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CFA EXAM REVIEW

W IL E Y
Wiley Study Guide for 2018
Level III CFA Exam Review

Complete Set
Thousands of candidates from more than 100 countries have relied on these Study Guides
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Wiley Study Guide for 2018
Level III CFA Exam Review

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Contents

About the Authors xi

Wiley Study Guide for 2018 Level III CFA Exam

Volume 1: Ethical and Professional Standards & Behavioral Finance

Study Session 1: Code of Ethics and Standards of Professional Conduct

Reading 1: Code of Ethics and Standards of Professional Conduct 3
Lesson 1: Code of Ethics and Standards of Professional Conduct 3
Reading 2: Guidance for Standards l-VII 9
Lesson 1: Standard I: Professionalism 9
Lesson 2: Standard II: Integrity of Capital Markets 36
Lesson 3: Standard III: Duties to Clients 46
Lesson 4: Standard IV: Duties to Employers 70
Lesson 5: Standard V: Investment Analysis, Recommendations, and Actions 84
Lesson 6: Standard VI: Conflicts of Interest 97
Lesson 7: Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate 107

Study Session 2: Ethical and Professional Standards in Practice

Reading 3: Application of the Code and Standards 119
Lesson 1: Ethical and Professional Standards in Practice, Part 1: The Consultant 119
Lesson 2: Ethical and Professional Standards in Practice, Part 2: Pearl Investment
Management 120
Reading 4: Asset Manager Code of Professional Conduct 121
Lesson 1: Asset Manager Code of Professional Conduct 121

Study Session 3: Behavioral Finance

Reading 5: The Behavioral Finance Perspective 131
Lesson 1: Behavioral versus Traditional Perspectives 131
Lesson 2: Decision Making 136
Lesson 3: Perspectives on Market Behavior and Portfolio Construction 140
Reading 6: The Behavioral Biases of Individuals 147
Lesson 1: Cognitive Biases 148
Lesson 2: Emotional Biases 154
Lesson 3: Investment Policy and Asset Allocation 159

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CONTENTS

Reading 7: Behavioral Finance and Investment Processes 165

Lesson 1:The Uses and Limitations of Classifying Investors into Types 165
Lesson 2: How Behavioral Factors Affect Advisor-Client Relations 168
Lesson 3: How Behavioral Factors Affect Portfolio Construction 169
Lesson 4: Behavioral Finance and Analyst Forecasts 172
Lesson 5: How Behavioral Factors Affect Committee Decision Making 178
Lesson 6: How Behavioral Finance Influences Market Behavior 179

Wiley Study Guide for 2018 Level III CFA Exam

Volume 2: Private Wealth Management & Institutional Investors

Study Session 4: Private Wealth Management (1)

Reading 8: Managing Individual Investor Portfolios 3
Lesson 1: Investor Characteristics: Situational and Psychological Profiling 3
Lesson 2: Individual IPS: Return Objective Calculation 6
Lesson 3: Individual IPS: Risk Objective 7
Lesson 4: Individual IPS: The Five Constraints 8
Lesson 5: A Complete Individual IPS 10
Lesson 6: Asset Allocation Concepts: The Process of Elimination 18
Lesson 7: Monte Carlo Simulation and Personal Retirement Planning 20
Reading 9: Taxes and Private Wealth Management in a Global Context 21
Lesson 1: Overview of Global Income Tax Structures 21
Lesson 2: After-Tax Accumulations and Returns forTaxable Accounts 23
Lesson 3: Types of Investment Accounts and Taxes and Investment Risk 31
Lesson 4: Implications for Wealth Management 34
Reading 10: Domestic Estate Planning: Some Basic Concepts 39
Lesson 1: Basic Estate Planning Concepts 39
Lesson 2: Core Capital and Excess Capital 42
Lesson 3: Transferring Excess Capital 46
Lesson 4: Estate Planning Tools 51
Lesson 5: Cross-Border Estate Planning 53

Study Session 5: Private Wealth Management (2)

Reading 11: Concentrated Single-Asset Positions 59
Lesson 1: Concentrated Single-Asset Positions: Overview and Investment Risks 59
Lesson 2: General Principles of Managing Concentrated Single-Asset Positions 60
Lesson 3: Managing the Risk of Concentrated Single-Stock Positions 66
Lesson 4: Managing the Risk of Private Business Equity 71
Lesson 5: Managing the Risk of Investment in Real Estate 74
Reading 12: Risk Management for Individuals 77
Lesson 1: Human Capital and Financial Capital 77
Lesson 2: Seven Financial Stages of Life 78
Lesson 3: A Framework for Individual Risk Management 80
Lesson 4: Life Insurance 83
Lesson 5: Other Types of Insurance 88
Lesson 6: Annuities 91
Lesson 7: Implementation of Risk Management for Individuals 95

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 CONTENTS

Study Session 6: Portfilio Management for Institutional Investors

Reading 13: Managing Institutional Investor Portfolios 103
Lesson 1: Institutional IPS: Defined Benefit (DB) Pension Plans 103
Lesson 2: Institutional IPS: Foundations 111
Lesson 3: Institutional IPS: Endowments 115
Lesson 4: Institutional IPS: Life Insurance and 117
Non-Life Insurance Companies (Property and Casualty)
Lesson 5: Institutional IPS: Banks 120

Wiley Study Guide for 2018 Level III CFA Exam

Volume 3: Economic Analysis, Asset Allocation, Equity & Fixed Income Portfolio Management

Study Session 7: Applications of Economic Analysis to Portfolio Management

Reading 14: Capital Market Expectations 3
Lesson 1: Organizing the Task: Framework and Challenges 3
Lesson 2: Tools for Formulating Capital Market Expectations,Part 1: Formal Tools 8
Lesson 3: Tools for Formulating Capital Market Expectations,Part 2: Survey and
Panel Methods and Judgment 13
Lesson 4: Economic Analysis, Part 1: Introduction and Business Cycle Analysis 19
Lesson 5: Economic Analysis, Part 2: Economic Growth Trends, Exogenous Shocks, and
International Interactions 27
Lesson 6: Economic Analysis, Part 3: Economic Forecasting 30
Lesson 7: Economic Analysis, Part 4: Asset Class Returns andForeign Exchange Forecasting 33
Reading 15: Equity Market Valuation 39
Lesson 1: Estimating a Justified P/E Ratio and Top-Down and Bottom-Up Forecasting 39
Lesson 2: Relative Value Models 46

