. They help investors in formulating
their strategic asset allocation, that is, in setting rational
return expectations on a long term basis for globally
diversified portfolios.
2.

2.1

By contrast, micro expectations represent the investors’
expectations regarding the risk and return prospects of
individual assets. They facilitate investors in security
selection and valuation.

ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES

A Framework for Developing Capital Market
Expectations

A framework for developing Capital market
expectations has the following seven steps.
1. Specify the final set of expectations that are needed,
including the investment time horizon: This step

involves clearly specifying the questions that need to
be answered.
• An investor/analyst must determine the specific
objectives of the analysis. E.g. for a taxable investor,
the objective is to develop long-term after-tax
capital market expectations.
• An investor/analyst must specify the relevant set of
asset classes (consistent with the investment
constraints) on which the investor/analyst needs to
develop capital market expectations.
• It is important to understand that the scope of the
capital market expectations-setting framework is
directly related with the number and variety of
permissible asset class alternatives i.e. the greater
the number and variety of permissible asset classes,
the wider the scope of setting capital market
expectations. Refer to Example 1 on page 9.
NOTE:
If the number of asset classes is n, the analyst will need to
estimate:
• n number of expected returns;
• n number of standard deviations;
• (n2 – n) / 2 distinct correlations (or the same number
of distinct covariances);
2. Research the historical record: Historical data provide
some useful information on the investment
characteristics of the asset. Hence, the historical
performance of the asset classes should be analyzed
in order to identify their return drivers. Analyzing each
asset class’s historical performance involves gathering

macroeconomic and market information in different
ways e.g., by:
• Geographical area (e.g., domestic, nondomestic, or

some subset e.g. a single international area); or
• Broad asset class (e.g. equity, fixed-income, or real
estate); or
• Economic sector/industry/sub-industry basis;
The historical data can be used as a baseline and may
be adjusted for analyst’s views e.g. if an analyst is
optimistic (pessimistic) relative to the consensus on the
prospects for asset class A, then he/she may make an
upward (downward) adjustment to the historical mean
return.
3. Specify the method(s) and/or model(s) that will be
used to formulate CME and the information required
to develop such models:
• The analyst should clearly specify the method(s)
and/or model(s) that will be used to develop CME.
• The method(s) and/or model(s) used must be
consistent with the objectives of the analysis and
investment time horizon e.g. a DCF method is most
appropriate to use for developing long-term equity
market forecasts.
4. Determine the best sources for the information
needed: The analysts/investors should search for the
best and most relevant sources for the information
needed and should be constantly aware of new,
superior sources for their data needs. It involves
considering following factors:

• Data collection principles and definitions;
• Error rates in collection and calculation formulas;
• Quality of asset class indices (i.e. Investability,
correction for free float, turnover in index
constituents);
• Biases in the data;
• Costs of data etc;
In addition, the analysts must select the appropriate
data frequency e.g. long-term data series should be
used for setting long-term expectations or evaluating
long-term volatility. In general,
• For setting long-term CME, quarterly or annual data
series are useful.

–––––––––––––––––––––––––––––––––––––– Copyright © FinQuiz.com. All rights reserved. ––––––––––––––––––––––––––––––––––––––

FinQuiz Notes 2 0 1 9

Reading 16


Reading 16

Capital Market Expectations

• For setting shorter-term CME, daily data series are
useful.
5. Interpret the current investment environment: The
analyst should interpret the current investment
environment using the selected data and methods

and should employ consistent set of assumptions.
Also, he should apply experience and judgment
(where necessary to interpret any conflicting
information within the data) so that the conclusions
are mutually consistent.
6. Provide the set of expectations that are needed and
document conclusions: This step involves
documenting answers to the questions formulated in
step 1. In addition to answers and conclusions, the
analyst should also document reasoning and
assumptions associated with the conclusion. The set of
expectations obtained in step 6 are then used to
develop forward-looking forecasts on capital markets.
7. Monitor actual outcomes to provide feedback to
improve the CME development process: This step
involves monitoring and comparing actual outcomes
against expected outcomes to identify weaknesses in
the CME development process so that the
expectations-setting process or methods can be
improved.
Beta versus Alpha Research:
Beta Research: Beta research involves developing
capital market expectations concerning the systematic
risk and returns to systematic risk. Unlike alpha research,
beta research is centralized which implies that CME
inputs used across all equity and fixed-income products
are consistent.
Alpha Research: Alpha research involves developing
expectations regarding individual assets in an attempt to
capture excess risk-adjusting returns by a particular

investment strategy.
Three Characteristics of Good Forecasts: Good forecasts
are
1) Unbiased, objective, and well researched;
2) Efficient i.e. has minimum forecasting errors;
3) Internally consistent i.e. if asset class A and B are
perfectly negatively correlated and asset class B and
C are also perfectly negatively correlated, then asset
class A and C must be perfectly positively correlated.

Practice: Example 4 & 5,
Volume 3, Reading 16.

2.2

FinQuiz.com

Challenges in Forecasting (section 2.2.1 - 2.2.9)

The data and assumptions used in the forecasting model
must be error free. The challenges associated with
forecasting include:
1) Limitations of Economic Data:
• Definitions and calculation methods may change
over time. This may affect the validity of time-series
data.
• Errors in collection and measurements of data and in
the calculation formulas;
• Timeliness of data i.e. time lag with which economic
data are collected, processed, and disseminated.

For example, the International Monetary Fund
sometimes provides macroeconomic data for
developing economies with a lag of two years or
more.
o The greater the lag before information is reported
(i.e. the older the data), the greater the risk that it
provides irrelevant and uncertain information
about the present situation.
• Changes in the construction method of data: The
bases of indices of economic and financial data are
changed on a periodic basis to reflect more current
bases. This process is known as re-basing. Re-basing
simply reflects a mathematical change rather than
substantive change in the composition of an index.
Re-basing may result in risk of mixing data indexed to
different bases.
2) Data Measurement Errors and Biases: The errors and
biases in data measurement include:
Transcription errors: The errors relating to gathering
and recording of data are called transcription errors.
Transcription errors are most serious when they reflect
bias.
Survivorship bias: Survivorship bias occurs when a
data series reflects data on surviving (or successful)
entities and do not reflect post-delisting data (e.g.
data on entities with poor performance which have
been removed from the database). This bias results in
overestimated historical returns.
Appraisal (smoothed) data: Infrequently traded and
illiquid assets (e.g. real estate, private equity etc) do

not tend to have up-to-date market prices; rather,
their values need to be estimated, known as
appraised values. Appraised values (i.e. smoothed
data) represent less volatile values. As a result, the
correlations of such assets with traditional assets (i.e.
equities and fixed income) and risk (S.D.) of assets are
underestimated or biased downward.
• Remedy to mitigate smoothing effect: The smoothed
data bias can be mitigated by rescaling the data so
that their dispersion (i.e. S.D.) is increased but the
mean of the data is unchanged.


Reading 16

Capital Market Expectations

3) The Limitations of Historical Estimates: The simplest
approach to forecasting is to use historical data to
directly forecast future outcomes. However, the
historical estimates may not be good predictors of
future results because the risk/return characteristics of
asset classes may change as a result of changes in
technological, political, legal and regulatory
environments and disruptions i.e. war or natural
disaster. These so called regime changes introduce
the statistical problem of non-stationarity (where
different parts of a data series exhibit different
underlying statistical properties). In addition, the
disruptions in a certain time period may temporarily

increase volatilities in that period which may not be
relevant for the future period.
• Although use of long time series data increases the
precision* of estimates of population parameters
and reduces the sensitivity of parameter estimates to
the starting and ending dates of the sample;
however, using long time series (reflecting multiple
regimes) may increase the risk of non-stationarity in
the data (due to structural changes during the time
frame) and consequently, the risk of including
irrelevant data.
• In addition, for some time-series analysis, the data
series of the required length may not be available.
Using high-frequency data (weekly or even daily) in
order to get data series of required length increases
risk of asynchronism (i.e. discrepancy in the dating of
observations due to use of stale/out-of-date data)
and results in underestimated correlations estimates.
*Precision of the estimate of the population mean is
proportional to 1 / √numberofobservations
4) Ex Post Risk Can Be a Biased Measure of Ex Ante Risk:
In general, the ex-ante risk and ex-ante return are
underestimated on backward-looking basis. Hence,
ex-post risk estimates may be a poor proxy of the ex
ante risk estimate. The investment decision-making
must be based on ex-ante risk measures rather than
ex-post risk measures.
5) Biases in Analysts’ Methods
Data-mining bias: Data mining bias refers to over-using
or overanalyzing the same or related data (i.e. mining

the data) until some statistically significant pattern is
found in the dataset. Two signs that may indicate the
existence of data-mining bias include:
i. Many of the variables used in the research are not
reported;
ii. No plausible economic relationship exists among
variables;
The data mining bias can be detected by using out-ofsample data to test the statistical significance of the
patterns found in the dataset.
Time-period bias: Time-period bias occurs when
outcomes/results are time-period specific. For example,

FinQuiz.com

a short time series may give period-specific results that
may not reflect a longer time period. Similarly, test based
on long time period may suffer from structural changes
occurring during the time frame, resulting in two data
sets with different relationships. As a result, forecasted
relationship estimated from the first period may not hold
for second sub-period.
6) The Failure to Account for Conditioning Information
may lead to misperceptions of risk, return, and riskadjusted return: Future risk and return of an asset as of
today depend or are conditional upon on specific
characteristics of the current marketplace and
prospects looking forward. Hence, the expectations
concerning future risk and return of an asset must take
into account any new, relevant information in the
present. For example, since systematic risk of an asset
class varies with business cycle, the expectations

concerning systematic risk of an asset class should be
conditioned upon the state of the economy.
EXAMPLE
Suppose,
• Beta of an asset class in economic expansions =
0.80
• Beta of an asset class in economic recessions = 1.2
• Expected return on market during expansion = 12%
• Expected return on market during recession = 4%
• Risk-free rate (both recession & expansion) = 2%
Unconditional beta = 0.50 (0.80) + 0.50 (1.2) = 1.0
Unconditional risk-free rate = 0.50 (2%) + 0.50 (2%) =
2%
Unconditional expected return on market = 0.50
(12%) + 0.5 (4%) = 8%
Unconditional expected return on asset class i
(using CAPM) = 2% + 1.0 (8% - 2%) = 8%
Expected return on market during expansion (using
CAPM) = 2% + 0.80 (12% - 2%) = 10%
Expected return on market during recession (using
CAPM) = 2% + 1.20 (4% - 2%) = 4.4%
Conditional expected return on market = 0.50 (10%)
+ 0.50 (4.4%) = 7.2%
Unconditional alpha = 7.2% - 8% = -0.8%
Alpha during expansion and recession = 0.50 (0%) +
0.50 (0%) = 0%
7) Misinterpretation of Correlations: A significantly high
correlation between variable A and B implies one of
the following things:
• Variable A is predicted by variable B i.e. variable B is

exogenous variable (which is determined outside
the system) and variable A is endogenous variable
(which is determined within the system).
• Variable B is predicted by variable A i.e. variable A is
exogenous variable and variable B is endogenous
variable.
• Neither variable A predicts B nor B predicts A; rather,
a third variable C predicts A and B. the variable C is
referred to as a control variable.


