Portfolio Management
Unit – III
Session No. 20
Topic: Tools for Formulating Capital Market Expectations
Session Plan
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Unit - III Briefing
Capital Market Expectation
Tools for Formulating Capital Market Expectations
Summarizing and Q & A
Tools for Formulating Capital Market Expectations
• Different range of tools that have been used in professional forecasting of
capital market returns.
• Although an analyst may have distinct preferences among these approaches.
• Different types of Tools are:
– 1. Formal Tools
– 2. Survey & Panel Method
– 3. Judgment Method
Tools for Formulating Capital Market Expectations
• 1. Formal Tools
• Formal tools are established research methods amenable to precise definition
and independent replication of results.
• The information data can help the analyst produce accurate forecasts.
– Statistical Methods (Historical Statistical Approach: Sample Estimators,
Shrinkage Estimators, Time-Series Estimators and Multifactor Models)
– Discounted Cash Flow Models
– The Risk Premium Approach
– Financial Market Equilibrium Models
Tools for Formulating Capital Market Expectations
• Statistical Methods
• Statistical methods relevant to expectations setting include descriptive
statistics (methods for effectively summarizing data to describe important
aspects of a dataset) and inferential statistics (methods for making estimates
or forecasts about a larger group from a smaller group actually observed).
• The simplest approach to forecasting is to use past data to directly forecast
future outcomes of a variable of interest.
• 1A. Historical Statistical Approach: Sample Estimators :
– The sample arithmetic mean total return or sample geometric mean total
return as an estimate of the expected return.
– The sample variance as an estimate of the variance.
– Sample correlations as estimates of correlations.
Tools for Formulating Capital Market Expectations
• Statistical Methods
• 1B. Shrinkage Estimators Shrinkage estimation involves taking
a weighted average of a historical estimate of a parameter.
– the analyst’s relative belief in the estimates
– This ‘‘two-estimates-are-better-than-one’’ approach has desirable
statistical properties.
• 1C. Time-Series Estimators Time-series estimators involve
forecasting a variable on the basis of lagged values of the variable
being forecast and often lagged values of other selected variables.
– Time-series methods have been found useful in developing
particularly short-term forecasts for financial and economic
variables.
Tools for Formulating Capital Market Expectations
• Statistical Methods
• 1D. Multifactor Models A multifactor model is a model that explains the
returns to an asset in terms of the values of a set of return drivers or risk
factors.
Tools for Formulating Capital Market Expectations
• 2. Discounted Cash Flow Models
• Discounted cash flow models (DCF models) express the idea that an asset’s
value is the present value of its (expected) cash flows. Formally, the value of an
asset using a DCF approach is as follows:
• 3. The Risk Premium Approach
• The risk premium approach expresses the expected return on a risky asset as
the sum of the risk-free rate of interest and one or more risk premiums that
compensate investors for the risky asset’s exposure to sources of priced risk
(risk for which investors demand compensation).
Tools for Formulating Capital Market Expectations
• 4. Financial Market Equilibrium Models
• Financial equilibrium models describe relationships between expected
return and risk in which supply and demand are in balance.
• In that sense, equilibrium prices or equilibrium returns are fair if the
equilibrium model is correct.
Tools for Formulating Capital Market Expectations
II. Survey and Panel Methods
• The survey method of expectations setting involves asking a group of
experts for their expectations and using the responses in capital market
formulation. If the group queried and providing responses is fairly stable, the
analyst in effect has a panel of experts and the approach can be called a panel
method.
• These approaches are based on the straightforward idea that a direct way to
uncover a person’s expectations is to ask the person what they are.
Tools for Formulating Capital Market Expectations
III. Judgment
• The analyst should be able to factually explain the basis and rationale for forecasts.
• Quantitative models such as equilibrium models offer the prospect of providing a
non-emotional, objective rationale for a forecast.
• The expectations setting process nevertheless can give wide scope to applying
judgment—in particular, economic and psychological insight—to improve forecasts.
• In forecasting, numbers, including those produced by elaborate quantitative models,
must be evaluated.
• Other investors who rely on judgment in setting capital market expectations may
discipline the process by the use of devices such as checklists.
• In any case, investment experience, the study of capital markets, and intelligence are
requisites for the development of judgment in setting capital market expectations.