Study Session 8: Asset Allocation and Related Decisions in Portfolio Management (1)
Reading 16: Introduction to Asset Allocation 53
Lesson 1: Asset Allocation in the Portfolio Construction Process 53
Lesson 2: The Economic Balance Sheet and Asset Allocation 54
Lesson 3: Approaches to Asset Allocation 55
Lesson 4: Strategic Asset Allocation 57
Lesson 5: Implementation Choices 64
Lesson 6: Strategic Considerations for Rebalancing 65
Reading 17: Principles of Asset Allocation 67
Lesson 1: The Traditional Mean-Variance Optimization (MVO) Approach 67
Lesson 2: Monte Carlo Simulation and Risk Budgeting 70
Lesson 3: Factor-Based Asset Allocation 71
Lesson 4: Liability-Relative Asset Allocation 72
Lesson 5: Goal-Based Asset Allocation, Heuristics, Other Approaches to Asset Allocation,
and Portfolio Rebalancing 75

Study Session 9: Asset Allocation and Related Decisions in Portfolio Management (2)
Reading 18: Asset Allocation with Real-World Constraints 81
Lesson 1: Constraints in Asset Allocation 81
Lesson 2: Asset Allocation for the Taxable Investor 84

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CONTENTS

Lesson 3: Altering or Deviating from the Policy Portfolio 85

Lesson 4: Behavioral Biases in Asset Allocation 87
Reading 19: Currency Management: An Introduction 89
Lesson 1: Review of Foreign Exchange Concepts 89
Lesson 2: Currency Risk and Portfolio Return and Risk 95
Lesson 3: Currency Management: Strategic Decisions 98
Lesson 4: Currency Management: Tactical Decisions 101
Lesson 5: Tools of Currency Management 104
Lesson 6: Currency Management for Emerging Market Currencies 112
Reading 20: Market Indexes and Benchmarks 113
Lesson 1: Distinguishing between a Benchmark and a Market Index and
Benchmark Uses and Types 113
Lesson 2: Market Index Uses and Types 117
Lesson 3: Index Weighting Schemes: Advantages and Disadvantages 119

Study Session 10: Fixed-Income Portfolio Management (1)

Reading 21: Introduction to Fixed-Income Portfolio Management 127
Lesson 1: Roles of Fixed Income Securities in Portfolios 127
Lesson 2: Fixed Income Mandates 129
Lesson 3: Bond Market Liquidity 133
Lesson 4: Components of Fixed Income Return 135
Lesson 5: Leverage 137
Lesson 6: Fixed Income Portfolio Taxation 140
Reading 22: Liability-Driven and Index-Based Strategies 143
Lesson 1: Liability-driven Investing 143
Lesson 2: Managing Single and Multiple Liabilities 144
Lesson 3: Risks in Managing a Liability Structure 147
Lesson 4: Liability Bond Indexes 148
Lesson 5: Alternative Passive Bond Investing 148
Lesson 6: Liability Benchmarks 149
Lesson 7: Laddered Bond Portfolios 149

Study Session 11: Fixed-Income Portfolio Management (2)

Reading 23: Yield Curve Strategies 153
Lesson 1: Foundational Concepts for Yield Curve Management 153
Lesson 2: Yield Curve Strategies 155
Lesson 3: Formulating a Portfolio Postioning Strategy for a Given Market View 161
Lesson 4: A Framework for Evaluating Yield Curve Trades 167
Reading 24: Fixed-Income Active Management: Credit Strategies 169
Lesson 1: Investment-Grade and High-Yield Corporate Bond Portfolios 169
Lesson 2: Credit Spreads 172
Lesson 3: Credit Strategy Approaches 175
Lesson 4: Liquidity Risk and Tail Risk in Credit Portfolios 185
Lesson 5: International Credit Portfolios 189
Lesson 6: Structured Financial Instruments 191

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 CONTENTS

Study Session 12: Equity Portfolio Management

Reading 25: Equity Portfolio Management 197
Lesson 1:The Role of the Equity Portfoli and Approaches to Equity Investing 197
Lesson 2: Passive Equity Investing 198
Lesson 3: Active Equity Investing 204
Lesson 4: Semiactive Equity Investing 215
Lesson 5: Managing a Portfolio of Managers 218
Lesson 6: Identifying, Selecting, and Contracting with Equity Portfolio Managers 222
Lesson 7: Distressed Securities 223

Wiley Study Guide for 2018 Level III CFA Exam

Volume 4: Alternative Investments, Risk Management, & Derivatives

Study Session 13: Alternative Investments for Portfolio Management

Reading 26: Alternative Investments for Portfolio Management 3
Lesson 1: Alternative Investments: Definitions, Similarities, and Contrasts 3
Lesson 2: Real Estate 5
Lesson 3: Private Equity/Venture Capital 9
Lesson 4: Commodity Investments 16
Lesson 5: Hedge Funds 21
Lesson 6: Managed Futures 30
Lesson 7: Distressed Securities 32

Study Session 14: Risk Management

Reading 27: Risk Management 39
Lesson 1: Risk Management as a Process and Risk Governance 39
Lesson 2: Identifying Risk 40
Lesson 3: Measuring Risk: Value at Risk (VaR) 44
Lesson 4: Measuring Risk: VaR Extensions and Stress Testing 52
Lesson 5: Measuring Risk: Credit Risk 53
Lesson 6: Managing Risk 60

Study Session 15: Risk Management Applications of Derivatives

Reading 28: Risk Management Applications of Forward and Futures Strategies 65
Lesson 1: Strategies and Applications for Managing Equity Market Risk 65
Lesson 2: Asset Allocation with Futures 74
Lesson 3: Strategies and Applications for Managing Foreign Currency Risk 83
Reading 29: Risk Management Applications of Option Strategies 89
Lesson 1: Options Strategies for Equity Portfolios 89
Lesson 2: Interest Rate Option Strategies 103
Lesson 3: Option Portfolio Risk Management Strategies 116
Reading 30: Risk Management Applications of Swap Strategies 121
Lesson 1: Strategies and Applications for Managing Interest Rate Risk 121
Lesson 2: Strategies and Applications for Managing Exchange Rate Risk 137
Lesson 3: Strategies and Applications for Managing Equity Market Risk 148
Lesson 4: Strategies and Applications Using Swaptions 153

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CONTENTS

Wiley Study Guide for 2018 Level III CFA Exam

Volume 5: Trading, Monitoring and Rebalancing, Performance Evaluation,
& Global Investment Performance Standards

Study Session 16: Trading, Monitoring, and Rebalancing

Reading 31: Execution of Portfolio Decisions 3
Lesson 1: The Context of Trading: Market Microstructure 3
Lesson 2: The Costs of Trading 10
Lesson 3:Types ofTraders and Their Preferred OrderTypes 15
Lesson 4: Trade Execution Decisions and Tactics and Serving the Client's Interests 17
Reading 32: Monitoring and Rebalancing 25
Lesson 1: Monitoring for IPS Changes (Individual and Institutional) 25
Lesson 2: Rebalancing the Portfolio 32
Lesson 3: The Perold-Sharpe Analysis of Rebalancing Strategies 35