Reading 16

Capital Market Expectations

The impact of multiple control variables can be
analyzed using multiple-regression analysis.
Multiple-regression analysis

A = β0 + β1 B + β2 C + ε

• The coefficient β1 represents the partial correlation
between A and B i.e. the effect of variable B on
variable A after taking into account the effect of the
control variable C on A.
• The coefficient β2 represents the partial correlation
between A and C i.e. the effect of variable C on
variable A after taking into account the effect of
variable B on A.
• When estimated value of β1 is significantly different

from 0 but β2 is not significantly different from 0, it
indicates that variable B predicts variable A.
Time series analysis

A = β0 + β1 Lagged values of A + β2
Lagged values of B + β2
Lagged values of C + ε

FinQuiz.com

c) The confirming evidence trap: It is a tendency of
people to seek and focus on information that
confirms their beliefs or hypothesis and ignore, reject
or discount information that contradicts their beliefs.
Confirmation bias implies assigning greater weight to
information that supports one’s beliefs. This bias can
be reduced or mitigated by:
• Collecting and examining complete information i.e.
both positive and negative.
• Actively looking for contradictory information and
contra-arguments.
• Being honest with one’s motives and investment
objectives.
d) The overconfidence trap: It is a tendency of people to
overestimate their knowledge levels and their ability
to process and access information. In this bias, people
tend to believe that they have superior knowledge
and they make precise and accurate forecasts than
it really is.

NOTE:
It must be stressed that two variables may reflect low or
zero correlation despite strong but non-linear relationship
because correlation measure ignores non-linear
relationships.
8) Psychological Traps
Psychological traps can undermine the analyst’s ability
to make accurate and unbiased forecasts.
a) The anchoring trap: It is a tendency of people to
develop estimates for different categories based on a
particular and often irrelevant value (both
quantitative & qualitative), called anchor (i.e. a
target price, the purchase price of a stock, prior
beliefs on economic states of countries or on
companies etc) and then adjusting their final
decisions up or down based on that “anchor” value.
• Anchoring bias implies investor under-reaction to
new information and assigning greater weight to the
anchor.
• Anchoring bias can be mitigated by avoiding
premature conclusions.
b) The status quo trap: It is a tendency of people to
prefer to “do nothing” (i.e. maintain the “status quo”)
instead of making a change. In the status-quo bias,
investors prefer to hold the existing investments in their
portfolios even if currently they are not consistent with
their risk/return objectives.
• It is closely related with avoiding “Error of
commission” (i.e. regret from an action taken) and
“Error of omission” (i.e. regret from not taking an

action).
• The status-quo trap can be overcome by following a
rational analysis in investment decision-making.

• The overconfidence trap may result in using too
narrow range of possibilities or scenarios in
forecasting.
• The overconfidence trap can be avoided by
widening the range of possibilities around the
primary target forecast.
e) The prudence trap: It is the tendency of analysts to be
extremely cautious in forecasting in an attempt to
avoid making any extreme forecasts which may
adversely impact their career. As a result, they make
forecast estimates that are in line with other analysts
(representing herding behavior).
• The prudence trap can be avoided by widening the
range of possibilities around the target forecast.
f) The recallability trap: It is the tendency of analysts to
assign higher weight to more easily available and
easily recalled information e.g. information related to
catastrophic or dramatic past events. This bias can be
avoided by using objective data and procedures in
decision-making.

Practice: Example 11,
Volume 3, Reading 16.

9) Model Uncertainty: Investment analysis may be
subject to two kinds of uncertainty i.e.

i. Model uncertainty is the uncertainty related to the
accuracy of the model selected. The model
uncertainty can be evaluated by analyzing the
variation in outcomes of the models from shifting
between the several most promising models.


Reading 16

Capital Market Expectations

ii. Input uncertainty is the uncertainty related to the
accuracy of inputs used in the model.
3.

3.1

Capital market anomalies (inefficiencies) often exist due
to input and model uncertainty.

TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS

Formal Tools (Section 3.1.1 – 3.1.4)

Formal tools used for formulating capital market
expectations include:
I.
II.
III.
IV.

FinQuiz.com

Statistical methods
Discounted cash flow models
The risk premium approach
Financial market equilibrium models

1. Statistical Methods: There are two major types of
Statistical methods.
• Descriptive Statistics: Statistical Methods that are
used to organize and summarize data so that
important aspects of a dataset can be described
are known as descriptive statistics.
• Inferential Statistics: Statistical Methods that are used
to make estimates or forecasts about a larger group
(population) based upon information taken from a
smaller group (sample) are known as inferential
statistics.
a) Historical Statistical Approach: Sample Estimators: In a
historical statistical approach, historical data is used
as the basis for forecasts.
• A sample estimator is a formula used to compute an
estimate of a population parameter. The value of
that estimate (statistic) is called a point estimate.
• The point estimate is useful to estimate population
parameter when the time series data is stationary.
• In a mean-variance framework, the analyst might
use:
o The sample arithmetic mean of total return or

sample geometric mean of total return as an
estimate of the expected return. The arithmetic
mean is appropriate to use to estimate the mean
return in a single period whereas the geometric
mean is appropriate to use to estimate mean
return for multi-periods. For a risky (volatile)
variable, the geometric mean return will always be
< the arithmetic mean return.
o The sample variance as an estimate of the
variance; and
o Sample correlation as an estimate of correlation.
b) Shrinkage Estimators: Shrinkage estimation is a
process in which an estimate of a parameter is
computed by taking weighted average of a historical
estimate of a parameter and some other estimate of
a parameter. Shrinkage estimation is also known as
the “two-estimates-are-better-than-one” approach.

Shrinkage Estimator = (Weight of historical estimate ×
Historical parameter estimate) +
(Weight of Target parameter
estimate × Target parameter
estimate)
For example,
Shrinkage estimator of the covariance matrix = (Weight
of historical covariance × Historical covariance) +
(Weight of Target covariance × Target covariance)
Where,
Target parameter estimate = Alternative parameter
estimate

• The target covariance matrix can be a factormodel-based estimate or can be a covariance
estimate based on the assumption that each pairwise covariance is equal to the overall average
covariance.
• Weights reflect the analyst’s relative belief in the
estimates e.g. the more strongly an analyst believes
in the historical estimate, the larger the weight of the
historical estimate.
• The historical sample covariance matrix is not
appropriate to use for small samples. Hence,
shrinkage estimation is a superior approach for
estimating population parameter for the medium
and smaller size because it helps to decrease (i.e.
shrink) the impact of extreme values in historical
estimates and increases the efficiency of the
parameter estimates. The more plausible target
estimate is selected, the greater the improvement in
the accuracy of the estimate.
• The Shrinkage estimation method is commonly used
for computing covariances and mean returns.
Example:
Suppose
• Using factor model, the estimated covariance
between domestic shares and bonds = 40
• Using historical estimate, the estimated covariance
between domestic shares and bonds = 75
• Weight of historical estimate = 0.30
• Weight of target estimate = 0.70
Shrinkage estimate of the covariance = 0.70 (40) + 0.30
(75) = 50.5

Reading 16

Capital Market Expectations

Practice: Example 12,
Volume 3, Reading 16.

c) Time-Series Estimators: Time series estimation involves
regressing the value of dependent variable on the
lagged values of dependent variable and lagged
values of other selected variables. Time series
estimation methods are useful to make short-term/
near-term forecasts for financial and economic
variables. They are also used to forecast near-term
volatility, assuming variance clustering exists.
• Variance clustering: When large (small) fluctuations
in prices are followed by large (small) fluctuations in
prices in random direction, it is referred to as
“Variance Clustering”.
σ2t = βσ2t-1 + (1 – β) ε2t
Where,
σ2t = Volatility in period t
σ2t-1 = Volatility in previous period
ε2t = a random “noise” term
β
= Weight on σ2t-1 Measure of rate of decay of
the influence of the value of volatility in period
t-1 on value of volatility in period t
with 0

<β< 1.
o The higher (lower) the β, the greater (smaller) the
influence of the value of volatility in period t-1 on
value of volatility in period t.

FinQuiz.com

Uses of Multifactor models for estimating covariances:
1) A multifactor model simplifies the method of
estimating covariances because the estimates of
covariances between asset returns can be computed
from the assets’ factor sensitivities.
2) A multifactor model helps to filter out noise (i.e.
random fluctuations in the data specific to the
sample period) provided that appropriate risk factors
are selected
3) A multifactor model simplifies verification of the
consistency of the covariance matrix because when
the smaller factor covariance matrix is consistent then
any covariances estimated using smaller factor
covariance matrix is also consistent.
Example:
Suppose that returns of all assets in the investable
universe depend on two factors*:
1. Global equity factor
• Standard deviation of global equity = 12%
Variance for global equity = (0.12)2 = 0.0144.
2. Global bond factor
• Standard deviation of global bonds = 5%
Variance for global bonds = (0.05)2 = 0.0025

• Correlation between global equity and global
bonds = 0.30

d) Multifactor Models: A multifactor model involves
regressing the value of dependent variable on values
of a set of return drivers or risk factors. It can be stated
as:

Covariance between global equity and global bonds =
S.D. of Global equity × S.D. of Global bonds × Correlation
between Global equity & Global bonds =

Ri = ai + bi1F1 + bi2F2 + … + biK FK + εi

12% × 5% × 0.30 = 0.0018

where,
Ri
ai
Fk
bik

= Return to asset i
= Intercept term in the equation for asset i
= Return to factor k, k = 1, 2, …, K
= Sensitivity of the return to asset i to the return to
factor k, k = 1,2, …, K

• Markets’ factor sensitivities (bik), also known as factor
betas or factor loadings, measure the responsiveness

of markets to factor movements.
εi = An error term that represents the asset’s
idiosyncratic or residual risk i.e. portion of the return
to asset i not explained by the factor model.
• It is assumed that an error has mean value of zero
and is uncorrelated with each of the K factors and
with the error terms in the equations for other assets.

Equity-bond covariance matrix
Global Equity
Global Bonds

Global Equity
0.0144
0.0018

Global Bonds
0.0018
0.0025

NOTE:
A covariance matrix is a table that shows the
covariances for the return drivers or risk factors.
Suppose the sensitivities of two markets A and B to
global equity and global bonds are as follows.

