Source: [Capital Market Expectation, Part 2: Forecasting Asset Class Returns - Christopher D. Piros]
1. A central theme is that disciplied approach to setting expectations will be rewarded
2. Forecasting returns is not simply a matter of estimating constant, but unknown parameters - for example, expected returns, variances and correlations. Time horizons matter.
2. Virtually all forecasting techniques rely on notions of central tendency, toward which opportunites tend to revert over time. This fact means although asset prices, risk premiums, volatilities, valuation ratios and other metrics may exhibit momentum, peresistence and clustering in the short run, over sufficiently long horizons, they tend to converge to levels consistent with economic and financial fundamentals.
3. In principle, we are interested in the whole probability distribution of future returns
4. Formal forecasting tools most commonly used in forecasting captial market retung fall into three broad categories - statistical methods, discounted cash flow models and risk premium models
5. DCF models express the idea that an sssets value is the present value of its expected cash flows.
6. Risk premium approach expresses the expected return on a risky asset as the sum of risk-free of interest and one or more risk premiums that compensate investors for the asset's exposure to sources of priced risk (risk for which investors demand compensation)
7. Three methods for modelling risk premium - an equilibrium model, such as CAPM, a factor model and building blocks
Other indicators that also influence the term permium
Forecasting Fixed-Income Returns
1. There are four main rivers of term premium for nominal bonds
a. Level-dependent inflation uncertanity
b. Ability to hedge recession risk
c. Supply and demand
d. Cyclical effects
2. The Cochrane and Piazzesi curve factor is a composite measure capturing both the slope and the curvature of the yield curve
Forecasting Equity Returns
1. Central focus of setting CME - forecasting equity market returns
2. In the very long-run assumptions that are consistent with economically plausible relationships are
3. The Grinold-Kroner model and similar models are sometimes said to reflect the "supply" of equity returns since they outline the sources of return. In contrast, risk premium reflect "demand" for returns
4. The term "equity premium" is most frequently used to describe the amount by which the expected return on equities exceeds the riskless rate ("equity vs bills")
5. Singer-Terhaar Model
- The Singer-Tehaar model is actually a combination of two underlying CAPM models. The first assumes that all global markets and asset classes are fully integrated. The second assumes complete segmentation of markets such that each asset class in each country is priced without regard to any other country/asset class
- Virtually all equilibrium models implicitly assume prefectly liquid markets. Thus, the analyst should assess the actual liquidity of each asset class and appropriate liquidity premiums
- Highly integrated markets are likely to be relatively liquid, and illiquidity is one reason that a market may remain segmented
Forecasting Real Estate Returnns
- Real estate is a major factor of production in the economy
- Estimated that residential real estate accounts for 75% of the total valude of developed properties globally
Forecasting Foreign Exchange Rates
Time-Varying Volatility - ARCH Models
- A class of models know collectively as autoregressive conditional hetroskedasticity (ARCH) models has been developed to address time-varying volatilities.
- The key idea is to model variance as a liner time-series process in which the current volatility depends on its own recent history or recent shocks, The shocks to volatility arise from unexpectedly large or small returns.
- In one of the simplest ARCH models, the current variance depends only onthe variance in the previous period and the unexpected component of the current return.
Adjusting a Global Portfolo