Study Session 17: Performance Evaluation

Reading 33: Evaluating Portfolio Performance 41
Lesson 1: Performance Measurement 41
Lesson 2: Benchmarks 49
Lesson 3: Performance Attribution (4 Models) 55
Lesson 4: Performance Appraisal 66
Lesson 5: The Practice of Performance Evaluation 71

Study Session 18: Global Investment Performance Standards

Reading 34: Overview of the Global Investment Performance Standards 75
Lesson 1: Background of the GIPS Standards 75
Lesson 2: Fundamentals of Compliance 76
Lesson 3: Input Data 78
Lesson 4: Return Calculation Methodologies 79
Lesson 5: Composite Construction Lesson 85
Lesson 6: Disclosure, Presentation, and Reporting 89
Lesson 7: Real Estate, Private Equity, and Wrap Fee/Separately Managed Accounts 96
Lesson 8: Valuation Principles and Advertising Guidelines 102
Lesson 9: Verification and Other Issues 104

2018 Wiley
ABOUTTHE AUTHORS

Wileys Study Guides are written by a team of highly qualified CFA charterholders
and leading CFA instructors from around the globe. Our team of CFA experts work
collaboratively to produce the best study materials for CFA candidates available today.

Wileys expert team of contributing authors and instmctors is led by Content Director Basit
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CFA candidates need for better study materials. As lead writer, lecturer, and curriculum
developer, Basits unique ability to break down complex topics helped the company grow
organically to be a leading global provider of CFA Exam prep materials. In January 2014,
Elan Guides was acquired by John Wiley & Sons, Inc., where Basit continues his work
as Director of CFA Content. Basit graduated magna cum laude from the Wharton School
of Business at the University of Pennsylvania with majors in finance and legal studies.
He went on to obtain his CFA charter in 2006, passing all three levels on the first attempt.
Prior to Elan Guides, Basit ran his own private wealth management business. He is a past
president of the Pakistani CFA Society.

There are many more expert CFA charterholders who contribute to the creation of
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To learn more about Wileys team of subject matter experts, please visit:
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 St u d y S essio n 7: A ppl ic a t io n s o f E c o n o mic
A n a l y sis t o Po r t f o l io M a n a g emen t

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 CAPITAL MARKET EXPECTATIONS

R e a d i n g 1 4 : Ca p i t al Ma r ket Ex pe c t a t io n s

Time to complete: 2 to 3 hours

Reading summary: This is one of the longest readings in the entire CFA Curriculum at
Level III, so plan your time accordingly. The focus of the first portion of the reading is
on formal tools to determine long-term expectations, mainly for returns. Then, short- and
long-term economic growth forecasting and analysis are explored. The reading then
examines how various asset classes perform at different stages of the business and inflation
cycles.

LESSON 1: ORGANIZING THE TASK: FRAMEWORK AND CHALLENGES

LOS I4a: Discuss the role of, and a framework for, capital market
expectations in the portfolio management process. Vol 3, pp 6-13

LEARNING OBJECTIVES

The portfolio management process begins with understanding the clients objectives and
constraints, which are documented in the investment policy statement (IPS). This client-
specific information is then combined with the portfolio managers expectations about the
long-term performance of asset classes to establish a unique strategic asset allocation. But
how do managers form their capital market expectations? That is the question addressed by
this reading.

After studying this material, the candidate should be able to:

1. Explain how capital market expectations fit within the portfolio management
process;
2. Describe analytical tools and models used to develop capital market expectations;
3. Discuss the implications of the business cycle and economic policy for capital
market expectations;
4. Explain how macroeconomic variables like inflation, interest rates, and exchange
rates are forecast and how they influence capital market expectations.

A SYSTEMATIC APPROACH

The strategic asset allocation represents the base case, or normal state, partitioning of a
portfolio among the various asset classes available in the investment universe. Each asset
class (e.g., stocks, bonds, real estate, etc.) has unique risk and return characteristics that
respond to changing economic conditions. So in order to ascertain which asset classes
belong in a particular investors portfolio and in what proportion, the manager must have
some idea of what the prevailing economic environment might look like and how asset
classes might react under those conditions. These insights are collectively referred to as the
managers capital market expectations.

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CAPITAL MARKET EXPECTATIONS

Given the vast amount of data available to asset managers, developing capital market
expectations is best implemented using a systematic approach. In a general framework, the
manager must address each of the following functions:

Data collection, analysis, and interpretation of output.

Deriving conclusions that lead to forecasts of expected returns, risk, and
correlations.
Monitoring, evaluating performance, and adjusting the process to improve future
performance.

The process of setting capital market expectations is usually considered beta research,
which emphasizes systematic risk of broad asset classes (e.g., equities, fixed income, and
real estate). The research takes a macroeconomic perspective that uses the same inputs
(e.g., interest rates, inflation, GDP growth, etc.) to develop expectations that are used to
design a strategic asset allocation. Alpha research is an investment-specific approach
that seeks to earn excess risk-adjusted returns, which is more closely related to security
selection.

Steps in Formulating Capital Market Expectations

Step 1: Specify the final objectives o f the process and the relevant time period. The purpose
of this step is to limit the scope of the research. With so much information available, the
manager cannot consider everything under the sun. For example, if the clients IPS limits
acceptable asset classes to only domestic stocks and bonds, there is no need to research
emerging-market real estate or commodity futures. Managers often complete this step by
drafting a set of questions to be answered, which helps to focus their efforts.

Step 2: Review past performance and conditions. While the past is not necessarily
indicative of the future, it is a logical place to start, with the understanding that relation
that held in the past are susceptible to change.

Step 3: Define methods and models. Establishing the methodology early in the process will
help determine what data is required.

Step 4: Collect data. When considering data sources, the manager must evaluate their
timeliness, accuracy, and reliability.

Step 5: Apply analytical techniques, models, and judgment to interpret results. Particular
attention should be paid to the assumptions underlying models, the consistency with which
data is used, and any conflicts that might challenge the plausibility of output.

Step 6: Draw conclusions. Here the manager determines and documents his or her
expectations that will be used in establishing the portfolios strategic asset allocation.

Step 7: Evaluate results and adjust. Actual results are compared to previous expectations
to assess the level of accuracy that the expectations-setting process is delivering. Good
forecasts are:

Unbiased, objective, and well researched;

Efficient, minimizing the magnitude of forecast errors; and
Internally consistent.

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 CAPITAL MARKET EXPECTATIONS

LOS 14b: Discuss challenges in developing capital market forecasts.

Vol 3, pp 13-23

Forecasting Challenges

Faulty analysis may create a portfolio that is inappropriate for the client. The analysis
might be compromised by unrealistic assumptions, unreliable data, or analyst biases.