Market A
Market B

Sensitivities

Global
Global
Equity
Bonds
1.11
0
1.07
0

Residual Risk
(%)
10.0
8.0

• The zero sensitivity of Market A to global bonds does
not imply that Market A has zero correlation with
global bonds; rather, it implies that the partial
correlation (i.e. correlation after removing impact of
the other markets) of Market A with global bonds is


Reading 16

Capital Market Expectations

FinQuiz.com

• The growth rate (g) can be estimated as the growth
rate in nominal GDP.

zero. Hence, return in Market A is not derived by
global bonds.
Variance of market i can be computed using following
formula:

Nominal GDP = Real growth rate in GDP + Expected
long-run inflation rate

Mii

= b2i1 Var (F1) + b2i2 Var (F2) + 2bi1bi2 Cov (F1, F2) +
Var(εi)
For i = 1 to n

Earnings growth rate = Nominal GDP growth rate +
Excess Corporate growth (for the
index companies*)

Covariance of market i with market j can be computed
using following formula:

*Excess corporate growth reflects adjustment for any
differences between economy’s growth rate and that of
equity index. E.g. for a broad-based equity index, the
excess corporate growth adjustment, if any, should be
small.
Grinold-Kroner Model: It is a restatement of the Gordon
growth model and it explicitly takes into account the
impact of number of shares in the market (as
represented by stock repurchases)and changes in

market valuations as represented by the price to
earnings (P/E) ratio. It is expressed as follows:

Mij

= bi1 bj1 Var (F1) + bi2 bj2Var (F2) + (bi1 bj2 + bi2 bj1)
Cov (F1, F2)
For i = 1 to n, j = 1 to n, and i ≠ j
Computing Covariance between Markets A and B: with i
= 1 for Market A and j = 2 for Market B:
M12 = (1.11) (1.07) (0.0144) + (0) (0) (0.0025) + [(1.11) (0) +
(0) (1.07)] (0.0018) = 0.01710288
*A multi-factor approach can also be used depending
on investors/analysts needs.
2. Discounted Cash Flow Models: In Discounted cash
flow models (DCF models), an asset’s intrinsic value is
computed as the present value of its (expected) cash
flows. It is a forward-looking model and is most
appropriate to use for making long-term forecasts.
It is expressed as:
∞

V0 =

CFt

∑ (1 + r )
t =1

t

Where,
V0 = Value of the asset at time t = 0 (today)
CFt = Cash flow (or the expected cash flow, for risky
cash flows) at time t
r
= Discount rate or required rate of return. Assuming
flat term structure, the discount rate will be the
same for all time periods.
3.1.2.1 Equity Markets
Gordon growth model: The Gordon growth model is
preferred to use for developed economies in setting
long-run expectations. It can be expressed as:

E (Re) =

D0 (1 + g )
D
+ g = 1 + g = Dividend Yield +
P0
P0
Capital gains Yield

Where,
E (Re) = the expected rate of return on equity
D0
= Most recent annual dividend per share
g
= Long-term growth rate in dividends, assumed
equal to the long-term earnings growth rate;

P0
= Current share price

E (Re) ≈

ࡰ
ࡼ

- ∆S + i + g + ∆PE

Where,
E (Re) = Expected rate of return on equity
D/P = Expected dividend yield
∆S
= Expected % change in number of shares
outstanding
this term is negative (i.e. -∆S)
when there are net positive share repurchases;
∆S is positive when number of shares outstanding
increases.
-∆S = Positive repurchase yield
+∆S = Negative repurchase yield
i
g

= Expected inflation rate
= Expected real total earnings growth rate
(generally, it is not identical to EPS growth rate,
with changes in shares outstanding)*
∆PE = Per period % change in the P/E multiple

*GDP Growth rate = Labor productivity growth + Labor
supply growth
Where, labor supply growth = Population growth rate +
Labor force participation growth rate
Sources of Expected rate of return on equity: The
expected rate of return on equity can be decomposed
as follows:
1) Expected income return = D/P - ∆S
2) Expected nominal earnings growth return = i + g
3) Expected repricing return = ∆PE P/E tends to
increase when investors expect stocks to be less risky
in future. It is considered as the most volatile source of
total return.
4) Expected Capital gains return = Expected nominal
earnings growth rate + Expected repricing return


Reading 16

Capital Market Expectations

Example: Suppose the analyst estimates a 2% dividend
yield, long term inflation of 3.2%, earnings growth rate of
4.5%, a repurchase yield of -0.5% and P/E re-pricing
return of 0.35%.
Expected return on the stock = 2.0% + 3.2% + 4.5% - 0.5%
+ 0.35% = 9.55%

Practice: Example 13 &14,
Volume 3, Reading 16.

Fed Model: According to the Fed model, stock market is
overvalued (undervalued) when the market’s current
earnings yield < (>) 10-year Treasury bond yield. The
earnings yield is a conservative estimate of the
expected return for equities because it is the required
rate of return for no-growth equities. For details, refer to
Reading 18.
3.1.2.2 Fixed-Income Markets
Bonds are quoted in terms of a single discount rate,
referred to as yield to maturity or YTM. YTM is the
discount rate that equates the present value of the
bond’s promised cash flows to its market price.
• Typically, YTM of a reference fixed-income security
(called bellwether) is used as a proxy for expected
rate of return on the bond.
• YTM is a superior estimate for expected rate of return
on the zero-coupon bond (i.e. bond with no
intermediate cash flows) because it assumes that as
interest payments are received, they can be
reinvested at an interest rate equal to YTM.
• For callable bonds, yield-to-worst is sometimes used
as a conservative estimate of expected rate of
return.
3. The Risk Premium Approach: In the risk premium
approach, the expected return on a risky asset “i” is
computed as follows.
E (Ri) = RF + (Risk premium)1 + (Risk premium)2 + …+ (Risk
premium) K
Where,

E(Ri) = Asset’s expected return
RF
= Risk-free rate of interest
NOTE:
When assets are fairly priced, an asset’s required return =
Investor’s expected return.
3.1.3.2 Fixed-Income Premiums
The expected bond return, E (Rb), can be estimated as
follows:
E(Rb) = Real risk-free interest rate + Inflation premium +
Default risk premium + Illiquidity premium +
Maturity premium + Tax premium

FinQuiz.com

Where,
a) Real risk-free interest rate is the single-period interest
rate for a completely risk-free security if no inflation
were expected. It represents the compensation
demanded by investors for forgoing current
consumption.
• The current real rate depends on cyclical factors.
• The long-term real rate depends on sustainable
equilibrium conditions.
b) Inflation premium represents the compensation
demanded by investors for risk associated with
increase in inflation. It is typically a more volatile
component of bond yield.
Inflation premium = Average inflation rate expected
over the maturity of the debt +

Premium (or discount) for the
probability attached to higher
inflation than expected (or greater
disinflation)
Or
Inflation premium = Yield of conventional government
bonds (at a given maturity) – Yield
on Inflation-indexed bonds of the
same maturity
• Inflation premium varies depending on base
currency consumption baskets.
c) Default risk premium represents the compensation
demanded by investors for the risk of default of the
borrower.
Default risk premium = Expected default loss in yield
terms + Premium for the nondiversifiable risk of default
d) Illiquidity premium represents the compensation
demanded by investors for the risk of loss associated
with converting assets (particularly illiquid assets) into
cash quickly. The illiquidity premium is positively
related to the illiquidity horizon e.g. the longer the
length of investment’s lock-up period for an
alternative investment, the greater the illiquidity
premium.
e) Maturity premium represents the compensation
demanded by investors for higher interest rate risk
associated with longer-maturity debt.
Maturity premium = Interest rate on longer-maturity,
liquid Treasury debt - Interest rate on
short-term Treasury debt

f) A tax premium represents the compensation
demanded by investors for assuming risk of lower
after-tax return due to higher tax rates.


Reading 16

Capital Market Expectations

3.1.3.3 The Equity Risk Premium
The equity risk premium is the compensation demanded
by investors for assuming greater risk associated with
equity relative to debt.
Equity risk premium = Expected return on equity (e.g.
expected return on the S&P 500) –
YTM on a long-term government
bond (e.g. 10-year U.S. Treasury
bond return)
Thus,
Expected return on equity = YTM on a long-term
government bond + Equity
risk premium

FinQuiz.com

World market portfolio: The global investable market
(GIM) can be used as a proxy for the world market
portfolio. GIM consists of traditional and alternative asset
classes with sufficient capacity to absorb meaningful
investment.

An asset class risk premium (RPi) = Sharpe ratio of the
world market portfolio × Asset’s own volatility × Asset
class’s correlation with the world market portfolio
RPi = (RPM / σM) × σi × ρi,M
Where,
RPM = Expected excess return
σM = Standard deviation of the world market
portfolio represents systematic or nondiversifiable risk.

• It is known as Bond-yield-plus-risk-premium method.

Or
ܴܲ௜ =

4. Financial Market Equilibrium Models
Financial equilibrium models explain relationships
between expected return and risk when financial market
is in equilibrium (i.e. where supply is equal to demand).
Types of Financial Market Equilibrium Models:
Black-Litterman approach: The Black-Litterman
approach determines the equilibrium returns using a
reverse optimization method i.e. “reverse engineering”
them from their market capitalization in relation to the
market portfolio. It then incorporates investor’s own
views in determining asset allocations. For example, in
the absence of any investors’ views about a particular
asset class, market implied returns are used because its
equilibrium and optimal weights are identical.
The international CAPM-based approach (ICAPM):
Under ICAPM, the

Expected return on any asset = Domestic risk-free rate +
Risk premium based on
the asset’s sensitivity to
the world market
portfolio and expected
return on the world
market portfolio in
excess of the risk-free
rate.
Or
E (Ri) = RF +βi [E (RM) – RF]
Where,
E(Ri) = The expected return on asset i given its beta
RF
= Domestic Risk-free rate of return
E(RM) = the expected return on the world market
portfolio
βi
= the asset’s sensitivity to returns on the world
market portfolio, = Cov (Ri, RM) / Var (RM)
Assumptions of ICAPM: Purchasing power parity
relationship holds, implying that the risk premium on any
currency equals zero.

ߚ௜ ሺܴܲ௠ ሻ = ሾ‫ܴ(ݒ݋ܥ‬௜ , ܴெ )/ߪெଶ ሿሺܴܲெ ሻ = ቆ
= ߪ௜ ߩ௜ெ ൬

ܴܲெ
൰
ߪெ

ߪ௜ ߪெ ߩ௜ெ
ቇ × ሺܴܲெ ሻ
ߪெଶ

• Commonly, 0.28 is used as an estimate of Sharpe
ratio of the GIM.
• The Sharpe ratio of the global market may change
with changes in global economic fundamentals.
The Singer-Terhaar Approach: The ICAPM assumes that
markets are perfect and as a result ignores market
imperfections. By contrast, the Singer-Terhaar approach
takes into account the market imperfections, including
illiquidity and market segmentation.
• Market integration: International markets are
integrated when there are no impediments or
barriers to capital mobility across markets. When
markets are integrated, two identical assets with the
same risk characteristics must have the same
expected return across the markets.
Types of Barriers:
a. Legal barriers i.e. restrictions placed by a national
emerging market on foreign investment;
b. Cultural impediments;
c. Investor preferences;
• Market segmentation: International markets are
segmented when there are impediments to capital
market movements. When markets are segmented,
two identical assets with the same risk characteristics
may have different expected returns (i.e. may trade

at different exchange rate adjusted prices in
different countries, violating the law of one price).
o The more the market is segmented, the more it is
dominated by local investors;
• In practice, the asset markets are neither perfectly
segmented nor perfectly integrated. In other words,
an asset market is partially segmented or integrated.


Reading 16

Capital Market Expectations

In summary: Steps of estimating Expected Return using
Singer-Terhaar Approach
1. Separately estimate the risk premium for the asset
class using the ICAPM under two cases i.e. a perfectly
integrated market and the completely segmented
market.

