Title LM2 Capital Market Expectations, Part 2- Forecasting Asset Class Returns IFT Notes.pdf ✅

LM2 Capital Market Expectations, Part 2 2024 Level III Notes © IFT. All rights reserved 1 LM2 Capital Market Expectations, Part 2 Forecasting Asset Class Returns 1. Introduction....................................................................................................... .............................3 2. Overview of Tools and Approaches...............................................................................................3 The Nature of the Problem............................................................................................................3 Approaches to Forecasting...........................................................................................................3 3. Forecasting Fixed-Income Returns...............................................................................................4 Applying DCF to Fixed Income.....................................................................................................4 The Building Block Approach to Fixed-Income Returns............................................................5 4. Risks in Emerging Market Bonds .................................................................................................7 Economic Risks/Ability to Pay........................................................................ ............................7 Political and Legal Risks/Willingness to Pay..................................................... .........................7 5. Forecasting Equity Returns................................................................................. ..........................8 Historical Statistics Approach to Equity Returns.............................................. .........................8 DCF Approach to Equity Returns.................................................................................................9 Risk Premium Approaches to Equity Returns.........................................................................10 Risks in Emerging Market Equities...................... .....................................................................12 6. Forecasting Real Estate Returns................................................................................................13 Historical Real Estate Returns...................................................................................................13 Real Estate Cycles ..................... .................................................................................................13 Capitalization Rates ...................................................................................................................13 The Risk Premium Perspective on Real Estate Expected Return ..........................................14 Real Estate in Equilibrium...................... ...................................................................................15 Public vs. Private Real Estate ....................................................................................................15 Long-Term Housing Returns.....................................................................................................15 7. Forecasting Exchange Rates.......................................................................................................16 Focus on Goods and Services, Trade, and the Current Account .............................................16 Focus on Capital Flows ..............................................................................................................17 8. Forecasting Volatility ..................................................................................................................19 Estimating a Constant VCV Matrix with Sample Statistics ...................................................19


LM2 Capital Market Expectations, Part 2 2024 Level III Notes © IFT. All rights reserved 4 o The second approach, shrinkage estimation, involves taking a weighted average of two estimates, one based on historical sample data and the other based on the analyst’s knowledge and judgment. This approach helps reduce the forecast error of the first approach. o The third approach, time-series estimation, involves forecasting a variable based on lagged values of the variable being forecasted. • Discounted cash flow models: These models are based on the idea that an asset’s value is equal to the present value of its expected cash flows. Given the asset’s current market price and future cash flows, these models can also be used to estimate the implied required rate of return. • Risk premium models: These models start with the risk-free rate and add one or more premiums to compensate investors for the additional risks of investing in the asset. Common risk premium models: (1) an equilibrium model, such as the CAPM, (2) a factor model, and (3) building blocks. 3. Forecasting Fixed-Income Returns Applying DCF to Fixed Income Fixed income securities have finite maturities and reasonably well-defined cash flows. Therefore, DCF is the most precise method of forecasting fixed income returns. Yield to maturity (YTM) is the discount rate that equates the present value of a bond’s cash flows to its current market price. It is the most commonly quoted metric of expected returns for bonds and is a reasonably good approximation of the actual returns that an investor will eventually realize. However, the realized rate of return may not be equal to the initial YTM for two reasons: 1. If the investment horizon is shorter than the bond’s maturity, a change in YTM will generate a capital gain/loss. 2. The cash flows from the bond may be invested at rates above or below the initial YTM. The investment horizon is compared with a bond’s Macaulay duration to evaluate which impact will dominate. (Macaulay duration = Modified duration x (1+r)) • Over horizons shorter than the Macaulay duration, capital gain/loss impact will dominate • Over horizons longer than the Macaulay duration, reinvestment impact will dominate. Example: Forecasting Return Based on Yield to Maturity (This is based on Example 1 from the curriculum.) A fixed income portfolio has a YTM of 1% and a modified duration of 4.84. Bond yields are expected to rise by 200 bps over the next two years. Compared to the initial YTM, what