Data Limitations

Economic data is notorious for problems related to timeliness (released with a lag), so
youre always looking backward to make forward-looking projections. It can also be error-
prone, requiring revision of previously released data. Finally, changes in the way the data
is collected or compiled can make past reporting incompatible with future releases.

Errors and Biases

Simple mistakes during the data gathering and compiling process can show up as
transcription errors. Elements that drop out of data sets over time, as a result of mergers
or bankruptcies for instance, make comparing indexes difficult across periods difficult
and can give an overly optimistic impression. This phenomenon is called survivorship
bias. Finally, valuation of illiquid assets is often done using appraisals. Because they are
somewhat subjective and are usually performed at wider intervals, rather than continuous
pricing found in high-volume trading, appraisals tend to underestimate volatility and
distort correlations between asset returns.

Historical Data

While historical data might be a good starting point in developing a forecast, simply
extrapolating the past into the future is a naive approach. The relation between variables
that held in the past are often subject to the conditions that prevailed at the time, such
as central bank policies and available technology. These underlying conditions are often
referred to as regimes. Regime changes create inconsistencies in the way variables interact
from one period to another. This creates a non-stationarity problem where the mean,
variance, and correlations of variables are unstable over time.

Analysts can also run into the problem of not having a long enough history of data to
work with. If this is the case, simply looking at time series drawn at greater frequency to
increase the number of observations is not usually an effective solution.

Ex Post Risk versus Ex Ante Measures

Ex post risk is backward-looking and may underestimate the perceived ex ante risk. In
other words, backward-looking risk metrics will not reflect possible events that were a
concern at the time but did not ultimately come to pass. Those concerns would be reflected
only in forward-looking (ex ante) risk metrics.

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CAPITAL MARKET EXPECTATIONS

Analysts Biases

Analytical biases lead to the finding of relations that dont really exist. So-called spurious
correlations are often the result of data-mining or time-period bias.

D ata-m ining bias occurs when a data set is analyzed over and over again until some
statistically significant relation is found. Analysts should always have some underlying
economic rationale for including a variable in a model so as to avoid including spurious
correlations that lead to faulty forecasts.

Time-period bias occurs when the analyst shifts time horizons in order to find the best
fit with the conclusions he or she is seeking. The relation between variables might be
significant for a particular time interval, but they do not hold outside that period. Testing
models with out-of-sample data is a good way to avoid this bias.

Ignoring Conditioning Information

Conditioning is adjusting our expectations when there are new facts that are relevant to
forecasting the future. Measurements of risk and return are often based on historical data.
However, an analyst should also consider the current and expected market environment.
Forecasts should be based on conditional information and not simply unconditional
averages of the past.

Correlation Is Not Causation

Just because two variables are correlated does not necessarily mean that one causes the
other to occur. Correlation can indicate one of three possibilities: A predicts B, B predicts
A, or C predicts A and B. Looking solely at the correlation between A and B could be very
misleading. Therefore, it is important to have a theoretical justification for the expected
relation between variables.

It is also possible to reach a false negative conclusion by blindly relying on correlations.

Recall that correlation measures the linear relation between two variables. However, it is
possible that they are related to one another in a nonlinear way. Their linear correlation
may be insignificant, but the relation between the two variables might still have predictive
power.

Psychological Biases
These six biases
affect economists Psychological traps are common mental biases that jeopardize the accuracy of forecasts.
and professional
forecasters, and
some might be A nchoring occurs when initial findings dominate the rest of the analysis. Analysts must
familiar from the keep an open mind and allow the entirety of the research to lead to their conclusions.
lessons related to
behavioral finance
(BF). Keep in mind
that this part of the
Status quo bias projects the recent past into the future. Regret avoidance might drive this
CFA Curriculum bias as analysts are loath to look foolish by predicting a major departure from what has
was written many
years before the prevailed in the past. Rigorous analysis can provide confidence to pursue an objective
BF readings. If forecast even if it seems out of the ordinary.
you are tested on
these specific six
biases, the question
will relate to an
The confirm ing evidence trap is the tendency to emphasize information that supports
economist instead ones initial hypothesis and discount evidence to the contrary. Maintaining self-awareness,
of an individual
investor. investigating contradictory evidence, and designating a person to play the devils advocate
are approaches to combating this form of bias.

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 CAPITAL MARKET EXPECTATIONS

Overconfidence bias is common among highly trained and specially skilled individuals
who tend to overestimate the precision of their forecasts. Analysts should consider a wider
range of possible outcomes as a means to avoid this trap.

Prudence trap is the temptation to moderate conclusions so as to appear more

conventional than the research itself indicates. Unorthodox forecasts that are far outside
consensus opinion can prove brilliant if they turn out to be accurate but humiliating if
they fail to materialize. Analysts can defend against this bias with rigorous research and
allowing for a wider range of possible outcomes.

Recallability bias occurs when the research is heavily influenced by events that have left
a lasting impression on the analyst, particularly catastrophic or dramatic events such as a
market crash. Grounding conclusions on objective data rather than on personal emotion
minimizes the distortion and addresses this trap.

Example 1-1

Amy Cobourg is the fund manager of a small emerging market fund that invests in both
large-cap and mid-cap stocks. Cobourg has seen large gains in her personal portfolio
from investments in Poland and is keen to take advantage of her knowledge of the region.

Currently, 25 percent of the portfolio is invested in the mining industry in Poland, which
saw great returns the previous year due to a global boom in commodity prices. Cobourg
is forecasting an average 12 percent (10 bps) return on investment for commodity
stocks for the coming year.

Cobourg recently read an article from a highly regarded mining industry analyst who
specializes in Polish companies. The article suggests doubt and concern for the three
largest businesses in the sector due to the authors forecast of economic recession and
lower prices. Cobourgs supervisor, John Curran, disagrees with the report and says
that the three companies are in a good position to handle a downturn, which he believes
will profit by a reduction in the supply of gold from South Africa due to a miners strike
there.

Cobourg revises her forecast to an expected return of 11 percent, only slightly lower
than her existing 12 percent expectation, believing that Poland will gain extra market
share at South Africas expense.

Identify three psychological traps in forecasting, justifying your answer with one reason
for each trap identified.

Solution:

OverconfidenceOverestimating own knowledge of Polish stocks based on her own

portfolio. Possibly used too narrow of range (10 bps) for her forecast.

Anchoring trapCobourg only slightly revised expectations to 11% from 12% despite
the negative outlook in the article.

Confirming evidence trapIgnores the negative outlook in the article but agrees with
the effect of potential profit from Polands gain in market share at South Africas
expense.