Calculations:
Step 1: Bond Risk premium under completely integrated
markets = 8% × 0.45 × 0.28 = 1.008%
Equity Risk premium under completely integrated
markets = 16% × 0.65 × 0.28 = 2.912%
Bond Risk premium under completely
segmented markets = 8% × 0.28 = 2.24%

• When a market is completely segmented, the
reference market portfolio is the same as the

individual local market. Consequently, the ρi,M = 1.
Risk premium for a perfectly segmented market = RPi
=

RPM

m

i ì

ã The risk premium for a perfectly segmented market is
greater than that for the perfectly integrated
markets, all else equal.
• Note: For simplicity, it is assumed that the Sharpe
ratio of the GIM is equal to the Sharpe ratio of the
local market portfolio.
2. Add the applicable illiquidity premium, if any, to the
ICAPM expected return estimates (from step 1).
3. Estimate the degree of integration of the given asset
market. For example, it has been observed that
developed market bonds & equities are approx 80%
integrated and 20% segmented.
4. Estimate the risk premium assuming partial
segmentation by taking a weighted average of risk
premium under perfectly integrated markets and risk
premium under perfectly segmented markets. The
weights represent degree of integration of the given
asset market (from step 3).
Risk premium of the asset class, assuming partial
segmentation = (Degree of integration × Risk premium

under perfectly integrated markets) + ({1 - Degree of
integration} × Risk premium under perfectly segmented
markets)
5. Estimate the expected return on the asset class by
adding the risk premium estimate (from step 4) to the
risk-free rate yields.
Example:

FinQuiz.com

Equity Risk premium under completely
segmented markets = 16% × 0.28 = 4.48%
Step 2: Since there is no illiquidity premium, the bond
and equity risk premium will remain the same as
calculated in step 1.
Step 3: The degree of integration is estimated to be 80%
or 0.80.
Step 4: Final risk premium estimates are as follows.
Risk Premium (fixed income) = (0.80 × 1.008%) +
(0.20 × 2.24%) = 1.2544%
Risk Premium (equities) = (0.80 × 2.912%) + (0.20 ×
4.48%) = 3.2256%
Step 5: Expected return on bonds or equities = Risk-free
rate + relevant risk premium.
Expected return on bonds = 5% + 1.2544%
= 6.2544%
Expected return on equities = 5% + 3.2256%
= 8.2256%
Estimating the amount of illiquidity premium: The amount
of illiquidity premium of an asset can be estimated using

investment’s multi-period Sharpe ratio (MPSR). MPSR
reflects investment’s multi-period return in excess of the
return generated by the risk-free investment adjusted for
risk. The MPSR must be calculated over the holding
period equal to lock-up period of investment.
Rule: The investor should invest in illiquid investment if it’s
MPSR at the end of the lockup period ≥ MPSR of the
market portfolio.
Illiquidity premium = Expected return of an illiquid asset –
Required rate of return on an illiquid asset at which its
Sharpe ratio is equal to that of market’s Sharpe ratio

Suppose
•
•
•
•
•
•

S.D. of Canadian bonds = 8%
S.D. of Canadian equities = 16%
Correlation of Canadian bonds with GIM = 0.45
Correlation of Canadian equities with GIM = 0.65
Risk-free rate = 5%
Illiquidity premium = 0.

Covariance between any two assets = Asset 1 beta ×
Asset 2 beta × Variance of the market
Where,

Beta of asset 1 =

 σ 1 × ρ (1, m) 


σ
m



Beta of asset 2 =

 σ 2 × ρ (2, m) 


σm




Reading 16

Capital Market Expectations

output from such surveys largely depends on the
professional identity of the respondent.

Practice: Example 18 &19,
Volume 3, Reading 16.

3.3
3.2

Survey and Panel Methods

In the Survey method of capital market expectations
setting, the analysts inquire a group of experts for their
expectations and then use their responses in formulating
capital market expectations. When a group of experts
provide fairly stable responses, the group is referred to as
a panel of experts and the method is called a panel
method. The limitation of survey method is that the
4.

Judgment

In a disciplined expectations-setting process, all the
assumptions and rationales used in the analysis must be
explicitly documented by an analyst. In addition, the
analyst must explicitly mention the judgments used in the
analysis in an attempt to improve forecasts. The process
of applying judgment can be formalized using a set of
devices e.g. checklists.

ECONOMIC ANALYSIS

According to the Asset-pricing theory, the risk premium
of an asset is positively correlated with its expected
payoffs in a given economic condition. For example,
assets with high expected payoffs during periods of

weak consumption (business cycle troughs) tend to
have lower risk premiums (implying higher prices)
compared to assets with low expected payoffs during
such periods.
An analyst who has greater ability to predict a change
in trend or point of inflection in economy activity and
who has the ability to identify economic variables
relevant to the current economic environment is
considered to have a competitive advantage. The
inflection points are indicators of both unique investment
opportunities and source of latent risk.
Two major Components of Economic Growth:
1) Trend Growth: It identifies the long-term component of
growth in an economy. It is relevant for setting longterm return expectations for asset classes.
2) Cyclical Growth: It measures short-term fluctuations in
an economy. Cyclical variation affects such variables
as corporate profits and interest rates etc.
4.1

FinQuiz.com

Business Cycle Analysis

There are two types of cycles associated with business
cycle analysis:
1) Short-term inventory cycle: This cycle typically lasts for
2-4 years.
2) Longer-term business cycle: This cycle typically lasts
for 9-11 years.
• It is important to note that the duration and

amplitude of each phase of the cycle, as well as the
duration of the cycle as a whole are sensitive to
major shocks in the economy (i.e. wars, petroleum or
financial crisis, and shifts in government policy) and

vary considerably; hence, they are difficult to
forecast.
The economic activity can be measured using the
following measures:
Gross domestic product (GDP): GDP represents the total
value of final goods and services produced in the
economy during a given year.
GDP (using expenditure approach) =Consumption +
Investment + Change in Inventories + Government
spending + (Exports - Imports)
• Economists prefer to focus on Real GDP (i.e. increase
in the value of GDP adjusted for changes in prices)
because it reflects the change in the standard of
living. The higher the real GDP, the greater the
standard of living.
Output gap:
Output Gap = Potential value of GDP (i.e. potential
output achieved if economy follows its
trend growth) – Actual value of GDP
• The output gap is positive (i.e. potential GDP >
actual GDP) during period of economic recession or
slow growth. Inflation tends to fall when output gap
is positive.
• The output gap is negative (i.e. potential GDP <
actual GDP) during period of economic expansion

or fast growth. Inflation tends to rise when output
gap is negative.
o When actual GDP growth rate > trend rate, it may
not give signs of overheating economy provided
that unemployment is relatively high and there is
spare capacity in the economy.
It is important to understand that real time estimates of
output gap may not necessarily always be accurate
because economy’s trend path is affected by changes
in demographics and technology.


Reading 16

Capital Market Expectations

Recession: A recession refers to a broad-based
economic downturn i.e. when an economy faces two
successive quarterly declines in GDP.
4.1.1) The Inventory Cycle
The inventory cycle is a cycle that identifies fluctuations
in inventories. The inventory cycle results from adjusting
inventories at desired levels in response to changes in
expected level of sales.
Phases of Inventory Cycle:
A. Up phase: Future sales are expected to increase
leading to increase in production in an attempt to
increase inventories
overtime pay and
employment increases to meet increasing production

needs
as a result, economy boosts and sales further
increase.
B. Down phase: After reaching some peak point
(referred to as inflection point), sales start falling
and/or future sales are expected to fall (e.g. due to
tight monetary policy, higher oil prices etc.)
Consequently, production is cut back and inventory
level decreases. Due to reduction in production
layoffs, increase and/or hiring process slows down. As
a result, economy slows down and sales further
decrease.
• Generally, after an inflection point, the inventory
levels are adjusted to their desired levels within a
period of year or two.
Indicator of Inventory Position: The inventory position can
be gauged using “Inventory/sales ratio”. It is interpreted
as follows:
• Falling inventory/sales ratio indicates that in the near
future, businesses will try to rebuild inventory; as a
result, economy is expected to strengthen in the
next few years.
• Sharply rising inventory/sales ratio indicates that in
the near future, businesses will try to reduce
inventory; as a result, economy is expected to
weaken in the next few years.
It is important to understand that due to improved
techniques, i.e. “just-in-time” inventory management,
inventory/sales ratio has been trending down.
4.1.2) The Business Cycle

The business cycle represents short-run fluctuations in
GDP (i.e. level of economic activity) around its long-term
trend growth path. A typical business cycle is comprised
of the following five phases:
1. Initial Recovery: The economy starts to grow from its
slowdown or recession. This phase lasts for few
months.
• Confidence among businesses starts to increase;
• Unemployment is still high → thus, consumer

FinQuiz.com

confidence is at low levels;
• Inflation falls;
• Output gap is still large & there is spare capacity;
• The recovery largely results from the simultaneous
upswing in the inventory cycle;
Economic Policies:
• Stimulatory monetary policy i.e. interest rates fall;
• Stimulatory fiscal policy i.e. budgetary deficit grows;
Capital Market Effects:
• Government bond yields continue to fall in
expectation of falling inflation and then start
bottoming;
• Stock markets may perform well (i.e. stock prices
rise);
Attractive Investments:
• Cyclical assets
• Riskier assets i.e. small stocks, higher-yield corporate
bonds, emerging market equities & bonds;

2. Early Upswing: The economy starts gaining
momentum. This phase is considered to be the
healthiest period of the cycle because of the
absence of any inflationary pressure in the economy.
This phase usually lasts for at least a year and often
several years provided that growth is not too strong
and the output gap closes slowly.
• Confidence among businesses is increasing;
• Unemployment starts to fall as more workers are
hired in response to increased production & higher
demand → consumer confidence starts rising → as
a result, consumers borrow more and spending
increases;
• Inflation falls;
• Output gap is still large & there is spare capacity;
• The recovery largely results from the simultaneous
upswing in the inventory cycle;
• Inventory levels build up in anticipation of future
increase in sales;
• Capacity utilization increases → per unit cost falls →
profits rise rapidly;
Economic Policies:
• Central bank starts withdrawing stimulatory
monetary & fiscal policies introduced during
recession;
Capital Market Effects:
• Short-term interest rates start rising;
• Longer-term bond yields may be stable or increase
slightly;
• Stock markets are rising;

Reading 16

Capital Market Expectations

3. Late Upswing: During this phase, an economy tends to
grow rapidly and is likely to be overheated and face
inflationary pressures due to closing of output gap.
• Confidence among businesses & consumers is still
rising;
• Unemployment is low (i.e. economy is at or near full
employment);
• Due to shortages of labor supply → wages rise →
consequently, production costs & inflation starts to
accelerate;
Economic Policies:
• Restrictive monetary policy i.e. interest rates
increase;
• However, the policy is not severly restrictive as it aims
to cool down the economy rather than pushing
economy into downturn; (known as "soft landing").
Capital Market Effects:
• Interest rates tend to rise due to heavy borrowing by
consumers & businesses;
• Bond yields also tend to rise;
o →Due to rising bond yields, bondholders incur
capital losses.
• Stock markets may rise because higher inflation
should be reflected in higher profits;

o but it is highly volatile, depending on the strength
of boom because investors fear that inflation may
be moving out of equilibrium.
4. Slowdown: The economy starts slowing down
primarily due to rising interest rates. During this phase,
an economy is highly in danger of going into
recession. It lasts just a few months, or it may last a
year or more.
• Confidence among businesses starts falling;
• Unemployment is still high → thus, consumer
confidence is at low levels & demand falls;
• Inflation is still rising despite slowdown in growth;
• Inventory levels are reduced due to cut back in
production;
Capital Market Effects:
• Short-term interest rates are high & rising;
• But, after reaching some peak point, they start falling
→ indicating inverted yield curve;
• As the yields fall afterwards, bonds rally sharply;
• Stock markets may perform poorly as higher interest
rates will lead to slowing economic growth, resulting
in lower sales, revenues and profits;
In addition, as interest rates rise, the return on
alternative investments increases and stocks become
less attractive;

FinQuiz.com

Attractive Investments:
• Interest-sensitive stocks i.e. utilities and financial

services;
5. Recession: Recession is associated with two
successive quarterly declines in GDP. This phase
typically lasts for 6 months to a year.
• Businesses & consumers confidence decline
significantly;
• Profits fall sharply;
• Production declines and inventory levels are
reduced considerably;
• Business investment falls;
• Consumer spending on luxury goods (i.e. car) fall;
• Unemployment rises sharply;
• Inflation starts to fall;
• Often associated with major bankruptcies, incidents
of uncovered fraud, or a financial crisis; as a result,
lenders are reluctant to lend.
Economic Policies:
• Stimulatory monetary policy i.e. interest rates fall;
however, very marginally initially;
Capital Market Effects:
• Both Short-term interest rates & longer-term bond
yields start falling;
• Stock markets start to improve in the later stages of
the recession;
Attractive Investments:
• Bonds generate capital gains ;
• But, deteriorating credit quality may offset such
gains for some bonds;
The Yield Curve, Recessions, and Bond Maturity:
The yield spread between the 10-year T-bond rate and

the 3-month T-bill rate indicates expected future growth
in output.
• Positive or widening yield spread between long-term
and short-term interest rates (i.e. a steepening or
upward sloping yield curve) indicates an
expectation of an increase in real economy activity
(economic upturn) because investors demand more
yield as maturity extends if they expect rapid
economic growth because of the associated risks of
higher inflation and higher interest rates in the future,
which can both hurt bond returns. When inflation is
rising, the Federal Reserve will often raise interest
rates to fight inflation.
o When yield spread is expected to narrow, it is
preferred to invest in shorter duration bonds;
• Conversely, negative or narrowing yield spread
between long-term and short-term interest rates (i.e.


Reading 16

Capital Market Expectations

a flattening or inverted yield curve) indicates an
expectation of a decline in real economy activity
(economic downturn or recession) because an
anticipation of a recession implies the expectation
of a decline of future interest rates that is reflected in
a decrease of long-term interest rates. In other
words, if investors expect a reduction of their

income, in case of a recession, they prefer to save
and invest in long-term bonds in order to get payoffs
in the recession. Consequently, the demand for
long-term bonds increase, leading to a decrease of
the corresponding yield. Further, to finance the
purchase of the long-term bonds, an investor may
sell short-term bonds whose yields will increase. As a
result, when a recession is expected, the yield curve
flattens or gets inverted..
o When yield spread is expected to widen, it is
preferred to invest in longer-duration bonds;

FinQuiz.com

for long.
What happens when Interest Rates Reach Zero? Once
interest rates are at zero, the monetary authorities can
stimulate the economy using the following measures:
1) The central bank can push cash (bank “reserves”)
directly into the banking system.
2) The central bank can devalue the currency.
3) The central bank can promise to keep short-term
interest rates low for an extended period.
4) The central bank can buy assets directly from the
private sector (process called open market
purchase); as a result, spending increases as money is
put directly into people’s hands and yields on these
assets fall.
Price indices are used to identify the overall trend in
prices. For example,

4.1.3) Inflation and Deflation in the Business Cycle
Inflation refers to continuous (not one time) increase in
aggregate price level, resulting in decrease in the
purchasing power of a unit of currency. Inflation is linked
to business cycle i.e.
• It tends to increase during late stages of a business
cycle when there is no output gap which puts
upward pressure on prices.
• It tends to fall during recessions and the early stages
of recovery when there is a large output gap which
puts downward pressure on prices.
Deflation refers to continuous (not one time) decrease in
aggregate price level, resulting in increase in the
purchasing power of a unit of currency. It negatively
affects the economy in two ways:
i. Deflation tends to reduce the value of debt-financed
investments because when the price of a debtfinanced asset falls, the value of the “equity” in the
asset (i.e. asset’s value - loan balance) tends to
decline at a leveraged rate. E.g. if the value of a
property financed with 67% loan-to-value mortgage
decreases by 5%, the value of equity in the property
will fall by = 5% / (1 – 0.67) = 5% / 0.33 = 15.15%.
ii. Deflation tends to undermine central bank’s ability to
affect monetary policy to control the economy:
During deflation, interest rates are near to zero; as a
result, the central bank is unable to stimulate the
economy with monetary policy (i.e. by lowering
interest rates below zero).
• Therefore, in order to keep inflation at low level but

without pushing the economy into deflation, central
banks prefer to use a low positive rate of target
inflation.
• An economy may suffer from a prolonged deflation
when its money supply is restricted; e.g. in gold
standard currency system, the money supply was
restricted by the size of a government’s gold
reserves. By contrast, when the money supply can
be easily expanded, deflation does not tend to last

• Consumer price index: It is calculated using a basket
of goods and services based on consumers’
spending patterns.
• GDP and consumer expenditure deflators: They are
used to adjust or deflate the nominal series for
inflation.
Three principles of Central bank Policy regarding
inflation:
A. Central banks’ policy-making decisions must be free
from political influence; otherwise, central banks may
use easy monetary policy which leads to increase in
inflation over time.
B. Central banks should have an inflation target which
serves dual roles i.e. act as a disciplining tool for
central bank itself and as a signal of central bank’s
intention to the market. It also helps to anchor market
expectations.
C. Central banks should use monetary policy (primarily
interest rates) to manage the economy and to
prevent it from either overheating or suffering from a

recession for too long.

Practice: Example 24,
Volume 3, Reading 16.

4.1.4) Market Expectations and the Business Cycle
It is quite difficult to identify the current phase of the
cycle and correctly predict the starting time of the next
phase because the phases of the business cycle vary
substantially in length (duration) and amplitude
(intensity): For example,
• Recessions can be steep with a huge decline in
output and a substantial rise in unemployment; or it
can be short lived with only a small decline in output
and only a modest rise in unemployment.


Reading 16

Capital Market Expectations

• Weak phase of the business cycle may involve only
a slower economic growth or a “growth recession”
rather than a recession. This particularly occurs
when:
o An economy has a rapid trend rate of growth;
o The upswing was relatively short or mild without
bubble or severe overheating in the stock market
or property market;
o Inflation is relatively low;

o The world economic and political environments

FinQuiz.com

are positive;

Equity

Real Estate/Other Real
Assets

Cash

Bonds

Inflation at or below
expectations

Short-term yields
steady or declining.
(Neutral)

Yield levels
maintained; Market is
in equilibrium.
(Neutral)

Bullish while market is
in equilibrium state.
(Positive)

Cash flow steady to
rising slightly.
Returns equate to
long-term average.
Market in general
equilibrium.
(Neutral)

Inflation above
expectations

Bias toward rising
rates.
(Positive)

Bias toward higher
yields due to a higher
inflation premium.
• As yields ↑, nominal
bond price ↓; also,
bond coupon &
principal become
less attractive on
real basis;
(Negative)

High inflation is
negative for financial
assets. Less negative

for companies/
industries able to pass
on inflated costs.
(Negative)

Asset values
increasing; increases
cash flows and higher
expected returns.
(Positive)

Deflation

Bias toward 0%
short-term rates.
(Negative)

Purchasing power
increasing.
Bias toward steady to
lower rates (may be
offset by increased
risk of potential
defaults due to falling
asset prices).
(Positive)

Negative wealth
effect slows demand.
Especially affects

asset-intensive,
commodityproducing (as
opposed to
commodity-using),
and highly levered
companies.
(Negative)

Cash flows steady to
falling. Asset prices
face downward
pressure.
(Negative)

Source: Curriculum, Reading 16, Exhibit 18.
4.1.5) Evaluating Factors that Affect the Business Cycle
In formulating capital market expectations, the business
cycle analysis should be performed by focusing on the
following four areas:
1) Consumer spending: The consumer spending
represents 60-70% of GDP in most large developed
economies. Thus, it is regarded as the most important
business cycle factor. Unlike business investments, it is
quite stable over the business cycles.
• Sources of data on consumer spending: Retail sales,
miscellaneous store sales data, consumer
confidence survey data (indicates changes in
household’s saving rates), and consumer
consumption data.
• Factor that affects consumer spending: Consumer

spending largely depends on consumer income
after tax which in turn depends on wage
settlements, inflation, tax changes, and employment
growth. In addition, consumer spending can also be
affected by unusual weather or holidays.
• Assuming household savings rate constant, ∆ in
income = ∆ in consumer spending
2) Business investment: Business investment represents a
smaller % of GDP relative to consumer spending.
Business investment and spending on inventories are
regarded as the most volatile business cycle factor.
• Sources of data on business investments: Purchasing
managers index (PMI) which is based on answers to
a series of questions about the company’s position,
including production plans, inventories, prices paid,
prices received, and hiring plans.


Reading 16

Capital Market Expectations

o Rising inventory levels during early stages of an
inventory cycle upswing may indicate that
businesses are spending on inventories as they
expect sales to increase in future, reflecting higher
economic growth.
o Rising inventory levels during late stage of the
inventory cycle may indicate that inventory levels

are increased due to lower than expected sales.
3) Foreign trade: For large economies (e.g. U.S. &
Japan), this factor represents a smaller % (i.e. 10-15%)
of GDP and therefore, considered as a less important
factor; whereas for smaller economies foreign trade is
an important factor, representing 30-50% of GDP, in
general.
4) Government Policy: Both the government and
monetary authorities tend to control the growth rate
of the economy to keep it close to its long-term
sustainable trend rate and attempt to meet inflation
target using different policies i.e.
• Monetary policy: Easy (tight) monetary policy
involves reducing (increasing) short-term interest
rates and/or increasing (decreasing) money supply.
Easy (tight or restrictive) monetary policy is used
when the economy is weak (in danger of
overheating).
o Over the long-run, the growth in money supply and
the growth in nominal GDP are positively related
i.e. as money supply increases, nominal GDP
increases, leading to increase in inflation.
o Monetary policy focuses on key variables,
including the pace of economic growth, amount
of excess capacity still available (if any),
unemployment level, and inflation rate.
• Fiscal policy: Easy (tight) fiscal policy involves
reducing (increasing) tax rates and/or increasing
(decreasing) governmental spending.

FinQuiz.com

which the potential growth of the economy is in balance
with target inflation rate. E.g. if the target inflation rate is
2% and economic growth is 2.5%, the neutral level of
interest rates = 2% + 2.5% = 4.5%.
The Taylor Rule: This rule relates a central bank’s target
short-term interest rate to the rate of growth of the
economy and inflation.
Taylor rule equation:
Roptimal = Rneutral + [0.5 × (GDPgforecast – GDPgtrend)]
+ [0.5 × (Iforecast – Itarget)]
Where,
Roptimal
Rneutral

GDPgforecast
GDPgtrend
Iforecast
Itarget

= the target for the short-term interest rate
= the short-term interest rate that would be
targeted if GDP growth were on trend and
inflation on target
= the GDP forecast growth rate
= the observed GDP trend growth rate
= the forecast inflation rate
= the target inflation rate

Interpretation of Taylor Rule: When forecast GDP growth
rate and/or the forecast inflation rate >(<) trend or
target level, central bank must increase (reduce) the
short term interest rates* by half the difference between
the forecast and the trend or target.
*Commonly, the federal funds rate, or fed funds rate
which is the interest rate on overnight loans of reserves
(deposits) at the Fed between Federal Reserve System
member banks.