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CAPITAL MARKET EXPECTATIONS

Model Risk

Financial and economic models are abstract representations of markets. They try to
uncover the factors that influence the behavior of the variable being forecast. However,
as abstract representations, they are incomplete, providing only estimates of dependent
variables.

A model used to forecast economic variables or asset returns has two sources of error. First
is the accuracy of the model inputs. Data is often imperfect, or model inputs themselves
must be estimated from other models. The second source of error is the model itself. To the
extent that the abstract representation departs from reality, the models forecast will also
deviate from the dependent variables actual value.

LESSON 2: TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS,

PART 1: FORMAL TOOLS

LOS 14c: Demonstrate the application of formal tools for setting capital
market expectations, including statistical tools, discounted cash flow
models, the risk premium approach, and financial equilibrium models.
Vol 3, pp 23^40

ANALYTICAL METHODS AND TOOLS

Financial theory and practice provide a variety of tools and techniques for analysis and
forecasting asset returns. Like more menial tasks, the analyst must select the right tool for
the right job. In this section, we consider formal tools, which include statistical models,
discounted cash flow models, and other quantitative techniques. We also consider survey
and consensus approaches.

Quantitative Tools: Statistical Methods

Recall that there are two types of statistics: descriptive and inferential. Descriptive
statistics seek to organize and present data in meaningful ways. Inferential statistics
attempt to estimate or predict the characteristics of a population by looking at smaller
samples.

Historical Averages and Estimators

The simplest forecast looks solely at past data. An analyst can compute the average return
and variance of a sampled time series over a specific period. If the distribution of the data
is stable, the sample statistics might be good estimates of their future values. There are,
however, different methods of computing an average. In finance, the most commonly used
methods are the arithmetic average, which is best for an estimate at a single point in time,
and the geometric average, which is best for averaging compound returns over time.

Shrinkage Estimation

Shrinkage estimation is the weighted average of two estimates of a parameter based on the
relative confidence the analyst has in using two methods. For example, an analyst might
use sample historical data to estimate a covariance matrix and an alternative method such
as a factor model to estimate a second covariance matrix, called a target covariance matrix.

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 CAPITAL MARKET EXPECTATIONS

Lets consider that the estimated covariance between stocks and bonds is 24 using a factor
model and 40 using a historical estimate, and assume that the optimal weights on the
model and historical estimates are 0.80 and 0.20, respectively. The shrinkage estimate of
the covariance would be 0.80(24) + 0.20(40) = 27.2.

In all cases, a shrinkage estimate using any target covariance matrix is a more efficient (or
at least not less efficient) estimate than the historical average.

Example 2-1

Richard Ayoade is using a shrinkage estimator approach to estimating covariances

between Mexican and Colombian equities. He estimates that the covariance between
Mexican and Colombian equities is 76 using historical data. He also estimates the
covariance as 64 using a factor model approach.

A. Determine the shrinkage estimate of the covariance between Mexican and

Colombian equities if the analyst has 80 percent confidence in the factor model
approach.

B. Contrast the quality of the shrinkage estimate of covariance versus the

historical average alone.

Solutions:

A. 0.20(76) + 0.80(64) = 66.4

B. The shrinkage estimator approach will lead to an increase in the efficiency of

the covariance estimates versus the historical estimate.

We can also determine a shrinkage estimate for mean returns by taking a weighted average
of historical mean return and some other target estimate, like the average mean of a group
of assets. For example, given five assets with sample mean returns of 7 percent, 11 percent,
13 percent, 15 percent, and 19 percent, respectively, and a weight of 70 percent on the
sample mean, we would calculate the grand mean return as 13 percent and the shrinkage
estimate of the first assets return as 0.3(9%) + 0.7(13%) = 11.2%.

Time-Series Analysis

Time-series estimators are based on regression using lagged variables, which are past
values of the dependent variable. For example, a model used to determine the short-term
volatility in a variety of asset markets was developed at JPMorgan. The model shows that
the variance (a 2) in time t is dependent upon its value in the preceding period t 1 and the
square of a random error term ef.

a? = p a ^ + (1 - p)e2

2
The larger the coefficient term, P, the greater influence the past variance (c^r_1) has on the

forecasted variance (of ). This variance memory from one period to the next is called
volatility clustering.

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Multifactor Regression Models

Multifactor models provide asset return forecasts (R,) based on risk factors (Fk) that are
thought to drive returns. The risk factors represent the required return for assuming that
particular source of risk. The factor sensitivities (bik) are the regression coefficients that
measure the degree to which the return is affected by a particular risk factor, or the assets
exposure to that risk.

Multifactor models are also well suited for estimating covariances between asset class
returns.

Quantitative Methods: Discounted Cash Flow Models

Discounted cash flow (DCF) models are based on the fundamental premise that the value
of any asset is the present value of its future cash flows.

DCF models estimate the intrinsic value of an asset. The expected return on the asset is
embedded in the relation between the assets intrinsic value and its current market price.
However, an expected return based on this intrinsic valuation approach is realized only
when the market price converges to the intrinsic value, which can take a long time to
happen. For that reason, intrinsic value approaches are generally regarded as useful in
setting long-term, strategic expectations as opposed to short-term, tactical expectations.

Dividend Discount Model (DDM)

The Gordon (constant) growth dividend discount model is a widely recognized DCF
model for estimating a stocks intrinsic value. The current price (P q) is determined by the
next dividend [D\ = D q(1 + g)], discounted at the required return on common equity (re)
adjusted for the estimated growth rate of dividends (g), which are assumed to grow at the
same rate as earnings.

A ^ Do<X+ g)
re ~ 8 re - g

The expected return of the stock, E(R), is the required return on equity. Rearranging the
preceding equation to solve for the required return provides an estimate of the expected
return on common stock.

D q <1+ 8)
E(R) =
Po

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 CAPITAL MARKET EXPECTATIONS

We can interpret this equation to read, The expected long-term rate of return on common
stock is the dividend yield (D {IPq) plus the long-term growth rate of earnings (g). The
dividend yield represents income, while the growth rate represents the capital gains yield,
g, which might be assumed to be the growth rate in nominal gross domestic product (GDP)
for a broadly defined equities asset class.

Grinold-Kroner Model

In many countries, particularly in the United States, firms have preferred to return excess
cash to shareholders in the form of share repurchases rather than dividend distributions.
Grinold and Kroner (2002) adapted the traditional DDM to account for this form of
distribution as well as expected changes in relative value that investors attach to earnings
via the price-earnings (P/E) multiple.

D
- %AS + INFL + gr + %APE
P

We can read the model as: The expected return on equity, E(R), is approximately equal
to the dividend yield (D/P) less the expected percent change in the number of shares
outstanding (%AS) plus the rate of inflation (INFL) plus the real expected earnings growth
rate (gr) plus the percent change in the price-earnings multiple (%APE).