Practice: Example 26 & 27,
Volume 3, Reading 16.

4.1.5.3 Monetary Policy
Mechanisms through which change in short-term interest
rates affects the economy include:
• Borrowing and lending effects: As short-term rates ↓,
borrowing by consumers and businesses ↑. (Due to
decline in interest rates, corporation’s cost of capital
decreases).
• Capital markets effects: As short-term rates ↓, bond
and stock prices ↑. Consequently, consumer
spending and business investment further rise.
• Foreign Trade effects: As short-term rates ↓ the
exchange rate ↓ currency depreciates in value
leading to increase in exports.
It must be stressed that impact of changes in interest
rates not only depends on the direction of change, but
also on the absolute level of interest rates compared to
their average or “neutral” level.

Neutral level of Interest Rates: The “neutral level” of
interest rate is the equilibrium short-term interest rate at

4.1.5.4 Fiscal Policy
Fiscal policy refers to the deliberate manipulation of the
budget deficit (government spending > taxes) in order
to influence the economy.
• Easy or expansionary fiscal policy involves increasing
government spending and/or reducing taxes to
stimulate the economy.
• Tight or restrictive fiscal policy involves decreasing
government spending and/or increasing taxes to
slow the economy.
Following two factors must be considered in analyzing
the fiscal policy:
1) Changes in the governmental budgetary deficit: It is
important to focus on the changes in the
governmental budgetary deficit rather than its
absolute level. E.g. when budget deficit increases
(decreases), it implies easy (tight) fiscal policy.


Reading 16

Capital Market Expectations

2) Deliberate changes in the budget deficit: It is
important to focus only on the deliberate changes in
the budget deficit in response to changes in fiscal
policy rather than changes in budget deficit in

response to the changes in economy, e.g. during
recessions or when the economy is slow (expansions

FinQuiz.com

or when the economy grows), tax revenues ↓ (↑) and
government spending on unemployment ↑ (↓);
consequently, budget deficit tends to increase
(decrease).

Linkages with Monetary Policy

Tight Fiscal Policy

Expansionary Fiscal Policy

Expansionary Fiscal Policy

Tight Fiscal Policy

4.2

+
+
+
+

Tight Monetary Policy

Expansioary Monetary

Policy

Tight Monetary Policy

Expansioary Monetary
Policy

Economic Growth Trends

Economic Growth Trend: The long-term, smooth growth
path of GDP is called the economic growth trend. It
reflects the average growth rate around which the
economy rotates (i.e. slows down or grows) in response
to business cycles but is independent of business cycle.
In other words, it represents the pace of growth of
economy over a number of years without any
unsustainable increase in inflation.
The economic growth trend is determined by other
economic trends, including:
•
•
•
•
•

Population growth and demographics
Business investment and productivity
Governmental structural policies
Inflation/deflation
Health of banking/lending processes

The expected trend rate of economic growth is a key
input in discounted cash flow models of expected
return.
• The higher the trend rate of economic growth of a
country, the more attractive returns for equity
investors.
• The higher the trend rate of economic growth of a
country, the more fast an economy can grow
without any unsustainable increase in inflation.

=
=
=
=

• Economy is expected to slow
• Yield curve tends to be inverted in
shape.
• Economy is expected to grow
• Yield curve tends to be steeply
upward sloping
• Ambiguous situation i.e. unlear
whether economy will slow or grow
• Yield curve tends to be flat.
• Ambiguous situation i.e. unlear
whether economy will slow or grow
• Bond yields tend to fall &Yield curve
tends to be moderately upward
sloping

Practice: Example 28,
Volume 3, Reading 16.

4.2.1) Consumer Impacts: Consumption and Demand
Consumption represents the largest source of aggregate
economic growth in both developed and developing
economies. It is also the most stable or even
countercyclical business cycle factor as explained by
the permanent income hypothesis.
Wealth effect: When % increase in consumers’ spending
is greater than % increase in consumers’ wealth
(income), it is referred to as the wealth effect.
The permanent income hypothesis: According to the
permanent income hypothesis, consumer spending
behavior is largely determined by long-term income
expectations rather than temporary or unexpected (or
one-time) change in income/wealth.
• When income temporarily increases (i.e. during
expansions), increase in spending will be less than
increase in income.
• When income temporarily decreases (i.e. during
recessions), decrease in spending will be less than
decrease in income.


Reading 16

Capital Market Expectations

4.2.2) A Decomposition of GDP Growth and Its Use in
Forecasting
Trend growth in GDP = Growth from labor inputs +
Growth from changes in labor
productivity
Where,
Growth from labor inputs reflects growth from changes in
employment.
Growth from labor inputs = Growth in potential labor
force size + Growth in actual
labor force participation
Growth from changes in labor productivity =
Growth from capital inputs + TFP growth*
*TFP growth = Growth associated with increased
efficiency in using capital inputs.

Impact of rate of investment on stock market returns:
The stock market returns depend on the rate of return on
invested capital i.e. the higher the rate of investment
the higher the growth in capital
the lower the returns
on invested capital; consequently, the lower the stock
market returns (despite higher rate of economic growth).

Practice: Example 29,
Volume 3, Reading 16.

4.2.3) Government Structural Policies
Government structural policies are the government
policies that affect the limits of economic growth and

incentives within the private sector.
Elements of pro-growth government structural policy:
1. Fiscal policy is sound: Regularly running a large
budget deficit does not indicate a sound fiscal policy.
A sound fiscal policy is the one in which budget
deficit is close to zero over the long-run. Following are
the three problems associated with running large
budget deficits on a consistent basis:
i. Twin deficits problem and currency devaluation:
An economy may need to borrow from abroad to
finance its budget deficit, that is, by running
current account deficit. When level of foreign debt
rises considerably, an economy needs to reduce
borrowing, usually through devaluing its currency.
ii. Higher inflation: If the budget deficit is financed by
printing money, it results in higher inflation in the
economy.
iii. Crowding-out effect: Government borrowing to
finance budget deficit puts upward pressures on
interest rates. The higher interest rates can cause
lower private sector spending and investment.

FinQuiz.com

2. The public sector has minimal interference with the
private sector: There should be minimal government
intervention in the economy because excessive
government intervention, particularly in the form of
regulations, creates inefficiency and leads to a
misallocation of scarce resources. For example, labor

market rules tend to increase the structural level of
unemployment (i.e. unemployment resulting from
scarcity of a factor of production).
3. Competition within the private sector is encouraged:
Competition within the private sector makes the
companies more efficient and consequently
increases productivity growth of an economy.
Government policies that encourage competition
within the private sector include reduction of trade
tariffs and barriers, removal of restrictions on foreign
investment etc. However, due to higher competition it
becomes difficult to earn high returns on capital; as a
result, stock market valuations decrease.
4. Infrastructure and human capital development are
supported: Governments must pursue infrastructure
and human capital development (i.e. education &
health) projects because they have important
economic benefits.
5. Tax policies are sound: Sound tax policies involve
simple, transparent, stable and low marginal tax rates,
and a very broad tax base. Generally, taxes represent
30-50% of GDP in many developed economies.
4.3

Exogenous Shocks

In general, it is relatively easy to forecast trends than
cycles because they are relatively constant over time.
Therefore, trends or changes in trends are already
discounted in market expectations and prices by

investors.
However, some trends are not forecastable. These are
referred to as “exogenous shocks” e.g. short-lived
political events, wars, abrupt changes in government tax
or trade policies, sudden collapse in an asset market or
in an exchange rate, natural disasters etc.
Two major types of economic shocks with contagion
effects include:
1) Oil shocks (section 4.3.1): Oil shocks refer to a sharp
increase in the price of oil, which reduces consumer
purchasing power and creates higher inflation. Over
time, as employment falls and economy slows down,
the output gap opens up; consequently, inflation
decreases to its previous level.
2) Financial shocks (section 4.3.2): Financial shocks are
associated with country’s inability to meet debt
payments, devaluation of currency, and considerable
decline in asset prices, (particularly real estate prices).
Usually, banks are highly vulnerable to financial
shocks. Financial shocks reduce economic growth


Reading 16

Capital Market Expectations

either directly through decreased bank lending or
through decreased investor confidence. Financial
crises are potentially more dangerous in a low interest
rate environment because during such environment,

the central bank is unable to further reduce interest
rates for the purpose of providing sufficient liquidity in
the economy.
4.4

International Interactions

Small countries with concentrated economies
(depending on a few commodities) tend to be highly
influenced by developments in other economies in the
world compared to large countries with diverse
economies (e.g. U.S.). However, international
interactions among countries in the world have
increased with increase in globalization of trade, capital
flows, and direct investment.
Types of International Interactions:
1) Macroeconomic Linkages: Economies are linked
through two broad channels
• Trade in goods and services: For example, as foreign
demand for exports increase, the exports increase
aggregate demand increase and consequently,
economic growth increases.
• Finance: As international investors shift their assets
around the world, they link asset markets here and
abroad, it affects income, exchange rates, and the
ability of monetary policy to affect interest rates.
2) Interest Rate/Exchange Rate Linkages: These linkages
affect countries that unilaterally peg their currencies
firmly or loosely to one of the major currencies (e.g.
U.S. dollar). The pegging exchange rates policy has

two benefits:
i. It reduces the volatility of the exchange rate (at
least in the short-run).
ii. It enables the pegged country to control inflation.
iii. It imposes some discipline on government policies.
Limitations of pegging exchange rate policy:
i. It can introduce currency speculation.
ii. In pegging exchange rate regime, the level of
domestic interest rates will depend on overall
market confidence in the peg i.e. the higher
(lower) the confidence in the exchange rate peg,
the lower (higher) the interest rate differential
(bond yields of pegged country – bond yields of
the major currency country).
Bond yields of the country with undervalued
(overvalued) exchange rate tend to be lower (higher).
NOTE:
Real and nominal rates tend to be high when there is:
• Increasing Budget deficit

FinQuiz.com

• Strong private sector economy (reflecting strong
demand for world savings)
• Tight monetary policy
4.4.3) Emerging Markets
4.4.3.1