Notice that a share repurchase would result in a negative change in the shares outstanding.
Subtracting a negative number results in a positive impact on the expected return.

The model can also be used to decompose historical returns. The three sources of the asset
return are:

1. An expected income return: D/P - %AS

2. An expected nominal earnings growth return: INFL + gr
3. An expected repricing return: %APE

Example 2-2

Fred Schepisi holds a $200 million equity portfolio. He is considering adding to the
portfolio based on an assessment of the risk and return prospects facing the economy
in Thailand. Information pertaining to the Thai economy and capital markets has been
collected as shown:

Expected dividend yield of 1.75 percent on equities;

Expected repurchase yield of 1.33 percent on equities;
Expected long-term inflation rate of 6.66 percent per year;
Expected long-term corporate real earnings growth rate of 2.33 percent
per year; and
Expected P/E multiple expansion of 0.50 percent per year.

Calculate the expected annual return for Thai equities using the Grinold-Kroner model.

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CAPITAL MARKET EXPECTATIONS

Solution:

The expected rate of return on Thai equities using the Grinold-Kroner model is:
/D \
E(R) -% A S + (INF + gr) + %APE
v y
= Income yield + Nominal + Repricing yield
= (1.75% + 1.33%) + (6.66% + 2.33%) + 0.50% = 12.57%

The Fed Model

The Fed model is based on the discounted cash flow approach. It relates the earnings yield
on stocks (E/P) to the 10-year U.S. Treasury bond yield. Since stocks are riskier than
bonds, the equity earnings yield, which is the required return of a no-growth stock and
the inverse of the P/E ratio, should be greater than the yield on the 10-year Treasury bond.
If the stock markets earnings yield (E/P) is lower than the 10-year Treasury bond yield,
stocks are overvalued, and investors would shift their money into the less risky T-bonds.

Fixed Income

The Fed model

The discounted cash flow model is also used to price fixed-income instruments as well.
is discussed in The yield to maturity (YTM) is the single discount rate that equates the present value of
more detail in
Reading 15. the bonds cash flows to the bonds market price. Therefore, the YTM can be used as an
estimate of the expected return to a bond.

The Build-Up Approach

The risk premium approach (build-up approach) starts with the nominal risk-free rate
and adds premiums for the various priced risk factors for which investors require to be
compensated for assuming.

jE(R^) = Rj7 + RPy + RP2 + + RR/c

where E(Rt) is the assets expected return, RF denotes the nominal risk-free rate
of interest, and RP represents the risk premiums.

Fixed-Income Premiums

To determine the expected return for a bond, E(Rb), the analyst begins with the real risk-
free rate of interest and adds the relevant premiums for priced risk factors.

E{Rb) - rrF + RPlNFL + RP'Default + RRLiquidity + RRMaturity + R ^Tax

The risk premiums compensate the bond investor for: deferring consumption (rrF), the
loss of purchasing power (RPINFL), difficulty in exiting the investment (RPLiquidity) putting
capital at risk for longer periods of time (RPMaturity) and the tax disadvantage of some
types of bonds versus others (RPTax).

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Equity Risk Premium

Because equity investors have a lower priority claim on a firms cash flows than debt
holders, the equity risk premium (ERP) compensates the equity investors for additional risk
of loss to their investment. Therefore, the equity risk premium is the excess return over the
nominal risk-free rate (RF), which is usually estimated by the 10-year U.S. Treasury yield.

E(RS) = Rf + ERP - YTM10_year Treasury + ERP

While the yield on the 10-year Treasury is readily available, the value of the equity risk
premium is a hotly debated topic among academics and practitioners.

LESSON 3: TOOLS FOR FORMULATING CAPITAL MARKET EXPECTATIONS,

PART 2: SURVEY AND PANEL METHODS AND JUDGMENT

LOS 14c: Demonstrate the application of formal tools for setting capital
market expectations, including statistical tools, discounted cash flow
models, the risk premium approach, and financial equilibrium models.
Vol 3, pp 40-48

Equilibrium Models

Equilibrium models are based on the principles of modern portfolio theory and mean-
variance optimization techniques. They define the risk-return relation when the supply and
demand for assets are equal.

The International Capital Asset Pricing Model

The International CAPM (ICAPM) approach assumes the same form as the regular CAPM
model you are likely very familiar with. The ICAPM relies on the return for the theoretical
global market portfolio (RM).

E(Ri) = RF + M E (R M) - R F]

The equation implies that an asset class risk premium = E(Rt) - RF ] is a function of
the world market risk premium [RPm = E{RM) - RF ] with the global investable market
(GIM) serving as a proxy for the world market. Given that the beta term is equal to the
covariance of the asset class with the GIM divided by the variance of the GIM, the asset
class risk premium can be estimated by:

0 iiWPi1M
V M J

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The terms in the preceding equation can be rearranged to show that the asset class risk
premium is equal to the GIMs Sharpe ratio [(/?M - RF) / o M = RPM/ o M ] multiplied by
the standard deviation of the asset classs return and its correlation with the GIMs return.

The ICAPM estimates the expected return for an asset class as the risk-free rate plus an
asset risk premium, which is the asset class beta times the GIM risk premium. This version
is a simple, one-factor model with very rigid, and not very realistic, assumptions. For
instance, it assumes perfect markets that are fully integrated and efficient.

Example 3-1

A portfolio manager is working on developing his capital market expectations. He

manages a balanced fund consisting of stocks and bonds. The manager believes that
the ICAPM will produce the best estimate of the expected returns for these two asset
classes. He collected the following information for each.

Asset Class Standard Deviation Correlation with GI1V1

Stocks 12 .0 % 0.75
Bonds 5.0% 0.65

The estimated Sharpe ratio for the global investable market (GIM) is 0.30 and the
nominal risk-free rate is estimated to be 3.2 percent.

Calculate the expected return for stocks and bonds using the ICAPM approach.

Solution:

For the two asset classes in question, RPst0Cks = 0.30(12.0%)(0.75) = 2.7% and
RPbonds = 0.30(5.0%)(0.65) = 0.975%. Adding these risk premiums to the risk-free rate
produces the managers estimate of the expected returns.

E(Ri) = RF +RPi
E(Rslocks) = 3.2%+ 2.7% = 5.9%
E {R-bonds) = 3.2% + 0.975% = 4.2%

Singer-Terhaar Approach

The Singer-Terhaar approach adds a level of sophistication to the simple ICAPM approach
by incorporating market imperfections into the analysis. The two imperfections we will
consider are market segmentation and illiquidity. Singer-Terhaar recognizes that the
standard ICAPM risk premium should be adjusted for market segmentation (RPl ) and

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 CAPITAL MARKET EXPECTATIONS

an additional risk premium should be added to the ICAPM return to compensate for
illiquidity (RPLiquidity).

Market integration versus segmentation refers to the ability of capital to freely flow
from one market to another. In a fully integrated market, the flow of capital between
countries and/or asset classes is unimpeded by excessive costs, government interventions,
or investor biases. Fully segmented markets are completely isolated from one another
so that no capital flows between them at all. The extent to which markets are integrated
is best thought of as a continuum with every country showing at least some degree of
segmentation.

To reestimate an asset classs risk premium in light of its degree of market segmentation, we
first recognize that the standard ICAPM risk premium assumes a fully integrated, frictionless
market. Taken to the opposite extreme, a fully segmented market restricts the reference global
investable market (RM) to the local market so that the correlation between its returns and the
asset classs returns is 1.0, which is effectively the correlation of the local market with itself.

To determine the market segmentation-adjusted risk premium (RPt ), the analyst must
compute two risk premiums, the fully integrated premium, which is the ICAPM risk
premium (RPj), using the correlation coefficient between the asset class and the GIM
(p;- M), and the fully segmented risk premium, which assumes that the asset class and the
market portfolio are perfectly positively correlated.

A shrinkage estimate is used to combine the two extreme scenarios into a single risk
premium. Recall that a shrinkage estimate is a weighted average where the weights sum to
1.0. The analyst may subjectively assign weights, but empirical research shows that most
developed markets are 65 to 85 percent integrated (35 to 15 percent segmented).

An example might help to illustrate the process of estimating the market segmentation-
adjusted risk premium. Assume we are given the following information about two asset
classes, stocks and bonds.

Asset Class Standard Deviation Correlation with GIM[

Stocks 18.1% 0.65
Bonds 9.1% 0.45

The Sharpe ratio for the GIM is 0.30 and the markets are 70 percent integrated with the
world market.

To compute the market segmentation-adjusted risk premium (RP( ), we first use the
ICAPM to estimate what it would be under a perfectly integrated scenario.

f \
RP,M
V w y

RPstocks = (0.30)(18.1 %)(0.65) = 3.53%

RPbonds = (0.30)(9.1%)(0.45) = 1.23%

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CAPITAL MARKET EXPECTATIONS

Next, compute the market segmentation risk premium under the opposite extreme of
completely segmented markets where the correlations rise to 1.0 (effectively dropping it
out of the equation).

RPstocks = (0.30)(18.1%)(1.00) = 5.43%

RPbonds = (0.30)(9.1%)(1.00) = 2.73%

On the exam,
make sure that Finally, compute a shrinkage estimate based on the degree of market integration, which
you provide the
examiners with the was given as 70 percent, leaving 30 percent applied to the fully segmented premium.
measure they want
you to provide. For
example, if you are
asked to provide RP*ocks = (0.70)(3.53%) + (0.30)(5.43%) = 4.10%
the risk premium
of the asset class RPLds = (0.70)(1.23%) + (0.30)(2.73%) = 1.68%
and you provide
the expected return,
then you would
only receive partial
credit for a morning Adding these risk premiums to the risk-free rate gives us updated expected returns that
session question.
reflect the degree of market segmentation.

The illiquidity Turning to the illiquidity premium, a CFA exam question might simply state an
premium is appropriate premium as part of the fact pattern. For example, an alternative asset class
determined using
the multiperiod might have an illiquidity premium of 0.3 percent. This premium would simply be added to
Sharpe ratio
(MPSR). You do not the risk-free rate along with the segmentation-adjusted risk premium for that asset class as
need to know the shown again here.
details of how to
calculate the MPSR,
but just be aware
of it.

If, however, you are asked to estimate the illiquidity premium, only one method is
described in the curriculum. It employs a multiperiod Sharpe ratio (MPSR), which is a
measure of risk-adjusted return. A rational investor would only choose an alternative asset
if its MPSR is at least as large as the market portfolios MPSR over the liquidity horizon.
So, if the alternative assets MPSR (RP/o,) computed using ICAPM is less than the market
portfolios (RPm/Gm ), we can derive the return that would make them equal. The difference
between this derived return and the ICAPM return is the liquidity premium.

Again, an example might help to illustrate the process of estimating the illiquidity risk
premium. Assume we are given the following information about the global investable
market (GIM) and two asset classes, common stocks and collectibles.

Asset Class Standard Deviation Correlation with GIM[

GIM 12.0% 1.00
Stocks 18.1% 0.65
Collectibles 19.1% 0.35

The Sharpe ratio for the GIM is 0.30, the risk-free rate is 3.2 percent, and all data are
computed over collectibles average one-year illiquidity period.

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 CAPITAL MARKET EXPECTATIONS

Common stocks are typically very liquid and do not carry a liquidity premium.
Collectibles, however, can be very illiquid, so we must estimate an appropriate premium
to account for illiquidity. To compute the illiquidity risk premium, we first compute the
ICAPM risk premium for the collectibles asset class (RPC).

/
RPm = (0.30)(19.1%)(0.35) = 2.0%
G cPc, M
V

Next, compute the MPSR for collectibles.

( RPC^ 2 .0%
MPSRC=
l J
c
= ------- = 0.10
19.1%

Derive what the asset classs risk premium should be to make the MPSRCequal to the
MPSRm.

Finally, subtract the ICAPM risk premium from the risk premium derived from the MPSR
to estimate the liquidity premium.

RPuquidity = 5.7% - 2.0% = 3.7%

Example 3-2

An analyst is using the Singer-Terhaar approach to estimate the expected returns for
domestic stocks, bonds, and private equity.

Standard Correlation Degree of Illiquidity

Asset Class Deviation with GIM Integration Premium
GIM 10.0% 1.00 1.00 0 .0%
Stocks 12.0% 0.75 0.65 0 .0%
Bonds 5.0% 0.65 0.65 0 .0%
Private equity 25.0% 0.35 0.50 2.4%

The expected return on the GIM is 8.0 percent and the risk-free rate is 3.5 percent.

Calculate the expected return for:

i. Domestic stocks

ii. Private equity

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CAPITAL MARKET EXPECTATIONS

Solutions:

i. The Singer-Terhaar approach starts with the ICAPM and adjusts the risk
premium for the level of market segmentation and adds an illiquidity premium
when appropriate.

(/?, ) = Rf + RP* + RPtliquidity

Since stocks are very liquid, the illiquidity risk premium is zero, dropping out of
the equation. The market segmentation-adjusted risk premium is the weighted
average of the ICAPM (fully integrated) version and the fully segmented
(perfect positive correlation), where the weights are the degree of integration and
its complement (degree of segmentation).