Essential Differences between Emerging and
Major Economies

• Emerging countries need higher rates of investment
in physical capital and infrastructure and in human
capital than developed countries.
• Due to inadequate domestic savings (unlike
developed countries), emerging countries heavily
depend on foreign capital (i.e. foreign debt).
• Emerging countries tend to have a highly volatile
political and social environment than developed
countries, which makes it difficult to achieve
structural reforms.
• Emerging countries tend to have a relatively large %
of people with low income and few assets and a
relatively small middle class.
• Emerging countries tend to have concentrated
economies e.g. with particular commodities or in a
narrow range of manufactured goods.
• Due to heavy reliance on oil imports, emerging
countries tend to be more sensitive to fluctuation in
oil prices or rely heavily on continuing capital inflows.
• Emerging countries tend to have excessive shortterm debt.
4.4.3.2 Country Risk Analysis Techniques
• For emerging countries’ bonds, investors focus on
assessing the risk of default of the country.
• For emerging countries’ stocks, investors focus on
the assessing the growth prospects of emerging
countries and their sensitivity to surprises.
Key Elements of Country Risk Analysis:
1. Soundness of fiscal and monetary policy: Persistently
large budget deficits tend to reduce economic

growth. In addition, the larger and the more persistent
the fiscal deficit, the greater the debt. The soundness
of fiscal policy is assessed through ratio of fiscal deficit
to GDP i.e.
• When ratio of fiscal deficit to GDP is persistently > 4%,
it is regarded as risky, indicating substantial credit
risk;
• When ratio of fiscal deficit to GDP is between 2-4%, it
is acceptable but still risky.
• When ratio of fiscal deficit to GDP < 2%, it is regarded
as safe.
• Ratio of debt to GDP > 70-80% is regarded as
extremely dangerous.
2. Economic growth prospects for the economy:
• Annual growth rates of < 4% is not favorable
because it indicates that the country is slowly
catching up with the industrial countries and per


Reading 16

Capital Market Expectations

capita income is growing very slowly or even falling.
• The structural health of an economy can be gauged
using the Economic Freedom Index, an index based
on a range of indicators of the freedoms enjoyed by
the private sector i.e. tax rates, tariff rates, and the
cost of setting up companies. Higher value of
Economic Freedom Index indicates greater

economic growth.
3. Degree of competitiveness of Currency and the level
of external accounts:
• When currency stays overvalued for a prolonged
time period it indicates increase in external debt and
large current account deficit. Also, an overvalued
and highly volatile currency negatively affects
business confidence and investment.
• The sustainability of the external accounts can be
measured using size of the current account deficit
i.e.
o Ratio of current account deficit to GDP persistently
> 4% is regarded as risky.
o Ratio of current account deficit to GDP between
1-3% is regarded as sustainable provided that a
country is growing.
o A current account deficit is less sustainable when it
is financed through debt because it will likely lead
to currency depreciation and economic
slowdown. As the economy slows down
imports
fall
current account deficit is reduced.
o A current account deficit is more sustainable when
it is financed through foreign direct investment
because foreign direct investment creates
productive assets.
4. The level of external debt: External debt is the foreign
currency debt owed to foreigners by both the
government and the private sector. It serves to fund

the savings deficit resulting from insufficient domestic
savings. The sustainability of the external debt can be
measured using
• Ratio of foreign debt to GDP i.e.
o Ratio of foreign debt to GDP > 50% indicates risky
level.
o Ratio of foreign debt to GDP between 25-30% is
regarded as the ambiguous level.
• Ratio of debt to current account receipts i.e.
o Ratio of debt to current account receipts > 200%
indicates risky level.
o Ratio of debt to current account receipts < 100%
indicates safe level.
5. Level of liquidity: Liquidity refers to level of foreign
exchange reserves compared to trade flows and
short-term debt (debt with maturity of < 12 months).
• Adequate level of foreign exchange reserves is
regarded as equal to the value of three months’
worth of imports.
• Ratio of foreign reserves to short-term debt i.e.
o Ratio of foreign reserves to short-term debt > 200%

FinQuiz.com

indicates safe level.
o Ratio of foreign reserves to short-term debt < 100%
indicates risky level.
6. Political situation in relation to the required policies:
• Political situation must be supportive of the required
structural reforms and policies (i.e. privatization and

the ending of monopolies).
• Strong and less volatile political environment is highly
important for countries with weak economy, slow
growth, slow policy liberalization, high debt and low
reserves.
4.5

Economic Forecasting

Following are the three economic forecasting
approaches:
1) Econometric Modeling: This method is a formal and
mathematical approach to economic forecasting as
it involves use of econometric models. Econometric
model comprises equations, which seek to model the
relationships between different economic variables
based on some sound economic theory to forecast
the future. E.g.
GDP Growth = α + β1Consumer spending growth +
β2Investment growth
Consumer spending growth = α + β1Lagged consumer
income growth +
β2Interest rate
Investment growth = α + β1Lagged GDP growth +
β2Interest rate
• Econometric models vary from small models with just
one equation or complex models with hundreds of
equations.
• It must be stressed that larger models with multiple
variables are not necessarily superior to smaller

models.
Strengths of Econometric modeling:
• Econometric models can be quite robust and may
provide forecasts close to reality.
• Econometric models consolidate existing empirical
and theoretical knowledge of how economies
function.
• Econometric models provide quantitative estimates
of the effects of changes in exogenous variables on
the economy.
• Econometric models help to explain their own
failures, as well as provide forecasts and policy
advice.
• Econometric models restrict the forecaster to a
certain degree of consistency.
• Econometric models are useful to forecast
economic upturns/expansions.


Reading 16

Capital Market Expectations

• Econometric models can be modified readily to
accommodate changing conditions.
Limitations of Econometric modeling:
• Econometric models may be quite complex and
time-consuming to build; difficult to implement; and
expensive to maintain.
• Econometric models are not useful to forecast

recessions.
• Econometric models depend on adequate
measures for the real-world activities and
relationships to be modeled, data on which may not
be easily available.
• Variables in the econometric models may be
measured with error.
• Econometric models assume constant relationships
among variables; hence, they may be misspecified
when relationships change over time due to
changes in the structure of the economy.
• Econometric models need forecasters to conduct
careful analysis of output.
2) Economic Indicators: Economic indicators are
economic statistics provided by government and
established private organizations. They provide
information on an economy’s recent past activity or
its current or future position in the business cycle.
Types of Economic Indicators: Following are the three
types of economic indicators.
A. Leading Economic Indicator (LEI): LEIs are indicators
that change before the change in the economy i.e.
they tend to exhibit declining (rising) trend before the
economy declines (rises), e.g. stock market returns.
They reflect future economic activity and therefore
help to predict the future performance of economy.
They are regarded as the most important type of
economic indicators for investors. Leading indicatorbased analysis is the simplest forecasting approach
because it involves only a limited number of variables.
B. Coincident Economic Indicator: Coincident

economic indicators are indicators that change
simultaneously with the economy, e.g. GDP. They
reflect current economic activity.
C. Lagging Economic Indicator: Lagging economic
indicators are indicators that change with some time
lag with the change in the economy (i.e., a few
months after the economy does). E.g. unemployment
rate tends to fall after a few months of economic
growth. They reflect recent past economic activity.
Composite LEIs or LEI index: Composite LEIs is a
collection of economic data releases that reflect an
overall future performance of the economy.
• Compared to individual leading indicators, LEI index
is less useful for predicting the economic activity
because some of its components are already public.

FinQuiz.com

Diffusion index: Diffusion index is a measure that reflects
number of upward trending indicators and downward
trending indicators. E.g. if 8 out of 10 indicators are
exhibiting downward trend, it indicates that an
economy is likely to contract.
General rule: Three consecutive months of increases
(decreases) in LEIs give signals of upturn (downturn) in
the economy within three to six months.
Strengths of Economic Indicators:
• They are usually intuitive and simple to construct.
• They are easily available from third parties.
• They can be easily tailored according to individual

needs.
• A literature suggests that they are effective in
assessing outlook of an economy.
Limitations of Economic Indicators:
• It has been observed in the past that they are not
effective on a consistent basis due to changes in the
relationships between inputs.
• They may provide false signals.
• Some data series are reported with a lag.
• Some data series are subject to revisions.
U.S. Composite Indices
Leading Index
1. Average weekly hours, manufacturing
2. Average weekly initial claims for unemployment
insurance
3. Manufacturers’ new orders, consumer goods and
materials
4. Vendor performance, slower deliveries diffusion
index
5. Manufacturers’ new orders, non-defense capital
goods
6. Building permits, new private housing units
7. Stock prices, 500 common stocks
Financial
8. Money supply, M2
components; All else
are non-financial
9. Interest rate spread, 10-year Treasury
components
bonds less federal funds

10. Index of consumer expectations
Coincident Index
1. Employees on nonagricultural payrolls
2. Personal income less transfer payments
3. Industrial production
4. Manufacturing and trade sales
Lagging Index
1. Average duration of unemployment
2. Inventory/sales ratio, manufacturing and trade
3. Labor cost per unit of output, manufacturing
4. Average prime rate
5. Commercial and industrial loans
6. Consumer installment credit to personal income ratio
7. Consumer price index for services


Reading 16

Capital Market Expectations

3) Checklists Approach: This method involves subjective
integration of the answers to a set of relevant
questions. The information gathered through answers
can be extrapolated into forecasts in two ways i.e.
objective statistical methods (i.e. time series analysis)
or subjective or judgmental means to assess the
outlook for the economy.
Strengths of Checklists approach:
• It is a simple and straightforward method.
• It provides flexibility as the forecaster is allowed to

quickly incorporate structural changes in the
economy by changing the variables or the weights
assigned to variables within the analysis.
Limitations of Checklists approach:
• It is time-consuming because it requires analysis of
broad range of data.
• It depends on subjective judgment.
• It is based on a process, which is manual in nature
which makes it difficult to use for modeling complex
relationships.
Guideline Set of Questions used to assess the outlook of
the economy:
What is the position of the economy in the business
cycle? It is judged by analyzing
• Previous data on GDP growth and its components;
• Degree of unemployment relative to estimates of
“full employment” and its trend i.e. declining or
increasing;
• Output gap;
• Businesses’ inventory position;
• Level of inflation relative to target and its trend i.e.
rising or declining;
How strong is the consumer spending? It is judged by
analyzing
• Wage/income patterns;
• Pace of growth of employment;
• Consumers’ level of confidence i.e. using consumer
confidence indices;
How strong is the business spending? It is judged by
• Reviewing survey data i.e. purchasing managers

indices;
• Reviewing recent capital goods orders;
• Assessing balance sheet health of companies;
• Assessing cash flow and earnings growth trends;
• Assessing trend of stock market i.e. is it rising or
falling;
• Reviewing inventory position i.e. low inventory/sales
ratio implies GDP strength;
What is the degree of import growth? It is judged by

FinQuiz.com

• Analyzing exchange rate competitiveness and
recent movements;
• Assessing strength of economic growth;
Reviewing government’s fiscal stance;
Reviewing monetary stance i.e.
• Recent changes in interest rates;
• Trend in real interest rates;
• Level of current interest rates in relation to the rate
under Taylor rule;
• Monetary conditions indices i.e. trends in asset prices
and exchange rate;
• Money supply indicators;
What is the trend of Inflation? i.e. is it rising or falling;

Practice: Example 30,
Volume 3, Reading 16.

4.6

Using Economic Information in Forecasting Asset
Class Returns
4.6.1) Cash and Equivalents

Cash includes short-term debt (e.g. commercial paper)
with maturity of less than or equal to one year.
• Given no change in overnight interest rates, longermaturity paper tends to pay higher interest rate than
shorter-maturity paper because of greater risk of loss
associated with their long-term maturity.
• When overnight interest rates are expected to
increase over time, then longer-maturity paper tends
to pay even higher rates than shorter-term paper.
Investment strategy during rising interest rate period:
During periods of rising short-term rates, an investment
strategy of buying shorter-maturity paper is preferred
because it is profitable to reduce the duration of bond
portfolio when the yield curve is upward sloping.
Investment strategy during declining interest rate period:
During periods of declining short-term rates, an
investment strategy of buying longer-maturity paper is
preferred because it is profitable to increase the
duration of bond portfolio when the yield curve is flat or
inverted.
Practice: Example 31,
Volume 3, Reading 16.
4.6.2) Nominal Default-Free Bonds
Nominal default-free bonds are conventional bonds with
zero or minimal default risk.

Reading 16

Capital Market Expectations

• Default-risk-free bonds have zero credit spread or
default risk premium.
• Relative value of default-risk-free bonds depends on
real yields and inflation i.e.
o If inflation is expected to increase rapidly
market
yields ↑ consequently, value of default-risk-free
bonds will fall below par value.
o When an economy is expected to grow strongly
demand for capital ↑ as well as inflation ↑ as a
result, bond yields rise (prices fall).
o Changes in short-term rates have uncertain effects
on bond yields:
Typically, as short-term rates increase
longerterm bond yields also increase (bonds price fall).
Sometimes, as short-term rates increase
economy slows down
as a result, longer-term
bond yields tend to fall (bonds price increase).
o When bond markets have confidence on the
ability of central banks to achieve inflation targets,
then changes in inflation tend to have no impact
on bond yields.
4.6.3) Defaultable Debt
Defaultable debt (mostly corporate debt) is debt with a

substantial amount of credit risk.
• Credit spreads on defaultable bonds tend to widen
during recessions because default rates tend to
increase when economic growth slows down and
business conditions weaken. As the credit spreads
increase
bond yields increase.
• Credit spreads on defaultable bonds tend to narrow
during expansions because when default rates tend
to decline there is strong economic growth and
strong business conditions. As the credit spreads
reduce
bond yields decrease.

FinQuiz.com

1) Economic Growth: When the economy is strong
(weak), real yields are high (low)
consequently, real
yields on inflation-indexed bonds will be higher
(lower).
2) Inflation expectations: Inflation-indexed bonds
provide hedge against inflation risk. Hence, the higher
(lower) the inflation and the more (less) volatile it is,
the greater (lower) the value of indexed bonds in
providing protection against inflation risk and
consequently, the lower (higher) the yields on
inflation-indexed bonds.
3) Supply of indexed bonds versus investors’ demand for
indexed bonds: When investors’ demand for indexed

bonds is greater (lower) than supply, yields on
inflation-indexed bonds are lower (higher). The real
yield is also affected by tax effects and the limited
size of the market.
4.6.6) Common Shares
4.6.6.1 Economic Factors Affecting Earnings
Over the long-run, the trend growth in aggregate
company earnings is positively correlated with the trend
rate of growth of the economy i.e. the higher (lower) the
growth of the economy, the greater (lower) the average
earnings growth because:
• During the early stages of an economy upswing
capacity utilization rises and employment
increases; however, the wages are still not higher
due to relatively high unemployment as a result,
profits are higher and earnings are strong. During
later stages of an economy upswing
wages start
to increase quickly
profits are reduced and
earnings growth slows down.
• During recessions
sales reduce, capacity utilization
is low
earnings are depressed.

4.6.4) Emerging Market Bonds
Emerging market debt is the sovereign debt of nondeveloped countries. Emerging market debt is
denominated in foreign currency; as a result, it tends to
have higher risk of default. The risk of emerging market

bonds is assessed in terms of their spread over domestic
Treasuries compared to similarly rated domestic
corporate debt.
4.6.5) Inflation-Indexed Bonds
Inflation-indexed bonds are bonds that pay a fixed
coupon (the real portion) plus an adjustment equal to
the change in consumer prices. For example, Treasury
Inflation-Protected Securities (TIPS) in the U.S. and IndexLinked Gilts (ILGs) in the U.K.
• Inflation-indexed bonds are perfectly risk-free assets
because they have no risk from unexpected
inflation.
• Nevertheless, the yield on inflation-indexed bonds is
not constant and change over time in response to
the following three economic factors:

Important to Note:
• Equity returns are positively affected by accelerating
economic growth, decreasing interest rates and
strong growth in consumer and business sector.
• Cyclical industries (with large fixed costs and a
pronounced sales cycle) tend to have higher
sensitivity to business cycles, e.g. car manufacturers
and chemical producers.
• The sales, earnings, and dividends of “Pro-cyclical”
industries tend to have large positive correlation with
GDP.
• When an industry’s earnings have higher correlation
with inflation and interest rates, it has a higher ability
to pass through to customers the increased costs of
higher inflation and interest rates.

• Export-oriented companies perform well when
domestic currency depreciates.
• Companies with higher (lower) earnings growth rate
during recessions tend to have higher (lower)
valuations.


Reading 16

Capital Market Expectations

Practice: Example 32 & 33,
Volume 3, Reading 16.
4.6.6.2 The P/E Ratio and the Business Cycle
The price-to-earnings ratio of a stock market reflects the
price that the market is willing to pay for the earnings of
that market.
• The P/E ratio tends to increase (decrease) when
earnings are expected to rise (fall).
• The P/E ratio tends to be high during the early stages
of an economic recovery.
• The P/E ratio tends to be high when interest rates are
low and fixed-rate investments (i.e. cash or bonds)
offer less attractive return.
• The P/E ratio tends to be low when inflation is high
because investors assign lower value to reported
earnings during inflationary periods. Hence, it is not
appropriate to compare current P/E with past
average P/E without controlling for the difference in
inflation rates.

Molodovsky Effect: P/Es of cyclical companies tend to
be high at the bottom of a business cycle (i.e. economic
downturns) due to expectations of rise in future earnings
when the economy recovers and tend to be low at the
top of a business cycle.
4.6.6.3 Emerging Market Equities
• Ex-post equity risk premiums for emerging markets,
on average, tend to be higher and more volatile
than those in developed markets.
• Ex-post, emerging market equity risk premiums in U.S.
dollar terms tend to have positive correlation with
business cycles in developed countries.
Transmission channels for G-7 macroeconomic
fluctuations to developing economies include trade (the
higher the growth in G-7 economies, the greater the
demand for the goods produced by emerging countries
i.e. natural resources), finance, and direct sectoral
linkages.
4.6.7) Real Estate
Systematic Determinants of Real estate returns include:
• Growth in consumption
• Real interest rates (that reflect construction financing
costs and the costs of mortgage financing):
Generally, lower interest rates imply lower
capitalization rates and consequently, net positive
return for real estate valuation.
• Term structure of interest rates
• Unexpected inflation

FinQuiz.com

4.6.8) Currencies
Exchange rate is affected through various channels i.e.
Trade: All else being constant, when imports of a country
increase (decrease), the domestic currency tends to
depreciate (appreciate).
Finance: Exchange rate is also affected by international
flows of capital resulting from foreign direct investment
as well as from investments in stocks, bonds, or short-term
instruments, including deposits.
• As domestic economic growth increases and new
industries are opened to foreign ownership, foreign
direct investment increases and consequently,
domestic currency appreciates. Capital inflows
associated with foreign direct investment are
considered to be more stable and less volatile
compared to capital inflows associated with
investments in stocks and bonds.
• As domestic interest rates increase, investments in
domestic bonds, short-term instruments, or deposits
increase
capital inflows increase
domestic
currency appreciates.
• However, domestic currency may depreciate rather
than appreciate when investors expect economic
slowdown due to higher interest rates.
4.6.9) Approaches to Forecasting Exchange Rates
There are four broad approaches to forecasting
exchange rates.

1) Purchasing Power Parity (PPP): According to PPP,
differences in inflation between two countries should
be reflected in the changes in the exchange rate
between them. That is, the currency of a country with
relatively higher (lower) inflation tends to depreciate
(appreciate) against the other currency.
For example, suppose that prices in Country A are
expected to increase by 4% over the next year while
prices in Country B are expected to rise by only 2%.
The inflation differential between the two countries is:
4% – 2% = 2%
• This implies that increase in prices in Country A is
greater than that of Country B. The PPP approach
forecasts that Country A’s currency will have to
depreciate by approximately 2% to keep prices
between countries relatively equal.
• If current exchange rate is 0.90 units of Currency A
per unit of Currency B, then under the PPP
approach, an exchange rate is forecasted to be =
(1 + 2%) × (0.90 A per B) = 0.918 units of Currency A
per 1 unit of Currency B.
PPP is more useful to forecast direction of exchange
rates in the long-run (≥ 5 years). It is not useful in the short
or even medium run (up to 3 years).

Practice: Example 34,
Volume 3, Reading 16.


Reading 16

Capital Market Expectations

2) Relative Economic Strength: According to relative
economic strength forecasting approach, strong
economic environment and favorable investment
climate attract investments from foreign investors (i.e.
investment flows) which in turn increases demand for
the domestic currency and consequently, domestic
currency appreciates in value.
• In addition, when domestic country has higher shortterm deposit rates (reflecting higher yield on
investments) demand for domestic currency
increases and consequently, domestic currency
appreciates in value.
• When domestic interest rates are low, it may induce
investors to avoid investing in a particular country or
even borrow that currency at low interest rates to
fund other investments (known as carry-trade).
Unlike PPP approach, the relative economic strength
approach does not predict about the level of exchange
rates; rather, it only helps to determine whether a
currency is going to appreciate or depreciate. This
approach can be used in conjunction with PPP
approach to develop a more complete forecast.
3) Capital Flows: The capital flows forecasting approach
is based on long-term capital flows i.e. equity
investments and foreign direct investment (FDI).
According to this approach, the greater the capital
inflows, the greater the demand for currency, and
consequently, the stronger the currency.

• When short-term rates are lower
economic growth
increases
stock markets perform well
long-term
investments become more attractive
demand for
currency increases and consequently, currency
appreciates.
Hence, central banks face a dilemma; to strengthen
depreciating currency, interest rates are required to
increase, but, higher interest rates may slow down the
economy, reducing the effectiveness of monetary
policy.
4) Savings-Investment Imbalances: The savingsinvestment imbalances forecasting approach is
based on imbalance between domestic savings and
investments. This approach is useful to determine
causes of long-term deviation of currencies from their
equilibrium values. According to this approach,

FinQuiz.com

When an economy grows rapidly but domestic
savings remain constant capital investments
(representing demand for savings) > supply of
domestic savings the investment must be financed
from foreign savings i.e. from capital inflows from
abroad or through increase in imports; in other words,
current account deficit (imports > exports) is needed.
And in order to increase imports or to attract and

keep the capital inflows needed to fund savings
deficit, the domestic currency must appreciate in
value (either as a result of higher interest rates or
through strong economic growth).
• Eventually, as the currency strengthens and
domestic investments fall
current account deficit
widens
and the domestic currency may start to
decline, leading to current account surplus.
NOTE:
Current account deficit of a country = Government
deficit + Private sector deficit.

Practice: Example 36,
Volume 3, Reading 16.

4.6.10) Government Intervention
It is difficult for governments to control exchange rates
via market intervention alone because of the following
three factors:
1) The total foreign exchange reserves of major central
banks combined is small compared to the total value
of foreign exchange trading (>US$1 trillion daily).
2) Exchange rates depend on various fundamental
factors besides government authorities.
3) It is difficult to control exchange rates without
imposing capital controls.

Practice: End of Chapter Practice

Problems for Reading 16 & FinQuiz
Item-set ID# 19084 &12513.