RP,ICAPM ^sPs.M s? s, M
V M J V
aM y
8.0% -3.5% \
(12.0%)(0.75) = 4.05%
10.0 % j
RPsesmented = (0.45)(12.0%)(1.00) = 5.40%

R P s - W ICAPM RPlCAPM + (1 ~ W ICAPM )RP,segmented

= 0.65(4.05%) + 0.35(5.40%) = 4.52%

With no illiquidity premium, our estimate of the expected return on domestic

stocks is the segmentation-adjusted risk premium added to the risk-free rate.

E(RS) = Rf + RP* + RPliquidity - 3.5% + 4.4% + 0% = 8.0%

li. We use exactly the same process to estimate the segmentation-adjusted risk
premium for private equity, but this time the illiquidity premium is not zero.

RPICAPM ' Rm - R f '

a p P r,M - p P r ,M
V J V
aM /
^8 .0 % -3.5'
(25.0%)(0.35) = 3.94%
v 10.0% y
^se g m en ted = (0.45)(25.0%)(1.00) = 11.25%

w ICAPM RPlCAPM + (1 w ICAPM )R P Segmented

= 0.50(3.94%)+ 0.50(11.25%) = 7.60%

The estimate for private equitys expected return is the risk-free rate, plus the
segmentation-adjusted risk premium, plus the liquidity premium, which was
given in the fact pattern to be 2.4 percent.

E(Rp) = RF + RP* + RPliquidity = 3.5% + 7.6% + 2.4% = 13.5%

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 CAPITAL MARKET EXPECTATIONS

LOS 14d: Explain the use of survey and panel methods and judgment in
setting capital market expectations. Vol 3, pp 48-50

Consensus Opinion Methods

Capital market expectations can also be determined by surveying the opinion of experts.
When the same group of experts is queried over a series of surveys, the approach is called
a panel method. This is effectively a consensus opinion approach that relies on the work of
others.

The Role of Judgment

Quantitative models provide an objective rationale for forecasts. However, experience and
judgment are critical complements to analysis. Remember that models are completely
dependent upon the quality of inputs. Garbage in ... garbage out.

LESSON 4: ECONOMIC ANALYSIS, PART 1: INTRODUCTION

AND BUSINESS CYCLE ANALYSIS

LOS 14e: Discuss the inventory and business cycles, the impact of consumer
and business spending, and monetary and fiscal policy on the business
cycle. Vol 3, pp 50-54

MACROECONOMICS

Asset returns (expected and actual) are closely related to economic activity. Accelerating
economic activity drives revenues higher, which in turn drive profits higher, which increase
cash flows available to the asset owners and increases the value of assets that represent
claims on those cash flows. Declining economic activity has the reverse effect.

This relation is consistent with asset-pricing theory, which predicts higher risk premiums
for assets that are strongly, positively correlated with the ups and downs of economic
activity and low risk premiums for assets with payoffs that are weakly, or negatively,
correlated with the economy.

The Business Cycle

The economy follows a general upward, long-term trend through time but not in a straight
line. The business cycle describes the recurring ebb and flow of economic activity along its
long-term trend line. Economists often refer to a short-term inventory cycle, lasting two to
four years, and a longer, nine- to eleven-year business cycle.

Although economic cycles reflect recurring and measurable variations in economic

activity that can be clearly seen in retrospect, anticipating those movements with effective
forecasts is a significant challenge. The key metrics for monitoring economic activity and
the business cycle include real GDP, the output gap, and whether or not the economy is in
recession.

Gross domestic product (GDP) is the standard measure of economic output representing
the value of all finished goods and services produced in a particular country during
the year regardless of who owns the assets that produced them. As measured from an

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CAPITAL MARKET EXPECTATIONS

expenditures approach, GDP is the sum of consumption (C), investment (7), government
spending (G), and net exports ( X - M).

GDP = C + I + G + ( X - M )

The change in total output is a function of change in quantity demanded and change in
pricing. GDP can change as a result of changes in prices (P) or a change in the quantity
of goods and services actually produced ( 0 , where nominal GDP = PQ. Since were
interested in economic output as a measure of well-being, well focus on real GDP, which
is nominal GDP adjusted to reflect a constant price level.

Output gap: Potential GDP measures the level of output that could be achieved if the
economy operates at its most efficient level. Potential GDP gradually increases as the
countrys capacity to produce increases. The path of this gradual rise in capacity is shown
as the long-term trend line in Exhibit 4-1.

Exhibit 4-1: The Business Cycle

An easy way to As shown in Exhibit 4-1, the output gap is the difference between potential GDP (the long-
remember the term trend line) and the current level of GDP (the purple fine). The business cycle represents
output gap is that a
positive output gap departures from potential GDP where a positive output gap shows real GDP below the long-
is associated with
times of recession, term trend line, and negative output gaps are represented by points above the trend fine. As the
slow growth, and economy expands beyond efficient capacity (overtime hours and accelerating wear and tear
declining inflation.
As the output gap on equipment), current real GDP rises above potential GDP and inflationary pressures build.
closes, economic
activity picks up
Once the economy slows and real GDP falls below potential GDP (idle workers, mothballed
along with rising facilities and equipment), the rate of unemployment increases.
inflation.

Recession: An economic contraction follows a peak in the business cycle. It can merely
represent movement back toward the long-term growth rate. However, if real GDP declines
in two successive quarters, the contraction is officially deemed a recession.

The following discusses the inventory cycle and the business cycle in more detail.

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 CAPITAL MARKET EXPECTATIONS

The Inventory Cycle

In the most basic model of a company, a product is manufactured and then sold to
customers. The managers of the company try to ensure that enough product inventory is
available to fill customer orders, but not so much that excessive storage costs are incurred
or that too much capital is tied up in unsold merchandise. However, manufacturing takes
time, so some inventory must be kept on hand, although carefully managed.

The inventory cycle measures the fluctuations in inventories, which come about because
of managements activities in balancing inventory levels based on their near-term
expectations about demand (economic activity). If inventories begin to build, managers
might slow down production in anticipation of an economic contraction. If inventories
begin to fall, they might increase production in order to meet rising demand.

In the positive phase of the inventory cycle, business confidence is high, production is
increasing, employment is expanding, and GDP grows. This continues up to an inflection
point when businesses view their inventories as too high, which might occur when sales
suddenly disappoint or real GDP growth slows. Restrictive monetary policy and higher
input prices may also provoke production cuts to reduce inventories. The inventory cycle
then enters the contraction phase with waning confidence, slowing production, rising
unemployment, and slow or declining GDP growth.

LOS 14f: Discuss the impact that the phases of the business cycle have on
short-term/ long-term capital market returns. Vol 3, pp 52-54

Phases of the Business Cycle

Here well take a closer look at the phases of the business cycle and the typical reactions
they elicit in the capital markets (see Exhibit 4-2 and Table 4-1).

Exhibit 4-2: Phases of the Business Cycle

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